Case #12: Stan and Casey Williams Case

Transcription

1 Case #12: Stan and Casey Williams Case NOTE: This is a difficult case. Watch who the question is asking about and their percentage of ownership. Stan and Casey Williams (married) have come to you for advice. Their primary concern is about Unique Products, Inc., an S corporation. Stan Stan is approaching age 55. He is in excellent health. His mother and father are still alive and in reasonably good health for their ages (80 s). Stan has seen the business grow from an operation out of Stan's garage to a multimillion dollar business. Stan runs the day to day business operations. Casey Casey just turned age 53. Her health is affected by her elevated blood pressure and borderline diabetes. She must watch her diet. This is difficult because she travels extensively. She is the marketing director for UP, Inc. Estate Planning Other than simple I to you wills, they have not done any estate planning. Sara Williams Stan and Casey s daughter Sara is age 24. She just graduated with her MBA in marketing. Sara was given stock in UP, Inc. through the years. The original stock was in a UTMA, but it was transferred to her when she turned age 21. All the transferred stock qualified under the annual exclusion. There have been no taxable gifts. She plans to join UP, Inc. and relieve her mother of some of her mother s marketing duties. For the past eight years, Sara has worked part time for UP, Inc. during the school year and full time in the summer (in excess of 750 hours per year). John Williams Stan and Casey s son John will be turning age 21 soon. He still has one year of college remaining. His plan is to continue his education and become an attorney. Stan and Casey have been paying the majority of his personal and college expenses. John has been given stock in UP, Inc. through the years. All the transferred stock qualified under the annual exclusion. There have been no taxable gifts. The stock is still in a UTMA account with Stan (his father) as a custodian. For the past four years, John has worked part time for UP, Inc. during the school year and full time in the summer (in excess of 750 hours per year). John s interest in UP, Inc. has waned. He is inclined to pursue other interests.

2 UP, Inc. Unique Products, Inc. started as a middleman between new startup companies who couldn t sell what they developed and distributors looking for new products. They buy the products and resell them. It has always been a problem for Casey to stop the distributor from bypassing UP, Inc. and going directly to the source. However, Casey has been successful in signing exclusive contracts to market many new products. Since UP, Inc. has been doing this for 20 years, UP, Inc. is well known for the services it performs. Stock Basis Stan Casey Contribution 20 years ago $ 50,000 $ 50,000 * Ordinary income over 20 years 600, ,000 Less gifts to children 100, ,000 Stock basis $550,000 $550,000 Debt Loan to UP, Inc. $500,000 $500,000 * After 20 years of leaving income in the company to avoid having to make bank loans, the company may suffer a small loss this year due to inventory being sold at a discount (due to product obsolescence). UP, Inc. Ownership % of Ownership Basis FMV Stan 40% $550,000 $2,000,000 Casey 40% $550,000 $2,000,000 Sara 10% $137,500 $ 500,000 John 10% $137,500 $ 500,000 Stan and Casey each take a salary of $200,000 per year. Due to a need for capital, they don t take distributions (income/profits). UP, Inc. used to be consistently profitable, but excess profits have slipped during the past few years (see profit sharing plan).

3 Stan and Casey Williams Statement of Financial Condition Assets Checking account (JT) $ 25,000 Money market (JT) 1 100,000 Profit sharing (S) 2 450,000 Profit sharing (C) 2 450,000 UP, Inc. (S) 3 2,000,000 UP, Inc. (C) 3 2,000,000 Loan to UP, Inc. (S) 4 500,000 Loan to UP, Inc. (C) 4 500,000 Commercial building (JT) 5 1,000,000 General investments (JT) 500,000 Home (JT) 400,000 Personal property (JT) 100,000 TOTAL $8,025,000 S Stan C Casey JT JTWROS 1 Currently paying 2% 2 The profit sharing plan was started 15 years ago. Prior to Tax Act 2001, the maximum of 15% was contributed. In the last few years, due to the competitive nature of UP, Inc. s business, plan contributions are down to 10%. The beneficiary of the plan is the spouse if living; if not, the children benefit equally. 3 FMV based on multiple factors 4 Loan interest is 5%. 5 The commercial building houses the Unique Products office and warehouse. Lease payments more than cover business expenses and produce some tax free income.

