Chapter 5

Problem Solutions
Fall 2011

18. Orange Corporation would like to transfer excess cash to its sole shareholder, DE C I S ION MAKING Danielle, who is also
an employee. Danielle is in the 28% tax bracket, and Orange is in the 34% bracket. Because Danielle’s contribution to the
business is substantial, Orange believes that a $ 50,000 bonus in the current year is reasonable compensation and should
be deductible by the corporation. However, Orange is considering paying Danielle a $ 50,000 dividend because the tax
rate on dividends is lower than the tax rate on compensation. Is Orange correct in believing that a dividend is the better
choice? Why or why not? (LO. 4, 8)

Danielle would prefer a dividend because she would have $42,500 after tax [$50,000 dividend – ($50,000 × 15% tax rate)]. If
paid a bonus, only $36,000 after tax [$50,000 bonus – ($50,000 × 28% tax rate)] results. However, this ignores the effect of
the payments on Orange Corporation. If Orange paid Danielle a deductible bonus, it would save $17,000 ($50,000
deduction for bonus payment x 34% tax rate) in taxes. (There is no deduction for a dividend payment.) Since Danielle is
$6,500 better off with a dividend ($42,500 after tax from a dividend – $36,000 after tax with a bonus) and Orange is $17,000
better off with a bonus, overall the two parties are $10,500 better off with a bonus ($17,000 benefit from bonus for Orange
– $6,500 benefit from a dividend for Danielle). As Danielle is the sole shareholder of the corporation, she is in a position to
choose the bonus alternative. Examples 28 and 29

19. Green Corporation has several employees. Their names and salaries are listed below: (LO. 6, 8)

Samantha $ 600,000
Chris ( Samantha’s daughter) 100,000
Joey ( Samantha’s son) 100,000
Jack ( an unrelated third party) 250,000

Chris and Joey are the only shareholders of Green Corporation. Samantha and Jack share equally in the management of
the company’s operations. Chris and Joey are both full- time college students at a university 200 miles away. Green has
substantial E & P and has never distributed a dividend. Discuss problems related to Green’s salary arrangement.

The salaries paid to Chris and Joey are vulnerable to constructive dividend treatment since neither shareholder appears to
have earned them. There is also a problem regarding the $600,000 salary payment to Samantha. Why is she receiving
$350,000 more than Jack when it appears they share equally in managing the company’s operations? Although Samantha is
not a shareholder, her relationship to Chris and Joey is enough of a tie-in to raise the unreasonable compensation issue.

Furthermore, Green Corporation has never distributed a dividend although it has substantial E & P. Given the dividend
history and the salary disparities, the IRS might successfully argue that all of the salary paid to Joey and Chris, as well as the
$350,000 paid to Samantha (beyond the amount paid to Jack), is unreasonable.

Example 30

24. At the start of the current year, Indigo Corporation ( a calendar year taxpayer) has accumulated E & P of $ 240,000.
Indigo’s current E & P is $ 160,000, and at the end of the year, it distributes $ 440,000 ($ 220,000 each) to its equal
shareholders, Sarah and Mason. Their basis in the stock is $ 8,000 for Sarah and $ 32,000 for Mason. How is the
distribution treated for tax purposes? (LO. 1, 4)

Sarah and Mason each have dividend income of $200,000 {[$240,000 (accumulated E & P) + $160,000 (current E & P)] ÷ 2}.
The dividend income will be subject to the reduced tax rate on dividends available to individuals. The remaining $40,000 of
the $440,000 distribution reduces the basis ($20,000 each) in the shareholders’ stock with any excess treated as a capital
gain. Thus, Sarah reduces her $8,000 stock basis to zero and has a capital gain of $12,000, while Mason reduces his stock
basis from $32,000 to $12,000 and has no income tax consequences. Example 1

25. Capon Corporation, a calendar year taxpayer, receives dividend income of $ 600,000 from a corporation in which
it holds a 12% interest. Capon also receives interest income of $ 90,000 from municipal bonds. ( The municipality
used the proceeds from the bond issue to construct a library.) Capon borrowed funds to purchase the municipal
bonds and pays $ 50,000 of interest on the loan. Excluding these items, Capon’s taxable income is $ 1.2 million.
(LO. 2)

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 a. What is Capon Corporation’s taxable income after these items are taken into account?

