3.0 Entity Tax Planning TCP Practice Quiz

• A. S corporations are limited to 100 shareholders, may only issue one class of stock, and cannot have nonresident alien shareholders or most entity shareholders (with limited exceptions)
• B. S corporations are subject to double taxation at both the entity and shareholder level, the same as C corporations
• C. S corporations must use a fiscal year ending June 30 and cannot change their tax year once elected
• D. S corporations are required to have at least three shareholders to maintain their pass-through status

S corporation eligibility requirements under §1361: (1) Maximum 100 shareholders (certain family members count as one shareholder); (2) Only one class of stock permitted, voting vs. nonvoting stock of the same economic terms is permitted, but different economic rights (different dividend or liquidation rights) are not; (3) Shareholders must be US citizens or resident aliens, nonresident alien shareholders are prohibited; (4) Shareholders must generally be individuals, certain trusts, or estates, partnerships, C corporations, and most LLCs cannot be shareholders. These restrictions make S corporations unsuitable for complex ownership structures, foreign investors, or businesses expecting rapid growth through multiple equity classes (venture capital often requires preferred stock with different economic rights).

• A. $400,000, the corporation may deduct 80% of the $500,000 taxable income, which is more than the available $300,000 NOL carryforward, so the full $300,000 is deductible
• B. $300,000, the corporation can deduct the full NOL carryforward in a single year
• C. $240,000, the 80% limitation on taxable income ($500,000 × 80% = $400,000) exceeds the available carryforward ($300,000), so the entire $300,000 carryforward is usable; wait, the 80% cap is $400,000 and the carryforward is $300,000, so the full $300,000 is deductible
• D. $0, C corporations may not carry NOLs forward under current law; they can only carry them back

Post-2017 NOL deduction analysis: (1) 80% limitation = $500,000 taxable income × 80% = $400,000 maximum NOL deduction; (2) Available NOL carryforward = $300,000; (3) Actual NOL deduction = min($400,000 limitation, $300,000 available) = $300,000; (4) Taxable income after NOL deduction = $500,000 − $300,000 = $200,000; (5) Federal tax = $200,000 × 21% = $42,000. The full $300,000 NOL is usable because the 80% cap ($400,000) exceeds the available carryforward. No NOL remains for future years. If the NOL had been $600,000, only $400,000 could be used in the current year (80% of $500,000), with $200,000 carried forward to subsequent years.

• A. S corporation, pass-through losses flow directly to founders in the early years when they can use them, and the single-class-of-stock restriction can be accommodated with careful structuring
• B. C corporation, despite double taxation on ultimate exit, C corporations accommodate multiple classes of stock required by VC investors (preferred stock), Section 1202 QSBS may eliminate capital gains on exit, and losses can be preserved at the entity level for future high-rate offset
• C. Partnership (or LLC taxed as partnership), maximum flexibility in allocations, no shareholder restrictions, can issue equity interests with varying economic rights, and losses flow through to partners
• D. Sole proprietorship, provides the simplest structure and maximizes loss utilization for the founding individual

C corporation analysis for VC-backed tech startup: (1) Multiple equity classes: C corporations can issue preferred stock with any economic terms, essential for VC investment (liquidation preferences, participating preferred, anti-dilution); (2) §1202 Qualified Small Business Stock (QSBS): shareholders of a qualified C corporation may exclude up to $10 million (or 10× basis) of gain from sale of QSBS held more than 5 years, potentially eliminating capital gains tax entirely on the exit; this is a powerful tax benefit that tips the analysis strongly toward C corporation for VC-backed startups; (3) Early losses: while losses don't flow through to shareholders (a disadvantage), the corporation can accumulate NOL carryforwards; (4) Employee options: ISOs are available in C corporations, favorable tax treatment for employee equity; (5) The combination of QSBS exclusion + VC compatibility typically outweighs the double-taxation concern for high-growth startups.

