Chapter Two: Corporations – Subchapter C
9. (d) A merger of two corporations requires the approval of a majority of both boards of directors and the approval of a majority of the voting stockholders of both corporations. The corporations must submit a copy of the merger plan to all stockholders and provide notice of the time and the place of the meeting at which the vote will occur. Answers (a) and (b) are incorrect because unanimous approval is not required by either the stockholders or the directors. Answer (c) is incorrect because the absorbed corporation no longer exists and, thus, has no articles of incorporation to amend.
10. (c) A merger of two corporations requires the approval of a majority of both boards of directors and the approval of a majority of the voting stockholders of both corporations. The corporations must submit a copy of the merger plan to all stockholders and provide notice of the time and the place of the meeting at which the vote will occur. Answers (a), (b) and (d) are incorrect because a formal plan of merger is required, it must be submitted to the stockholders and receive approval of the majority of those voting and it must receive the approval of a majority of the board of directors. Answer (c) is correct because receipt of voting stock by all stockholders of both corporations is not required.
11. (a) A stockholder may be held personally liable for corporate debts (piercing the corporate veil). Specifically this may be done by a showing of fraud, undercapitalization of the corporation and commingling of corporate and personal funds by the stockholder. Thus, the corporate veil may be pierced if the stockholder undercapitalized the corporation when it was formed. Answer (b) is incorrect because one of the principal reasons for choosing the corporate form over others is to obtain limited personal liability. It is not grounds to pierce the corporate veil.
Answers (c) and (d) are incorrect because the mere fact that a stockholder sold property to the corporation or was an officer, director or employee is insufficient grounds to pierce the corporate veil.
12. (b) A stockholder may be held personally liable for corporate debts (piercing the corporate veil). Specifically this may be done by a showing of fraud, undercapitalization of the corporation and commingling of corporate and personal funds by the stockholder. Thus, the corporate veil may be pierced if the stockholder commingled their personal funds with those of the corporation. Answers (a), (c) and (d) are incorrect because choosing S corporation status, commission of an ultra vires act and incorporation to obtain limited personal liability are all insufficient grounds to pierce the corporate veil.
13. (a) Stockholders get to vote on fundamental changes in the corporation. This specifically includes the right to vote on mergers, consolidations, compulsory share exchanges, sale of substantially all of the corporation’s assets (but not buying all of another corporation’s assets), dissolutions and amending the articles of incorporation. Selling substantially all of the corporation’s assets, dissolving the corporation and amending the articles of incorporation are all examples of fundamental changes that would require stockholder approval. Answer (a) is correct because purchasing substantially all of the assets of another corporation may be a minor matter to the acquiring corporation and thus not constitute a fundamental change requiring a stockholder vote.
14. (c) Stockholders get to vote on fundamental changes in the corporation. This specifically includes the right to vote on mergers, consolidations, compulsory share exchanges, sale of substantially all of the corporation’s assets (but not buying all of another corporation’s assets), dissolutions and amending the articles of incorporation.
Answer (a) is incorrect because stockholders do not get to elect officers. They elect directors. Answer (b) is incorrect because there is no inherent right to receive dividends. Answer (d) is incorrect because stockholders cannot prevent corporate borrowing. Corporate borrowing need not involve a fundamental change in the corporation and stockholders may only vote on fundamental changes.
15. (c) Stockholders have dissenters’ rights or a right of appraisal for certain fundamental changes in the corporation. Such changes include mergers, consolidations, compulsory share exchanges, sale of substantially all of the corporation’s assets (but not buying all of another corporation’s assets) and any amendment to the articles of incorporation that materially and adversely affects stockholders’ rights concerning their shares. I is a correct statement because dissenters’ rights would be available for an amendment that materially and adversely affected a preferential right of the stockholders’ shares. II is a correct statement because dissenters’ rights are available for mergers and consolidations and would thus be available if a corporation’s shares were being acquired by another business.