Capon reports the $600,000 dividend as gross income but claims a dividends received deduction under § 243 of
$420,000 (70% × $600,000). None of the other items affect taxable income. Thus, taxable income is $1,380,000
($1,200,000 taxable income before dividends + $600,000 dividend – $420,000 dividends received deduction).

b. What is Capon Corporation’s accumulated E & P at the start of next year if its begin-ning balance this year is $
400,000?

Capon Corporation’s E & P as of December 31 is $2,240,000, computed as follows: $400,000 (beginning balance in
E & P) + $1,380,000 (taxable income) + $420,000 (dividends received deduction) + $90,000 (tax-exempt interest) –
$50,000 (interest on indebtedness to purchase tax-exempt bonds).

pp. 5-3 and 5-4

26. On September 30, Jade Corporation, a calendar year taxpayer, sold a parcel of land (basis of $ 300,000) for a $ 900,000
note. The note is payable in five installments, with the first payment due next year. Because Jade did not elect out of the
installment method, none of the $ 600,000 gain is taxed this year.

Jade Corporation had a $ 400,000 deficit in accumulated E & P at the beginning of the year. Before considering the effect
of the land sale, Jade had a deficit in current E & P of $ 100,000.

Robert, the sole shareholder of Jade, has a basis of $ 150,000 in his stock. If Jade distributes $ 950,000 to Robert on
December 31, how much income must he report for tax purposes? (LO. 1, 2, 3)

Robert reports a $500,000 taxable dividend and a $300,000 capital gain. The $600,000 gain on the sale of the land increases
current E & P. Current E & P before the distribution is $500,000 [$600,000 (gain on sale) – $100,000 (current year deficit)].
The current E & P balance triggers dividend treatment for $500,000 of the distribution. Of the remaining $450,000
distributed, $150,000 is a tax-free recovery of basis and $300,000 is taxed as capital gain. After the distribution, Robert’s
stock basis is $0. pp. 5-4, 5-9, and Examples 1 and 6

27. Sparrow Corporation (a calendar year, accrual basis taxpayer) had the following transactions in 2011, its second year of
operation: (LO. 2)

Taxable income $ 330,000

Federal income tax liability paid 112,000
Tax- exempt interest income 5,000
Meals and entertainment expenses (total) 3,000
Premiums paid on key employee life insurance 3,500
Increase in cash surrender value attributable to life insurance premiums 700
Proceeds from key employee life insurance policy 130,000
Cash surrender value of life insurance policy at distribution 20,000
Excess of capital losses over capital gains 13,000
MACRS deduction 26,000
Straight- line depreciation using ADS lives 16,000
Section 179 expense elected during 2010 100,000
Organizational expenses incurred during 2010 14,000
Dividends received from domestic corporations ( less than 20% owned) 25,000

Sparrow uses the LIFO inventory method, and its LIFO recapture amount increased by $ 10,000 during 2011. In addition,
Sparrow sold property on installment during 2010. The property was sold for $ 40,000 and had an adjusted basis at sale
of $ 32,000. During 2011, Sparrow received a $ 15,000 payment on the installment sale. Finally assume that Sparrow
elected to amortize qualified organizational expenses during 2010 and that no additional first- year depreciation was
claimed. Compute Sparrow’s current E & P.

Sparrow Corporation’s current E & P is computed as follows:

Taxable income $330,000

Federal income tax liability (112,000)

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 Interest income from tax-exempts 5,000
Disallowed portion of meals and entertainment expenses (1,500)
Life insurance premiums paid, net of increase in
cash surrender value ($3,500 – $700) (2,800)
Proceeds from life insurance policy, net of cash
surrender value ($130,000 – $20,000) 110,000
Excess capital losses (13,000)
Excess of MACRS depreciation over E & P
depreciation ($26,000 – $16,000) 10,000
Allowable portion of 2010 § 179
expenses (20%  $100,000) (20,000)
Organizational expense amortization 933*
Dividends received deduction (70%  $25,000) 17,500
LIFO recapture adjustment 10,000
Installment sale gain (3,000)**
Current E & P $331,133  

