AX FORM/RETURN PREPARATION PROBLEM

C:3-63 Knoxville Musical Sales, Inc. is located at 5500 Kingston Pike, Knoxville, 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 depreciationBuildings 125,000 175,000

Equipment 600,000 840,000

Accumulated depreciationEquipment 100,000 115,333

Trucks 230,000 145,000

Accumulated depreciationTrucks 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 stockCommon 1,500,000 1,500,000

Retain earningsUnappropriated

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.