Chapter 13 Homework Solutions
1. What are the primary nontax factors to consider when choosing a form for doing
business?
When choosing a form for doing business, the number of owners, ability to limit
personal liability of the owners, the ease with which ownership can be transferred,
the anticipated life of the business, the degree of management control desired, the
cost of organizing the entity, and the ability to raise capital are the nontax factors
that should be considered.
2. Compare and contrast the characteristics of sole proprietorships, partnerships,
corporations, S corporations, limited liability companies, and limited liability partnerships.
A sole proprietorship is a one owner business, giving the owner complete
managerial control. Because the sole proprietor and the business entity are not
treated as separate entities by state law, a sole proprietor is liable for all debts of
the business (unlimited liability). A sole proprietorship is easy (least costly) to
form and ownership is easily transferable. However, a sole proprietorship often
finds raising large amounts of capital difficult.
A corporation is a separate legal entity formed under state law. As such, a
corporation can enter into contracts, purchase assets, and conduct business in its
own name. The separation of the corporation from its owners allow corporations to
have an unlimited life, free transferability of ownership interests, and centralized
management structures. More importantly, the owners of a corporation have
limited liability. The costs of organizing a business as a corporation can be
extensive. However, corporations can raise additional capital easily by selling
additional stock.
A partnership exists when two or more individuals engage collectively in an activity
with the expectation of generating profits. Each partner is personally responsible
for any partnership obligations that arise during the existence of the partnerships.
Unlike a sole proprietorship, a partnership can transact business and own property
in its name separate from the partners. General partners legally have equal ability
to contribute to managing the partnership.
An S corporation has the basic legal characteristics of a corporation combined with
conduit entity taxation. However, the number of owners is restricted to 100, only
certain types of entities can be owners, the corporation can have only one class of
stock, and all of the owners must consent to the S corporation election.
A limited liability company (LLC) combines limited liability with conduit tax treatment. It
has many of the features of a corporation with a few significant exceptions. An
LLC can create special income (loss) allocations (i.e., allocations based on factors
other than ownership percentage) and controls who can be an owner (free
transferability of interest does not exist). LLCs also have greater flexibility in
determining management structures than a corporation.
A limited liability partnership (LLP) is a general partnership with limited liability for
its partners. Partners in an LLP are not liable for general business contractual
obligations, but remain liable for their own acts. This differentiates an LLP from an
LLC where no single owner has unlimited liability. Because it is a partnership, an
LLP generally must have more than one owner.
A summary of the characteristics of all the entity forms is provided in Table 13-1.
4. Limiting the liability of the owner(s) of a business is often the primary motive for using the
corporate form. Under what circumstances may the use of a corporation not shield the
owner(s) from all liabilities of the business?
Because bankers and other creditors want assurance that the money they loan to a
corporation is secure, they often require owners of closely held corporations to
personally guarantee loans made to the corporation. Therefore, owners of small
corporations are often only shielded from product liability and malpractice type
judgments brought against the business.
7. How is a limited liability company different from a corporation?
A limited liability company (LLC) shares most of the legal characteristics of a
corporation, but is taxed as a conduit entity. However, an LLC is a more flexible
ownership arrangement due to its ability to create special allocations of income to
its owners (i.e., based on factors other than ownership percentage) and to control
who owns an interest (free transferability of interest does not exist for an LLC). In
addition, an LLC has greater flexibility in organizing its management structure.
14. Which entity form(s) recognize owners as employees of the business?
Only owners of corporations (including S corporations) can be employees of the
business. This treatment occurs because a corporation is the only entity that is
considered to be separate from its owners.
29. Which of the following are organizational costs?
a. State fees for incorporation
b. Legal and accounting fees incident to organization
c. Expenses for the sale of stock
d. Organizational meeting expenses
Any costs incurred to get the entity ready to operate are organizational costs.
Expenditures related to issuance of stock are selling expenses and reduce the
equity from the sale of stock. Item c is a selling expense; items a, b, and d are
organizational costs incurred to get a corporation ready to operate.
33. Herman, who is unmarried and has two dependent children, owns and
operates a used car lot as a sole proprietorship. The net income from the
business is consistently $120,000 annually. Herman’s friends have told him
that he should incorporate his business, but he does not understand how
this would give him any advantage. He has come to you for advice. Write
Herman a letter explaining the advantages and disadvantages of
incorporating his business.
One advantage of the corporate form is limited liability for the owners
of the corporation. Limited liability refers to an owner’s liability
extending only to the amount invested in the entity. This would
shelter Herman’s personal assets from any claims related to the
business.
Another advantage of incorporating is the ability to spilt income
between Herman and the corporation. Shifting income to the entity
with the lowest marginal tax rate can reduce the overall tax liability.
Because the corporation is a taxable entity, Herman can receive a
salary that is taxable to him and deductible by the corporation.
Another consideration in choosing the corporate form of doing
business is the effect on a stockholder who also serves as a corporate
employee. The value of the benefits is generally excludable from
taxation for the owner-employee who receives them, and the
corporation receives a tax deduction.
If Herman incorporates and the corporation distributes dividends to
him, he will incur additional income taxes. This situation is a case of
double taxation that may mitigate the tax advantage of incorporating.
Double taxation occurs when dividends of a corporation (which are
paid out of earnings that have previously been taxed) are taxed again
to the shareholders receiving the dividends.
37. Polly owns CopyEdit, a sole proprietorship. The net income from CopyEdit
is consistently around $200,000. Polly is considering making Kevin, one of
her employees, an owner of the business. He would continue to be paid his
$40,000 salary and own a 25% interest in the business. Polly would
receive a salary of $100,000 from the new entity. She has asked you to
determine the total income tax liability for each of the entities listed below.
Assume that both Polly and Kevin have income from other sources that
offset their allowable deductions and that they are both single.
a. Partnership
A partnership is a conduit entity. Partners cannot be employees, so
the salaries are not deductible by the partnership and would not be
income to Polly and Kevin. Polly and Kevin will recognize their
proportionate shares of the income from CopyEdit, $150,000 ($200,000
x 75%) for Polly and $50,000 ($200,000 x 25%) for Kevin. The total
income tax liability if CopyEdit is organized as a partnership would be
$44,242:
Polly’s tax – $17,025.00 + [28% x ($150,000 – $83,600)] $
35,617
Kevin’s tax – $ 4,750.00 + [25% x ($ 50,000 – $34,500)]
8,625
Total income tax liability $
44,242
b. Corporation
Polly and Kevin can be employees of the corporation, which is a
separate taxable entity. They will be taxed on the salaries they receive
and the corporation deducts the salaries in calculating its taxable
income of $60,000 ($200,000 – $100,000 – $40,000). The total income
tax liability if CopyEdit is organized as a corporation would be
$37,742:
