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Tax Chapter 15

1. Corporations are legally formed by filing articles of organization with the state in which the corporation will be created.
T/F
FALSE

Corporations file articles of incorporation.

2. General partnerships are legally formed by filing a partnership agreement with the state in which the partnership will be formed.
T/F
FALSE

General partnerships may be formed by written agreement among the partners, called a partnership agreement, or may be formed informally without a written agreement when two or more owners join together in an activity to generate profits.

3. Limited partnerships are legally formed by filing a certificate of limited partnership with the state in which the partnership will be organized.
T/F
TRUE
4. Sole proprietorships are treated as legal entities separate from their individual owners.
T/F
FALSE
5. S corporation shareholders are legally responsible for paying the S corporation’s debts because S corporations are treated as flow-through entities for tax purposes.
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FALSE
6. LLC members have more flexibility than corporate shareholders to alter their legal arrangements with respect to one another, the entity, and with outsiders.
T/F
TRUE
7. Corporations are legally better suited for taking a business public compared with LLCs and general partnerships.
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TRUE
8. Both tax and nontax objectives should be considered when choosing an appropriate business entity.
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TRUE
9. C corporations and S corporations are separate taxpaying entities that pay tax on their own income.
T/F
FALSE

S corporations are flow-through entities whose income “flows through” to their owners who are responsible for paying tax on the income.

10. All unincorporated entities are generally treated as flow-through entities for tax purposes.
T/F
TRUE
11. An unincorporated entity with more than one owner is, by default, taxed as a partnership.
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TRUE
12. A single-member LLC is taxed as a partnership.
T/F
FALSE

Single-member LLCs are taxed as sole proprietorships.

13. Unincorporated entities with only one individual owner are taxed as sole proprietorships.
T/F
TRUE
14. S corporations have more restrictive ownership requirements than other entities.
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TRUE
15. Entities taxed as partnerships can use special allocations to reward owners based on their responsibilities, contributions, and individual needs.
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TRUE
16. Sole proprietors are subject to self-employment taxes on net income from their sole proprietorships.
T/F
TRUE
17. Losses from C corporations are never available to offset a shareholder’s personal income.
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TRUE
18. Which of the following legal entities file documents with the state to be formally recognized by the state?

A. Limited Liability Company
B. General Partnership
C. Sole Proprietorship
D. None of these

A. Limited Liability Company
LLCs file articles of organization with the state to receive formal recognition from the state, but general partnerships typically don’t file their partnership agreements. Because sole proprietorships are not treated as legal entities separate from their owners, sole proprietors don’t need to do anything to receive legal recognition from the state.
19. Which legal entity is correctly paired with the party that bears the ultimate responsibility for paying the legal entity’s liabilities?

A. LLC – LLC members
B. Corporation – Corporation
C. General Partnership – Partnership
D. Limited Partnership – General partner
E. Corporation – Corporation and Limited Partnership – General partner.

E. Corporation – Corporation and Limited Partnership – General partner.

Corporations and LLCs, rather than their owners, are responsible for their debts. General partners are responsible for debts of general and limited partnerships.

20. Which legal entity is generally best suited for going public?

A. Corporation
B. LLC
C. Limited Liability Partnership
D. General Partnership
E. All of these entities are equally suited for going public.

A. Corporation
Corporations have the governance structure to successfully achieve an initial public offering. The other entities would have to restructure to make this possible.
21. What document must LLCs file with the state to organize their business?

A. Articles of incorporation
B. Certificate of LLC
C. Articles of organization
D. Partnership agreement
E. None of these. LLCs do not have to file with the state to organize their business.

C. Articles of organization
LLCs must file articles of organization with the state the LLC desires to organize its business in.
22. Which of the following entity characteristics are generally key drivers for small business owners in deciding which entity to choose?

A. Double taxation
B. Required accounting period
C. Liability protection
D. Double taxation and required accounting period
E. Double taxation and liability protection

E. Double taxation and liability protection
While each circumstance is different, small business owners typically seek liability protection while avoiding double taxation.
23. On which form is income from a single member LLC with one corporate (C corporation) owner reported?

A. Form 1120 used by C corporations to report their income
B. Form 1120S used by S corporations to report their income
C. Form 1065 used by partnerships to report their income
D. Form 1040, Schedule C used by sole proprietorships to report their income
E. None of these.

A. Form 1120 used by C corporations to report their income

Single member LLC with one corporate owner is considered to be a disregarded entity. In essence, the entity is treated like a division of its parent company. Thus, its income will be reported on the Form 1120 of its parent corporation.

24. On which tax form does a single member LLCs with one individual owner report its income and losses?

A. Form 1120
B. Form 1120S
C. Form 1065
D. Form 1040, Schedule C

D. Form 1040, Schedule C

Single member LLCs, with one individual owner, follow the same filing guidelines as sole proprietorships. Thus, their income is reported on Form 1040, Schedule C.

