Pearson’s Federal Taxation 2022: Corporations, Partnerships, Estates, and Trusts, 35e

(Anderson et al.)
Chapter C5: Other Corporate Tax Levies

LO1: Use of C Corporation to Avoid Income Taxes

1) A high tax bracket individual can enhance the avoidance of income taxes through a C
corporation by having the corporation retain its after tax earnings rather than paying them out as
a dividend.
Answer: TRUE
Explanation: A high tax bracket individual can enhance the avoidance of income taxes through a
C corporation by having the corporation retain its after tax earnings rather than paying them out
as a dividend.
Page Ref.: C:5-2
Objective: 1

2) A high tax bracket individual can enhance the avoidance of income taxes through a C
corporation by having the corporation retain its after tax earnings so that when the individual
dies, his or her heirs can liquidate the corporation and realize little to no gain because of a step-
up in basis.
Answer: TRUE
Explanation: A high tax bracket individual can enhance the avoidance of income taxes through a
C corporation by having the corporation retain its after tax earnings so that when the individual
dies, his or her heirs can liquidate the corporation and realize little to no gain because of a step-
up in basis.
Page Ref.: C:5-2
Objective: 1

3) A low tax bracket individual can enhance the avoidance of income taxes through a C
corporation by having the corporation retain its after tax earnings rather than paying them out as
a dividend.
Answer: FALSE
Explanation: Still subject to AE tax
Page Ref.: C:5-2
Objective: 1

4) In years beginning in 2018 through 2020, any minimum tax credit carryover from prior
alternative minimum tax.years will be allowed to the extent of the regular tax liability plus 50%
of the excess of the minimum tax credit over the amount credited against the regular tax.
Answer: TRUE
Explanation: In years beginning in 2018 through 2020, any minimum tax credit carryover from
prior alternative minimum tax.years will be allowed to the extent of the regular tax liability plus
50% of the excess of the minimum tax credit over the amount credited against the regular tax.
Page Ref.: C:5-2
Objective: 1

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LO2: Personal Holding Company Tax

1) Wind Corporation is a personal holding company. Its taxable income for this year is $100,000.
The corporation's charitable contributions are $5,000 greater than its income tax charitable
contribution deduction limitation. Wind's UPHCI is $95,000, assuming no other adjustments
must be made.
Answer: TRUE
Explanation: 100,000 - 5,000 = 95,000
Page Ref.: C:5-6 and C:5-7
Objective: 2

2) The personal holding company tax might be imposed

A) on both partnerships and corporations.
B) on companies whose gross income arises solely from rentals, if the lessors render no services
to the lessees.
C) if more than 50% of the company is owned by five or fewer individuals for the entire year.
D) on small business investment companies licensed by the Small Business Administration.
Answer: C
Explanation: 5 or fewer individuals triggers PHC.
Page Ref.: C:5-15
Objective: 2

3) Foster Corporation has gross income for regular tax purposes of $100,000, which includes a
net Sec. 1231 gain of $10,000 and a net capital gain of $10,000. Ordinary gross income for
personal holding company purposes is
A) $70,000.
B) $80,000.
C) $90,000.
D) $100,000.
Answer: B
Explanation: 100,000 -10,000 -10,000 = 80,000
Page Ref.: C:5-15
Objective: 2

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4) Identify which of the following statements is false.
A) Askew Corporation has ten unrelated shareholders, each of whom owns 10% of the
outstanding stock. This corporation is a personal holding company.
B) Stock owned by an individual, in addition to stock attributed from her spouse, parents,
children, and siblings, are all counted towards whether or not the personal holding company
stock ownership test has been met.
C) S corporations and tax-exempt organizations are excluded from the personal holding company
(PHC) definition.
D) A person who holds an option to acquire stock is considered to own the stock for purposes of
the PHC stock requirements.
Answer: A
Explanation: 5 or fewer
Page Ref.: C:5-15
Objective: 2

5) Identify which of the following statements is true.

A) The personal holding company tax is levied to prevent closely held corporations from
sheltering passive income.
B) Caleb Corporation is owned by a mother and her two daughters. It reports $100,000 of rental
income; $30,000 of depreciation, interest, and property taxes on the rental real estate; and
$10,000 of dividend income. Caleb Corporation is classified as a personal holding company.
C) Luke Corporation is owned by a father and his son. The corporation employs 10 individuals
to provide public accounting services. Father and son make all of the work assignments for the
professional employees. The professional fees earned by the corporation are personal holding
company income.
D) The personal holding company taxes that are paid by a corporation can be used as a credit
against its regular tax amount.
Answer: A
Explanation: The personal holding company tax is levied to prevent closely held corporations
from sheltering passive income.
Page Ref.: C:5-14
Objective: 2

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6) Identify which of the following statements is true.
A) The personal holding company taxes that are paid by a corporation can be used as a credit
against its regular tax amount.
B) Whether a corporation is subject to the personal holding company tax is determined by using
two objective tests, while the determination of whether a corporation is subject to the
accumulated earnings tax is determined subjectively.
C) Income from personal service contracts are not included in personal holding company
income.
D) Luke Corporation is owned by a father and his son. The corporation employs 10 individuals
to provide public accounting services. Father and son make all of the work assignments for the
professional employees. The professional fees earned by the corporation are personal holding
company income.
Answer: B
Explanation: Whether a corporation is subject to the personal holding company tax is
determined by using two objective tests, while the determination of whether a corporation is
subject to the accumulated earnings tax is determined subjectively.
Page Ref.: C:5-15 and C:5-22
Objective: 2

7) The personal holding company penalty tax rate is

A) 20%.
B) 10%.
C) 15%.
D) 35%.
Answer: A
Explanation: PHC tax rate is 20%.
Page Ref.: C:5-19
Objective: 2

8) Which of the following is not an adjustment to taxable income when computing the personal
holding company tax?
A) dividends-received deduction
B) dividends-paid deduction
C) NOL carryover from immediately preceding tax year
D) All of the above are adjustments.
Answer: D
Explanation: See C5-20
Page Ref.: C:5-20; Figure C:5-2
Objective: 2

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9) Identify which of the following statements is false.
A) The 80% dividends-received deduction can be claimed when computing a corporation's
undistributed personal holding company income (UPHCI).
B) Rental expenses in excess of rental income are added back to taxable income to arrive at
personal holding company income (PHCI).
C) Wind Corporation is a personal holding company. Its taxable income for this year is
$100,000. The corporation's charitable contributions are $5,000 greater than its income tax
charitable contribution deduction limitation. Wind's UPHCI is $95,000, assuming no other
adjustments must be made.
D) The PHC tax is assessed at 20%.
Answer: A
Explanation: Cannot be claimed
Page Ref.: C:5-20
Objective: 2

10) Identify which of the following statements is true.

A) Consent dividends are cash dividends paid following an authorizing vote of the shareholders.
B) Dividends that are paid in the two preceding tax years can be used as a dividend carryover to
reduce the amount of the current year's personal holding company (PHC) tax liability.
C) Dividends paid by a personal holding company in the first 2 1/2 months of a tax year are
automatically throwback dividends.
D) All of the above are false.
Answer: B
Explanation: Dividends that are paid in the two preceding tax years can be used as a dividend
carryover to reduce the amount of the current year's personal holding company (PHC) tax
liability.
Page Ref.: C:5-20 and C:5-23
Objective: 2

11) Identify which of the following statements is true.

A) A deficiency dividend is included in the shareholder's gross income for his/her tax year that
includes the last day of the tax year in which the personal holding company claims a dividends-
paid deduction.
B) A shareholder who receives a deficiency dividend must report the dividend as gross income
for the tax year that includes the last day of the distributing corporation's tax year on which it
was a PHC.
C) A personal holding company's payment of a deficiency dividend eliminates its need to pay the
personal holding company tax as well as any interest and underpayment penalties on the tax
deficiency.
D) All of the above are false.
Answer: D
Explanation: See C5-22
Page Ref.: C:5-20 and C:5-23
Objective: 2

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12) A personal holding company cannot take a dividends-paid deduction for
A) throwback dividends.
B) consent dividends.
C) deficiency dividends.
D) preferential dividends.
Answer: D
Explanation: Preferential dividends are not eligible for DRD
Page Ref.: C:5-20 and C:5-23
Objective: 2

13) Dragon Corporation reports a distribution on its return from the third previous year as a stock
redemption producing a capital gain. When the return is audited during the current year, the
distribution of the third previous year is characterized by the IRS as a dividend. This change
causes Dragon Corporation to be classified as a personal holding company for the third previous
year. Which of the following statements is correct?
A) Dragon Corporation will owe interest and/or underpayment penalty even if the PHC tax is
avoided by a deficiency dividend.
B) Dragon Corporation will owe no interest and/or underpayment penalty if the PHC tax is
avoided by a deficiency dividend.
C) A deficiency dividend is not permitted to be paid by Dragon.
D) A dividend must be paid within 120 days of establishing the PHC tax liability and a claim for
a dividends-paid deduction must be filed within 90 days of the determination date.
Answer: A
Explanation: Dragon Corporation will owe interest and/or underpayment penalty even if the
PHC tax is avoided by a deficiency dividend.
Page Ref.: C:5-20 and C:5-23
Objective: 2

14) Which of the following actions cannot be used to eliminate a possible personal holding
company tax liability involving a corporation owned by a mother and a father?
A) Sell additional stock to other family members.
B) Make a cash distribution within 2 1/2 months of the end of the tax year.
C) Make a deficiency distribution within 90 days of the date on which the IRS determines that a
personal holding company liability is owed.
D) Liquidate the corporation.
Answer: A
Explanation: Attribution rules
Page Ref.: C:5-20 and C:5-23
Objective: 2

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15) The personal holding company tax
A) may be imposed regardless of the number of equal stockholders in a corporation.
B) may be eliminated by the payment of a deficiency dividend.
C) qualifies as a tax credit, which may be used by the shareholders to reduce their individual
income taxes.
D) applies to any corporation whose shareholders satisfy the stock ownership requirement.
Answer: B
Explanation: Deficiency dividend may eliminate PHC tax.
Page Ref.: C:5-11
Objective: 2

16) Smartmoney, Inc. was formed by three wealthy dentists to pool their investment funds. They
each invested $200,000 in the corporation, which was immediately used to purchase stocks to be
held as investments. The first year, the corporation received dividends of $70,000 and filed a tax
return paying a corporation tax in the amount of $7,350 [($70,000 dividends - $35,000 DRD)
× .21 = $7,350]. The IRS audits this corporation and sends a tax bill in the amount of $12,530
($62,650 UPHCI × 0.20 = $12,530) plus underpayment penalty and interest. What is this
additional tax and what should the dentists do about it? What action(s) do you recommend the
corporation take for the tax year in question and subsequent tax years?
Answer: This additional tax that was imposed is the personal holding company tax. The dentists
should arrange to have the corporation pay deficiency dividends so as to avoid the penalty tax.
The interest and penalties that have been imposed cannot be avoided by the payment of the
deficiency dividend. The dentists should consider liquidating the corporation and have the assets
held individually by the shareholders. The liquidating distributions are eligible for the dividends-
paid deduction and can reduce the UPHCI amount. An S election might be considered. It could
alleviate the personal holding company problem for future tax years, but not for prior tax years.
Page Ref.: C:5-21 and C:5-22
Objective: 2

17) Investors Corporation has ten unrelated individual shareholders who each own 10% of the
outstanding stock. For their tax year ended December 31 of this year, Investors' gross income
includes:

Interest on federal government obligations $10,000

Dividends from savings and loan associations
on passbook savings accounts $2,000
Interest earned on notes receivable $5,000
Net rental income $3,000

No dividends are paid during the tax year or during the 2-1/2 month throwback period.
Deductible administrative expenses total $4,000 for the year. Rental income has been reduced by
$1,000 of depreciation and $2,000 of interest expense. What is Investors' undistributed personal
holding company income?
Answer: Investors is not a personal holding company since it is not more than 50% owned by
five or fewer shareholders.
Page Ref.: C:5-15
Objective: 2

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18) Khuns Corporation, a personal holding company, reports the following:

Rental income $50,000

Depreciation 10,000
Interest expense 5,000
Real estate taxes 2,000
Maintenance expenses 5,000
Administrative expenses 5,000

Calculate Khuns Corporation's adjusted income from rents (AIR).

Answer:
Rental income $50,000
Minus: depreciation (10,000)
interest ( 5,000)
Real estate taxes ( 2,000)
Adjusted income from rents $33,000
Page Ref.: C:5-16; Example C:5-14
Objective: 2

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19) Lake Corporation is a personal holding company. Lake reports the following results for the
current year:

Rental income $100,000

Operating profit 80,000
Dividend income 30,000
Interest income 20,000
Depreciation 30,000
Mortgage interest expense 18,000
Real estate taxes 8,000
Other expenses 20,000

No dividends are paid during the current year or the 2-and-one-half-month throwback period.
The mortgage relates to the rental properties. Calculate the adjusted income from rents exclusion
from personal holding company income.
Answer: OGI $230,000
Minus:
rental expenses ( 56,000)
AOGI $174,000

Rental income $100,000

Minus: depreciation ( 30,000)
interest ( 18,000)
real estate taxes ( 8,000)
AIR $ 44,000

The rents cannot be excluded since AIR ($44,000) does not exceed 50% of AOGI ($87,000 =
$174,000 × 0.50).
Page Ref.: C:5-18; Example C:5-15
Objective: 2

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20) Eagle Corporation, a personal holding company, has the following results:

Taxable income $200,000

Dividends-received deduction 30,000
Excess charitable contributions 10,000
Long-term capital gains 10,000
Federal income taxes 61,000

Calculate the PHC tax.

