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									                                    CHAPTER 10

                   CORPORATIONS: EARNINGS & PROFITS
                      AND DIVIDEND DISTRIBUTIONS

                     SOLUTIONS TO PROBLEM MATERIAL




                                                          Status:          Q/P
Question/                                                 Present        in Prior
Problem              Topic                                Edition        Edition


    1       Amount of dividend income                        Unchanged      1
    2       Amount of taxable income; balance in E & P Unchanged            2
    3       Ethics problem                                   Unchanged      3
    4       Deficit in E & P followed by sale on             Unchanged      4
                installment method; taxation of dividend
                distribution
    5       Effect of selected transactions in adjusting     Unchanged      5
                taxable income (for determining E& P)
    6       Amount of dividend income; deficit in current Unchanged         6
            E & P with positive balance in accumulated
                E&P
    7       Cash distributions; determination of taxable     Unchanged      7
                amount
    8       Cash distributions; determination of taxable     Unchanged      8
                amount; gain on sale of stock
    9       Cash distributions; determination of taxable     Unchanged      9
                amount
   10       Effect of specified transactions on              Unchanged     10
                taxable income; on E & P
   11       Effect of specified transactions on taxable      Unchanged     11
                income; on E & P
   12       Tax treatment to shareholder and to              New
                corporation on distribution of property
                subject to liability in excess of basis
   13       Effect of specified transactions on taxable      New
                income; on E & P
   14       Tax treatment to corporate shareholder and to Unchanged        13
                distributing corporation of property subject
                to a liability
                                            10-1
10-2                             2003 Entities Volume/Solutions Manual


                                                                     Status:         Q/P
Question/                                                            Present     in Prior
Problem                  Topic                                       Edition     Edition

   15               Taxation of dividend when E & P has positive     Unchanged        14
                        balance but corporation has current loss
   16               Unreasonable compensation, ways to draw          New              15
                        funds from corporation
   17               Issue recognition                                Unchanged        17
   18               Constructive dividends                           Unchanged        18
   19               Selected factors in determining reasonableness   Unchanged        19
                        of compensation
   20               Property dividend; liability assumed by share-   Unchanged        20
                        holder; determination of E & P;
                        distribution of loss property
   21               Property distribution to corporate               Unchanged        21
                        shareholder; basis in excess of FMV;
                        liability assumed by shareholder
   22               Dividend distribution; effect on E & P           Unchanged        22
   23               Dividend distribution; effect on E & P           New
   24               Basis of nontaxable preferred stock dividend     New
   25               Election to receive common or preferred          Unchanged        24
                        stock dividend
   26               Stock dividend; basis allocation; gain or sale   Unchanged        26
   27               Stock rights; basis allocation; gain on sale     Unchanged        27
   28               How to structure a dividend payment              Unchanged        28
   29               Meaningful reduction test in a not essentially   Unchanged        29
                        equivalent redemption
   30               Disproportionate redemption; consequences        Unchanged        32
                        to shareholder and effect of
                        redemption on E & P
   31               Redemption of stock to pay death taxes;          Unchanged        31
                        estate sale of property received
   32               Disproportionate redemption [[§ 302(b)(2)];      Unchanged        30
                        family attribution
   33               Complete termination redemption                  New
                        [§ 302(b)(3)]; family attribution waiver
Bridge Discipline
Problem

       1            Total return and dividend yield of corporate     Unchanged         1
                        stock

Research
Problem

       1            Earnings and profits and tax evasion             Unchanged         1
       2            Repayment of unreasonable compensation           Unchanged         2
       3            Dividend in anticipation of corporate sale       Unchanged         3
       4            Corporate deduction of luxury auto &             Unchanged         4
                         constructive dividend to shareholder
       5            Internet activity                                Unchanged         5
       6            Internet activity                                Unchanged         6
       7            Internet activity                                New
                    Corporations: E & P and Dividend Distributions                              10-3


PROBLEM MATERIAL

1.   George and Albert have ordinary dividend income of $130,000 each [$200,000 (Swan
     Corporation’s accumulated E & P) + $60,000 (Swan Corporation’s current E & P) ÷ 2]. The
     remaining $20,000 of the $280,000 distribution reduces the basis (up to $10,000 each) in the
     shareholders’ stock in Swan Corporation with any excess treated as a capital gain. George
     reduces his basis from $48,000 to $38,000. Albert has a reduction in stock basis from $8,000
     to zero and a capital gain of $2,000. pp. 10-2, 10-3, and Example 1

2.   a.    Vireo reports $300,000 dividends as taxable income but has a dividends received
           deduction under § 243 of $210,000 (70% X $300,000). None of the other items affect
           taxable income. Thus, there is a net increase of $90,000 (as a result of the dividends and
           associated dividends received deduction), or a taxable income of $315,000.

     b.    Vireo Corporation’s E & P as of December 31 is $630,000, computed as follows:
           $80,000 (beginning balance in E & P) + $315,000 (taxable income) + $210,000
           (dividends received deduction) + $50,000 (tax-exempt interest) - $25,000 (interest on
           indebtedness to purchase tax-exempt bonds).

     pp. 10-4 to 10-7

3.   Steve is courting disaster. An obscure set of Code provisions (§§ 1311-1314) serves to
     mitigate the effect of the statute of limitations. Based on the concept of equity, these
     provisions preclude both the IRS and taxpayers from taking current advantage of past errors,
     the correction of which is no longer possible. These provisions would permit the IRS to reopen
     tax year 1994 and assess against Steve the tax he would have paid had he properly reported the
     dividend income.

     On the other hand, if Steve stays with the basis reduction he originally made, he has not taken
     an inconsistent position. Therefore, §§ 1311-13114 cannot be used by the IRS. pp. 10-2 and
     10-3

4.   Buck reports $300,000 as a taxable dividend. The $550,000 gain on the sale of the land
     increases E & P by that amount in 2002. Current E & P before the distribution is $430,000
     [$550,000 (gain on sale) - $120,000 (current year deficit)]. Since there is adequate current E &
     P, the entire distribution is a dividend. pp. 10-4, 10-5, and Example 6


5.   a.     To determine current E & P for 2002, Oriole Corporation's taxable income is increased
            by the entire amount of the deferred gain on the installment sale.

     b.     Oriole Corporation's taxable income for 2002 is increased by the amount of the capital
            loss carryover in determining Oriole Corporation's E & P for 2002. As the excess
            capital losses would have reduced E & P in 2001, there is no need for further reduction
            in 2002.