*($14,000 organizational expenses/180 months)  12 months

**[($40,000 sales price – $32,000 adjusted basis)/$40,000 sales price]  $15,000

Concept Summary 5.1

30. Lark Corporation is a calendar year taxpayer. At the beginning of the current year, Lark has accumulated E & P of $
330,000. The corporation incurs a deficit in current E & P of $ 460,000 that accrues ratably throughout the year. On June
30, Lark distributes $ 200,000 to its sole shareholder, Adrienne. If Adrienne’s stock has a basis of $ 40,000, how is she
taxed on the distribution? (LO. 1, 3)

Dividend income is $100,000, tax-free recovery of basis is $40,000, and capital gain is $60,000. To determine the amount of
dividend income, the balances of both accumulated and current E & P as of June 30 must be netted because of the deficit in
current E & P. As one-half of the loss (or $230,000) is deemed to have occurred on June 30, the $330,000 in accumulated
E & P is reduced by $230,000. The $100,000 balance in E & P triggers dividend income. The remaining $100,000 of the
distribution is recovery of capital, reducing basis to zero and then triggering capital gain. Example 11

31. At the beginning of its taxable year, Turkey Corporation had E & P of $ 405,000. For the calendar year, Turkey incurred a
deficit in current E & P of $ 550,000, which includes a $ 405,000 loss on the sale of an asset on June 30. If Turkey made a
distribution of $ 75,000 to its sole shareholder on July 1, how is the shareholder taxed? (LO. 1, 3)

The shareholder has a return of capital of $75,000. The $75,000 reduces the basis in Turkey Corporation stock; any excess
over basis is capital gain. There is no dividend income because of the absence of E & P. On the date of the sale, E & P is a
negative $72,500 [$405,000 (beginning balance in accumulated E & P) – $405,000 (deficit in current E & P from sale of the
asset on June 30) – $72,500 (one-half of the $145,000 negative E & P not related to asset sale)]; thus, the $75,000
distribution constitutes a return of capital. Generally, deficits are allocated pro rata throughout the year unless the parties
can prove otherwise. Here the shareholder can prove otherwise. Examples 11 and 26

32. Cardinal Corporation (a calendar year taxpayer) had a deficit in accumulated E & P of $ 500,000 at the beginning of the
current year. Its net profit for the period January 1 through July 30 was $ 600,000, but its E & P for the entire taxable year
was only $ 80,000. If Cardinal made a distribution of $ 120,000 to its sole shareholder on August 1, how will the
shareholder be taxed? (LO. 1, 3)

Cardinal Corporation has no accumulated E & P at the time of the distribution. The shareholder has a taxable dividend equal
to the current E & P determined at year-end, which was $80,000. The balance of the distribution, $40,000, reduces the
shareholder’s basis in the stock, and any excess over basis results in capital gain. pp. 5-8 to 5-10

33. Bunting Corporation and Jennifer each own 50% of Sparrow Corporation’s common stock. On January 1,
Sparrow has a deficit in accumulated E & P of $ 150,000. Its current E & P is $ 65,000. During the year, Sparrow
makes cash distributions of $ 30,000 each to Bunting and Jennifer. (LO. 1, 3)

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 a. How are the two shareholders taxed on the distribution?

Bunting Corporation and Jennifer each have a taxable dividend of $30,000. Sparrow Corporation’s current E & P is
$65,000; thus, the entire distribution is a taxable dividend even though Sparrow has no accumulated E & P.
Assuming the taxable income limitation does not apply, Bunting Corporation is entitled to a dividends received
deduction of $24,000 (80% × $30,000). Thus, Bunting is only taxed on $6,000 ($30,000 distribution – $24,000
dividends received deduction). Because Jennifer is an individual, she pays tax on the entire dividend, subject to the
preferential 15%/0% tax rates if the dividend is qualifying.

b. What is Sparrow Corporation’s accumulated E & P at the end of the year?

To determine Sparrow Corporation’s accumulated E & P at the end of the year, its current E & P ($65,000) is
reduced by the amount of the distributions ($60,000). The remaining $5,000 is then netted against the deficit in
accumulated E & P of $150,000, leaving a net deficit of $145,000.

pp. 5-8 to 5-11

36. Sarah, a shareholder of Cardinal Corporation, is in the 35% tax bracket. This year, she receives a $ 10,000 qualified
dividend from Cardinal, incurs investment interest expense of $ 21,000, and has net investment income of $ 11,000 ( not
including the qualified dividend). Assume that Sarah does not expect to have any investment income in the foreseeable
future. Should Sarah treat the distribution as a qualified dividend or classify it as net investment income? (LO. 4)

If Sarah does not include the dividend in net investment income, her tax is $1,500 ($10,000 dividend × 15% tax rate). In
addition, $10,000 of investment interest expense is not deductible until she has investment income. At that point, the
interest expense generates a tax benefit of $3,500 (35% × $10,000). Thus, excluding the dividend from net investment
income yields a current-year tax of $1,500 and a tax savings in the future of $3,500.

If Sarah elects to treat the dividend as net investment income, ordinary income of $10,000 and an additional deduction of
$10,000 result. Her tax liability, therefore, is $0 [($10,000 dividend income – $10,000 interest expense) × 35%]. Ignoring the
time element, Sarah is better off by using qualifying dividend treatment. Overall, she saves a total of $2,000 in tax ($3,500
tax saved in the future – $1,500 tax paid this year). However, because the tax savings will not be available for many years,
Sarah should perform a present value analysis. If the expected present value of the $3,500 tax saved is less than the current
tax of $1,500, Sarah is better off electing to include the dividend in investment income.
p. 5-12

37. In November of the current year, Emerald Corporation declared a dividend of $ 2 per share ( the shareholder record date
is December 15). Assume that Emerald has sufficient current E & P to cover the dividend payment. If Judy purchases 500
shares of Emerald stock on December 5 and sells the stock on December 25, how is she taxed on the $ 1,000 dividend?
(LO. 4)

The $1,000 dividend will be taxed to Judy as ordinary income. Because she did not hold the stock for more than 60 days
during the 121-day period beginning 60 days before the ex-dividend date, the dividend does not qualify for the preferential
15%/0% tax rates. Example 12

38. Heather, an individual, owns all of the outstanding stock in Silver Corporation. Heather purchased her stock in
Silver nine years ago, and her basis is $ 56,000. At the beginning of this year, the corporation has $ 76,000 of
accumulated E & P and no current E & P ( before considering the effect of the distributions). What are the tax
consequences to Heather ( amount and type of income and basis in property received) and Silver Corporation
( gain or loss and effect on E & P) in each of the following situations? (LO. 1, 5)

a. Silver distributes land to Heather. The land was held as an investment and has a fair market value of $ 54,000 and
an adjusted basis of $ 42,000.

Silver recognizes a gain on the distribution of the land to Heather. The amount of the gain is $12,000 ($54,000 fair
market value – $42,000 adjusted basis). Since Silver’s gain increases its E & P, it will have $12,000 of current E & P
and $76,000 of accumulated E & P available to apply to the distribution. The entire value of the land ($54,000) is a
dividend to Heather, leaving $34,000 of accumulated E & P ($88,000 total E & P at year-end – $54,000 distribution)
as the beginning balance for next year. Heather’s basis in the land is its fair market value ($54,000).

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 b. Assume that Silver Corporation has no current or accumulated E & P prior to the dis-tribution. How would your
answer to ( a) change?

The distribution triggers $12,000 of gain to Silver and creates $12,000 of current E & P. Consequently, the
distribution generates a $12,000 dividend to Heather (to the extent of current E & P). The remaining $42,000 of
the value of the land decreases Heather’s stock basis from $56,000 to $14,000 and is a tax-free recovery of capital.
Heather’s basis in the land is $54,000.

c. Assume that the land distributed in ( a) is subject to a $ 46,000 mortgage ( which Heather assumes). How would
your answer change?

Silver recognizes $12,000 of gain and increases current E & P by $12,000, as a result of the distribution of
appreciated land. The amount deemed distributed is the fair market value of the land, net of the mortgage, or
$8,000 ($54,000 fair market value – $46,000 mortgage). Since there is $12,000 of current E & P and $76,000 of
accumulated E & P, the entire $8,000 distribution is taxed as a dividend. Current E & P is reduced by the $8,000
distribution, leaving accumulated E & P with a beginning balance for the following year of $80,000 ($76,000
accumulated E & P + $12,000 current E & P – $8,000 distribution). Heather’s basis in the land is its fair market value
($54,000).

d. Assume that the land has a fair market value of $ 54,000 and an adjusted basis of $ 62,000 on the date of the
distribution. How would your answer to ( a) change?