25. On which tax form do LLCs with more than one owner report their income and losses?

A. Form 1120
B. Form 1120S
C. Form 1065
D. Form 1040, Schedule C

C. Form 1065

LLCs with more than one owner are taxed as partnerships and report their income on Form 1065.

26. Which tax classifications can potentially apply to LLCs?

A. S corporation
B. Partnership
C. Sole proprietorship
D. S corporation and Partnership
E. S corporation and Sole proprietorship
F. Partnership and Sole proprietorship
G. All of these

G. All of these

LLCs can elect to be taxed as corporations and then make an S election if they satisfy the requirements for number and type of shareholder. The default tax status for LLCs with more than one member is partnership, and the default tax status for single-member LLCs with an individual owner is sole proprietorship.

27. Which of the following legal entities are classified as C corporations for tax purposes?

A. Limited Liability Company
B. S corporations
C. Limited partnerships
D. Sole proprietorship
E. None of these

E. None of these

Limited liability companies and limited partnerships are generally taxed as partnerships. S corporations are taxed under a separate set of rules applicable to S corporations. Sole proprietorships are not taxed separately from their owners.

28. If PST Corporation is a shareholder of MNO Corporation, how many levels of tax is MNO’s pre-tax income potentially exposed to?

A. No taxation
B. Single taxation
C. Double taxation
D. Triple taxation

D. Triple taxation

MNO will have to pay taxes on the amount of pre-tax income it earns. Then, if MNO pays a dividend to PST, the income will be taxed a second time. If PST pays a dividend to its shareholders, the income will be taxed a third time.

29. Crocker and Company, Inc. had taxable income of $550,000. At the end of the year, it distributes all its after-tax earnings to Jimmy, the company’s sole shareholder. Jimmy’s marginal ordinary tax rate is 34 percent and his marginal tax rate on dividends is 15 percent. What is the overall tax rate on Crocker and Company’s pre-tax income?

A. 9.9%
B. 15.0%
C. 35.0%
D. 44.8%
E. 66.7%

D. 44.8%

Crocker and Company pays taxes of $192,500 ($550,000 × .35). Therefore $357,500 ($550,000 – $192,500) will be distributed to the shareholder as a dividend. The shareholder pays taxes of $53,625 ($357,500 × .15). The total taxes paid on Crocker and Company’s pre-tax income are $246125 ($192,500 + $53,625), and the overall tax rate will be 44.75 percent ($246,125 / $550,000).

30. If C corporations retain their after-tax earnings, when will their shareholders be taxed on the retained earnings?

A. Shareholders will be taxed when they sell their shares at a gain
B. Shareholders will be taxed in the year they elect to be taxed on undistributed retained earnings
C. Shareholders will be taxed on undistributed retained earnings in the year the corporation files its tax return
D. None of these

A. Shareholders will be taxed when they sell their shares at a gain

Corporate shareholders generally pay taxes on corporate earnings when they sell their shares or when they receive dividends.

31. While a C corporation’s losses cannot be used by their shareholders to offset personal income, a C corporation may carry back and carry forward losses to help offset the taxable income a corporation had or will have. How are these net operating losses carried back and carried forward?

A. Carried back two years, carried forward indefinitely
B. Carried back indefinitely, carried forward two years
C. Carried back two years, carried forward five years
D. Carried back two years, carried forward twenty years
E. None of these.

D. Carried back two years, carried forward twenty years

A C corporation may carry back an NOL two years and carry forward an NOL 20 years.

32. Which of the following is not an effective strategy for mitigating double taxation in a C corporation?

A. C corporations can shift income to shareholders via deductible payments
B. C corporations can make an S election
C. C corporations can pay dividends to their shareholders
D. None of these. All of these statements are effective strategies to mitigate or avoid double taxation.

C. C corporations can pay dividends to their shareholders

Paying dividends actually triggers the double tax rather than avoid it.

33. Robert is seeking additional capital to expand ABC Inc. In order to qualify ABC as an S corporation, which type of investor group should Robert obtain capital from?

A. 30 different partnerships
B. 10 different C corporations
C. 90 nonresident individuals
D. 120 unrelated resident individuals
E. None of these.

E. None of these.

S corporations have strict rules regarding the number and type of owners they may have. An S corporation cannot have more than 100 unrelated shareholders. Furthermore, shareholders may not be corporations, partnerships, nonresident aliens, or certain types of trusts.

34. What tax year-end must unincorporated entities with only one owner adopt?

A. The entity is free to adopt any tax year-end
B. The entity must adopt the same year-end as its owner
C. The entity must adopt a calendar year-end
D. The entity may adopt any year-end except for a calendar year-end

B. The entity must adopt the same year-end as its owner

Owners of unincorporated entities can be either individuals or corporations. In either case, the tax year-end of the entity must match the tax year-end of the owner.

35. Roberto and Reagan are both 25 percent owner/managers for Bright Light Inc. Roberto runs the retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA. Bright Light Inc. generated a $125,000 profit companywide made up of a $75,000 profit from the Sacramento store, a ($25,000) loss from the San Francisco store, and a combined $75,000 profit from the remaining stores. If Bright Light Inc. is an S corporation, how much income will be allocated to Roberto?