Answer:
Taxable income $200,000
Plus: dividends-received deduction 30,000
Minus:
excess charitable contributions ( 10,000)
Long-term capital gains (net of taxes)* ( 7,900)*
Federal income taxes ( 42,000)
Undistributed personal holding company income $170,100
Times: rate × 0.20
Personal holding company tax $ 34,020

*$10,000 - (0.21 × $10,000) = $7,900

Page Ref.: C:5-22; Example C:5-18
Objective: 2

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21) Raptor Corporation is a PHC for 2019 and reports $200,000 of taxable income on its federal
income tax return.

Operating profit $100,000

Long-term capital gain 80,000
Dividends (20%-owned corporation) 90,000
Interest 100,000
Gross income 370,000
Salaries expense (50,000)
General and administrative expense (25,000)
Dividends-received deduction (72,000)
Taxable income $223,000
Regular tax liability $ 46,830

What is Raptor's PHC tax, assuming that it does not pay any dividends?
Answer:
Taxable income 223,000
Less: federal tax (46,830)
Less: Net capital gain (net of taxes)* (63,200)
Plus DRD 72,000
PHCI 184,970
PHC Tax (0.20 tax rate) 36,994

* 80,000 - (80,000 * .21) = 63,200

Page Ref.: C:5-21 and C:5-22
Objective: 2

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22) Mullins Corporation is classified as a PHC for the current year, reporting $263,000 of
taxable income on its federal income tax return:

Operating profit $150,000

Long-term capital gain 20,000
Short-term capital gain 20,000
Dividends (from 25%-owned domestic corporation) 200,000
Interest 150,000
Gross income $540,000
Minus:
general and administrative expenses ( 40,000)
Minus: salaries ( 30,000)
"Adjusted" taxable income $470,000
Minus: charitable contributions ( 47,000)
Taxable income before special deductions $423,000
Minus: dividends-received deduction (130,000)
Taxable income $293,000

Actual charitable contributions made by Mullins Corporation were $75,000. What are the federal
income tax due and the personal holding company (PHC) tax liability? Discuss the methods (if
any) by which payment of the PHC tax can be avoided.
Answer:
Corporate Income tax liability (293,000 * .21) $61,530

Taxable income $293,000

Plus: dividends-received deduction 130,000
Minus: excess charitable contributions ($75,000 - $47,000) ( 28,000)
Federal income tax ( 61,530)
Long-term capital gain (net of taxes) ( 15,800)a
UPHCI $317,670
Times: tax rate × 0.20
PHC tax $ 63,534

a$20,000 - ($20,000 × 0.21) = $15,800

Payment of the PHC tax can be avoided by paying a timely deficiency dividend in the amount of
$296,980.
Page Ref.: C:5-22; Example C:5-18
Objective: 2

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23) What is a personal holding company?
Answer: A personal holding company is any corporation that (1) has five or fewer individual
shareholders who own more than 50% of the corporation's outstanding stock at any time during
the last half of its tax year, and (2) has personal holding company income that is at least 60% of
its adjusted ordinary gross income for the tax year. Corporations that have certain special tax
status generally are excluded from the PHC definition. Among those excluded are S corporations
and tax-exempt organizations.
Page Ref.: C:5-14
Objective: 2

24) Define personal holding company income.

Answer: Personal holding company income includes dividends, interest, annuities, adjusted
income from rents, royalties, produced film rents, income from personal service contracts
involving a 25% or more shareholder, rental income for corporate property used by a 25% or
more shareholder, and distributions from estates or trusts.
Page Ref.: C:5-16
Objective: 2

25) What is the effect of the two-pronged test that allows the exclusion from PHCI of certain
AIR (adjusted income from rents)?
Answer: The effect of the two-pronged test is that it makes it difficult to use rents to shelter
other passive income. PHCI does not include rents if (1) AIR is at least 50% of AOGI, and (2)
the dividends-paid deduction equals or exceeds the amount by which nonrental PHCI exceeds
10% of OGI.
Page Ref.: C:5-17
Objective: 2

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26) Church Corporation is a closely held C corporation. All of the stock is owned by Charles and
Chanda Church. The corporation, in its second month of operation in its initial tax year,
anticipates earning $150,000 of gross income in the current year. Gross income is expected to be
approximately 40% dividends, 30% corporate bond interest, and 30% net real estate rentals (after
interest, property taxes, and depreciation). Administrative expenses are expected to be $20,000.
What special problems does the large amount of passive income that Church Corporation expects
to earn present to you as their CPA?
Answer: The following tax issues need to be addressed about Church Corporation's first year of
operations:

• Will Church Corporation be classified as a PHC based on its first-year income projections?
Do the projections forecast that this will be a long-term problem?
• If Church Corporation is projected to be a PHC for its initial year of operation, what action
can be taken before year-end to avoid being classified as a PHC?
• Would Church Corporation benefit by making a timely S election applicable to its initial tax
year? To a later tax year?
• If Church Corporation is a PHC for its initial year of operation, what action (e.g., throwback
distributions) can be taken after year-end to avoid incurring the PHC penalty tax?

Projections indicate that 70% of Church Corporation's gross income will be interest and
dividends. The remaining 30% is net rental income. Therefore, it appears that all of Church's
income is personal holding company income. Since Church has only two shareholders (both of
whom are related), it is quite likely that Church Corporation will be classified as a personal
holding company. Church can attempt to change the nature of its activities to increase net rental
income above 50% of AOGI and reduce the level of other PHCI earned (e.g., dividends and
interest). If such changes are made, perhaps personal holding company status can be avoided in
the initial tax year. If personal holding company status cannot be avoided for the initial year, the
PHC can pay a large enough amount of dividends to minimize the penalty tax, interest, and
penalties. Alternatively, Church Corporation might consider an S election for its initial year or its
second year, although the built-in gains tax may pose a possible problem when the corporation
has retained C corporation status in its initial tax year and makes an S election for its second tax
year.
Page Ref.: C:5-16 through C:5-17
Objective: 2

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LO3: Accumulated Earnings Tax

1) A corporation can be subject to both the accumulated earnings tax and the personal holding
company tax in the same year.
Answer: FALSE
Explanation: A corporation can NOT be subject to both the accumulated earnings tax and the
personal holding company tax in the same year.
Page Ref.: C:5-12
Objective: 3

2) To avoid the accumulated earnings tax, a corporation needs to have a definite plan for
expending the accumulated earnings.
Answer: TRUE
Explanation: To avoid the accumulated earnings tax, a corporation needs to have a definite plan
for expending the accumulated earnings.
Page Ref.: C:5-13
Objective: 3

3) The accumulated earnings tax does not apply to corporations that

A) have more than one class of stock.
B) are personal holding companies.
C) are members of a controlled group.
D) are closely held corporations.
Answer: B
Explanation: PHC are not subject to AE tax
Page Ref.: C:5-13
Objective: 3

4) Identify which of the following statements is true.

A) A corporation can be subject to both the accumulated earnings tax and the personal holding
company tax in the same year.
B) The accumulated earnings tax is applied to a corporation's earnings. If the earnings are not
subsequently distributed, the earnings will be taxed again under the accumulated earnings tax the
next year.
C) The accumulated earnings tax is not levied on the corporation's total accumulated earnings
balance, but only on its current-year addition to the balance.
D) The accumulated earnings tax is levied on the corporation's total accumulated earnings
balance, but only on its current-year addition to the balance.
Answer: C
Explanation: The accumulated earnings tax is not levied on the corporation's total accumulated
earnings balance, but only on its current-year addition to the balance.
Page Ref.: C:5-13
Objective: 3

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5) Which of the following entities is subject to the accumulated earnings tax?
A) Sec. 501 tax-exempt corporation
B) personal holding company
C) C corporation
D) S corporation
Answer: C
Explanation: AE tax is subjected to corporations
Page Ref.: C:5-13
Objective: 3

6) Identify which of the following statements is true.

A) In practice, the accumulated earnings tax applies only to closely held corporations.
B) A corporation bears the burden of proving that its earnings are not being accumulated to avoid
income taxes.
C) To avoid the accumulated earnings tax, a corporation needs to have a definite plan for
expending the accumulated earnings.
D) All of the above are true.
Answer: D
Explanation: See C5-23
Page Ref.: C:5-23
Objective: 3

7) Which of following generally does not indicate an unreasonable earnings accumulation?