While Silver realizes an $8,000 loss, none of the loss is recognized on the distribution. Heather receives a $54,000
dividend and she takes a basis of $54,000 in the land. Silver has accumulated E & P at the beginning of the
following year of $14,000 [$76,000 accumulated E & P – $62,000 (greater of $62,000 adjusted basis of the land or
$54,000 fair market value)].

e. Instead of distributing land in (a), assume that Silver decides to distribute equipment used in its business. The
equipment has a $ 14,000market value, a $ 1,200 adjusted basis for income tax purposes, and a $ 5,200 adjusted
basis for E & P purposes. When the equipment was purchased four years ago, its original fairmarket value was $
18,000.

Silver recognizes gain on the distribution of $12,800 for income tax purposes ($14,000 fair market value – $1,200
adjusted basis for income tax purposes). Current E & P is increased to $8,800 ($14,000 fair market value – $5,200
adjusted basis for E & P). Heather receives a $14,000 dividend and takes a $14,000 basis in the furniture. Silver’s
E & P is reduced by $14,000, leaving $70,800 of accumulated E & P at the start of the following year ($76,000
accumulated E & P + $8,800 current E & P – $14,000 distribution).

pp. 5-13 to 5-15

40. Green Corporation, with E & P of $ 600,000, distributes land ( worth $ 300,000, adjusted basis of $ 340,000) to Michael,
its sole shareholder. The land is subject to a liability of $ 130,000, which Michael assumes. What are the tax
consequences to Green and to Michael? (LO. 1, 5)

Michael has a taxable dividend of $170,000 [$300,000 (fair market value of the land) – $130,000 (liability assumed)].
Michael’s basis in the land is $300,000. Green Corporation does not recognize a loss on the distribution, but the distribution
reduces its E & P account by $210,000 [$340,000 (adjusted basis of the land) – $130,000 (liability assumed by Michael)]. pp.
5-13 to 5-15

42. Penguin Corporation distributes equipment ( adjusted basis of $ 80,000; fair market value of $ 65,000) to its shareholder,
Holly. What are the tax consequences to Penguin Corporation and to Holly? (LO. 1, 5)

Holly has a $65,000 taxable dividend and a $65,000 basis in the land. Penguin Corporation does not recognize a loss on the
distribution and its E & P is reduced by $80,000. pp. 5-13 to 5-15

44. Purple Corporation has accumulated E & P of $ 65,000 at the beginning of the DE C I S ION MAKING year. Its
current- year taxable income is $ 320,000. On December 31, Purple distributed business property ( worth $
140,000, adjusted basis of $ 290,000) to Peter, its sole shareholder. Peter assumes an $ 80,000 liability on the
property. Included in the determination of Purple’s current taxable income is $ 16,000 of income recognized

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 from an installment sale in a previous year. In addition, the corporation incurred a Federal income tax liability of
$ 112,000, paid life insurance premiums of $ 3,500, and received term life insurance proceeds of $ 55,000 on the
death of an officer. (LO. 1, 2, 5)

a. What is Peter’s gross income from the distribution?

Peter’s gross income from the distribution is $60,000 [$140,000 (value of the property) – $80,000 (liability)].

b. What is the E & P of Purple Corporation after the property distribution?

Corporate E & P after the distribution is $102,450, computed as follows:

Accumulated E & P at start of year $ 65,000

Add:
Taxable income $320,000
Proceeds of term life insurance 55,000
Subtract:
Federal income tax (108,050)
Life insurance premiums (3,500)
Property distribution (210,000)*
Prior-year installment sale income (16,000) 37,450
E & P of Purple after the distribution $102,450

*E & P is reduced by the greater of the fair market value ($140,000) or adjusted basis of the property ($290,000), less the amount
of liability on the property ($80,000).

c. What is Peter’s tax basis in the property received?

Peter’s tax basis for the property is $140,000.

d. How would your answers to (a) and (b) change if Purple had sold the property at its fair market value, used $
80,000 of the proceeds to pay off the liability, and then distributed the remaining cash and any tax savings to
Peter?