A. $31,250
B. $62,500
C. $75,000
D. $125,000

A. $31,250

S corporations may not specially allocate income to shareholders; thus, the $125,000 companywide profit must be allocated to Roberto based on his ownership percentage in Bright Light, Inc. Roberto would receive 25 percent of the total profits, or $31,250 ($125,000 × .25).

36. Roberto and Reagan are both 25 percent owner/managers for Bright Light Enterprises. Roberto runs the retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA. Bright Light generated a $125,000 profit companywide made up of a $75,000 profit from the Sacramento store, a ($25,000) loss from the San Francisco store, and a combined $75,000 profit from the remaining stores. If Bright Light is taxed as a partnership and decides that Roberto and Reagan will be allocated 70 percent of his own store’s profit with the remaining profits allocated pro rata among all the owners, how much income will be allocated to Reagan?

A. $25,000
B. $17,500
C. $5,000
D. $20,000

C. $5,000

Because Bright Lights Enterprises is a partnership, the special allocation described is permissible. Reagan would receive 70 percent of the loss from his store, or ($17,500) (($25,000 × 70 percent)). Additionally, Reagan will receive 25 percent of the remaining profits not specially allocated, or $22,500 [.25 × (125,000 + 17,500 – ($75,000 × .7))] Thus, Reagan will be allocated a total of $5,000 of income.

37. When an employee/shareholder receives an income allocation from an S corporation, what taxes apply to the income allocation?

A. FICA tax only.
B. Self-employment tax only.
C. FICA and self-employment tax.
D. None of these. This income will never be taxed.
E. None of these. This income will be taxed, but another type of tax will apply.

E. None of these. This income will be taxed, but another type of tax will apply.

An S corporation employee/shareholder must pay FICA tax on any salary received from an S corporation; however, any S corporation ordinary business income allocated to them is not subject to either FICA or self-employment tax. Rather, it will only be subject to the marginal ordinary income tax rate of the shareholder.

38. What is the tax impact to a C corporation or an S corporation when it makes a property distribution to a shareholder?

A. Recognizes either gain or loss
B. Doesn’t recognize gain or loss
C. Recognizes gain but not loss
D. Recognizes loss only

C. Recognizes gain but not loss

Gains must be recognized on distributed appreciated property for both taxable corporations and S corporations. However, losses are not allowed if the distributed property has depreciated in value.

39. Assume you plan to start a new enterprise; you know the probability of having losses for the first three years of operations is almost 90 percent, and you know you will report a substantial amount of income from other sources during those same three years. From a tax perspective, which of the following entity choices would be least favorable?

A. C corporation
B. LLC
C. General partnership
D. S corporation

A. C corporation

A C corporation is the least favorable entity choice because the losses from the first three years of operations will not flow-through to you and be available to offset income from other sources.

40. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs and the entity has assets that have declined in value?

A. Partnership
B. S corporation
C. LLC
D. Partnership and S corporation
E. S corporation and LLC

B. S corporation

When assets that have declined in value are distributed in liquidation, S corporations may immediately deduct losses from the assets whereas these losses are typically deferred if the distributing entity is taxed as a partnership.

41. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs and the entity has appreciated assets?

A. Partnership
B. S corporation
C. LLC
D. Partnership and LLC
E. S corporation and LLC

D. Partnership and LLC

Partnerships and their owners generally don’t recognize any gain during a liquidating distribution. Conversely, S corporations and their shareholders must recognize gain when appreciated assets are distributed in a liquidating distribution.

42. If you were seeking an entity with the most favorable tax treatment regarding (1) the number of owners allowed, (2) the flexibility to select your accounting period, and (3) the availability of preferential capital gains rates when selling your ownership interest, which entity should you decide to use?

A. C corporation
B. S corporation
C. Partnership
D. Sole proprietorship

A. C corporation

These three tax considerations are most favorable for a company that chooses to be taxed as a taxable corporation. There is no limit to the number of owners allowed, no restrictions on what accounting period to use, and all of the gains from selling shares in a C corporation are capital gains.

43. Which of the following is not an effective strategy for mitigating the double tax associated with C corporations?

A. Paying a salary to a shareholder-employee
B. Leasing property from a shareholder
C. Borrowing money from a shareholder
D. Paying fringe benefits to a shareholder-employee
E. All of these are effective strategies for mitigating double taxation

E. All of these are effective strategies for mitigating double taxation

All of the strategies will reduce the amount of double taxation because they all shift income from C corporations to their shareholders with payments that are deductible at the corporate level.

44. What is the maximum number of unrelated shareholders a C corporation can have, the maximum number of unrelated shareholders an S corporation can have, and the maximum number of partners a partnership may have?

A. 100; no limit; no limit
B. no limit; 100; 2
C. no limit; 100; no limit
D. 100; 100; no limit

C. no limit; 100; no limit

An S corporation is the only type of entity that has a limit on the maximum number of owners it may have. S corporations may have up to 100 unrelated shareholders.

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