Unit 3: Entity Tax Planning

• Topic 01

  Corporate Tax Planning

  27 questions
• Topic 02

  Partnership Tax Planning

  49 questions
• Topic 03

  Mergers and Acquisitions Tax

  46 questions
• Topic 04

  International Tax Planning

  45 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A company incorporated in the Netherlands holds a 30% interest in a US subsidiary and receives US-source dividends. The company passes neither the publicly traded test nor the ownership and base erosion test under the US-Netherlands LOB article. It argues it qualifies under the 'active trade or business' test because it actively manages investments in the US subsidiary. The IRS denies treaty benefits. Which analysis most accurately supports the IRS position?

   • A
     The IRS position is correct solely because the company's 30% ownership of the US subsidiary is below the 50% threshold required for the active trade or business test; at 30% ownership, no LOB test can be satisfied.
   • B
     The active trade or business test is satisfied because investment management is classified as a financial services business — an active business — under the OECD Transfer Pricing Guidelines; the IRS cannot deny benefits to financial services companies.
   • C
     The IRS position is incorrect because any company that derives income from the US is automatically entitled to treaty benefits for that income under the non-discrimination provisions of the US-Netherlands treaty.
   • D
     The active trade or business test requires that the treaty-country resident derive the treaty-benefited income 'in connection with' or 'incidentally to' an active trade or business conducted in the treaty country; the mere management of investment holdings is generally not considered an active trade or business, so the company does not satisfy the test.
     Correct answer
   Explanation

   Under the US-Netherlands LOB article and the US Model Treaty, the active trade or business test permits a company to claim treaty benefits for income that is derived 'in connection with' or is 'incidental to' an active trade or business conducted by the company in the treaty country. Courts and the IRS have consistently held that the mere holding and management of investment assets (such as stock in a subsidiary) does not constitute an 'active trade or business' for LOB purposes — an active business requires something more than passive investment activity. The company's 30% ownership and receipt of dividends, without additional active business functions performed in the Netherlands for the benefit of the US subsidiary, is insufficient to satisfy the active trade or business test.

2. Under Treas. Reg. §1.704-1(b)(2)(ii), what is a "deficit restoration obligation" (DRO), and why is it necessary for a special allocation of losses to a partner with a negative capital account?

   • A
     A DRO is an IRS-required disclosure statement attached to Form 1065 that documents the partner's obligation to contribute additional capital if the partnership incurs losses exceeding the partner's capital account balance
   • B
     A DRO is a tax election that allows a partner to deduct losses allocated to them even if the losses exceed their outside basis in the partnership, functioning as an alternative to the at-risk rules under §465
   • C
     A DRO is an unconditional obligation of a partner to restore any deficit in their capital account to zero upon liquidation of the partnership; it is necessary because it ensures that the partner who receives the tax loss also bears the corresponding economic risk, giving the loss allocation true economic effect
     Correct answer
   • D
     A DRO is a provision that requires the partnership to restore distributions made to partners in prior years if the partnership later incurs losses; it protects creditors rather than satisfying the economic effect test
   Explanation

   Under Treas. Reg. §1.704-1(b)(2)(ii)(b)(3), the third prong of the economic effect test requires that each partner with a deficit capital account at the end of the year must be unconditionally obligated to restore that deficit to zero by the end of the year in which the partnership liquidates. Without a DRO, a loss allocation that drives a partner's capital account negative cannot have economic effect because the partner bears no real economic burden for the loss — they receive the tax deduction but do not have to make the partnership whole. The qualified income offset (QIO) is the alternative to a DRO for limited partners.

3. A private equity fund acquires a target company in an LBO for $200,000,000 using $140,000,000 of acquisition debt and $60,000,000 of equity. The target’s post-acquisition EBIT is $15,000,000 annually. Interest expense on the acquisition debt is $9,800,000. The target has no business interest income. What is the disallowed excess business interest expense, and how does the §163(j) carryforward interact with a subsequent increase in EBIT if EBIT grows to $40,000,000 in Year 3?

   • A
     Year 3: the carryforward EBIE from Year 1 expires because §163(j) carryforwards have a five-year carryforward period; EBIE carried from Year 1 cannot be used in Year 3 or later.
   • B
     Year 1: deductible interest = 50% of EBIT = $7,500,000 because the 50% ATI cap applied during 2018–2021 and still applies to LBO debt incurred before December 31, 2021.
   • C
     Year 1: ATI = $15,000,000 (EBIT); deductible interest = 30% × $15,000,000 = $4,500,000; disallowed EBIE = $9,800,000 − $4,500,000 = $5,300,000 carried forward. Year 3: ATI = $40,000,000; deductible current-year interest = $9,800,000 (within 30% × $40,000,000 = $12,000,000 limit); excess capacity of $2,200,000 may absorb prior-year EBIE carryforward.
     Correct answer
   • D
     Year 1: deductible interest = 30% × ($15,000,000 + $9,800,000) = $7,440,000; the §163(j) ATI includes interest expense before the limitation. Disallowed EBIE = $2,360,000.
   Explanation

   Year 1: ATI (EBIT basis, post-2021) = $15,000,000. Deductible interest = 30% × $15,000,000 = $4,500,000. Disallowed EBIE = $9,800,000 − $4,500,000 = $5,300,000, carried forward indefinitely. Year 3: ATI = $40,000,000. The limitation for current-year interest = 30% × $40,000,000 = $12,000,000. Current-year interest expense is still $9,800,000, which is below the $12,000,000 cap — so all current-year interest is deductible. Excess capacity = $12,000,000 − $9,800,000 = $2,200,000. The carryforward EBIE from Year 1 ($5,300,000) can be used to the extent of excess capacity ($2,200,000) in Year 3, leaving $3,100,000 of EBIE still carried forward. The §163(j) EBIE carryforward is indefinite; there is no five-year expiration.