16. (b) When a corporation owns 90% or more of the shares of a subsidiary corporation, the subsidiary may be merged into the parent corporation without the approval of the stockholders of either the parent corporation or the subsidiary corporation and without the approval of the subsidiary corporations board of directors. This is called a short-form merger. Thus, answers (a) and (c) are incorrect. In a short-form merger stockholders of the subsidiary corporation have dissenters’ rights, but the stockholders of the parent corporation do not. Thus, answer (b) is correct and answer (d) is incorrect.
17. (a) A stockholder has the right to inspect books and records of the corporation at reasonable times and upon written demand. They lose this right if they have an improper motive. Obtaining corporate information for use in a personal business would be an improper motive. Answer (b) is incorrect because the stockholder may use an agent to inspect. Answers (c) and (d) are incorrect because commencing a derivative suit on behalf of the corporation and investigating management misconduct both have the proper motive of attempting to protect their investment.
18. (c) A stockholder has the right to inspect books and records of the corporation at reasonable times and upon written demand. Answer (a) is incorrect because there is no inherent right to dividends for stockholders.
Answer (b) is incorrect because stockholders elect directors, not officers. Officers are appointed by the directors.
Answer (d) is incorrect because stockholders do not generally have the right to participate in management. They have only two management rights: electing directors and voting on fundamental changes in the corporation. They do not have the right to have the corporation issue a new class of stock as this is not a fundamental change in the corporation.
19. (b) By definition, preemptive rights are the right of a stockholder to purchase a proportionate amount of a new issue equal to his/her percentage of ownership. Although stockholders have the right upon dissolution to a proportionate share of corporate assets after all creditors have been paid, this is not preemptive rights.
20. (d) A derivative suit is a law suit brought by a large group of stockholders on behalf of the corporation to enforce a corporate right. Derivative suits may specifically be brought to recover damages for management’s ultra vires acts. A derivative suit must be brought for a corporate harm and cannot be brought to enforce personal stockholder rights. Answers (a), (b) and (c) are incorrect because compelling payment of a properly declared dividend, inspecting corporate records and compelling dissolution of the corporation are personal rights of stockholders and not a harm to the corporation itself.
21. (d) Although stockholders usually do not owe a fiduciary duty to others, a majority stockholder may owe a fiduciary duty to fellow stockholders. This is due to the fact that a majority stockholder is in a position of control.
Answer (b) is incorrect because a director owes a fiduciary duty of loyalty to the corporation and to the stockholders. Answer (a) is incorrect because disclosure by itself will not discharge a director’s fiduciary duty of loyalty. Answer (c) is incorrect because a promoter owes a duty of loyalty to subscribers, future stockholders and the corporation.
22. (c) Debt securities or bonds create a creditor-debtor relationship between the bondholder and the corporation and are not an ownership interest in the corporation. Convertible bonds can be exchanged for other corporate securities. Debenture bonds are unsecured bonds. Since both convertible bonds and debenture bonds are types of bonds, they are debt securities. Warrants are stock options that are evidenced by a certificate. Stock options are equity securities and are not debt securities.
23. (c) Treasury stock can be sold by the corporation at a price that is less than par value. Thus, one who purchased treasury stock for less than par value would not be liable. If par value stock was purchased at less than par in connection with an original issue, it would be watered stock and the purchaser would be liable or the difference in price. Thus, (a) is incorrect. Answer (b) is incorrect because a stockholder must pay present value for stock. An agreement to perform future services in exchange for stock would leave the stockholder liable until the future services were performed. Answer (d) is incorrect because a stockholder must pay present value for stock.
Failure to pay the full amount owed on a subscription contract would leave the stockholder liable for the amount unpaid.
24. (c) Treasury stock may be distributed as a stock dividend. Answer (a) is incorrect because a corporation may purchase treasury stock as long as it has the surplus funds to do so. The power to purchase does not require specific
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authorization by the articles of incorporation. Answer (b) is incorrect because there are no pre-emptive rights with treasury stock. Answer (d) is incorrect because there are no cash dividends paid on treasury stock.
