630 MODULE 36 TAXES: CORPORATE
corporation is a pass-through entity and its items of income
and deduction flow through to be reported on shareholders'
returns .. Since Smith is a 50% shareholder, half of the ordi-
nary business income ($80,000 x 50% = $40,000) and half
of the tax-exempt interest ($6,000 x 50% = $3,000) would
pass through to Smith. Since the income passed through to
Smith would retain its .character, Smith must include the
$40,000 of ordinary income in gross income, while the
$3,000 of tax-exempt interest retains its exempt characteris-
tic and would be excluded from Smith's gross income.
Smith's $12,000 of stock basis at the beginning of the year
would be increased by the pass-through of the $40,000 of
ordinary income as well as the $3,000 of tax-exempt in-
come, to $55,000. As a result, the $53,000 cash distribution
received by Smith would be treated as a nontaxable return of
stock basis and would reduce the basis of Smith's stock to
$2,000.
129. (a) 'The requirement is to determine the effect of the
revocation statement on Dart Corp.'s S corporation election.
A revocation of an S election will be effective if it is signed
by shareholders owning more than 50% of the S corpora-
tion's outstanding stock. For this purpose.both voting and
nonvoting shares are counted. Here Dart Corp. has a total of
100,000 shares outstanding. As a result, the revocation
statement consented to by shareholders holding a total of
40,000 shares, would not be effective and would not termi-
nate Dart Corp.'s S corporation election.
130. (d) The requirement is to determine the incorrect
statement regarding S corporation eligibility requirements.
The eligibility requirements restrict S corporation sharehold-
ers to individuals (other than nonresident aliens), estates, and
certain trusts. Partnerships and C corporations are not per-
mitted to own stock in an S corporation. However, an S
corporation is permitted to be a partner in a partnership, and
may own any percentage of stock of a C corporation, as well
as own 100% of the stock of a qualified subchapter S sub-
sidiary.
131. (b) The requirement is to determine the portion of
the $310,000 distribution that must be reported as dividend
income by Robert. Distributions from an S corporation are
generally treated as first coming from its accumulated ad-
justment account (AAA), and then are treated as coming
from its accumulated earnings and profits (AEP). A positive
balance in an S corporation's AAA is generally nontaxable
when distributed because it represents amounts that have
already been taxed to shareholders during S years. In con-
trast, an S corporation's AEP represents earnings accumu-
lated during C years that have never been taxed to share-
holders, and must be reported as dividend income when
received. In this case, the beginning balance in the AAA
and shareholder stock basis must first be increased by the
pass through of the $200,000 of ordinary income that is
taxed to Robert for 2009. This permits the first $250,000 of
the distribution to be nontaxable and will reduce the balance
in the AAA to zero and Robert's stock basis to $50,000.
The remaining $60,000 of distribution is a distribution of the
corporation'S AEP and must be reported as dividend income
by Robert.
132. (b) The requirement is to determine the date on
which Village Corp.'s S status became effective. A sub-
chapter Selection that is filed on.or before the 15th day of
the third month of a corporation's taxable year is generally
effective as of the beginning of the taxable year in which
filed. If the S election is filed after the 15th day of the third
month, the election is generally effective as of the first day
of the corporation's next taxable year. Here, Village Corp.
uses a calendar year and its S election was filed on Septem-
ber 5,2009, which is beyond the 15th day of the third month
of the taxable year (March 15). As a result, Village's sub-
chapter S status becomes effective as of the first day of its
next taxable year, January 1,2010.
133. (d) The requirement is to determine whether a
. shareholder's basis in the stock of an S corporation is in-
creased by the shareholder's pro rata share of tax-exempt
interest and taxable interest. An S corporation is a pass
through entity and its 'items of income and deduction pass
through to be reported on shareholder returns. As a result, a
shareholder's S corporation stock basis is increased by the
pass through of all items of income, including both taxable
as well as tax-exempt interest. An S shareholder's stock
basis must be increased by tax-exempt interest in order to
permit a later distribution of that interest to be nontaxable.
134. (c) The requirement is to determine the amount of
income that should be allocated to Zinco Corp.'s short S
year when its S election is terminated on April 1, 2009.
When a corporation's subchapter S election is terminated
during a taxable year, its income for the entire year must be
allocated between the resulting S short year and C short
year. If no special election is made, the income must be
allocated on a daily basis between the Sand C short years.
In this case, the daily income equals $318,250/365 days =
$850 per day. Since the election was terminated on April 1,
there would be ninety days in the S short year, and $850 x
90 = $76,500 of income would be allocated to the tax return
for the S short year to" be passed through and taxed to share-
holders.
135. (d) The requirement is to determine the correct
statement regarding the termination of an S election. An-
swer (d) is correct because an S election will be terminated
if an S corporation has passive investment income in excess
of 25% of gross receipts for three consecutive taxable years,
if the corporation also has subchapter C accumulated earn-
ings and profits at the end of each of those three years. An-
swer (a) is incorrect because an S corporation is permitted to
have a maximum of one hundred shareholders. Answer (b)
is incorrect because a decedent's estate may be a shareholder
of an S corporation. Answer (c) is incorrect because S cor-
porations are allowed to make charitable contributions:
Contributions separately pass through to shareholders and
can be deducted as charitable contributions on shareholder
returns.
136. (b) The requirement is to determine the amount of
income from Manning (an S corporation) that should be
reported on Kane's 2009 tax return. An S corporation's tax
items are allocated to shareholders on a per share, per day
basis. Since Manning had income of $73,000 for its entire
year, its per day income is $73,000/365 = $200. Since there
are 100 shares outstanding, Manning's daily income per
share is $2001100 = $2. Since Kane sold twenty-five of his
shares on the .40th day of 2009 and held his remaining
seventy-five shares throughout the year, the amount of in-
come to be reported on Kane's 2009 return would be deter-
mined as follows: