That's No Way to Spend a Busy Season!

[Griet van Vliet]

After returning from Wayland, the reality sets in that she's returning to Karideph and work a busy season in tax; assurance was essentially a means to spend the off-season to her. Here, unlike in Talz-land, where there are three federal corporate tax brackets, two of which apply to active business income (10% if eligible for the SBD, 15% otherwise) and the third was 38 1/3% for passive income, but tribes varied wildly, it was 21% federally on Karideph on all income. The ages-old salary-vs-dividend dilemma, and the business had 150,000 in profits, and here salary is all-inclusive of payroll taxes. The owner pays 37% marginal tax rate (combined clan and federal), and receives 63,000 after-tax from paying 100,000 in salary. Now, if 79,000 was paid out in dividends (after paying 21,000 out of the profits), the owner is then paying 20% taxes on those dividends, for a total of 15,800, and then the owner would receive 63,200. Conclusion: dividends are preferred.

 

[Griet van Vliet]

Now for another client's M-1 schedule, operating in a clan that does not levy corporate taxes:

Net income per books: 205,050
Income tax expense per books: 55,650
Tax-exempt interest income (from municipal bonds): (4,500)
CCA in excess of depreciation per books: (7,200)
Excess of capital loss over capital gains 9,400 (has no capital gains in the carry back period so must be carried forward for up to five years)
Nondeductible meals and entertainment 5,500
Interest on loan to purchase municipal bonds 1,100

Taxable income 265,000

Current tax expense 55,650
Deferred tax expense 1,512 (CCA in excess of depreciation per books times 21%)

Total income tax expense 57,162

 

[Griet van Vliet]

Section 351... or Kari-Section 85. Four Kari entrepreneurs, codenamed A, B, C and D, contribute the following to their new corporation, Kingfisher, issuing shares worth 3,000 each:

Items | Basis to transferor | FMV | Number of shares issued | Other notes
From A: Inventory | 30,000 | 96,000 | 30 | Receives 6,000 in cash as well
From B: Fixed assets | 45,000 | 99,000 | 30 | Receives 9,000 in cash as well; 30,000 taken in CCA in previous years
From C: Proprietary process | 15,000 | 90,000 | 30 | N/A
From D: Cash | 30,000 | 30,000 | 10 | N/A

So D's basis was 30,000 and C's basis was 15,000, and neither recognized any gain. Then the basis (ACB or UCC) to Kingfisher was equal to basis to transferor plus any recognized gain. With that said, the recognized gain is the lesser of NSC or realized gain (unlike in Talz-land, where a NSC in a S85 rollover would mean the ACB of the shares would be reduced by its value). Kingfisher's basis in the inventory is therefore 36,000 and its fixed assets' combined UCCs is 54,000, but then their ACB in their Kingfisher stakes are 30,000 and 45,000 respectively.

Also, A discussed either selling the entire inventory for 96,000 on the open market, and be taxed at a combined 35% rate, or use Section 351, and then wait five years to sell the shares, assuming the shares remain the same in value, forecasting that the resulting capital gain would be taxed at 15%.

On the open market: 66,000* 35% = 23,100
If using S351: 6,000*35% + 60,000*15% = 11,100

So he was in fact saving 12,000 in taxes doing it.

 

[Griet van Vliet]

Now, an assurance file landed on her desk from a prospective client, Speedy Loans, a payday lender, whose previous auditor, one of those hordes of mom-and-pop firms that was operated as a sole proprietorship, has ditched it as a client and the client asked for a forensic audit. As tempting as it sounds, having the firm do all 3 engagements is not straightforward: the forensic audit, the regular audit or the tax return. For normal clients I would usually say, you have us for assurance, and we will do the tax return at a discount, no aggressive tax positions, no problems with tax authorities. But the forensic audit was complicating the game a bit. Some Pantorans claim that a forensic audit amounts to self-review, but not in this case: the scope of the proposed forensic audit engagement does not cover the year we could offer the audit on, she thought, realizing that the forensic audit was asked for because of a lawsuit for criminal negligence. Yes, she knew competing firms that dealt in all three tended to offer a low price on the regular audit or the tax return, but independence threats weren't that great for doing the tax return and the audit. There were four elements to criminal negligence:

- Duty of care
- Breach of the duty of care
- Proof that a damage or loss resulted (the hardest one to prove in court for the plaintiff/prosecution)
- Proof of causality between damage and negligence

 

[Griet van Vliet]

"Fine, I'll accept the firm to perform the forensic audit engagement, there is no going around that"

The forensic audit turned up a large number of issues: the firm charged a flat fee, and the proprietor declared bankruptcy before going the sole proprietor route. Both of these were self-interest independence threats; on top of that, never had the auditor in question done any audit planning. Poor treatment of building, personal expenses not treated properly, breaches of confidentiality from the old firm, soliciting, made a decision for Speedy's management and failed to exercise professional skepticism, materiality set by the client. It was obvious that there were tons of things the defendant did wrong. Plus, in her mind, the responsibility of the old auditor extended not only to the client, but also to the bank. No risk planning, no assessment of internal controls (normally one wouldn't go around designing internal controls without first knowing what was there), no documentation of test execution, and gave an unqualified opinion based on materially misstated financial statements. The bank suffered a loss.