     c.     Oriole Corporation's taxable income is reduced by the excess charitable contributions
            in determining its E & P. The excess charitable contributions that cannot be utilized in
            computing Oriole Corporation's taxable income is nonetheless a reduction in its E & P
            account for the year.
     d.     Gains and losses from property transactions affect the determination of E & P only to
            the extent that they are recognized for tax purposes. Thus, the deferred gain would also
            be deferred for purposes of E & P and no adjustment to taxable income would be
            necessary.
10-4                         2003 Entities Volume/Solutions Manual


       e.     Oriole Corporation's taxable income for 2002 is reduced by the Federal income taxes
              paid in computing its E & P for 2002.

       f.     For E & P purposes, § 179 expenses are deducted over a five-year period.
              Consequently, one-fifth of the § 179 deduction in 2000 would be subtracted from
              taxable income in 2002 to determine current E & P.

       pp. 10-2 to 10-10

6.     Dividend income is $50,000 and $150,000 is a return of capital, of which $135,000 is taxed as
       a capital gain. To determine the amount of dividend income, the balances of both accumulated
       and current E & P as of September 30 must be netted because of the deficit in current E & P.
       Three-quarters of the loss, or $300,000, is deemed to have occurred by September 30; thus, the
       $350,000 in accumulated E & P is reduced by $300,000. The $50,000 balance remaining in E
       & P triggers dividend income. p. 10-10 and Example 11

7.           Amount          Return of
             Taxable         Capital

       a.    $ 70,000        $80,000        Accumulated E & P and current E & P are netted
                                            on the date of distribution. There is a dividend
                                            to the extent of any positive balance.

       b.    $ 40,000        $50,000        Taxed to the extent of current E & P.

       c.    $220,000        $ -0-          Taxed to the extent of current and accumulated
                                            E & P.

       d.    $ 80,000        $40,000        Accumulated E & P and current E & P netted on
                                            date of distribution.

       e.    $110,000        $10,000        When the result in current E & P is a deficit for
                                            the year, the deficit is allocated on a pro rata basis
                                            to distributions made during the year. On June 30,
                                            E & P is $110,000 [current E & P is a deficit of
                                            $30,000 (i.e., 1/2 of $60,000) netted with
                                            accumulated E & P of $140,000].
       pp. 10-7 to 10-10
                      Corporations: E & P and Dividend Distributions                              10-5


8.              Amount         Capital
                Taxable        Gain

      a.        $120,000       $10,000      Taxed to the extent of current E & P. Capital gain to
                                            extent distribution exceeds E & P plus stock basis.

      b.        $100,000       $ -0-        Taxed to the extent of current and accumulated E & P.

      c.        $ 70,000       $ -0-        Taxed to the extent of current E & P.

      d.        $ 50,000       $20,000      Accumulated E & P and current E & P are netted on the
                                            date of distribution. There is a dividend to the extent of
                                            any positive balance.

      e.        $ 90,000       $ -0-        When the result in current E & P is a deficit for the year,
                                            such deficit is allocated on a pro rata basis to
                                            distributions made during the year. Thus, on June
                                            30, current E & P is a deficit of $80,000 (i.e., 1/2 of
                                            $160,000). This is netted with accumulated E & P of
                                            $210,000 to cause all of the distribution to be taxed.

      pp. 10-7 to 10-10

9.    The $80,000 in current E & P is allocated on a pro rata basis to the two distributions made
      during the year; thus, $40,000 of current E & P is allocated to Carrie Lynn’s distribution and
      $40,000 is allocated to Rajib’s distribution. Accumulated E & P is applied in chronological
      order beginning with the earliest distribution. Thus, the entire $95,000 is allocated to Carrie
      Lynn’s distribution. As a result, the distribution of $150,000 to Carrie Lynn on July 1 is taxed
      as dividend income to the extent of $135,000 ($95,000 AEP + $40,000 current E & P for ½ of
      the year). The remaining $15,000 reduces the basis in Carrie Lynn’s stock to $35,000. Carrie
      Lynn then recognizes a capital gain of $165,000 on the sale of the stock [$200,000 (selling
      price) - $35,000 (remaining basis in the stock)]. The distribution to Rajib of $150,000 is a
      taxable dividend of $40,000 and a $110,000 reduction in his stock basis. Thus, Rajib’s basis in
      the Junco stock is $90,000 [$200,000 (original cost) - $110,000 (reduction in basis from the
      distribution)]. pp. 10-7 to 10-10

10.           Taxable Income                 E&P
            Increase (Decrease)          Increase (Decrease)
      a.            $20,000                     ($20,000)
      b.           No effect                    ($27,000)
      c.           No effect                    ($ 7,500)
      d.           No effect                    ($43,000)
      e.           No effect                    ($ 8,500)
      f.            $25,000                      $ -0-

      Note: E & P is not increased in f. because the $25,000 has already been included in taxable
      income. The realized gain is not an increase in E & P, only the recognized gain that is included
      in taxable income.

      p. 10-7
10-6                           2003 Entities Volume/Solutions Manual


11.             Taxable Income                    E&P
              Increase (Decrease)          Increase (Decrease)

       a.          No effect                    ($ 40,000) *
       b.         ($30,000)                      $ 26,000 **
       c.          $50,000                       $150,000
       d.          $ 3,000                       $ 7,000 ***
       e.          No effect                     No effect
       f.         ($12,000)                      $ 9,600 †
       g.          No effect                    ($ 2,400) ††
       h.         ($80,000)                      $ 30,000 †††
       i.          No effect                     $ 60,000

       *        While the related party loss is not deductible under the income tax, it must be
                subtracted from E & P.

       **       Although intangible drilling costs are deductible in full under the income tax, they must
                be amortized over 60 months when computing E & P. Since $500 per month is
                amortizable ($30,000/60 months), $4,000 is currently deductible for E & P purposes
                ($500 X 8 months). Thus, of the $30,000 income tax deduction, $26,000 must be
                added back to E & P ($30,000 - $4,000 deduction allowed).

       ***      The receipt of a $10,000 dividend will generate a dividends received deduction of
                $7,000. The net effect on taxable income is an increase of $3,000. For E & P purposes,
                the dividends received deduction must be added back.
       †
                Only 20% of current-year § 179 expense is allowed for purposes of E & P. Thus, 80%
                of the amount deducted for income tax purposes is added back.
       ††
                In each of the four succeeding years, 20% of the § 179 expense is allowed as a
                deduction for E & P purposes.
       †††
                Only ADS straight-line depreciation reduces E & P; thus, E & P is increased by
                $30,000, which is the excess of MACRS depreciation taken over the amount allowed
                under ADS.

