The Corporate Income Tax Chapter 3 ©2014 Pearson Education, Inc. 3-1 THE CORPORATE INCOME TAX (1 of 2)  Corporate elections  Computing corporation’s taxable income  Determining a corporation’s income tax liability ©2014 Pearson Education, Inc. 3-2 THE CORPORATE INCOME TAX (2 of 2)  Controlled groups of corporations  Tax planning considerations  Compliance and procedural considerations  Financial statement implications ©2014 Pearson Education, Inc. 3-3 Corporate Elections Initial Tax Year  New corp elects tax year by filing return  First return may be for short period  Some corporate restrictions S-corporation uses calendar year Affiliated group member same as parent PSCs usually calendar year ©2014 Pearson Education, Inc. 3-4 Corporate Elections Changing Tax Year  Usually requires IRS approval  Automatic approval if Annualizes short-period income Keeps books based on new year Short period does not have a NOL No change in acctg period for 48 mo. No interest in flow-through entities Not a specialized corporation ©2014 Pearson Education, Inc. 3-5 Corporate Elections Accounting Methods  Accrual GAAP generally required for C corps  Cash PSC, or C corp w/ gross receipts < $5M Inventories  If cannot be significant significant, use hybrid method Family farm w/ gross receipts < $25M ©2014 Pearson Education, Inc. 3-6 Determining a Corporation’s Taxable Income  Sales and exchanges of property  Business expenses  Special deductions  Exceptions for closely held corporations ©2014 Pearson Education, Inc. 3-7 Sales and Exchanges of Property Capital Gains & Losses  Net capital gain taxed at ordinary income rates  Net capital losses cannot offset ordinary income  Net capital losses Carryback 3 years and forward 5 years Carryovers classified as short-term Expired losses are lost forever ©2014 Pearson Education, Inc. 3-8 Sales and Exchanges of Property §291 Tax Benefit Recapture Rule  §1250 property sold at a gain Ordinary income portion Depreciation in excess of straight line plus 20% of all depreciation characterized as ordinary income under §291  No §1250 recapture under MACRS ©2014 Pearson Education, Inc. 3-9 Business Expenses  General rule  Organizational expenditures  Start-up expenditures  Limitations on deductions for accrued compensation  Charitable contributions ©2014 Pearson Education, Inc. 3-10 General Rule  All ordinary and necessary expenses reasonable in amount  No deductions for Interest Illegal Fines on loans to buy tax exempts bribes or kickbacks or penalties Insurance premiums if corp is beneficiary ©2014 Pearson Education, Inc. 3-11 Organizational Expenditures (1 of 2)  Expenses incident to creating corp E.g., legal, accounting, temporary director fees, state incorporation fees  §248 election deemed to be made No need to file election w/1st return May expense first $5K of org costs $5K reduced $ for $ in excess of $50K ©2014 Pearson Education, Inc. 3-12 Organizational Expenditures (2 of 2)  Amortize remainder over 180 months  Expenditures must be incurred before end of first year of business  May elect to capitalize and not amortize Election irrevocable ©2014 Pearson Education, Inc. 3-13 Start-Up Expenditures Basic Concepts  Non-organizational  Ordinary and necessary expenses  Paid or incurred BEFORE the actual start of business operations ©2014 Pearson Education, Inc. 3-14 Start-Up Expenditures Types of Expenditures  Investigate creation or acquisition of an active trade or business  Create an active trade or business  Conduct an activity engaged in for profit or production of income before business operations begin ©2014 Pearson Education, Inc. 3-15 Start-Up Expenditures Election  $5K reduced $ for $ above $50K  Remainder amortized over 180 mo.  