4 1. UP, Inc. owns and pays the premiums on a $2 million term life insurance policy on Casey. The policy is a key person policy. How are the premiums and death benefit treated? I. The death benefit will be subject to corporate AMT (gross receipts in excess of $7.5 million). II. The term premiums will reduce the shareholders basis (pro rata). III. The term life insurance proceeds will increase the shareholders basis (pro rata). IV. The premiums are deductible as a business expense. A. All of the above B. I, II, III C. I, II D. II, III E. IV 2. Stan and Casey own the UP, Inc. stock as tenants in common. How many eligible shareholders (for S status) do they count as? A. 1 B. 2 C. 3 D Did UP, Inc. lose its S status when Stan and Casey issued nonvoting common stock to their children s UTMA accounts years ago? A. Yes. For a corporation to qualify as an S corporation, it can have only one class of stock. B. No. An S corporation is permitted to have voting and nonvoting common stock. C. Yes. If the S corporation issued preferred nonvoting stock, the S election would have been broken.

5 4. Stan and Casey are considering transferring their S corporation stock ownership from tenant in common to individual grantor trusts. Which type of grantor trust would you suggest? A. A revocable intervivos trust or living trust B. A testamentary trust C. A qualified subchapter S trust (QSST) D. A qualified terminable interest property (QTIP) trust 5. If Stan dies before John turns age 21, will John s stock be included in Stan s estate? A. No, the owner of the UTMA is John, not Stan. B. No, the gift of the stock was a completed gift. C. Yes, the Stan was the donor. D. Yes, the UTMA will revert to Stan. 6. UP, Inc. pays for the family s medical insurance. How is the medical insurance premium treated for tax purposes? I. Payments are treated as wages for withholding and FICA taxes. II. Payments are deductible by the corporation. III. Payments are not deductible by the corporation. IV. More than 2 percent shareholders are denied fringe benefits. A. I, II B. I, III C. I D. III E. IV 7. UP, Inc. owns a large life insurance policy on Casey. Since the corporation has over $7.5 million annually in gross receipts, will UP, Inc. be subject to corporate AMT? A. Yes because the policy is owned by UP, Inc. B. Yes because the gross receipts exceed $7.5 million C. No because it is an S corporation D. No because the policy is used as a key person policy, not an entity purchase policy

6 8. When UP, Inc. was formed some years ago, which method of accounting did Stan and Casey have to elect? A. Cash. UP, Inc. had gross receipts of less than $5 million. B. Accrual C. Hybrid D. LIFO 9. The distributions paid by UP, Inc. are which of the following? A. tax free B. a return of basis C. taxable D. subject to self employment tax 10. Last year, Stan and Casey each were paid a salary of $200,000. In addition, UP, Inc. had income of $50,000 that was not distributed. How much self employment tax (do not count Medicare tax) did Stan and Casey have to pay? A. $0 B. $7, C. $13, D. $26, UP, Inc. anticipates a small loss ($100,000) in the current year. Can Sara and John take the loss against income? A. No, they don t materially participate. B. No, they have no earned income. C. No, they have no investment income. D. Yes, they materially participate. E. Yes, they have investment income. 12. If the loss is $100,000, how much of the loss can Sara and John take individually? A. $0 B. $5,000 C. $10,000 D. $13,750 E. $20,000