            Concept Summary 10-1
12.    a.       Pelican has a gain of $75,000 on the distribution, computed as follows: $225,000
                (liability on the property exceeds fair market value) - $150,000 (basis of the property).
                Pelican’s E & P is increased by the $75,000 gain. In addition, E & P is decreased by
                $225,000 (representing the deemed fair market value of the property), reduced by the
                $225,000 liability on the property, or zero. Thus, E & P is $375,000, computed as
                follows: $300,000 (beginning E & P balance) + $75,000 (gain on distribution).

       b.       Ginger has dividend income of zero, computed as follows: $225,000 (value of the
                property based on liability) - $225,000 (liability on the property). Ginger has a basis of
                $225,000 in the property.

       pp. 10-11 to 10-15
                      Corporations: E & P and Dividend Distributions                             10-7


13.   Taxable income:

               Income from services rendered                                         $300,000
               Dividend income                                                         50,000
                                                                                     $350,000
                Less: Salaries                                    $80,000
                      Depreciation ($80,000 cost X 14.29%)         11,432             (91,432)
               Taxable income before dividends received deduction                    $258,568
               Less: Dividends received deduction (70% X $50,000)                     (35,000)
               Taxable income                                                        $223,568

      E & P:

               Taxable income                                                        $223,568
               Add:
                      Tax-exempt income                                   $25,000
                      Excess of MACRS depreciation over straight-line:
                       Straight-line is $4,000 [($80,000 cost  10)  2].
                      MACRS depreciation of $11,432 less
                         $4,000 straight-line                               7,432
                      Dividends received deduction                         35,000      67,432
                                                                                     $291,000
               Deduct:
                     STCL on sale of stock                              $20,000
                     Estimated Federal income tax                        15,400       (35,400)
               E&P                                                                   $255,600

      pp. 10-3 to 10-7

14.   a.    Dividend income to Orca is $80,000 [$110,000 (fair market value of the property) -
            $30,000 (liability assumed)]. The amount taxed to Orca is reduced by the dividends
            received deduction.

      b.    Orca’s basis in the property is $110,000.

      c.    The distribution reduces Penguin’s E & P account by $120,000 [$150,000 (adjusted
            basis of the property) - $30,000 (liability assumed by Orca)].
      pp. 10-11 to 10-15

15.   To determine the taxability of the $35,000 distribution, the balance of both accumulated and
      current E & P as of July 1 must be determined and netted. This is necessary because of the
      deficit in current E & P. One-half of the $30,000 loss, or $15,000, reduces E & P to $25,000 as
      of July 1 ($40,000 - $15,000). Thus, of the $35,000 distribution, $25,000 is taxed as a dividend
      and $10,000 represents a return of capital. p. 10-10 and Example 11

16.   There would be a problem. Amethyst Corporation will have satisfied Fiona’s obligation.
      Amethyst Corporation's payment to the charity may be treated as indirect compensation to her.

      In determining whether Amethyst Corporation has paid Fiona ―unreasonable‖ compensation,
      both the direct payment of $300,000 and the indirect $50,000 will be considered. Fiona should
      not have made a pledge to the charity. She should have just permitted the corporation to make
      the contribution directly. p. 10-17
10-8                        2003 Entities Volume/Solutions Manual


17.        What basis do Cybil and Sally have in their stock in Copper Corporation after their
            initial transfers for stock?

           Does Sally’s transfer qualify under § 351 of the Code as a nontaxable exchange?

           How is Copper Corporation taxed on the property distribution to Cybil?

           How do the distributions to Cybil and to Sally affect Copper’s E & P?

           How will Cybil and Sally be taxed on the distributions?

           What is Cybil’s basis in her stock when she sells it to Dana?

           How are Cybil and Dana taxed on the $80,000 distribution to each?

       pp. 10-7 to 10-15
18.    a.     Redwing has a realized loss of $15,000 (the difference between basis of $33,000 and
              fair market value of $18,000) and a constructive dividend of $13,000 (the difference
              between the $18,000 fair market value and the $5,000 paid for the parking lot). Due to
              the application of § 267, Redwing cannot recognize the realized loss. However, the
              loss does reduce Redwing’s E & P. The constructive dividend also reduces E & P.
              Thus, E & P is reduced by $28,000 (the sum of the $15,000 disallowed loss and the
              $13,000 constructive dividend).

       b.     The loan to Royce will generate imputed interest since no interest was charged. The
              amount of imputed interest will be $9,000 ($200,000 X 9% X ½ year). This amount
              will be deemed paid as interest from Royce to the corporation. The deductibility of the
              interest by Royce will depend upon how the loan proceeds are used. Redwing will have
              taxable interest income of $9,000. Finally, Redwing will be deemed to pay a dividend
              to Royce equal to the amount of interest. Redwing’s E & P will be increased by the
              amount of interest income and reduced by the amount of deemed dividend payment.

       c.     Bargain rentals create constructive dividends to shareholders. In the present case, the
              amount of constructive dividend to both Mike and Royce equals the fair rental value of
              the yacht. Thus, both shareholders will receive dividend income of $30,000 ($7,500 X
              4 weeks) and Redwing’s E & P will be reduced by the same amount.
       d.     The $7,000 excess amount ($20,000 - $13,000) paid to Mike by Redwing over the fair
              rental value of the equipment will be treated as a constructive dividend taxable to Mike.
              The dividend will also reduce Redwing’s E & P.

       pp. 10-16 to 10-19

19.    a.   The determination of the reasonableness of compensation paid to an employee who is
            not a shareholder but is related to the sole owner of the corporate-employer should be
            made in the same manner as that for salary paid the shareholder-employee. The degree
            of relationship between the sole owner of the corporation and the employee should be
            considered initially to determine if, in essence, the salary could be considered as having
            been paid to the owner. If so, the same factors used to determine the reasonableness of
            that paid to the owner should be used to determine the reasonableness of that paid to the
            related employee.

       b.   That the employee-shareholder never completed high school should be relevant only
            with respect to the nature and scope of the employee's work. Is education beyond high
                    Corporations: E & P and Dividend Distributions                               10-9


           school required for the type of work performed by the employee-shareholder and the
           salary received for such work?

      c.   The fact that the employee-shareholder is a full-time college student might well cause
           any salary paid to be deemed excessive.

      d.   If the employee-shareholder was underpaid during the formative period of the
           corporation, this is evidence of reasonableness of the compensation if a portion thereof is
           for service rendered in prior years.

      e.   If a corporation has substantial E & P and pays only a nominal dividend each year, a
           constructive dividend may be found.

      f.   Year-end bonuses would be vulnerable to constructive dividend treatment, particularly if
           they are related to profit for the year, are paid only to shareholder-employees, and are
           determined at year-end on an arbitrary basis.
      pp. 10-17 and 10-18
20.   a.     Taxable income to Lea is $20,000 [$100,000 (value of the property) - $80,000
             (liability)].
      b.     Corporate E & P after the distribution is $77,350, computed as follows:
             Beginning E & P                                              $51,000
             Add:
                    Taxable income                    $320,000
                    Proceeds of term life insurance      46,400
             Subtract:
                    Federal income tax                 (108,050)
                    Life insurance premiums              (2,000)
                    Property distribution              (220,000) *
                    Prior year installment sale income (10,000)            26,350
             E & P of Plover after the distribution                       $77,350