A) loans to shareholders
B) expenditure of corporate funds for the personal benefit of the shareholders
C) planned expansion of business facilities
D) investments in properties or securities unrelated to the activities of the corporation
Answer: C
Explanation: Future planned expansions are reasonable earnings accumulation.
Page Ref.: C:5-23 through C:5-25
Objective: 3

8) All of the following are recognized as reasons for accumulating earnings except
A) working capital needs.
B) product liability loss reserves.
C) redemption of stock of deceased shareholder.
D) All of the above are recognized reasons for accumulating earnings.
Answer: D
Explanation: See C5-25
Page Ref.: C:5-12
Objective: 3

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9) When using the Bardahl formula, an increase in annual credit sales (while holding the average
accounts receivable balance constant) has which of the following effects on the working capital
requirements?
A) increase
B) decrease
C) no effect
D) increase, decrease, or no effect, depending on other factors
Answer: B
Explanation: Reduction in working capital. A/R cycle would be less and therefore operating
would be less.
Page Ref.: C:5-16 through C:5-17
Objective: 3

10) Identify which of the following statements is true.

A) The Bardahl formula is based on the firm's inventory period, receivables period, credit period,
and total cash expenditures for cost of sales and operating expenses.
B) The Bardahl formula uses the concept of working capital, cash over current liabilities.
C) The Bardahl formula provides mathematical exactness when calculating reasonable working
capital needs for accumulated earnings tax purposes.
D) All of the above are false.
Answer: A
Explanation: The Bardahl formula is based on the firm's inventory period, receivables period,
credit period, and total cash expenditures for cost of sales and operating expenses.
Page Ref.: C:5-16 through C:5-17
Objective: 3

11) When using the Bardahl formula, an increase in accounts payable (while holding purchases
and operating expenses constant) has which of the following effects on the working capital
requirements?
A) increase
B) decrease
C) no effect
D) increase, decrease, or no effect, depending on other factors
Answer: B
Explanation: Reduction in working capital. Additional working capital required to pay for
increase in A/P.
Page Ref.: C:5-16 through C:5-17
Objective: 3

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12) Identify which of the following statements is true.
A) A corporation accumulates earnings to fund the redemption of a shareholder's stock following
her death so as to provide her estate with liquidity to pay death taxes. Such an accumulation of
earnings is a reasonable business need.
B) A corporation accumulates earnings to fund a buy-sell agreement. Such an accumulation of
earnings is a reasonable business need.
C) A corporation's net capital gain (minus any federal income taxes paid with respect to such
gain) increases the tax base for the accumulated earnings tax.
D) A corporation cannot reasonably accumulate earnings to protect against pending litigation.
Answer: A
Explanation: A corporation accumulates earnings to fund the redemption of a shareholder's
stock following her death so as to provide her estate with liquidity to pay death taxes. Such an
accumulation of earnings is a reasonable business need.
Page Ref.: C:5-15
Objective: 3

13) A corporation cannot reasonably accumulate earnings to

A) protect against pending litigation.
B) fund an employee retirement plan.
C) self-insure.
D) redeem stock of an elderly shareholder where such accumulation occurs prior to the
shareholder's death.
Answer: D
Explanation: Accumulation of anticipation of death is not allowed.
Page Ref.: C:5-15
Objective: 3

14) The accumulated earnings tax is imposed at what rate?

A) 10%
B) 20%
C) 15%
D) 35%
Answer: B
Explanation: AE Tax rate is 20%.
Page Ref.: C:5-12
Objective: 3

15) When computing the accumulated earnings tax, which of the following is not a reduction to
arrive at accumulated taxable income?
A) accumulated earnings credit
B) NOL deduction claimed
C) accrued federal income taxes
D) dividends-paid deduction
Answer: B
Explanation: NOL is not a reduction.
Page Ref.: C:5-19
Objective: 3

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16) Identify which of the following statements is true.
A) Payment of deficiency dividends will prevent the imposition of the accumulated earnings tax.
B) All corporations are exempt from the accumulated earnings tax on their first $250,000 of
accumulated earnings.
C) A health service corporation can claim an accumulated earnings credit of $250,000.
D) All of the above are false.
Answer: D
Explanation: See C5-20
Page Ref.: C:5-20
Objective: 3

17) When computing the accumulated earnings tax, the dividends-paid deduction is not available
for
A) dividends paid during the tax year.
B) throwback dividends.
C) stock dividends.
D) property dividends.
Answer: C
Explanation: Stock dividends have no effect.
Page Ref.: C:5-22
Objective: 3

18) In determining accumulated taxable income for the purpose of the accumulated earnings tax,
which one of the following is allowed as a deduction?
A) excess charitable contributions
B) dividends-received deduction
C) net operating loss deduction
D) net capital loss for the current year
Answer: D
Explanation: Net capital loss is allowed for current year.
Page Ref.: C:5-19
Objective: 3

19) Which of the following is not permitted an accumulated earnings credit based on reasonable
needs of the business?
A) an operating company
B) an investment company
C) an incorporated engineer
D) All of the above are permitted a credit based on reasonable business needs.
Answer: B
Explanation: Investment company is ineligible.
Page Ref.: C:5-13
Objective: 3

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20) Which of the following actions cannot be used to eliminate a potential accumulated earnings
tax liability situation involving a corporation owned by a mother and a father?
A) Create plans to invest retained earnings in a plant expansion.
B) Make a cash distribution within 2 1/2 months after the end of the tax year.
C) Make a deficiency distribution within 90 days of the date on which the IRS determines that an
accumulated earnings tax liability is owed.
D) Liquidate the corporation.
Answer: C
Explanation: Payment of deficiency dividend does not relieve from liability for interest and
penalities.
Page Ref.: C:5-11
Objective: 3

21) The following information is reported by Acme Corporation.