Election made by due date for 1st yr. tax return or 1st yr. of ownership  Election deemed made w/1st return May elect to capitalize w/o amortization ©2014 Pearson Education, Inc. 3-16 Limitation on Deductions for Accrued Compensation  Accrued bonuses/compensation must be paid within 2-1/2 months after close of tax year If paid after 2-1/2 months, payment deemed deferred compensation and is deductible in year paid ©2014 Pearson Education, Inc. 3-17 Charitable Contributions Timing  Deducted in year paid  Accrual basis corp. election Include payments w/in 2½ months after year-end Contribution authorized by BoD during year accrued  Must meet substantiation requirements to deduct contribution ©2014 Pearson Education, Inc. 3-18 Charitable Contributions Types of Contributions (1 of 2)  Donated money  Non-cash property USUALLY FMV of property donated Ordinary income property Deduction limited to FMV less Ord Inc or STCG that would have been recognized if property were sold (includes recapture) ©2014 Pearson Education, Inc. 3-19 Charitable Contributions Types of Contributions (2 of 2)  Non-cash property (continued) Inventory related to exempt function Deduction = adjusted basis + 1/2 gain Similar rule for computer technology donated for educational purposes Special rules for contributions of computer equipment, book inventory, and wholesome food inventory ©2014 Pearson Education, Inc. 3-20 Charitable Contributions Limitations  Max deduction 10% of ATI ATI - taxable income before charitable contribution deduction, NOL carryback, capital loss carryback, DRD, & U.S. prod. activities ded.  Excess carried forward for 5 yrs Creates a deferred tax asset ©2014 Pearson Education, Inc. 3-21 Special Deductions  U.S. production activities deduction  Dividends-received deduction  Net operating losses  Sequencing of the deduction calculations ©2014 Pearson Education, Inc. 3-22 U.S. Production Activities Deduction Basic Concepts  Deduction is Qualified 9% times lesser of prod. activities income OR Taxable income before the U.S. production activities deduction  Limited to 50% of W-2 wages  Not an expense for financial acctg. Creates a permanent difference ©2014 Pearson Education, Inc. 3-23 U.S. Production Activities Deduction Qualified Production Activities Income  Domestic production gross receipts from lease, rental, sale, or exchange of tangible property manufactured in the U.S. LESS  Expenses related to qualified income including CoGS, & indirect allocable expenses ©2014 Pearson Education, Inc. 3-24 Dividends-Received Deduction (1 of 3)  Corps owning < 20% of a domestic corporation deduct lesser of 70% of Dividends Received or 70% of taxable income before NOL, capital loss carryback or DRD Exception to taxable income limitation If 70% of dividend received creates an NOL, then the full DRD is deductible ©2014 Pearson Education, Inc. 3-25 Dividends-Received Deduction (2 of 3) owning  20% and < 80% of a domestic corp  Corps 80%  Corps deduction instead of 70% owning  80% of domestic corp Member 100% of affiliated group deduction ©2014 Pearson Education, Inc. 3-26 Dividends-Received Deduction (3 of 3)  No deduction is allowed if: Paying corp is a foreign corp Stock purchased w/borrowed money Stock of paying corp held for < 46 days  Results in a permanent difference Affects effective tax rate, but not deferred taxes ©2014 Pearson Education, Inc. 3-27 Net Operating Losses (NOL)  Deductions exceed gross income for the year before NOL carrybacks  NOL may be carried back 2 yrs & then forward 20 yrs Corp may elect to forgo carryback & only carry NOL forward 20 yrs  Creates a deferred tax asset ©2014 Pearson Education, Inc. 3-28 Sequencing of the Deduction Calculations 1. 2. 3. 4. 5. All other deductions Charitable contributions DRD NOL U.S. production activities deduction ©2014 Pearson Education, Inc. 3-29 Exceptions for Closely-Held Corps Shareholders Owning > 50% of Corp. (1 of 2)  §1239  Sale of depreciable property to corp. Causes gain to be ordinary income to the controlling shareholder  §267 Disallows loss on sale of property by corp to controlling shareholder Loss may be recovered by shareholder if later sells prop at a gain ©2014 Pearson Education, Inc. 3-30 Exceptions for Closely-Held Corps Shareholders Owning > 50% of Corp. (2 of 2)  Corporation and shareholder using different accounting methods Defers deduction for accrued expenses owed by accrual-method corp to cash-method controlling shareholder until income recognized by cash-method shareholder ©2014 Pearson Education, Inc. 3-31 Exceptions for CloselyHeld Corps Loss Limitation Rules > 