"I would never have done what the old auditor did, much less issued an unqualified opinion. The old auditor was a fraudster!"

 

[Griet van Vliet]

E&P (earnings and profits) according to the KRC is very much like the Talz concepts of safe income and ABIL (whenever tax-basis retained earnings are greater or lower than zero respectively). One needed to remove all non-deductible items such as fines, expenses incurred to earn non-taxable income, and so on, so forth. Now the Lazy Bee Ranch receives 250,000 in dividends from a 10% NCI (meaning the Ranch received a dividend deduction of 125,000), interest income from municipal bonds of 35,000, bought with a loan for which the non-deductible interest expense is 20,000, and before any dividends are considered, made 500,000 in profits. This meant the taxable income was 625,000 and the resulting Kari federal tax income was 131,250, paid in full by year-end under the form of installment payments so the balance owing was nil. But then the starting balance in the E&P was 150,000.

Starting E&P balance 150,000

Taxable income 625,000
Untaxed dividend income 125,000
Municipal bond interest 35,000
Less: Income taxes paid 131,250
Less: Interest expense on loan 20,000

Ending E&P balance 783,750

 

[Griet van Vliet]

For the first time in my life as an accountant I saw LIFO used: nowhere else in the galaxy did I see LIFO, last in, first out, in use! Everyone else uses either FIFO or weighted average, and only mom-and-pop entities dealing in custom work use specific identification, she thought, while the next client file arrived for the calculation of E&P, with a key employee (usually the CEO or CFO is considered a key employee for lending purposes) passing away during the year:

Starting E&P Nil

Taxable income 330,000
Income taxes payable (69,300)
Tax-exempt interest income 5,000
Meals expense (1,500)
Premiums paid for key employee life insurance (2,800; net of 700 in increase of cash surrender value)
Proceeds from key employee life insurance 110,000 (net of 20,000 in cash surrender value)
Excess of capital losses over capital gains (13,000)
Excess of MACRS-basis CCA over ADS-basis CCA 10,000 (for tax E&P purposes, ADS-basis CCA was used; MACRS-basis CCA was 26,000 and ADS-basis CCA was 16,000)
LIFO recapture increase 10,000
Dividend adjustment 17,500 (less than 20% NCI)
Allowable portion of Section 179 (5,000; only 20% of a S179 election can be taken the year of election for E&P, and the remainder must be amortized over the following four years)
Installment sale gain (3,000; for E&P purposes installment sale gains must be recognized in full the year of the sale, but any taxed amounts in subsequent years must be removed from E&P)

Ending E&P: 387,900

 

[Griet van Vliet]

In Kari corporate tax, dividends were partially taxable to a corporate shareholder, and how much the dividends received deduction, or DRD, one could claim depended on how much of a stake they had: a <20% NCI was entitled to a 50% DRD, a stake from 20% to 80%, a 65% DRD, and a controlling interest > 80% could be entitled to the full deduction of 100%.

Three unrelated calendar-year corporations, codenamed Red, White and Blue, report the following information at year-end:

Item | Red | White | Blue
Gross income from operations | 400,000 | 320,000 | 220,000
Expenses from operations | (340,000) | (340,000) | (340,000)
Dividends received from domestic corporations (<20% NCI) | 200,000 | 200,000 | 200,000
Taxable income before the DRD | 260,000 | 180,000 | 80,000

Tentative DRD | 100,000 | 100,000 | 100,000
Limitation based on taxable income | 130,000 | 90,000 | 40,000
DRD | 100,000 | 90,000 | 100,000

 

[Griet van Vliet]

Now, two Kari entrepreneurs, Ann and Bob, form Olive Corporation, are debating whether to use Section 351 (if it was in Talz-land, a Section 85 election would not need to meet the 80% stake test) or not, and would like Griet to arbitrate.