Cost of goods sold $350,000

Average inventory balance 35,000
Average accounts receivable balance 65,000
Sales (all on account) 325,000
Average accounts payable balance 45,000
Operating expenses (excluding depreciation) 500,000
Purchases 40,000

What is Acme Corporation's average operating cycle as a percentage of the year?

Answer:
Inventory turnover = ($35,000/$350,000) × 365 = 36.50 days
Receivables turnover = ($65,000/$325,000) × 365 = 73.00 days
Payables turnover = [$45,000/($40,000 + $500,000)] × 365 = 30.42 days
Operating cycle = [(36.50 + 73.00 - 30.42)/365] × 100 = 21.67% of a year
Page Ref.: C:5-17; Example C:5-9
Objective: 3

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22) Given the following information about Jones Corporation, what are Jones's working capital
needs using the Bardahl formula, assuming that federal income taxes are not an operating
expense?

Average inventory $ 33,000

Cost of goods sold 300,000
Purchases 250,000
Average accounts receivable balance 80,000
Average credit sales 320,000
Average accounts payable balance 30,000
Operating expense 400,000
Depreciation claimed as operating expense 50,000
Federal income taxes 25,000
Advances to suppliers 30,000
Answer:
Inventory turnover (as a percent of the year) = $33,000/$300,000 = 0.11.
Accounts receivable turnover = $80,000/$320,000 = 0.25.
Credit turnover = $30,000/($400,000 - $50,000 + $250,000) = 0.05.
Operating cycle = (0.11 + 0.25 - 0.05) = 0.31.
Working capital needs = 0.31 × ($400,000 - $50,000 + $300,000 + $25,000) = $209,250.
Page Ref.: C:5-17; Example C:5-9
Objective: 3

23) A manufacturing corporation has accumulated E&P of $210,000 and current E&P of
$65,000. Accumulated taxable income, before reduction for the accumulated earnings credit, is
$90,000 for the current year. No dividends were paid during the year. The corporation has an
increase in reasonable business needs of $35,000. If the corporation is not a service corporation
and has reported no long-term capital gains, what is the amount of earnings subject to the
accumulated earnings tax?
Answer:
$90,000 - $40,000 accumulated earnings credit* = $50,000 accumulated taxable income.

1.* Accumulated E&P $210,000

2. Lifetime minimum credit 250,000
2a. Current year minimum credit 40,000
3. Current E&P 65,000
3a. Current E&P retained for reasonable needs 35,000
3b. Current E&P greater than reasonable needs 30,000
4. Accumulated earnings credit (greater of 2a or 3a) 40,000
Page Ref.: C:5-21 and C:5-22
Objective: 3

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24) Green Corporation, a closely held operating corporation, reports the following:

Taxable income $200,000

Long-term capital gain 30,000
Dividends-received deduction 20,000
Federal income taxes on long-term capital gain 11,700
Accumulated earnings credit 80,000
Federal income taxes 42,000

Calculate Green's accumulated taxable income.

Answer:
Taxable income $200,000
Plus: dividends-received deduction 20,000
Minus: LTCG (net of taxes)* ( 23,700)
Minus: accumulated earnings credit ( 80,000)
Minus: federal income taxes ( 42,000)
Accumulated taxable income $ 74,300

*$30,000 * 21% = $6,300

$30,000 - $6,300 = $23,700
Page Ref.: C:5-21 and C:5-22
Objective: 3

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25) Lawrence Corporation reports the following results during the current year:

Taxable income $500,000

Federal income taxes 105,000
Dividends paid: June 5 50,000
Accumulated E&P balance: January 1 800,000