7 13. In regard to the $100,000 loss, how will Stan s basis be affected? A. His stock basis will be reduced by $40,000 to $510,000. B. His loan will be reduced by $40,000 to $460,000. C. His stock basis will be reduced by $20,800, and his debt will be reduced by $19,200. D. He will be limited to a $3,000 loss unless he has capital gains. 14. If UP, Inc. needs more working capital (planned expansion) and UP, Inc. takes a loan (corporate debt) of $1,000,000, how will the loan interest of $70,000 (7% interest) be treated if it is part of a future loss? A. As investment interest expense, reducing basis B. As an ordinary loss, reducing basis C. As nondeductible, increasing basis D. S corporation shareholders are not responsible for corporate debt. 15. Let s say that due to the planned expansion of UP, Inc., income increases by $150,000, and distributions increase by $100,000. How would Stan s basis be affected? A. Increased by $20,000 B. Decreased by $20,000 C. Increased by $100,000 D. Decreased by $100,000 E. Increased by $50, Stan and Casey are considering adding 401(k) provisions to the UP, Inc. profit sharing plan. Which of the following is true? A. S corporation owners cannot participate in 401(k) deferrals (5% ownership rules). B. Stan and Casey could defer $17,500 plus $5,500 catch up. C. Employer contributions would be limited to 25% of compensation. D. All the employees must participate.

8 17. Casey travels extensively on business. Her entertainment expenses for the past year were $25,000. Which of the following is/are true? A. I, II, IV B. I, III C. I D. III E. IV I. The company can reimburse her for 100% of the entertainment expenses. II. The company will only be able to deduct 50% of the entertainment expenses. III. The other 50% is subject to unreimbursement business expenses (less 2% of AGI). IV. Casey will be taxed on $5,000 of entertainment expenses. 18. If Casey should die and the death benefit of the $2,000,000 term life insurance policy is paid to UP, Inc., what would be the value of the stock inherited by Stan? A. Casey s basis plus the pro rata basis share of the $2 million of key person term life insurance B. $550,000 C. $1,500,000 D. Fair market value on the date of death E. Fair market value using the 6 month alternative valuation date 19. Last year, UP Inc, had income of $50,000 which was not distributed. How did that affect Stan and Casey tax wise? I. The basis in their stock increased by $40,000 ($20,000 each). II. They paid taxes on $40,000 at ordinary income tax rates. III. They paid taxes on $50,000 of 1231 capital gains. IV. The $40,000 was phantom income to them. A. I, II, IV B. II C. III, IV D. III E. IV

9 Case 12 Answers 1. Answer: D S corporations are not subject to corporate AMT. Only C corporations with gross receipts in excess of $7.5 million would be subject to corporate AMT. Life insurance premiums are not deductible as a business expense. Premiums for term insurance should reduce a shareholder s basis. It is an expense that the corporation cannot deduct. Therefore, it is charged as income to the shareholders. An expense that cannot be deducted has to be charged to the shareholders of an S Corp. Income is charged to the owners on a K-1. Life insurance death benefits increase the S corporation stockholder s basis. 2. Answer: A When stock is held jointly by a husband and wife either as joint tenants or as tenants in common, the husband and wife are treated as one shareholder. Husband and wife, no matter the ownership, is always 1. Note: the question is only asking about Stan and Casey, not their children. When stock is held by a custodian under the UTMA, the minor is deemed the owner, not the custodian. 3. Answer: B Answer C is also true, but it doesn t answer the question. The question says that nonvoting common stock was issued. 4. Answer: A There are six types of trusts that are permitted to be S corporation shareholders. All four of the trusts listed qualify, but Answer A is the best answer. A grantor trust would minimize probate costs. The testamentary trust can only hold the stock for two years. In two years or less, the testamentary trust becomes a QSST, and the S election will be lost. The QSST is useful for legal support and income situations. 5. Answer: C It will be included in Stan s estate should he predecease John before John turns age 21. The main issue for the exam is the donor - custodian (beneficial enjoyment). The case information says Stan is the custodian. The answer C says he is the donor. It is the donor-custodian relationship the exam is looking for. There are two different usages of the word "owner". The son is the owner for S corporation ownership because he is the owner of the UTMA. But the father is both the donor and custodian of the UTMA. If the father dies before the son turns 21, then UTMA will be included in his estate under beneficial enjoyment rules. This is in the Live Review book E-30 and more spelled out in the prestudy. 6. Answer: A Health insurance paid on more than 2% owners is changed to them as income. Then it is deductible by the corporation sentence is not part of this question/answer, but important to know. Then the health premium is deductible on the front of the Reference Page T-5 of the Live Review. 7. Answer: C Only C corporations with gross receipts in excess of $7.5 million annually are subject to corporate AMT.

10 8. Answer: B UP, Inc. does not manufacture anything. UP, Inc. buys and resells inventory. LIFO is an inventory method. 9. Answer: B Until basis is used up, the excess earnings are a return of basis. Tax free isn t the best answer. In regard to the gift to the UTMA account, a donee s basis in the S corporation stock received as a gift is generally equal to the basis of the stock in the hands of the donor. 10. Answer: A S corporation salaries are subject to FICA, not self-employment tax. Nondistributions and distributions are both treated as unearned income. 11. Answer: D A shareholder is deemed to materially participate if the individual satisfies one of several rules. (One rule is the 500 hour test regarding material participation.) Tough question. 12. Answer: C The question is asking about the children's ownership, not the parent's ownership. Each owns 10% of the stock of the company individually. 10% of $100,000 is the loss each of them can take. 13. Answer: A A shareholder is allowed to deduct losses from S corporation operations against his basis in loans to the corporation after the stock basis is reduced to zero. Note: If you read the question carefully, it says how will Stan s basis be affected? not his loan to the company. Remember he is a 40% owner so 40% of the $100,000 loss is allocated to him. His basis on page 2 is $550,000 plus his loan of $500,000 to UP, Inc. 14. Answer: A Deductions (losses) are broken down to separately stated (investment interest expense) and nonseparately stated. An S corporation s investment interest expense (and investment income) passes through to its shareholders. It remains separate and is subject to the characteristics of investment interest expense. Although Answer D is true (limited liability), the question is asking about the interest not the debt. 15. Answer: A Income $150,000 (Increases the basis) less distributions 100,000 (Decreases the basis) $ 50,000 (Increases the basis) Ownership 40% Basis increase $ 20,000 The question is only asking about Stan (owns 40%). The $50,000 is not distributed and creates phantom income. The phantom income creates the basis increase. 16. Answer: B S corporations can do any type of qualified plan or SIMPLE/SEP plan. Answer C is wrong for various reasons. The compensation level is not spelled out ($265,000), and it is limited by the

11 lesser of 100% of compensation or $53,000. Answer D is wrong. A certain percentage of employees must participate. 17. Answer: A Nasty. Only 50% of the entertainment is deductible ($12,500). The other $12,500 is allocated pro rata (ownership) to the shareholders. $12,500 x 40% = $5,000 (Answer IV) This is an S corporation (conduit). He is a 40% owner. Go to tax page 9 of the "Live Review". It is one step beyond a C corporation answer. In a C, the employee can be reimbursed in full, and the corporation can deduct 50%. The corporation pays tax on the other 50%. In an S, the employee can be reimbursed in full, and the corporation can deduct 50%. But he other 50% is not deductible by the S and is taxed to the shareholder as conduit income. 18. Answer: D Since all the property owned by Casey is inherited by Stan, Stan will get a step-up in basis to FMV on the date of death. The alternative valuation date cannot be used if there is no estate tax due. 19. Answer: A The income increases their basis. It is taxed at ordinary income tax rates (phantom income). Special note: The basic rule of pass-through is that an item of income, expense, and so on remains separate and may be subject to special treatment. Income can be Section 1231 gain or loss, but the case data would have to indicate the situation. They only own 40% each (80% total). $50,000 x 40% = $20,000 each Answer IV is true. The $50,000 was phantom income. (80% of $50,000)