If Purple had sold the business property at its $140,000 fair market value, it would have recognized a loss of
$150,000. This loss would offset $150,000 of taxable income in the current year, creating Federal tax savings of
$58,500 ($150,000  0.39). After paying off the $80,000 loan, Purple would have a total of $118,500 to distribute
to Peter [$58,500 (tax savings) + $140,000 (sales proceeds) – $80,000 (loan balance)]. Immediately following the
property sale and distribution of cash, Purple’s E & P balance would be:

Accumulated E & P at start of year $ 65,000

Add:
Taxable income (reduced by $150,000 loss) $170,000
Proceeds of term life insurance 55,000
Subtract:
Federal income tax (49,550)
Life insurance premiums (3,500)
Cash distribution (118,500)
Prior-year installment sale income (16,000) 37,450
E & P of Purple after the distribution $102,450

Thus, Peter recognizes a taxable dividend of $118,500. Purple’s E & P would be reduced to $98,500 after the
distribution. Note that this result is better than distribution of the property to Peter. In particular, the corporation
receives a $150,000 deduction, while Peter’s income is only increased by $58,500.

Concept Summary 5.1 and Examples 2, 14, and 20

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45. Iris Corporation owns 30% of Fresia Corporation’s stock. On November 15, Fresia Corporation, with current E & P
of $ 320,000, distributes land ( fair market value of $ 100,000; basis of $ 160,000) to Iris. The land is subject to a
liability of $ 80,000, which Iris assumes. (LO. 5)

a. How is Iris Corporation taxed on the distribution?

Iris Corporation has dividend income of $20,000 [$100,000 (fair market value of the land) – $80,000 (liability on the
land)]. The $20,000 dividend creates a $16,000 dividends received deduction under § 243. Consequently, only
$4,000 of the dividend is subject to tax. Iris Corporation has a basis of $100,000 in the land.

b. What is Fresia Corporation’s E & P after the distribution?

Fresia Corporation may not deduct the loss on the land. Its E & P is reduced by $80,000 [the $160,000 basis of the
land (which is greater than the fair market value) – the $80,000 liability on the land].

Examples 14 and 20

48. Katie purchased 5,000 shares of Grebe Corporation common stock six years ago for $ 80,000. In the current year, Katie
received a preferred stock dividend of 400 shares, while the other holders of common stock received a common stock
dividend. The preferred stock Katie received has a fair market value of $ 40,000, and her common stock has a fair market
value of $ 120,000. Assume that Grebe has ample E & P to cover any distributions made during the year. What is Katie’s
basis in the preferred and common stock after the dividend is received? When does her holding period commence for the
preferred stock? (LO. 7)

Because the distribution of preferred stock is taxable to Katie, her basis in the newly acquired shares is equal to its fair
market value of $40,000. The holding period of the preferred stock begins on the date of receipt. p. 5-19

50. Denim Corporation declares a nontaxable dividend payable in rights to subscribe to common stock. One right and $ 60 entitle the holder
to subscribe to one share of stock. One right is issued for every two shares of stock owned. At the date of distribution of the rights, the
market value of the stock is $ 110 per share, and the market value of the rights is $ 55 per right. Lauren owns 300 shares of stock that she
purchased two years ago for $ 9,000. Lauren receives 150 rights, of which she exercises 105 to purchase 105 additional shares. She sells
the remaining 45 rights for $ 2,475. What are the tax consequences of this transaction to Lauren? (LO. 7)

Because the fair market value of the rights is 15% or more of the value of the old stock, Lauren must allocate her basis in the stock between
the stock and the stock rights. Lauren allocates basis as follows:

Fair market value of stock: 300 shares x $110 = $33,000

Fair market value of rights: 150 rights  $55 = 8,250
$41,250
Basis of stock: $9,000  $33,000/$41,250 = $7,200
Basis of rights: $9,000  $8,250/$41,250 = $1,800
Basis per right: $1,800 ÷ 150 rights = $12
There is a capital gain on the sale of the rights of $1,935, computed as follows:

Sales price of 45 rights $2,475

Less: Basis of 45 rights (45  $12) (540)
Long-term capital gain $1,935 

Basis of new stock is $7,560, computed as follows:

105 rights  $12 $1,260

Additional consideration ($60  105 shares) 6,300
Basis on newly acquired stock $7,560

Holding period of the 105 new shares begins on the date of purchase.

Example 25

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