AX FORM/RETURN PREPARATION PROBLEM C:3-63 Knoxville Musical Sales, Inc. is located at 5500 Kingston Pike, Kno
xville, TN 37919. The corporation uses the calendar year and accrual basis for both book and tax purposes. It is engaged in the sale of musical instruments with an employer identification number (EIN) of 75-2008006. The company incorporated on December 31, 2002 and began business on January 2, 2003. Table C:3-3 contains balance sheet information at January 1, 2006, and December 31, 2006. Table C:3-4 presents an income statement for 2006. These schedules are presented on a book basis. Other information follows. Estimated Tax Payments (Form 2220): The corporation deposited estimated tax payments as follows: April 17, 2006 (April 15 fell on a Sunday) $118,000 June 15, 2006 243,000 September 15, 2006 285,000 December 15, 2006 Total Taxable income in 2005 was $2,200,000, and the 2005 tax was $748,000. The corporation earned its 2006 taxable income evenly throughout the year. Therefore, it does not use the annualization or seasonal methods. Inventory and Cost of Goods Sold (Schedule A): The corporation uses the periodic inventory method and prices its inventory using the lower of FIFO cost or market. Only beginning inventory, ending inventory, and purchases should be reflected in Schedule A. No other costs or expenses are allocated to cost of goods sold. Note: the corporation is exempt from the uniform capitalization (UNICAP) rules because average gross income for the previous three years was less than $10 million. Line 9 (a) Check (ii) (b), (c) & (d) Not applicable (e) & (f) No $931,000 285,000 The Corporate Income Tax ▼ Corporations 3-61 Compensation of Officers (Schedule E): Mary Travis 345-82-7091 100% 50% $265,000 John Willis 783-97-9105 100% 25% 160,000 Chris Parker 465-34-2245 100% 25% Total Bad Debts: For tax purposes, the corporation uses the direct writeoff method of deducting bad debts. For book purposes, the corporation uses an allowance for doubtful accounts. During 2006, the corporation charged $36,000 to the allowance account, such amount representing actual writeoffs for 2006. Additional Information (Schedule K): 1 b Accrual 6-7 No 2 a 451140 8 Do not check box b Retail sales 9 Fill in the correct amount c Musical instruments 10 3 3-4 No 11 Do not check box 5 Yes, 50% 12 Not applicable 13 No $585,000 160,000 (a) (b) (c) (d) (f) TABLE C:3-3 Knoxville Musical Sales, Inc.—Book Balance Sheet Information January 1, 2006 December 31, 2006 Account Debit Credit Debit Credit Cash $ 254,567 $ 107,357 Accounts receivable 417,960 486,000 Allowance for doubtful accounts $ 35,527 $ 41,310 Inventory 2,250,000 3,150,000 Investment in corporate stock 180,000 37,000 Investment in municipal bonds 30,000 30,000 Cash surrender value of insurance policy 20,000 34,000 Land 500,000 500,000 Buildings 2,500,000 2,500,000 Accumulated depreciation—Buildings 125,000 175,000 Equipment 600,000 840,000 Accumulated depreciation—Equipment 100,000 115,333 Trucks 230,000 145,000 Accumulated depreciation—Trucks 69,000 14,500 Accounts payable 1,500,000 550,000 Notes payable (short-term) 500,000 600,000 Accrued payroll taxes 25,000 28,000 Accrued state income taxes 8,000 11,000 Accrued federal income taxes 126,000 Bonds payable (long-term) 1,800,000 1,400,000 Deferred tax liability 70,000 75,000 Capital stock—Common 1,500,000 1,500,000 Retain earnings—Unappropriated Totals $6,982,527 $6,982,527 $7,829,357 $7,829,357 1,250,000 3,192,213 3-62 Corporations ▼ Chapter 3 Organizational Expenditures: The corporation incurred $6,000 of organizational expenditures on January 2, 2003. For book purposes, the corporation expensed the entire expenditure pursuant to Statement of Position 98-5. For tax purposes, the corporation elected under Sec. 248 to amortize this amount over 60 months (the rule then in effect), with a full month’s amortization taken for January 2003. The corporation reports this amortization in Part VI of Form 4562 and includes it in “Other Deductions” on Form 1120, Line 26. Capital Gains and Losses: The corporation sold 100 shares of PDQ Corp. common stock on March 7, 2006 for $95,000. The corporation acquired the stock on December 15, 2005 for $65,000. The corporation also sold 75 shares of JSB Corp. common stock on September 17, 2006 for $62,000. The corporation acquired this stock on September 18, 2003 for $78,000. The corporation has an $8,000 capital loss carryover from 2005. Fixed Assets and Depreciation: For book purposes: The corporation uses straight-line depreciation over the useful lives of assets as follows: Store building, 50 years; Equipment, 15 years (old) and ten years (new); and Trucks, five years (old and new). The corporation takes a half-year’s depreciation in the year of acquisition and the year of disposition and assumes no salvage value. The TABLE C:3-4 Knoxville Musical Sales, Inc.