Consideration | Basis | FMV
Services | Nil | 20,000
Installment obligation | 5,000 | 40,000
Inventory | 10,000 | 30,000
Secret process | Nil | 10,000

Without S351:

Item | Ordinary income | Capital gain
Services | 20,000 | Nil
A/R | 35,000 | Nil
Inventory | 20,000 | Nil
Secret process | Nil | 10,000

ACB of Ann: 20,000
ACB of Bob: 80,000

The ACBs to the corporation is the same as the FMV.

With S351:

Item | Ordinary income | Capital gain | ACB to Olive
Services | 20,000 | Nil | 20,000
A/R | Nil | Nil | 5,000
Inventory | Nil | Nil | 10,000
Secret process | Nil | Nil | Nil

ACB of Ann: 20,000
ACB of Bob: 15,000

 

[Griet van Vliet]

And somehow, Gore Range Carpet Cleaning turns around, and had a beginning E&P of 10,000. Current E&P could somehow get to 30,000 when they were operating at a loss when she last dealt with GRCC! Two shareholders, Matt and Megan, with an ACB of 15,000 in GRCC each, and Megan sells their half of the business for 20,000, to Helen. GRCC was making distributions of 40,000 on July 1 and 40,000 on December 31. This gong show of a business is poorly-managed! This suggests they are on the verge of liquidating! she thought, before thinking of buying GRCC or telling Janick about it.

Source of distribution | Current E&P | Accumulated E&P | Return of capital (or capital gain)
July 1 distribution | 15,000 | 10,000 | 15,000
December 31 distribution | 15,000 | Nil | 25,000

July 1 | Matt | Megan
Dividend | 12,500 | 12,500
ROC | 7,500 | 7,500
CG | Nil | Nil
ACB | 7,500 | 7,500

August 1:
Megan: Capital gain 12,500
Helen: ACB 20,000

December 31 | Matt | Helen
Dividend | 7,500 | 7,500
ROC | 7,500 | 12,500
CG | 5,000 | Nil
ACB | Nil | 7,500

 

[Griet van Vliet]

Crimson and Indigo are equal partners in CI. Crimson uses the calendar year because Crimson is an individual, and Indigo uses a fiscal year ending 2/3 into the year. The tests for determining the year-end of the partnership is as follows:

1) Must use the same year-end as the majority partners
2) Must use the same year-end as the principal partners
3) Must use the least aggregate deferral

12/31 | Year-end | % | Deferral | Weighted deferral

Crimson | 12/31 | 50 | 0 | 0
Indigo | 8/31 | 50 | 8 | 4

8/31 | Year-end | % | Deferral | Weighted deferral

Crimson | 12/31 | 50 | 4 | 2
Indigo | 8/31 | 50 | 0 | 0

Conclusion: the year-end of the partnership is August 31.

 

[Griet van Vliet]

Beachside Properties LLC had the following transactions during the year:

Jointly stated:

Active business income:

Sales revenue 2,000,000
Cost of sales 800,000
Salaries to employees 500,000
CCA 91,984
Utilities, supplies and other expenses 128,016
Taxes and licenses 60,000

Net ABI: 420,000

Separately stated:

Charitable contributions 6,000 (limitations: 10% for corporations, 20/30/50% for individuals)
Payment of medical expenses on behalf of Kyle 4,000 (deemed distribution)
Distribution to Maria 20,000 (taxed if exceeded ACB)
Short-term capital gain 12,000 (can offset capital losses)
Net income from rental real estate 300,000 (can offset rental losses)
Qualified dividends received 4,000 (different rate for individuals, DRD for corps)
Tax-exempt income 2,100 (increases the ACB)

 

[Griet van Vliet]

Jim and Becky contribute property to form the JB partnership. Jim contributes cash of 30,000, while Becky contributes land with an ACB and FMV of 45,000, subject to a liability of 15,000. The partnership borrowed 50,000 to finance construction of a building on the contributed land, and had 3,500 in AP but no profit.

In the second year, the partnership earns income of 70,000. At the end of it, the partnership distributes cash of 90,000 to Jim and property with tax basis (ACB or UCC, depending) of 90,000 to Becky.

Year 1 | Jim | Becky
Cash | 30,000 | Nil
Land | Nil | 45,000
Liability on land | 7,500 | (7,500)
Mortgage | 25,000 | 25,000
A/P | 1,750 | 1,750
Ending ACB | 64,250 | 64,250

Year 2 | Jim | Becky
ABI | 35,000 | 35,000
Mortgage decrease | (25,000) | (25,000)
A/P | (1,750) | (1,750)

Ending ACB prior to distribution | 72,500 | 72,500

Distribution
Cash | 90,000 | Nil
Property | Nil | 90,000

Taxable gain to Jim 17,500
ACB/UCC to Becky 72,500 (one must decrease the basis by the excess of distribution over the partnership's ACB)