• A. 30%, apportionment = average of payroll (20%), property (20%), and sales (30%) factors
• B. 23.3%, apportionment = average of payroll ($800,000/$4,000,000 = 20%), property ($2,000,000/$10,000,000 = 20%), and sales ($6,000,000/$20,000,000 = 30%) = (20% + 20% + 30%) / 3 = 23.33%
• C. 30%, the sales factor alone determines State A's apportionment because destination-based sales always govern
• D. 20%, apportionment uses only the property and payroll factors because sales are not a reliable measure of nexus

Three-factor equal-weighted apportionment calculation: (1) Payroll factor = State A payroll / Total payroll = $800,000 / $4,000,000 = 20.0%; (2) Property factor = State A property / Total property = $2,000,000 / $10,000,000 = 20.0%; (3) Sales factor = State A sales / Total sales = $6,000,000 / $20,000,000 = 30.0%; (4) Apportionment percentage = (20.0% + 20.0% + 30.0%) / 3 = 70.0% / 3 = 23.33%. Note: Many states have moved away from the three-factor equal-weighted formula toward a single-sales-factor or double-weighted sales formula. Tax planning implications: corporations can reduce state tax burden by locating payroll and property outside high-tax states while maintaining sales relationships there, sales factor is often less controllable than property/payroll factors.

• A. Both alternatives produce identical total tax because the IRS requires reasonable compensation to equalize the tax treatment of salary and dividends
• B. Salary: corporation deducts $100,000 saving $21,000 in corporate tax; shareholder pays $37,000 income tax + FICA; Dividend: corporation pays $21,000 corporate tax on income; shareholder pays $20,000 dividend tax; total tax on salary = approximately $55,800 (after FICA); total tax on dividend = $41,000
• C. Salary: total tax (corporate + shareholder) ≈ $55,800 (no corporate tax on deducted salary + $37,000 income tax + FICA); Dividend: total tax ≈ $41,000 ($21,000 corporate tax + $20,000 qualified dividend tax); dividends are more tax-efficient at high brackets despite double taxation
• D. Dividends always produce lower total tax than salary in a C corporation context because corporate rates are lower than individual rates

Detailed comparison: Alternative A. Salary of $100,000: Corporation deducts salary: $100,000 × 21% = $21,000 corporate tax savings (net corporate tax on this income = $0 after deduction). Shareholder pays income tax: $100,000 × 37% = $37,000. FICA: employee portion $100,000 × 7.65% = $7,650; employer portion $100,000 × 7.65% = $7,650 (additional corporate cost, deductible). Total tax: $37,000 individual + $7,650 employee FICA + $7,650 employer FICA = approximately $52,300 (plus minor details). Alternative B. Dividend of $100,000: Corporation earns $100,000 and pays corporate tax: $100,000 × 21% = $21,000. After-tax amount available = $79,000 (but to deliver $100,000 to shareholder, corp needs pre-tax income of $126,582). Assuming the corporation distributes exactly $100,000 as a dividend from pre-existing after-tax earnings: Shareholder pays qualified dividend tax: $100,000 × 20% = $20,000 + 3.8% NIIT = $23,800 total. Corporate tax on the income that generated the dividend (if $100,000 pre-tax earnings): $21,000. Total tax on dividend: $21,000 + $23,800 = $44,800. Salary is generally more tax-efficient for owner-employees in the 37% bracket, the corporate deduction effectively reduces the income to zero at the entity level, and only individual tax (plus FICA) applies, avoiding the double-tax layer of dividends.

• A. Each partner recognizes no gain or loss on the liquidating distribution; each partner's basis in the land = $60,000 and basis in inventory = $60,000
• B. The partnership recognizes $170,000 of gain on distribution of appreciated assets ($180,000 − $50,000 land gain + $70,000 − $30,000 inventory gain) taxed at the entity level
• C. Each partner recognizes no gain; each partner's basis in the land received = $90,000 and basis in inventory = $30,000 (carryover from partnership), with outside basis reduced to $0
• D. Each partner receives land worth $90,000 and inventory worth $35,000; each recognizes gain equal to the difference between FMV received and their outside basis

Liquidating partnership distribution analysis (assuming equal in-kind distribution): Each partner receives 50% of each asset. Per-partner amounts: Land: basis $25,000, FMV $90,000; Inventory: basis $15,000, FMV $35,000. Each partner's outside basis = $120,000. Under §732(b), in a liquidating distribution, the basis of distributed property is determined by the partner's outside basis reduced by cash received ($0 here). Total property received by each partner has partnership basis of $25,000 + $15,000 = $40,000. The partner's outside basis ($120,000) exceeds the partnership's aggregate basis in distributed assets ($40,000). Under §732(c): basis is first assigned to each asset based on their partnership bases ($25,000 land, $15,000 inventory), then excess outside basis ($120,000 − $40,000 = $80,000) is allocated to the appreciated assets (land) based on FMV ratios. Land FMV $90,000 vs. inventory FMV $35,000 = 72%/28% split. Land gets additional basis of $80,000 × 72% ≈ $57,600; inventory gets $80,000 × 28% ≈ $22,400. Simplified: land basis ≈ $25,000 + $57,600 = $82,600; inventory basis ≈ $15,000 + $22,400 = $37,400. Option B's $90,000 land basis and $30,000 inventory basis represents an approximation of the full allocation. The key point: no gain/loss recognized on the liquidating distribution of only property.

• A. No benefit, when tax rates are constant, the timing of income and deductions has no effect on total taxes paid over both years
• B. Significant benefit, accelerating deductions and deferring income generates a tax refund in Year 1 that is larger than the tax owed in Year 2
• C. Time value of money benefit, deferring $200,000 of income to Year 2 and accelerating deductions to Year 1 reduces Year 1 tax, providing use of the tax savings for one additional year before the tax is due in Year 2
• D. No benefit, tax authorities require matching income and deductions within the same year under the all-events test

Tax benefit from timing strategy at constant rates: (1) Defer $200,000 of service revenue to Year 2: reduces Year 1 tax by $200,000 × 21% = $42,000; increases Year 2 tax by $42,000; (2) Accelerate depreciation to Year 1: reduces Year 1 tax by the accelerated depreciation amount × 21%; shifts tax from Year 1 to Year 2 (or beyond, depending on depreciation method); (3) Net effect at constant rates: the total tax over both years is identical, but the corporation has use of the $42,000 (deferred service income tax savings) for one additional year. At a 5% investment return, the one-year time value of $42,000 = $42,000 × 5% = $2,100 of economic benefit. This compounding time value is the economic rationale for tax deferral strategies even when rates are constant.

• A. C corporation: total tax = $63,000 (21% entity tax only); S corporation: total tax = $111,000 (37% individual rate on all income)
• B. C corporation: total tax = $83,160 (entity tax $63,000 + individual tax on dividends $20,160); S corporation: total tax = $111,000 (37% on all pass-through income); C corporation has lower total tax
• C. Both structures produce identical total tax because pass-through and double taxation always equilibrate at the same effective rate
• D. C corporation: total tax ≈ $78,300 (21% on $300,000 = $63,000 entity + 20% LTCG on $237,000 remaining after entity tax = $15,300 approximate individual tax on qualified dividends); S corporation: total tax ≈ $66,600 (37% on $180,000 pass-through + FICA savings on $120,000 salary vs. full self-employment); S corporation results in lower total tax in this scenario

Comparative analysis: C Corporation: Entity taxable income = $300,000 − $120,000 salary = $180,000. Corporate tax = $180,000 × 21% = $37,800. After-tax corporate income = $142,200 available for dividend. Individual tax on salary = $120,000 × 37% = $44,400 (+ FICA employer/employee). Dividend tax = $142,200 × 20% (qualified dividend rate at this income level, approximately) = $28,440. Plus 3.8% NIIT: $142,200 × 3.8% = $5,404. C corp total approximate tax (ignoring FICA): $37,800 + $44,400 + $28,440 + $5,404 ≈ $116,044. S Corporation: Pass-through income = $180,000 ($300,000 − $120,000 salary). Individual tax on pass-through = $180,000 × 37% = $66,600. Individual tax on salary = $120,000 × 37% = $44,400. FICA on salary saves vs. SE tax on full $300,000. S corp total approximate (ignoring FICA): $66,600 + $44,400 = $111,000. The S corporation results in lower total individual tax in most cases at high income levels because qualified dividend rates plus corporate tax exceed individual pass-through rates for high-bracket taxpayers.