1
Income Taxation of Corporations
Solutions to Tax Research Problems
Tax Research Problems
1-35 Linda is correct in her assessment that the regular corporate form will not be a suitable vehicle for holding her investment property. This option is not viable because losses will remain within the corporation for possible future use against corporate income. Because she can qualify for the $25,000 exception to the passive activity loss rules for actively managed rental realty, she will want the losses passed through to her for use on her individual return.
Linda is also correct with respect to using an S corporation as a vehicle for holding her investment. Although use of an S corporation would appear ideal because losses flow through to the shareholders, the total amount of deductible losses allowed to her would be limited to the basis in her capital account ($40,000). Given the high rate of interest on her loan and the riskiness of her investment, her basis could be reduced to zero within several years.
Linda's third option is interesting and, according to the Supreme Court case of Bollinger, viable. If the corporation can be formed as a regular corporation and be treated for Federal income purposes as Linda's agent, all losses will pass through to her and may be used against her total basis in the investment of $240,000. Her basis in her investment includes the nonrecourse note because the investment in realty was acquired with a nonrecourse loan from a qualified lender [see § 465 (b)(6)].
There are, however, a number of precautions for ensuring acceptability of this third option by the IRS. According to the Supreme Court in Bollinger, the corporate-agent relationship is established if (1) the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, (2) the corporation functions as the agent and not the principal with respect to the asset for all purposes, and (3) the corporation is held out as the agent and not the principal in all dealings with third parties relating to the asset.
If Linda follows the Supreme Court guidelines, it is very likely she will obtain her objectives. What specifically can she do? The Bollinger case provides a model of specific steps to take to establish an agency relationship. Bollinger formed an agency relationship with his corporation and stipulated that the corporation was formed solely to obtain financing, that the corporation was not liable for maintenance of the property or for repayment of any promissory notes, and that Bollinger would indemnify and hold the corporation harmless from any liability it might sustain as his agent.
Note: Solutions to tax return problems 1-33 and 1-34 are located after the test bank and answers.
1
Income Taxation of Corporations
Test Bank
True or False
________ 1. The proprietorship uses gross ordinary income as the basis for calculating any self-employment tax due.
________ 2. In contrast to a regular corporation, an S corporation's pass-through of income and deductions to its shareholders allows it to avoid double taxation of the same source of income.
________ 3. In transactions between the partners and the partnership, the parties are generally treated like unrelated parties.
________ 4. Section 11 of the Code imposes a tax on all corporations, including nonprofit organizations.
________ 5. A corporation is an artificial "person" created by Federal law.
________ 6. If an individual taxpayer creates a legal corporation under state law, the government (i.e., the IRS) cannot disregard the entity and tax the individual taxpayer on the income.
________ 7. Although recognized as partnerships under state law, certain partnerships are treated and taxed as corporations for Federal income tax purposes.
________ 8. All bad debts of a corporation are treated as business rather than nonbusiness bad debts.
________ 9. A corporation is allowed a