 Hello and welcome to the session. This is Professor Farhad and this session I'm gonna go over a CPA simulation that a student asked me to review. So this way I would review and benefit everyone as well. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, tax, finance, CPA questions, CPA simulations. So if you're studying for your CPA, a strongly suggest you visit my YouTube and website. On my website, I do have additional resources such as PowerPoint, slides, notes, true, false, multiple choice. If you're studying for your CPA exam, I have 2,000 plus CPA questions plus practice other simulations of your serious about passing your exam. I strongly suggest you check out my website. You're gonna invest for your CPA once in your lifetime. So let's go ahead and take a look at this simulation. So this is the simulation at face value. It might look intimidating. If you look under the documentation, you have a mortgage statements, you have to worry about, you have a purchase agreement, you have a lot of numbers flying around. The first thing you wanna do with the simulation is just to get a general idea what you are looking for. As I always say in all my lectures about simulations, simulations are no more than multiple choice questions, a package in a different way. It's just a multiple choice, but the way they package the material, it's in a different way. Sometimes it's easier than the multiple choice. The only thing is they try to confuse you, they try to intimidate you. Therefore, just you have to calm down when you get to the simulation and look at what they're asking you. So let's go over it real quick and I will tell you how to find out what is the simulation is about. So first you wanna read the main information before you look at the exhibit. Stone and Company, CPA has been engaged to assist with the filing of tax return for a new real estate development startup, Lifestyle Living, Incorporated, which is Lifestyle Living, which formed on January 1st, 2019. Gerald contributed a piece of land on a Newberry Road in exchange for $100,000 cash and 14% of the lifestyle common stock. So we have one shareholder named Gerald. The contributed land was subject to a mortgage which was assumed by the new company, Lifestyle Living. Jenny contributed $900,000 cash for a 40% of the lifestyle common stock. What does that mean? It means Gerald, immediately I know that Gerald also received 9,000 worth of stock. Why? Because if Jenny contributed cash for 900,000 and received 40% and Newberry, I'm sorry, Newberry, Gerald also got 40%. It means Gerald value, okay, stock value is 900,000 or the stock received because 40% must not be 900,000. And Adam contributed legal service in exchange for 20%. So what are we looking at here real quick if you really want to look at this just in case, I mean, if we're gonna look at this one moment and here if you watch sharp tank, you should be familiar with this. So if we said 900,000 equal to 40% of the company, it means the company is worth the overall 2,250,000 if we multiply it by 0.2, that's Adam's share, 450,000 plus 900,000 for Gerald plus 900,000 for Jenny, that's 2,250,000. You don't have to do this. You just, you wanna make sure you are comfortable with these percentages, okay? So this is how I knew that the stock value that Gerald received is 900,000 from what from the information that was given about Jenny so far so good. Documentations of the schedule in question can be found in exhibit tab after initial review of the documentation staff associate prepare the draft letter to Gerald, Donald the partner in charge of the engagement ask you to review the documentation and correct any errors. So we're dealing with Gerald here it seems whether Gerald contributed the land, they got 100,000 in return, the land had a loan of 125 to revise the document, click on each segment of the underlying text below and select the needed correction. If any from the list provided if the underlying text is correct and the context of the document select the original text of the removal of the underlying text is the best revision of the document select the lead text from the list if available. So here's the letter. So we are addressing it to Gerald. Gerald happens to be the president and dear Gerald, we would like to provide you a few updates upon review in the documentation you have provided for lifestyle incorporated. We first had to evaluate the amount of gain you must recognize in the transfer of land to the lifestyle living after evaluation according to internal revenue code section 351. Right there at this moment we're dealing with a section 351. Okay, so if you're not comfortable with section 351 if you are not comfortable going into the exam you're gonna bomb this simulation. Otherwise if you're comfortable with section 351 you're gonna say bring it on, I can do this. Okay, so this is what I'm trying to say is you wanna know what is it about? What is the simulation about? It seems it's revolving around section 351. And it makes sense. If Gerald contributed land and received boot of 100,000 and the land has liabilities, I would say right from the beginning we're gonna be talking about section 351. The first thing, the first draft it says you don't have to recognize any gain of the transfer. Is this correct? And the answer is no. You don't wanna keep this as the right answer. You don't have to recognize any gain. Why? Because Gerald received, received boot, received $100,000 boot. So we need to know how much is Gerald responsible for? Well, here are the options. We really don't know. I mean, it could be 100,000, 375, 225. So is it no gain? Yes, there is a gain and we need to know how much is the gain. Now you need to know how much we know the boot. We know the boot is 100,000, okay? Now we need to know how much did, what is the realized gain to compare the realized gain to the boot? What do I mean by this? Okay, let me see this. Let me