             *      E & P is reduced by the greater of the fair market value ($100,000) or adjusted
                    basis of the property ($300,000), less the amount of liability on the property
                    ($80,000).
      c.     The tax basis of the property to Lea is $100,000.
10-10                         2003 Entities Volume/Solutions Manual

        d.     If Plover had sold the business property at its $100,000 fair market value, it would have
               recognized a loss of $200,000. This loss would offset $200,000 of taxable income in
               the current year, creating Federal tax savings of $78,000 ($200,000 X 0.39). After
               paying off the $80,000 loan, Plover would have a total of $98,000 to distribute to Lea
               [$78,000 (tax savings) + $100,000 (sales proceeds) - $80,000 (loan balance)].
               Immediately following the property sale, Plover’s E & P balance would be:
               Beginning E & P                                                      $51,000
               Add:
                      Taxable income                         $120,000
                      Proceeds of term life insurance          46,400
               Subtract:
                      Life insurance premiums                  (2,000)
                      Federal income tax                      (30,050)
                      Income from prior year installment sale (10,000)             124,350
               E & P of Plover after the distribution                             $175,350

              Thus, Lea recognizes a taxable dividend of $98,000. Plover’s E & P would be reduced to
              $77,350 after the distribution. Note that this result is superior to a distribution of the
              property to Lea. In particular, the corporation receives a $200,000 deduction, while
              Lea’s income is only increased by $78,000.

        pp. 10-2 to 10-15

21.     a.    Verdigris Corporation has dividend income of $10,000 [$60,000 (fair market value of
              the land) less $50,000 (liability on the land)]. The $10,000 is subject to the dividends
              received deduction under § 243 of $8,000, so that only $2,000 is taxed to Verdigris
              Corporation. Verdigris Corporation has a basis of $60,000 in the land.

        b.    Rust Corporation may not deduct the loss on the land. Its E & P is reduced by $40,000,
              the $90,000 basis of the land (which is greater than the fair market value) less the
              $50,000 liability on the land.

        pp. 10-11 to 10-15

22.     The shareholder has a return of capital of $40,000. The $40,000 reduces the basis in the
        Bunting Corporation stock; any excess over basis is capital gain. There is no taxable dividend
        because the accumulated E & P account is brought up to date on the date of the sale. On the
        date of the sale, E & P is a negative $10,000 [$175,000 (beginning balance in accumulated E &
        P) - $175,000 (existing deficit in current E & P from sale of the asset) - $10,000 (one-half of
        $20,000 negative E & P not related to asset sale)]; thus, the $40,000 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. (If the $195,000
        deficit in E & P were prorated throughout the year, there would have been a taxable dividend of
        $40,000 because E & P would have a positive balance of $77,500 [$175,000 (beginning
        balance in accumulated E & P) - $97,500 (one-half the $195,000 deficit for the year)]. p.
        10-10 and Example 11
                     Corporations: E & P and Dividend Distributions                              10-11


23.   The shareholder has a taxable dividend of $20,000 and a return of capital of $30,000. Teal
      Corporation has no accumulated E & P at the time of the distribution. The shareholder is taxed
      on the current E & P of Teal, which was only $20,000. The balance of the distribution,
      $30,000, first reduces the adjusted basis of the stock in Teal Corporation. To the extent that the
      $30,000 exceeds the basis in the stock, a capital gain results. pp. 10-7 to 10-10


24.   Immediately after the distribution, Stan has $60,000 worth of Robin stock ($50,000 in
      common stock and $10,000 in preferred stock). Consequently, the basis of the common stock
      will equal the ratio of the common stock’s fair market value to the total fair market value times
      the stock basis, or $50,000/$60,000 X $30,000, or $25,000. Similarly, the basis of the preferred
      stock will equal $5,000 ($10,000/$60,000 X $30,000). p. 10-21

25.                          Smith, Raabe, and Maloney, CPAs
                                     5191 Natorp Boulevard
                                       Mason, OH 45040


      November 1, 2002

      Cormorant Corporation
      6730 Pima Drive
      Madison, WI 53708

      Dear President of Cormorant Corporation:

      This letter is in response to your question with respect to the stock dividend distributed to your
      shareholders. Our conclusion is based upon the facts as outlined in your November 1 letter.
      Any change in facts may cause our conclusion to be inaccurate.

      Your shareholders will have taxable income in the amount of the fair market value of the stock
      dividend. Distributions of preferred stock to some common shareholders and of common
      stock to other common shareholders is a taxable event.

      Should you need more information or need to clarify our conclusion, do not hesitate to contact
      me.

      Sincerely yours,

      Jon S. Davis, CPA
      Partner

      TAX FILE MEMORANDUM

      November 1, 2002

      FROM:          Jon S. Davis

      SUBJECT:       Cormorant Corporation

      Today I conferred with the President of Cormorant Corporation with respect to his November
      1 letter. The corporation asked whether their shareholders would have any taxable gain on the
      receipt of a stock dividend. Cormorant Corporation declared a dividend permitting its
      shareholders to elect to receive either 8 shares of cumulative preferred stock or 2 additional
10-12                         2003 Entities Volume/Solutions Manual


        shares of Cormorant common stock for every 10 shares of common stock held at the time of
        the dividend declaration. Two of the shareholders elected to receive preferred stock while all
        other shareholders chose the common stock dividend.

        At issue: Is the distribution of a stock dividend taxable if some of the shareholders elect to
        receive preferred stock while others elect to receive common stock?

        Analysis: Section 305 governs the taxability of stock dividends. It provides that stock
        dividends are not taxable if they represent pro rata distributions on common stock. However,
        this general rule has five exceptions. One of the exceptions applies in the current situation. In
        particular, a distribution of preferred stock to some common shareholders and of common
        stock to other common shareholders is a taxable event.

        Conclusion: The shareholders will have taxable income equal to the fair market value of the
        stock dividend.

        pp. 10-21
26.                            Smith, Raabe, and Maloney, CPAs
                                       5191 Natorp Boulevard
                                         Mason, OH 45040

        February 20, 2002

        Sarah Beckert
        1822 N. Sarnoff Rd.
        Tucson, AZ 85710

        Dear Ms. Beckert:

        This letter is in response to your question with respect to your sale of the Grebe Corporation
        stock you received as a nontaxable stock dividend. Our conclusion is based upon the facts as
        outlined in your February 10 letter. Any change in facts may cause our conclusion to be
        inaccurate.

        You paid $10,000 for 3,000 shares of stock in Grebe Corporation two years ago. Last year, a
        nontaxable stock dividend of 1,000 additional shares in Grebe Corporation was received. The
        1,000 shares were sold in the current year for $8,000. Your gain on the sale of the 1,000 shares
        is determined by subtracting your basis in the shares sold from the sales price. The tax basis in
        the 1,000 shares is determined by dividing the $10,000 cost of the original 3,000 shares by
        4,000 (to include the 1,000 new shares). Your basis then would be $2.50 per share ($10,000 
        4,000). Your gain of $5,500 would then be computed as follows: [$8,000 (selling price) -
        $2,500 (tax basis in the 1,000 new shares)]. The $5,500 gain on the sale is a long-term capital
        gain. The gain is long term because you have held your original Grebe stock for more than one
        year.

        Should you need more information or need to clarify our conclusion, do not hesitate to contact
        me.

        Sincerely yours,
        Jon S. Davis, CPA
        Partner
                     Corporations: E & P and Dividend Distributions                              10-13


      TAX FILE MEMORANDUM

      February 15, 2002

      FROM:          Jon S. Davis

      SUBJECT:       Sarah Beckert

      Today I conferred with Sarah Beckert regarding her letter to me dated February 10. Two years
      ago, Ms. Beckert purchased 3,000 shares of Grebe Corporation for $10,000. Last year, she
      received a nontaxable stock dividend of 1,000 additional shares in Grebe. She sold the 1,000
      shares this year for $8,000. She asked me to determine the tax consequences of the stock sale.

      At issue: How is the gain on the sale of shares of stock received as nontaxable stock dividends
      determined and how is it taxed?

      Conclusion: The shareholder's basis in the original 3,000 shares, $10,000, is reallocated to the
      4,000 shares she held after receiving the nontaxable stock dividend. Her basis per share after
      the stock dividend is $2.50 per share ($10,000  4,000 shares). Her gain on the sale of the
      1,000 shares is therefore $5,500 [$8,000 (selling price) - $2,500 (basis in 1,000 shares)]. The
      gain is a long-term capital gain because the holding period of the original shares tacks on to the
      shares received as a nontaxable stock dividend.

      Example 27

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

             Fair market value of stock: 200 shares X $100 =         $20,000
             Fair market value of rights: 100 rights X $45 =           4,500
                                                                     $24,500

             Basis of stock: $6,000 X $20,000/$24,500 = $4,898
             Basis of rights: $6,000 X $4,500/$24,500 = $1,102
             Basis per right: $1,102  100 rights = $11.02

      There is a capital gain on the sale of the rights of $1,319.40, computed as follows:
             Selling price of 30 rights                            $1,650.00
             Less: Basis of 30 rights (30 X $11.02)                  (330.60)
             Long-term capital gain                                $1,319.40

      Basis of the new stock is $4,271.40, computed as follows:

             70 rights X $11.02                                    $ 771.40
             Additional consideration ($50 X 70 shares)             3,500.00
             Basis of newly-acquired stock                         $4,271.40

      Holding period of the 70 new shares begins on the date of purchase.pp. 10-21, 10-22, and
      Example 28
10-14                         2003 Entities Volume/Solutions Manual


28.     Partridge should recognize the loss as soon as possible and immediately thereafter make the
        cash distribution. For example, assume these two steps took place on January 2. Because
        current E & P would be a deficit, accumulated E & P would be brought up to date. At the time
        of the distribution, the combined E & P balance would be zero [$300,000 (beginning balance in
        E & P) - $300,000 (existing deficit in current E & P)], and the entire $180,000 would be a
        return of capital. Current deficits are allocated pro rata throughout the year unless the parties
        can prove otherwise. Here they can. Example 12

29.     a.   Shonda must report the $60,000 as dividend income. The redemption does not qualify as
             a not essentially equivalent redemption. Shonda owned 55% of the stock of Hawk
             Corporation prior to the redemption (110 ÷ 200). After the redemption, Shonda owns
             50% of the stock of Hawk [90 (Shonda's remaining shares in Hawk) ÷ 180 (remaining
             outstanding shares in Hawk)]. Shonda still has the dominant control of Hawk; thus,
             there has not been a ―meaningful reduction‖ in her interest in Hawk. Further, her
             remaining ownership interest fails the 50% test of a disproportionate redemption.

        b.   The basis in the 20 shares redeemed attaches to Shonda’s remaining stock. Shonda’s
             basis in her remaining 90 shares is therefore $110,000.

        c.   Since the redemption is treated as an ordinary dividend distribution, Hawk’s E & P is
             reduced to $140,000 ($200,000 – $60,000).

        pp. 10-22 and 10-23

30.     a.     Ann would have a capital gain of $55,000 [$80,000 - $25,000 (basis in the 25 shares)].
               The redemption qualifies as a disproportionate redemption. Ann had a 50% (50
               shares  100 shares) ownership in Teal Corporation prior to the redemption and a
               33.33% (25 shares  75 shares) ownership after the redemption. Both the 50% and the
               80% tests are met.

        b.     E & P of Teal Corporation will be $90,000 after the redemption: $100,000
               (accumulated E & P) + $20,000 (current E & P) - $30,000 [25% (the percentage stock
               redemption) X $120,000 (the balance in E & P)].

        pp. 10-22 and 10-23

31.     Losses are not recognized in nonliquidating corporate distributions; thus, Red Corporation will
        not recognize the $200,000 loss inherent in the land distributed to the estate. Red
        Corporation’s E & P is reduced by $800,000 (limited to 20% X $4 million) as a result of the
        distribution. The estate will have a basis in the land equal to its fair market value, or
        $1,000,000. When it sells the land for $1,000,000, the estate will recognize no gain. pp. 10-22
        and 10-23
                     Corporations: E & P and Dividend Distributions                           10-15


32.                                 Smith, Raabe, and Maloney, CPAs
                                     5191 Natorp Boulevard
                                       Mason, OH 45040

      May 10, 2002

      Lana Pierce
      1000 Main Street
      Oldtown, MN 55166

      Dear Lana:

      This letter is in response to your question concerning the tax consequences of the redemption
      of 100 shares of stock you own in Stork Corporation. You were paid $45,000 for the shares
      and you have a tax basis of $10,000 in the stock. Your mother, Lori, owns 100 shares in Stork,
      and the remaining shares are owned by an unrelated individual. Our conclusion is based upon
      the facts as outlined in your May 5 letter. Any change in facts may cause our conclusion to be
      inaccurate.

      You will have a capital gain of $35,000 on the redemption. Stork Corporation redeemed 100
      of the 200 shares you owned in the corporation. For purposes of this transaction, you are
      deemed to own all of Lori’s 100 shares. Prior to the redemption, you had a 30% ownership
      (20% direct ownership + Lori’s 10% constructively owned) in the corporation as Stork
      Corporation had 1,000 shares outstanding. After the redemption you have only a 22.22%
      ownership [200 (your remaining 100 shares in Stork + Lori’s 100 shares) ÷ 900 (remaining
      outstanding shares in Stork)]. Because, after the redemption, you owned less than 50% of the
      stock in Stork Corporation and less than 80% of your original ownership [22.22% is less than
      24% (80% X 300 shares/1,000 shares)], the redemption qualifies for capital gain treatment.

