QFC Tax Planning & Preparation 3 — Questions and Answers
Question 1: A private equity fund uses a 'tax blocker' corporation when investing on behalf of foreign limited partners. What is the primary purpose of this structure?
- To avoid US estate tax on the fund's US situs assets
- To prevent foreign investors from being subject to US effectively connected income (ECI) and FIRPTA withholding (Correct answer)
- To convert ordinary income to capital gains before distribution
- To elect mark-to-market accounting for the fund's portfolio
Correct answer: To prevent foreign investors from being subject to US effectively connected income (ECI) and FIRPTA withholding
Tax blocker corporations shield foreign investors from US ECI taxation and FIRPTA withholding by converting pass-through income into corporate dividends subject only to withholding tax.
Question 2: Under the 'constructive receipt' doctrine, when must a cash-basis taxpayer recognize income?
- Only when cash is physically received in hand
- When income is credited to the taxpayer's account or made available without restriction (Correct answer)
- When the payor issues a Form 1099
- At the earlier of actual receipt or the end of the tax year in which earned
Correct answer: When income is credited to the taxpayer's account or made available without restriction
The constructive receipt doctrine requires recognition when income is credited, set apart, or otherwise made available to the taxpayer without substantial restriction.
Question 3: An investor contributes $100,000 of appreciated stock (basis $20,000) to a Donor Advised Fund (DAF). What are the tax consequences?
- Deduction of $20,000 (basis) and no capital gains tax
- Deduction of $100,000 FMV and no capital gains tax on the appreciation (Correct answer)
- Deduction of $100,000 FMV but must pay capital gains tax on $80,000 gain
- No current deduction; deduction taken when DAF makes grants to charities
Correct answer: Deduction of $100,000 FMV and no capital gains tax on the appreciation
Contributing long-term appreciated securities to a DAF allows the donor to deduct the full FMV and permanently avoid capital gains tax on the built-in appreciation.
Question 4: What is the 'alternative minimum tax' (AMT) preference item most commonly triggered by exercise of incentive stock options (ISOs)?
- The option premium paid at grant
- The spread between the exercise price and FMV at exercise date (Correct answer)
- The gain recognized when the ISO shares are ultimately sold
- The difference between the ISO exercise price and the 409A valuation
Correct answer: The spread between the exercise price and FMV at exercise date
For AMT purposes, the bargain element (FMV minus exercise price) at ISO exercise is an AMT preference item even though it is not recognized for regular income tax.
Question 5: Which transfer pricing method is generally considered the most reliable under IRC §482 and OECD guidelines when a comparable uncontrolled price exists?
- Cost Plus Method
- Comparable Uncontrolled Price (CUP) Method (Correct answer)
- Profit Split Method
- Transactional Net Margin Method (TNMM)
Correct answer: Comparable Uncontrolled Price (CUP) Method
The CUP method is the most direct and preferred transfer pricing method when reliable comparable uncontrolled transactions exist because it directly benchmarks the price.
Question 6: An S corporation has accumulated earnings and profits (AE&P) from years when it was a C corporation. A distribution that exceeds the accumulated adjustments account (AAA) and AE&P triggers what tax consequence?
- Return of capital treatment, tax-free to the extent of basis
- Dividend income taxed at the shareholder's ordinary income rate (Correct answer)
- Capital gain treatment to the extent of the shareholder's basis
- No tax consequence as S corporation distributions are always tax-free
Correct answer: Dividend income taxed at the shareholder's ordinary income rate
Distributions from an S corporation's AE&P (from prior C corporation years) are treated as dividends, taxable as ordinary income to the shareholder.
Question 7: A quantitative fund structured as a partnership allocates $1M of passive losses to a limited partner. The LP has no passive income. How much of this loss can the LP deduct currently?
- The full $1M against any income
- $1M only against portfolio income from the same fund
- $0 currently; the loss is suspended until future passive income or disposition (Correct answer)
- $25,000 against active income if MAGI is below $100,000
Correct answer: $0 currently; the loss is suspended until future passive income or disposition
Under the passive activity loss rules (IRC §469), passive losses can only offset passive income; excess losses are suspended until the taxpayer has passive income or disposes of the activity.
QFC Tax Planning & Preparation 3
A private equity fund uses a 'tax blocker' corporation when investing on behalf of foreign limited partners.
What is the primary purpose of this structure?