if I can write this here. Let me just capture this. So once we have section 351 in boot, well, what we have to do, we have to look at the boot and the boot is well known. We know the boot is 100,000 and we have to compute the realized gain. How much is the realized gain? And the lesser of these two will be taxable, okay? The reason is because Gerald received 100,000, received the boot. Therefore, we have to know how much is the realized gain and we're gonna select the lower of the two. Now to figure out how much is the realized gain, we have to know how much did Gerald received in value versus the basis of the property because he kind of contributed the property. So what is the realized gain on the property? Well, now we have to kind of go into the different information to find out. Well, we know that Gerald received 900,000 worth of stocks. How do I know this? I already told you this earlier. 40% of the total value of the company is 900,000. So what else did Gerald received? So in addition to the 900,000, Gerald received 100,000 in cash and Gerald also in a sense received 100 and, oh well, let's see what else did they receive. It has a mortgage. The land has a mortgage. If we look at the mortgage statement, so here where you have to kind of calm down and don't be too nervous here, there's a lot of numbers. If it's a mortgage, it means I'm dealing with it that. Go to see where the balance is. The balance of the loan for that piece of land is 125. Here's the property, Lot 57 Newberry Road. It seems when Gerald contributed this property, there was a loan of 125, okay? So now I know how much did Gerald received and I'm gonna write those later on in a moment. They received stocks worth of 100,000. They received cash worth 100,000 and in a sense they received a debt relief of 125. Now, those are what they received. What is the basis of the land? Well, here's the purchase agreement. Let's see how much did Gerald paid for that land. Well, this purchase agreement dated January 1st, 2017 between Larson real estate and Gerald. Good. The seller agrees to sell Lot 57 Newberry Road on the following terms and condition under the purchase price of 750,000. The seller would deliver to the buyer. It doesn't matter, not really that much. In the event of the seller isn't able to deliver, that's fine. So I know the basis, the cost basis is 750, okay? Now, let me go back and figure out what's my realized gain? What's my realized gain? Okay. Now, again, let's take a look at this. So Gerald received 900,000 worth of stocks. Okay, how did I know this? Again, I told you if Jenny received 40% for 900,000 and he got 900,000, it means the stock is worth 900,000. That's worth of stocks. Received 100,000 in cash and received 125,000 in a debt relief. Okay, and I got this from the mortgage statement. Okay, so all in all Gerald received 1,125,000 and the basis of the land was 750. How did I know the basis is 750? It's from the purchase agreement. So the realized gain, if my math is right, is 375. This is the realized gain. So now, how much is taxable? How much is taxable? Well, again, I have to choose between the two. I have to choose between the boot and we say the boot is 100,000. Now, my quite say, isn't the 125 a boot? No, the debt, if it's less than the land, the debt is considered a boot if it's greater than the land. The debt is less than the land. So the 125 is not technically a boot for this purpose. 100,000 and realized gain, RG, realized gain is 375. So which one, the lower of these two? The lower of these two is 100,000. Therefore, I can make my first correction. I can make my first correction. If we first have to evaluate the amount of any gain you must recognize after our evaluation, you must recognize $100,000 worth of gain. Notice they're giving you 375 to confuse you. This is the realized, realized. The 375 is the realized. The recognized is only 100,000. They're giving you 225. They're giving you 125, which is the debt. They're giving you the debt plus the cash, which is the debt is not considered a boot here. And the 150, I'm not really sure how they're trying to confuse it with the 150, but you could figure it out. I'm sure somehow that's computation gives you 150. So what's recognized here is 100,000, okay? So simply put, this question could be in a multiple choice setting. All what they did is they gave you a lot of information to try to confuse you. We have determined that the basis of the Newberry land contributed to lifestyle living incorporated will be, they're saying 750. Well, and the answers are 750, which is the basis of the land, a million dollar, which is the fair market value of the land minus the mortgage, because it was 1,125 minus 125, is it 850 or adjusted basis in the land plus recognized gain? I would say this is the answer. This is the answer because the basis for the land is the basis plus any gain recognized. Any gain recognized, recognized. So what's important about this question? If you didn't get one right, you may get two wrong. Because if you don't know how much gain was recognized, we recognized gain of 100,000. Therefore the basis for the corporation is 850, the basis plus any gain recognized by the shareholder, which is 100,000. So 850 is the answer here. 850 or adjusted basis in the land plus recognized gain, okay? And the reason that is, is you already pay taxes on the gain, the 100,000. Phase one of the Newberry Town Center was completed under budget, which allowed you to receive a 60,000 of cash distribution. For tax purposes, it seems the entire amount is considered a qualified dividend. And will be taxed at the capital gain rate. So this is the original document. Now let's talk, let's look at the earnings and profit here. Let's look at this exhibit. So lifestyle, living, incorporated, they have earnings and profit in total of 100,000. Taxable income, interest from the minibon, depreciation and access of the straight line, 