      Should you need additional information or need to clarify our conclusion, do not hesitate to
      call on me.

      Sincerely,

      Marilyn C. Jones, CPA
      Partner

      TAX FILE MEMORANDUM

      DATE:          May 8, 2002

      FROM:          Marilyn C. Jones

      SUBJECT:       Lana Pierce

      Today I talked to Lana Pierce with respect to her May 5 letter. She received a cash payment of
      $45,000 from Stork Corporation in exchange for 100 of the 200 shares she owned in the
      corporation. Lana’s mother, Lori, owns 100 shares of Stork, and the remaining shares are
      owned by an unrelated individual. She wants to know the tax consequences of the redemption.
      At issue: Will the stock redemption qualify for capital gain treatment or will the $45,000 be
      treated as a taxable dividend?
10-16                         2003 Entities Volume/Solutions Manual


        Conclusion: Lana Pierce has a capital gain of $35,000. Lana is deemed to own Lori’s 100
        shares before and after the redemption. Lana's percentage ownership in Stork Corporation was
        30% (300 shares/1,000 shares) before the redemption and 22.22% (200 shares/900 shares)
        after the redemption. Because the 80% and 50% tests set out in § 302(b)(2) are met, the stock
        redemption qualifies for capital gain treatment.

        pp. 10-22 and 10-23

33.     a.     The redemption cannot qualify as a complete termination redemption. Jacque is
               deemed to own Monique’s 800 shares or 67% (800/1,200) of the remaining shares
               outstanding. The family attribution waiver does not apply because Jacque holds a
               prohibited interest in Thrush Corporation (i.e., directorship) immediately after the
               redemption.

        b.     The redemption can qualify as a complete termination redemption. Monique’s position
               as a director does not constitute a prohibited interest for Jacque. Thus, if the other
               requirements for the family attribution waiver are satisfied (e.g., Jacque files the
               required agreement with the IRS), the redemption completely terminates Jacque’s
               ownership interest in Thrush.

        c.     The redemption cannot qualify as a complete termination redemption. To qualify for
               the family attribution waiver, the former shareholder cannot acquire a stock ownership
               interest in the corporation (other than by bequest or inheritance) during the 10 years
               following the redemption.


BRIDGE DISCIPLINE PROBLEM

1.      Answers will vary by student.


RESEARCH PROBLEMS

1.
                                     Smith, Raabe, and Maloney, CPAs
                                      5191 Natorp Boulevard
                                        Mason, OH 45040


        November 23, 2002

        Mr. Monty Davis
        1212 S. Camino Seco
        Tucson, AZ 85710



        Dear Monty:

        I am writing this letter to provide you with some information that might be relevant to the
        IRS’s criminal tax evasion charges against Joe and Simone Simpson. Based on my recent
        telephone conversation with Joe Simpson, I understand that these charges are based on the
        belief that Joe and Simone intended to evade taxes when they withdrew and hid $250,000 from
        Spifficar over the last several years.
               Corporations: E & P and Dividend Distributions                              10-17


Upon hearing about this situation, I reviewed my files regarding Spifficar and discovered that,
over the period in question, the corporation had a deficit in earnings and profits. It occurred to
me at that time that the money withdrawn from the corporation probably would not be properly
treated as a dividend. Instead, it might be argued that the money should be treated as a tax-free
recovery of stock basis (the Simpsons have approximately $300,000 in stock basis; this should
be more than sufficient to cover the hidden funds).

After investigating this issue further, I found three court decisions that might have some
bearing on their case. In U.S. v. D’Agostino, 98-1 USTC ¶50,380, 81 AFTR2d 98-1923, 145
F.3d 69 (CA-2, 1998), the Second Court of Appeals reversed an unreported District Court
conviction against a husband and wife who owned two commercial laundromats through
wholly owned corporations. The facts in D’Agostino are very similar to those in the current
case; over a series of years, the owners took $400,000 home from the laundromats and kept the
cash in a kitchen drawer. The money was never reported as taxable income by the taxpayers
and the IRS sought criminal tax evasion charges on the basis of evidence suggesting that there
existed a clear intent to evade. The taxpayers in the case argued that the diverted income was
corporate income received by the shareholders and that the income should only be taxed to the
extent that E & P existed. In their case, as in the current situation, the corporation had no E &
P, so the distributions would be properly treated as a nontaxable recovery of basis. In
D’Agostino, the Second Court of Appeals followed the reasoning in DiZenzo v. Commissioner,
65-2 USTC ¶9518, 16 AFTR2d 5107, 348 F.2d 122 (CA-2, 1965): the lack of E & P precludes
taxation to the taxpayers (to the extent of basis in the stock and outstanding loans from
shareholders). Thus, the court in D’Agostino concluded that the hidden funds could not
constitute taxable income; so no evasion was possible.

The decision by the Second Court of Appeals in D’Agostino stands in sharp contrast to an
Eleventh Court of Appeals decision, U.S. v. Williams, 89-2 USTC ¶9390, 64 AFTR2d
89-5061, 875 F.2d 846 (CA-11, 1989). In Williams, the Eleventh Court of Appeals held that, in
criminal tax evasion cases, the government should not be required to prove that corporate
distributions are taxable. Instead, demonstrating that the shareholder has control over the
corporate funds is sufficient for criminal tax evasion statutes to apply. Notably, even though
the Second Court of Appeals was constrained to follow their decision in DiZenzo, the court
explicitly rejected the reasoning in the Williams case because it felt that decision had
eliminated proof of a tax deficiency—a key requirement for criminal tax evasion in § 7201.

Thus, my research indicates that the courts are divided on this issue. Given that the Simpsons
reside in the Ninth Court of Appeals, neither case appears to provide direct precedent. While
the answer to the Simpson’s problem is unclear, I believe that you should be able to make a
strong argument on their behalf by following the reasoning in both D’Agostino and DiZenzo.

If you have any additional questions regarding the Simpson case, or if you require additional
assistance, please do not hesitate to contact me.

Sincerely yours,

Jon S. Davis, CPA
Partner
10-18                         2003 Entities Volume/Solutions Manual


2.                                     Smith, Raabe, and Maloney, CPAs
                                        5191 Natorp Boulevard
                                          Mason, OH 45040



        November 15, 2002

        Ms. Julie Preston
        1803 E. Monroe Street
        Madison, WI 53706

        Dear Julie:

        I am writing this letter to describe the tax consequences of the compensation proposal you
        suggested at our last board of directors meeting. In particular, you proposed that PLS set your
        2002 compensation at $2.5 million, to be funded with the $500,000 in legal fees due in 2002
        from the class action suit, the $1.3 million in cash currently held by the corporation, and a loan
        from you for $700,000. It is anticipated the PLS will pay back your loan using the Federal tax
        refund it will receive from carrying back the current year $2 million net operating loss to 2000.