25. (a) If par value stock is sold at less than par in an original issue, the stock is watered stock and the purchaser is liable for the difference between the amount paid and the par value. All other purchasers with notice that the stock was being sold for less than par value would also be liable for the difference in price. Ambrose purchased 400 shares of $100 par value stock in an original issue for $25 a share. Ambrose is therefore liable for
$75 per share, the difference between the $25 per share paid and $100 par value. The total amount of Ambrose’s liability would be $75 times the 400 shares purchased, or $30,000. Thus, answer (a) is correct and (b) is incorrect.
Answer (c) is incorrect because subsequent purchasers are only liable if they had notice that the stock was being sold for less than par. The lack of notice by Harris would be material. Answer (d) is incorrect because Gable’s purchase with knowledge that the stock was sold at less than par would make Gable liable.
26. (c) Cumulative preferred stock entitles the holder to a dividend carryover to future years if the dividend is not paid in any given year. Answer (a) is incorrect because it does not permit the holder to convert preferred stock into common stock. Answer (b) is incorrect because cumulative preferred stock is usually non-voting. Answer (d) is incorrect because no stockholder has an inherent or guaranteed right to dividends.
27. (c) Once a dividend is duly declared by the board of directors, the stockholders become unsecured creditors of the corporation. Since $7 per share dividend on Sky’s preferred stock was declared and West owned 5,000 shares, Sky is liable to West as an unsecured creditor for $35,000 ($7 times 5,000 shares). Answers (a) and (b) are incorrect because West as an unsecured creditor does not have a priority over any other creditor. Answer (d) is incorrect because no other dividends were declared on the preferred stock. Thus, West is only entitled to $35,000, not $70,000.
28. (b) Once a dividend is duly declared by the board of directors, the stockholders become unsecured creditors of the corporation. Thus, once Abco declares a cash dividend, Johns became an unsecured creditor of Abco. Answer (a) is incorrect because a preferred stockholder is not entitled to convert preferred stock into common stock unless this right is specifically authorized. Answer (c) is incorrect because Johns is a holder of cumulative preferred stock, not participating preferred stock. Only participating preferred stock shareholders may participate with common stock shareholders on dividend distributions. Answer (d) is incorrect because cumulative preferred stock is usually non-voting stock. Whether voting or non-voting depends on the stock, not whether dividend payments are in arrears.
29. (a) Once a dividend is duly declared by the board of directors, the stockholders become unsecured creditors of the corporation. Since Universal declared a $5 per share dividend on their preferred stock and Price owned 2,000 shares, Universal would be liable to Price as an unsecured creditor for $10,000 ($5 per share times 2,000 shares). Answer (b) is incorrect because Price is not a secured creditor. Additionally, Price is not entitled to
$20,000 because no other dividends were declared. Answers (c) and (d) are incorrect because Price is an unsecured creditor and does not have a priority over any other creditor.
30. (c) Stock dividends have no effect on earnings or profits of a corporation for federal income tax purposes.
Answer (a) is incorrect because a stock dividend is a "no sale transaction" wherein a corporation is dealing exclusively with existing shareholders without payment of a commission. No sale transactions are exempt from registration under the Securities Act of 1933. Answer (b) is incorrect because stock dividends are not usually treated as gross income for federal tax purposes. Answer (d) is incorrect because dividends are declared by the board and do not require stockholder approval. Stockholders may only vote to elect directors and on fundamental changes in the corporation.
31. (b) A stock split is a type of stock dividend and neither reduces the assets of a corporation nor increases the stockholder’s percentage of ownership. It is not considered a distribution and does not distribute assets. Thus, it cannot be considered an asset or capital distribution. Answer (a) is incorrect because a liquidating dividend is a distribution of capital assets to stockholders. Answer (c) and (d) are incorrect because both property distributions and cash distributions involve distribution of assets to stockholders. One distributes the assets in property and the other in cash.
32. (c) Under the business judgment rule, directors and officers are not liable if they acted reasonably and in good faith. Thus, the Mix’s board may avoid liability by showing that it acted in good faith and in a reasonable manner. Answer (a) is incorrect because a director is not strictly liable. Answer (b) is incorrect because the negligence of the CPA firm is not automatically imputed to the board. The board may usually rely on the reports of officers and agents (like a CPA firm’s report). Answer (d) is incorrect because the board can be liable without proof of scienter (intent to deceive). A director is liable for negligence, which does not require proof of scienter.