100,000 in total, that's EMP. And remember Gerald owned 80, sorry, 40%, Jenny owned 40%, and Armstrong owned 20%. So here's what's gonna happen. The company made, not made earnings and profit is 100,000 and they contributed 60, 60 and 30, they did distribution of 150. And what they're telling Gerald here, they're telling Gerald that the whole 60 is dividend. Is that correct? Well, remember the dividend is to the extent of EMP. Okay, well let's take a look at this. Let's capture this, let's capture this and work with this. Let's capture this. Here's what we are saying. If we're gonna be distributing 150, it's more than 100,000 of the EMP. Here's what's gonna happen. Technically, not technically, we have this 100,000, this 100,000, it's gonna be distributed at 40, 40 and 20. So we have Gerald, Jenny and Adam. So Gerald technically will get 40,000 in dividend because dividend is only to the extent of EMP. Same thing with Jenny, 40,000 and that will be considered dividend and 20,000 and that will be considered dividend. Now notice Gerald got 60,000. So what happened to the extra 20,000? That's ROC, return of capital, or I'm not sure what language they're gonna be using for the simulation, but it's basically return of capital, return of capital. Same thing with this extra 20,000 here plus the extra 10,000 that Adam got. Now, if you pay an excess of return of capital, if basically a reduction in the basis, then it's capital gain. So return of capital is tax free. You don't pay taxes on that. So let's go back here and see what we have as options for the simulation. The distribution is not considered qualified dividend, but it's considered dividend, all such countries considered non-qualified dividend. Under IRS 301s, distribution of the profit are not allowed. That's fine. Therefore, the amount you receive must be returned to that now. That's not true. Under section 301, the entire is considered in order of capital that reduces your basis. No, there's EMP. Under IRS section 316, 40,000 is considered dividend and 20,000 is considered return of capital that reduces your basis or also return of capital. So that's the correct answer. That's the correct answer. So that's the correct answer. So you wanna know what 301. I'm not gonna go into section 301, but you need to know what section 301 is. Lastly, we notice lifestyle living announced a stock split to attract new investors. No additional shares were sold until January 1st when the fair market value per share was 525. Your basis in stock of the lifestyle living is of December 31st. So what are your basis in the stock? And they're saying 605 and the answer is correct, but the original answer is correct. They were giving you 625, 900,000, 12.5 million. So they're giving you 900,000 to confuse you with the value of the stock with a 40%. Don't select 12 million, 500,000. And I'm not sure how they come up with 945. I'm sure there is a way to do this, but how do you come up with the basis of your stock? Remember in section 351, your basis transfer. So you contributed. Here's what happened here. So you need to know the formula for the basis. And again, I cover all of these in my lectures. So section 351, you'll start with your basis, which is you started with your basis of the property. Remember this is section 351 is 750, the basis, because your basis transferred. Then you recognize the gain of 100,000. When you recognize the gain, you add the gain to your basis, recognized gain. Now, why do you do so? Because higher basis gives you lower taxes in the future. So you increase your basis, you increase your basis by the recognized, realized, recognized gain. Then you receive the boot. You receive a boot, you reduce your basis by the boot. But remember too, in addition to that, there was a relief of debt. It's gonna reduce your basis because you got a benefit that assumed, because they assumed that on your behalf, that's gonna reduce your basis. So basically 100,000 plus $100,000 minus is zero. So 750 minus 125. But remember also, you had to reduce your basis by 20,000, why the 20,000? Remember when they gave you $60,000 in dividend, don't forget about this, 40,000 was dividend and 20,000 was return of capital, which reduces your basis, gives you a basis in the stock of 605, the basis of the stocks of 605. And that's why the answer is correct. As you can see, I mean, this simulation is pretty intimidating at first, when you look there's a lot, we have a mortgage statement, we have a purchase agreement, we have earnings and profit. I didn't even look at the stock split news announcement because I felt I did not really need it. So first, how do you attack a simulation? See what is it about and don't panic. Sometime they're gonna give, and the way I feel, the more they give you documents, the simpler is the simulation, why because they try to overwhelm you. So the key is remember, what's the big idea? Don't panic and start to work with this. And unfortunately, a simulation like this, if you get one wrong, you're gonna get two wrong, okay? And if you get one and two, you may get three because you really don't understand the concept, but three, it could be independent because if you know that they paid 60,000, 40,000 goes to Gerald, the other must be return of capital. And four is dependent on one and two, if you understand what, recognize gain, if you understand the boot. So it's easy, but it's nasty because the answers depend on other answers. Don't panic, don't panic. Just be as comfortable as possible. What can I do for you? Go to my website. I have plenty of lectures about section 351, exercises, illustrations to help you get comfortable. The more you are comfortable on the CPA exam day, the more you're gonna be able to attack those questions. Good luck and subscribe. You're gonna invest in your career. You're gonna do this once in a lifetime. This is 30 to 40 year career. Take it seriously, pass your CPA exam.