        There are two important tax issues that need to be addressed before we move ahead with your
        plan. First, for PLS to deduct the compensation, § 162(a) requires that the payment is
        reasonable in amount. On the basis of practices in other professional service firms, I believe we
        can make a strong argument that your compensation is reasonable. It is common in
        professional service firms to adopt compensation practices similar to ours (where fees in
        excess of expenses are paid out in full to the professional employees in the firm). While we do
        not follow this practice precisely (we will pay out considerably more in compensation this year
        than will be received in fees), this should not be a problem. With $2.5 million in compensation
        this year, the aggregate compensation to you over the last three years will be $5,850,000,
        which is less than the fees that you generated over the same period. Thus, our position will be
        that compensation for 2002 is provided, in part for services rendered in prior years. A similar,
        multi-year perspective was taken by the judge in Richard Ashare, P.C., 78 TCM 348, T.C.
        Memo 1999–282, where compensation in a law firm was paid in years following the years in
        which legal fees were generated.
        The reasonableness of your compensation is further supported by the factors elaborated in
        Mayson Manufacturing Co. v. Comm., 49-2 USTC ¶ 9467, 38 AFTR 1028, 178 F.2d 115
        (CA–6, 1949). In particular, your role in PLS is vital to the conduct of the company’s business;
        the business is complex and highly specialized and you are unique in your level of expertise.
        Furthermore, the revenues generated by PLS are attributable in full to your efforts. Based on
        your success in the class action case, I believe we have prima facie evidence that the proposed
        amount of compensation to be paid in 2002 is reasonable, especially in light of the increasing
        emphasis on the reasonable investor standard [e.g., see Alpha Medical, Inc. v. Comm., 99–1
        USTC ¶ 50,461, 83 AFTR2d 99–697, 172 F.3d 942 (CA–6, 1999)].

        A second issue that may arise as a result of your proposal pertains to the motivation for the
        compensation payment. The IRS may suggest that the increase in compensation ($2 million
        over fees received) this year is motivated primarily by the desire to recapture the taxes PLS
        paid in 2000 (via a net operating loss carryback) rather than to compensate you for services. If
        such an argument stands, then the compensation payment would not be deductible. Again, our
        case is substantially similar to the facts in Ashare. In that case, the attorney/sole shareholder
        was paid compensation in excess of revenues, generating a net operating loss carryback. The
        compensation was funded in part by the refund received as a result of the carryback. The judge
                    Corporations: E & P and Dividend Distributions                               10-19


     in Ashare indicated that, since compensation was reasonable and paid for services rendered in
     the past, evidence supported a motivation for compensating the sole employee over a
     tax-driven motive.

     If you have any further questions about the tax consequences of PLS’s 2002 compensation
     proposal, please do not hesitate to contact me.

     Sincerely yours,

     Jon S. Davis, CPA
     Partner

3.   a.                             Smith, Raabe, and Maloney, CPAs
                                     5191 Natorp Boulevard
                                       Mason, OH 45040


     November 20, 2002

     Bill Gateson
     601 Pittsfield Dr.
     Champaign, IL 61821

     Dear Bill:

     This letter is to provide you with our firm’s opinion regarding the likely tax consequences of
     the planned distribution of $4,000,000 of cash and securities from Egret Corporation to Aqua
     Corporation, followed by sale of Egret for $5,500,000. You expect the distribution to be taxed
     as a dividend since it is equal to the E & P of Egret Corporation. In addition, you expect to
     recognize no gain on the sale of Egret, since Aqua’s basis in the Egret stock equals the
     projected sales price. As you indicated in our phone conversation, the purpose of this plan is to
     (1) reduce the price of Egret stock, thereby facilitating a sale and (2) avoid tax on the sale of
     Egret.

     After much research, our firm has identified two cases that are similar to your situation. In the
     first case, a distribution was made after an offer was received for the subsidiary stock. In that
     situation, the court held that the dividend was, in substance, part of the sales price received for
     the subsidiary. Dividend treatment was disallowed and the distribution was taxed as a capital
     gain to the parent corporation.

     In the second case, which more closely resembles your situation, a distribution was made to the
     parent corporation in anticipation of a future sale of the subsidiary (no offer had yet been
     received). In this context, since no sale was in progress, the court allowed dividend treatment
     and the parent corporation had no taxable income or gain on the transaction.

     Provided that you do not publicly announce your intent to sell Egret Corporation or enter into
     any negotiations regarding a sale until after you make the $4,000,000 distribution, it is our
     opinion that you will receive the tax treatment you desire. In particular, the distribution will be
     treated as a dividend subject to the 100% dividends received deduction and no gain will be
     recognized on subsequent sale of Egret.
     If you have any additional questions regarding this matter, please do not hesitate to call me.

     Sincerely yours,
10-20                          2003 Entities Volume/Solutions Manual



        Jon S. Davis, CPA
        Partner

        TAX FILE MEMORANDUM


        November 20, 2002

        From: Jon S. Davis

        Subject: Proposed distribution, followed by sale of Egret Corporation

        Facts: Aqua Corporation is the sole shareholder of Egret Corporation. Aqua’s basis in Egret
        stock is $5.5 million. Egret has E & P of $4 million. The assets of Egret consist of software
        patents worth $5 million and cash and marketable securities of $4.5 million. For strategic
        business reasons, Aqua is planning on selling Egret Corporation sometime in the next two
        years. In anticipation of the sale, Aqua has considered two possibilities:

        (1)     Sell Egret for its current fair market value of $9.5 million. This would generate a gain
        on sale of $4 million.

        (2)     Distribute $4 million in cash and securities to Aqua as a dividend. The dividend would
        be tax free since Aqua is entitled to a 100% dividends received deduction. Then, sell Egret for
        $5.5 million, resulting in no taxable gain on sale.

        After considering these two possibilities, Aqua executives have decided the latter is preferable,
        provided that the expected tax consequences are correct. They have contacted our office to
        confirm the expected tax treatment of the distribution and subsequent sale.

        At issue: Is the distribution of $4 million in cash and securities properly treated as a dividend
        subject to the dividends received deduction, and is the subsequent sale of stock tax free?

        Discussion: Waterman Steam Ship Corporation, 50 T.C. 650 (1968), rev’d by 70–2 USTC
        ¶9514, 26 AFTR2d 70–5185, 430 F.2d 1185 (CA-5, 1970) involves a similar situation. In
        Waterman, a corporation received an offer to purchase the stock of its wholly-owned
        subsidiary. After receiving the offer, the subsidiary paid a dividend equal to the fair market
        value of the subsidiary’s stock less the parent corporation’s adjusted basis in the stock. The
        parent corporation argued that the dividend resulted in no taxable income (due to the 100%
        dividends received deduction under § 243(a)(3)), and no gain was recognized on the sale since
        the stock was sold at its adjusted basis. The court recast the dividend as sales proceeds and
        treated it as long-term capital gain using substance over form as a basis for the decision.