—Book Income Statement 2006 Sales $ 9,000,000 Returns ) Net sales $ 8,775,000 Beginning inventory $2,250,000 Purchases 4,950,000 Ending inventory ) Cost of goods sold ) Gross profit $ 4,725,000 Expenses: Amortization $ -0- Depreciation 142,833 Repairs 18,720 General insurance 49,500 Premium-Officers’ life insurance (net of cash buildup) 40,500 Officer’s compensation 585,000 Other salaries 360,000 Utilities 64,800 Advertising 43,200 Legal and accounting fees 45,000 Charitable contributions 27,000 Employment tax 56,250 State tax 67,500 Interest 189,000 Bad debts Total expenses (1,731,087) Loss on exchange of trucks (18,000) Gain on sale of equipment 90,000 Interest on municipal bonds 4,500 Net gain on stock sales 14,000 Dividend income Net income before FIT expense $ 3,095,213 Federal income tax (FIT) expense ) Net income per books $ 2,032,213 (1,063,000 10,800 41,783 (4,050,000 (3,150,000 (225,000 The Corporate Income Tax ▼ Corporations 3-63 book financial statements in Tables C:3-3 and C:3-4 reflect these calculations. The designation “old” refers to property placed in service before 2006, and the designation “new” refers to property placed in service in 2006. For tax purposes: All assets are MACRS property as follows: Store building, 39-year nonresidential real property; Equipment, seven-year property; and Trucks, five-year property. The corporation acquired the store building for $2.5 million and placed it in service on January 2, 2003. The corporation acquired two pieces of equipment for $200,000 (Equipment 1) and $400,000 (Equipment 2) and placed them in service on January 2, 2003. The corporation acquired the old trucks for $230,000 and placed them in service on July 18, 2004. The corporation did not make the expensing election under Sec. 179 on any property acquired before 2006 and elected not to claim bonus depreciation. Also, the corporation did not elect the straight-line option or the alternative depreciation system (ADS) under MACRS. Accumulated tax depreciation through December 31, 2005 on these properties is as follows: Store building $189,725 Equipment 1 112,540 Equipment 2 225,080 Trucks 119,600 On November 16, 2006, the corporation sold for $250,000 Equipment 1 that originally cost $200,000 on January 2, 2003. The corporation had no Sec. 1231 losses from prior years. In a separate transaction on November 17, 2006, the corporation acquired and placed in service a piece of equipment costing $440,000. These two transactions do not qualify as a like-kind exchange under Reg. Sec. 1.1031(k)-1(a). The new equipment is seven-year property. The corporation made the Sec. 179 expensing election with regard to the new equipment. The corporation relies on Sec. 179(d)(3) and Reg. Sec. 1.179-4(d) to determine the cost of its Sec. 179 property. On May 15, 2006, the corporation exchanged its entire fleet of delivery trucks, which cost $230,000 on July 18, 2004 for similar trucks. On the date of exchange, the old trucks had a $120,000 FMV, and the new trucks had a $145,000 FMV. As part of the exchange, the corporation paid $25,000 cash in addition to the old trucks. For tax purposes, the exchange qualifies as a like-kind exchange. The new trucks are five-year property. Assume that neither the old nor new trucks are listed property according to Reg. Sec. 1.280F-6(c)(3)(iii) and Temp. Reg. Sec. 1.274-5T(k). The corporation relies on Temp. Reg. Sec. 1.168(i)-6T(e) to compute depreciation on the new trucks. Where applicable, use published IRS depreciation tables to compute 2006 depreciation (reproduced in Appendix C of this text). Other Information: • The corporation’s activities do not qualify for the U.S. production activities deduction. • Ignore the AMT and accumulated earnings tax. • The corporation received the $10,800 in dividends from taxable, domestic corporations, the stock of which Knoxville Musical Sales, Inc. owns less than 20%. • The corporation paid $90,000 in cash dividends to its shareholders during the year and charged the payment directly to retained earnings. • The corporation issued the bonds payable at par. Thus, no premium or discount need be amortized. • The corporation is not entitled any credits. Required: Prepare the 2006 corporate tax return for Knoxville Musical Sales, Inc. along with any necessary supporting schedules. Also, prepare Schedule M-3 as well as Schedule M-1 even though the IRS does not require both schedules.