No dividends were paid in the throwback period. A long-term capital gain of $50,000 is included
in taxable income. The statutory accumulated earnings tax exemption has been used up in prior
years. An additional earnings accumulation of $60,000 for the current year can be justified as
meeting the reasonable needs of the business. What is Lawrence Corporation's accumulated
earnings tax liability?
Answer:
Taxable income $500,000
Minus: long-term capital gain $50,000
Minus: income taxes (10,500) ( 39,500)
Minus: federal income taxes (105,000)
Minus: dividends-paid deduction ( 50,000)
Minus: accumulated earnings credit ( 20,500)*
Accumulated taxable income $285,000
Times: tax rate × 0.20
Accumulated earnings tax $ 57,000

*$60,000 reasonable needs of business accumulation - $39,500 capital gains net of taxes =
$20,500.
Page Ref.: C:5-21 and C:5-22
Objective: 3

26) The courts and the Treasury Regulations have mentioned a number of reasonable needs that
allow a corporation to accrue earnings and avoid the accumulated earnings tax. What are these
reasons?
Answer:
• Expansion of a business or replacement of plant
• Acquisition of a business enterprise
• Debt retirement
• Working capital
• Loans to suppliers or customers
• Product liability losses
• Stock redemptions
• Business contingencies
Page Ref.: C:5-19
Objective: 3

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27) How is the accumulated earnings tax liability computed?
Answer: See Page C:5-19.
Page Ref.: C:5-19
Objective: 3

28) Eight individuals own Navy Corporation, a C corporation. Three shareholders make up the
board of directors and own 51% of the stock. The corporation has a successful manufacturing
business. It has accumulated $3 million of E&P and expects to accumulate another $200,000 of
E&P annually. Annual dividend payments are $30,000. Demand for Navy's goods has been
strong, but the company does not anticipate any expansion or repair of the current plant for three
to five years. Management has invested $200,000 annually in growth stocks. Its current
investment portfolio is $1.2 million. The portfolio is held as protection against a business
slowdown. Loans to shareholder-employees currently are $400,000. As Navy's CPA, what tax
issues should you have your client consider?
Answer: The following tax issues need to be addressed about Navy Corporation's earnings
accumulation:

• Has Navy Corporation accumulated earnings beyond the reasonable needs of the business?
• If Navy Corporation has accumulated earnings beyond the reasonable needs of the business,
was tax avoidance one of the directors' motivations for retaining the earnings?
• What business needs can Navy Corporation's management use to justify the current and prior
years' earnings accumulation?
• What business needs can Navy Corporation's management use to justify any future earnings
accumulations?
• What steps can Navy Corporation take to reduce its current accumulated earnings tax
exposure? Its future accumulated earnings tax exposure?
• Should Navy Corporation bring the accumulated earnings tax issue to the IRS's attention?
• Should an S election be made to reduce future exposure to the accumulated earnings tax?

Navy Corporation has a large E&P balance ($3 million currently), which is growing annually at a
$200,000 rate. Few dividends have been paid, and a substantial portion of the current-year profit
has been invested in portfolio investments or loaned to shareholders. The investment activities
and loans indicate a possible accumulated earnings tax problem. Guidance should be provided to
Navy Corporation that "active business" investments should replace "portfolio" investments if
the corporation is to avoid the accumulated earnings penalty tax. The corporation is well past its
statutory exemption and needs to document that the earnings are being retained to meet the
reasonable needs of the business. No indication has been given whether such documentation
exists, although there is an indication that some of the investments are being made to protect
against a business downturn, which is a legitimate use of corporate earnings.
Page Ref.: C:5-19
Objective: 3

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LO4: Tax Planning Considerations

1) A corporation can change the amount and type of its income by adding "operating" activities
to its business to decrease the proportion of passive or investment earning in its total income to
avoid the PHC tax.
Answer: TRUE
Explanation: Adding operating activities to decrease the proportion of passive or investment
income.
Page Ref.: C:5-22
Objective: 4

2) A corporation can exclude certain categories of income (e.g., adjusted income from rents)
from PHCI
through the payment of dividends sufficient to reduce the amount of other PHCI to 10% or less
of OGI.
Answer: TRUE
Explanation: Payment of dividends can sufficiently reduce the amount of income subject to
PHCI tax.
Page Ref.: C:5-23
Objective: 4

LO5: Compliance and Procedural Considerations

1) Identify which of the following statements is false.

A) A corporation files a Schedule AE to report the amount of its accumulated earnings tax
liability for the tax year.
B) A corporation that is subject to the accumulated earnings tax may also be subject to interest
and underpayment penalties on the amount of the unpaid liability.
C) A corporation files a Schedule PH to report its PHC tax for the tax year.
D) The corporate AMT liability is reported on Form 4626.
Answer: A
Explanation: Incorrect Schedule - Taxpayers would utilize Schedule PH
Page Ref.: C:5-23 through C:5-25
Objective: 5

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