        Several features of the current case differ from the facts in Waterman. First, there is a good
        business reason for Egret to make a distribution. In particular, distributing assets currently will
        reduce the corporation’s value, thereby lowering any future sales price; this facilitates a
        business-motivated future sale. Second, and most important, no offer has yet been made to
        purchase Egret. Since no offer is outstanding, it would be difficult to argue that the dividend is
        properly treated as part of the sales price of Egret.
        Another case, more similar to the Aqua and Egret situation, is Litton Industries, Inc., 89 T.C.
        1086 (1987). In Litton, a large dividend was paid before the corporation attempted to sell its
        subsidiary. In particular, Litton did not announce its intention to sell the subsidiary until two
        weeks following the distribution. The Tax Court distinguished Litton from Waterman on these
                    Corporations: E & P and Dividend Distributions                               10-21


     grounds and allowed dividend treatment, together with the 100% dividends received
     deduction.

     Conclusion: Because the present situation is more similar to the facts in Litton Industries, we
     believe that Aqua is correct in its assessment of the tax consequences of the proposed
     transaction. The dividend should be properly offset by the 100% dividends received deduction
     and no gain should be recognized on the subsequent sale of the Egret stock.

4.   Section 162 allows as a deduction all ordinary and necessary business expenses. The term
     ―ordinary‖ refers to expenses that are common or frequently occurring in the context of the
     particular business [Deputy v. duPont, 40-1 USTC ¶ 9161, 23 AFTR 808, 60 S.Ct. 363 (USSC,
     1940)]. Necessary expenses are those that are appropriate or helpful to the taxpayer’s trade or
     business [Comm. v. Heininger, 44-1 USTC ¶ 9109, 31 AFTR 783, 64 S.Ct. 249 (USSC, 1943)].
     Finally, in order to be deducted, there must be a proximate relationship between the expense
     and business operations [Henry v. Comm., 36 T.C. 879 (1961)]. The determination of
     deductibility under each of these three conditions rests on the facts and circumstances of the
     case. Thus, reference to case law is necessary.
     A number of cases have some bearing on the question of deductibility for NetBiz. In David M.
     Connelly, 68 TCM 614, T.C. Memo. 1994-436, a plastic surgeon was the sole officer,
     shareholder and key employee of a medical corporation. Allegedly to promote and advertise
     medical services, the corporation leased a Rolls Royce Silver Shadow that was used by the
     doctor to attend medical conventions and for other business purposes. When disallowing the
     lease payments as a deduction, the court held in that case that the relation between leasing a
     Rolls Royce and enhancement of the taxpayer’s skill or reputation was “at best, dubious.” In
     addition, the court noted that no evidence was introduced suggesting that patients were
     attracted to the medical practice by virtue of the Rolls Royce.

     The reasoning in Connelly was followed in a subsequent unpublished decision, Mohan Roy,
     M.D., Inc. v. Comm., 99-1 USTC ¶ 50,588, 83 AFTR2d 99-2849 (CA-9, 1999). As in
     Connelly, Dr. Roy owned and was employed by a medical corporation, which purchased a
     Rolls Royce for his use in order to attract patients. Roy has greater similarity to NetBiz’s fact
     pattern because the doctor used the car only occasionally, for both business and personal
     reasons, and he kept the car at his home. In addition, as in the present case, Dr. Roy indicated
     in testimony that he rarely used the Rolls Royce because he thought it would discourage
     patient referrals. One possible distinction between the facts in Roy and the present case is that
     the taxpayer in Roy failed to provide adequate substantiation required under § 274(d).
     However, regardless of the substantiation issue, the court noted that Dr. Roy’s testimony
     regarding the expected negative impact on business, together with the car’s limited use (and
     personal use) undermined any claim that the automobile was an ordinary and necessary
     expense. No deduction for expenses related to the Rolls Royce was allowed in the case.
     In light of the above cases, it will be very difficult to make an argument for deductibility of the
     Ferrari’s operating expenses and depreciation. In order to do so, at a minimum, NetBiz will
     need to provide evidence that the Ferrari increased business (and perhaps compare the role
     played by an exotic car in medical practices and systems consulting). Corey’s belief that
     clients see the car as ostentatious works against this argument, however.

     With respect to the amount of constructive dividend received by Corey, the answer is unclear.
     In Joseph Proctor, 42 TCM 725, T.C. Memo. 1981-436, where a corporation’s automobile
     expense was disallowed because it was attributable to shareholders’ personal use, the value of
     the constructive dividend was deemed to be the fair market value of the benefits received (fair
     rental value plus operating expenses paid for by the corporation). This amount exceeded the
     amount of disallowed auto expenses. In contrast, in Roy and in Ruth Rodenbaugh, et al., 33
     TCM 169, T.C. Memo. 1974-36, the court judged the amount of dividend to be some portion of
10-22                          2003 Entities Volume/Solutions Manual


        disallowed expenses. In Rodenbaugh, the amount of operating expenses plus disallowed
        depreciation was deemed to be a constructive dividend, but no discussion regarding this
        judgment is provided in the decision. In Roy, the doctor testified that the fair rental value of the
        Rolls Royce was $85 to $96 per day. The IRS provided expert testimony regarding rental rates
        for a Rolls Royce, but the rates were several years old. The court rejected both testimonies as
        uninformative and, instead, used operating expenses (excluding disallowed depreciation) to
        determine value.

        Because of the Ferrari 550’s rarity, it will probably be difficult to find appropriate rental rates.
        Hence, it is likely that the court will find Corey’s dividend to be either operating expenses or
        operating expenses plus disallowed depreciation. Since Roy is the most similar case, the use of
        operating expenses as a measure of the dividend is probably reasonable.

5.      The Internet Activity research problems require that the student access various sites on the
        Internet. Thus, each student’s solution likely will vary from that of the others.

        You should determine the skill and experience levels of the students before making the
        assignment, coaching them where necessary so as to broaden the scope of the exercise to the
        entire available electronic world.

        Make certain that you encourage students to explore all parts of the World Wide Web in this
        process, including the key tax sites, but also information found through the web sites of
        newspapers, magazines, businesses, tax professionals, government agencies, political outlets,
        and so on. They should work with Internet resources other than the Web as well, including
        newsgroups and other interest-oriented lists.

        Build interaction into the exercise wherever possible, asking the student to send and receive
        e-mail in a professional and responsible manner.

6.      See the Internet Activity comment above.

7.      See the Internet Activity comment above.

								
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