33. (b) Officers are agents of the corporation and are therefore fiduciaries. All agents can have actual and apparent authority. Answer (a) is incorrect because stockholders elect directors, not the officers. Answer (c) is incorrect because stockholders do not have the right to vote on removal of officers. They may only vote on the election of directors and on fundamental matters. Answer (d) is incorrect because directors declare dividends, not officers.
34. (a) Directors may rely on reports of officers or agents. Answers (b) and (d) are incorrect because a director is a fiduciary and must act solely in the corporation’s best interest. Serving on the board of a competing company and profiting from insider information would be a breach of a director’s fiduciary duty of loyalty. Answer (c) is incorrect because a director does not own control of the corporation, the majority stockholders do. Since the director does not own control of the corporation, the director can not sell control of the corporation
35. (d) An officer or director may make a personal profit on a contract with their own corporation if they make a full disclosure and do not participate in the approval process. Absent pre-approval, they may do so only if the contract is fair and reasonable to the corporation. Knox did not receive pre-approval for the stationery contract. However, since the price charged by Knox was less than any other supplier, the contract was fair to Quick and would be valid. Answers (a) and (b) are incorrect because the contract was valid. Answer (c) is incorrect because the disclosure was only made after the contract. Without pre-approval the contract could only be valid if it was fair and reasonable.
36. (b) Under the Revised Model Business Corporation Act a corporation may indemnify an officer or director for liability incurred in a suit by stockholders if they acted in good faith in the best interests of the corporation. Answer (a) is incorrect because an officer may also be a director. This is a common occurrence in business. Answer (c) is incorrect because stockholders elect directors, not officers. Answer (d) is incorrect because an officer is not required to own stock.
37. (a) Voluntary dissolution requires both a resolution to dissolve by the board of directors and approval by a majority of the stockholders. Answer (b) is incorrect because dissolution does not require approval by the officers. Answer (c) is incorrect because dissolution does not require an amendment to the articles of incorporation.
Once the corporation is dissolved there is no need for the articles of incorporation. Answer (d) is incorrect because dissolution requires approval by a majority of the stockholders, not a unanimous vote.
38. (b) An involuntary dissolution may be forced by stockholders for waste of corporate assets. Answers (a), (c) and (d) are incorrect because refusal of a board to declare dividends, loss operations for three years, and failure to file federal income tax are insufficient grounds for an involuntary dissolution.
39. (d) The maximum number of shareholders allowed in an S Corporation is 100.
40. (a) An S Corporation is allowed only one class of stock. That stock may, however, have different voting rights.
41. (b) Since the shareholders of Village Corporation did not make the consent by March 15, 2003, the election takes effect on January 1, 2004 (the next year).
42. (d) Since the shareholders of Ace Corporation made the consent by March 15, 2003, the election takes effect on January 1, 2003 (the current year).
43. (d) An S Corporation may have 100 shareholders. It may also have a decedent's estate as a shareholder.
However, if it has accumulated C Corporation earnings and profits, then violating the passive income rules for three consecutive years will cause the termination of the S Corporation status.
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44. (c) 10,000 and 16,000. What is needed is a majority of the voting and nonvoting shares to revoke the election.
In this problem the total number of shares is 50,000, therefore more than 25,000 is needed. Only answer (c) with 26,000 shares qualifies.
45. (c) 5 years. Once an S Corporation is revoked or terminated, the corporation generally may not re-elect for five years without IRS consent to an earlier election.
46. (c) November 1, 2003. In order to make a valid S Corporation election, all the shareholders must consent in writing. Form 2553 must be filed by the 15th day of the third month of the year in which the election is to be valid, or anytime during the preceding year. Since the election was not made by January 15, 2003, the election is effective for the following tax year beginning November 1, 2003.
47. (a) An S Corporation has restrictions on its shareholders, must be a domestic corporation and have only one class of stock. However, it does not need to be a member of a controlled group.
48. (b) March 15. This is same as for a regular C Corporation. The 15th day of the third month following the close of the taxable year.
49. (d) Yes and Yes. Since the corporation was always an S Corporation (and therefore cannot have any accumulated C Corporation earnings) the passive income is not an issue. A shareholder may be a bankruptcy estate.
50. (d) $0 and $0. An S Corporation is a pass-through entity. The ordinary income and long-term capital gains flow-through to its shareholders.
51. (c) Distributions to a shareholder decrease the shareholder's basis.
52. (b) $30,000. A shareholder in an S Corporation must recognize his proportionate share of income, deductions, credits and losses. In addition, the amounts of income reported by Haas Corporation will cause each shareholder's basis to increase by their share of the income (50% of $60,000, or $30,000). Recognize that the total income of
$60,000 is passed through to the shareholders in their separate components of ordinary income and interest income.
Also note that any tax-exempt income, while not present in this problem, also increases a shareholder's basis.
53. (b) $2,000. Meyer's share of the $36,500 loss is based upon two factors: (1) his share of the corporate stock and (2) the length of time holding the stock. As a 50% shareholder for 40 days, Meyer's loss is determined as follows:
$36,500 y 365 days $100 per day per shareholder $100 u 40 days $4,000 loss for 40 days
$4,000 lossu 50% ownership $2,000.
54. (c) Charitable contributions are separately stated items which are not allowed as deductions in the determination of ordinary income. Separately stated items are passed through to the individual shareholders to be used on their own returns. In this case, if the shareholder was an individual, the charitable contribution would be claimed as an itemized deduction on Schedule A. Unlike a partnership compensating its partners, the compensation of a corporation's officers is allowable as a deduction.
55. (d) An S Corporation may deduct the compensation paid to its officers in determining its ordinary income. The charitable contributions, net operating losses and foreign income taxes represent flow-through items which are required to be separately stately on the shareholders' K-1.
56. (c) $76,500. Zinco must allocate a prorata share of the income to the S Corporation's short year. The allocation is based upon the 90 days Zinco was an S Corporation.
$310,250 y 365 days = $850 per day
57. (a) $56,750. Kane's share of the $73,000 income is based upon two factors: (1) his share of the corporate stock and (2) the length of time holding the stock. As a 100% shareholder for 40 days, and then as a 75% shareholder for 325 days, Kane's share of the income is determined as follows:
Step 1 $73,000 365 days $200 per day
$200 40 days $8,000 (as sole shareholder) Step 2 $73,000 365 days $200 per day
$200 325 days $65,000 total income
$65,000 75% ownership $48,750
Step 3 Share of income as 100% shareholder $ 8,000 Share of income as 75% shareholder U 48,750 Total reported income by Kane $ 56,750
58. (d) Similar to the rules for a partnership, the "at risk" rules are determined at the shareholder level rather than at the corporate level.
59. (d) The payment of federal income taxes which are attributable to when the corporation was a C Corporation, would be reflected in the Accumulated Earnings and Profits account, not the Accumulated Adjustments Account.
The AAA account measures the undistributed earnings of the S Corporation.
60. (d) A S Corporation may have up to 75 shareholders. However, it may not have both common and preferred stock; have a corporation as a shareholder; or be a member of an affiliated group (at least 80%).
61. (b) $20,000. When a corporation incurs liabilities, the individual shareholders do not necessarily share in the responsibility to pay these liabilities. One characteristic of a corporation is limited liability. However, even if a shareholder was personally responsible for a debt (the shareholder guaranteed a bank loan), the shareholder's basis is not increased for the liability. This is a major difference from the rules related to partnerships. If, however, the shareholder lends money to the corporation, the shareholder's basis is increased by that amount. The basis of each shareholder determines the amount of the loss they can claim. Their basis is determined as follows:
Initial investment $ 5,000
Personal loan U15,000
Total basis $ 20,000
62. (d) A shareholder's basis is increased by the interest from both taxable and tax-exempt interest.
63. (b) Corporations require a recommendation by the board of directors and approval by a majority of all shareholders entitled to vote. Contrast this with a partnership, which requires the unanimous consent of all partners.
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