50% ownership by ≤ 5 sh’s Corp’s losses limited to “at risk” amount Losses not currently deductible Carried May over to be used in a later year be subject to passive activity rules  PSCs and closely held corps subject to passive activity limitation rules ©2014 Pearson Education, Inc. 3-32 Computing a Corporation’s Income Tax Liability  General rules  Regular income tax formula  Personal service companies ©2014 Pearson Education, Inc. 3-33 General Rules  Tax rates are graduated  Rate surcharges eliminate benefit of lower graduated tax rates from lower income brackets  Corps with income >$18.33M pay a flat 35% on all income ©2014 Pearson Education, Inc. 3-34 Regular Tax Formula Regular Tax Liability before Credits Gross Income - Deductions and Losses - Special Deductions Taxable Income x Appropriate Rate (or rates) Regular Tax Liability before credits ©2014 Pearson Education, Inc. 3-35 Regular Tax Formula Regular Tax Liability Regular Tax Liability before credits - Foreign tax credit - Other credits + Credit recapture Regular tax liability ©2014 Pearson Education, Inc. 3-36 Regular Tax Formula Refund or Tax Due Regular Tax Liability + AMT Liability + Special Taxes (if any) - Estimated Payments Refund or tax due ©2014 Pearson Education, Inc. 3-37 Personal Service Corporations (1 of 2)  Taxed at a flat 35%  Substantially all activities involve services in following fields: Health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting ©2014 Pearson Education, Inc. 3-38 Personal Service Corporations (2 of 2)  Substantially all stock must be owned by employees, former employees or survivors of employees ©2014 Pearson Education, Inc. 3-39 Controlled Groups  Why special rules are needed  What is a controlled group?  Special rules applying to controlled groups  Consolidated tax returns ©2014 Pearson Education, Inc. 3-40 Why Special Rules are Needed  Prevent shareholders from using multiple corporations to avoid having income taxed at 35% Each corp would be able to take advantage of lower graduated rates  Lower graduated rates must be spread among all corporations in a controlled group ©2014 Pearson Education, Inc. 3-41 What Is a Controlled Group?  Two or more corps owned directly or indirectly by same shareholder or group of shareholders  Types of controlled groups Parent-subsidiary Brother-sister Combined ©2014 Pearson Education, Inc. 3-42 Parent-Subsidiary Controlled Group (1 of 2)  One corp directly owns at least: 80% of voting power of all classes of voting stock OR 80% of total value of all classes of stock of subsidiary corporation ©2014 Pearson Education, Inc. 3-43 Parent-Subsidiary Controlled Group (2 of 2)  Axle is a sub of Parent due to 80% direct ownership  Wheel is a member of same p-s group because of 80% owned by Parent & Axle ©2014 Pearson Education, Inc. 3-44 Brother-Sister Controlled Group (1 of 2)  50%-80% ≤ definition 5 individuals, trusts or estates own: ≥ 80% of voting power or ≥ 80% of value of stock of two or more corps AND > 50% of voting power or value held by identical owners (common ownership)  50%-only definition is 2nd test above ©2014 Pearson Education, Inc. 3-45 Brother-Sister Controlled Group (2 of 2)  80% Test  Walt & Gail own 100% of North and South  50% Test  Walt’s & Gail’s common ownership is 60% (30% of North & 30% of South) ©2014 Pearson Education, Inc. 3-46 Combined Controlled Groups (1 of 2)  Three or more corps which meet the following criteria: Each corp. is a member of a parentsubsidiary or brother-sister group At least one corp. is both a parent and a member of a brother-sister group ©2014 Pearson Education, Inc. 3-47 Combined Controlled Groups (2 of 2)  Able & Coast are brother-sister controlled group  Able & Best are parent-subsidiary controlled group  Parent member of both groups ©2014 Pearson Education, Inc. 3-48 Special Rules Applying to Controlled Groups Brother-Sister ParentSubsidiary 50%Only 50%80% ≥ 80% Low-bracket tax rates X X X AMT exemption X X X Min accum. earnings credit X X X §179 expense limit X X Gen. business credit limit X X Item ©2014 Pearson Education, Inc. ≥ 50% X 3-49 Consolidated Tax Returns  Affiliated groups  Advantages of filing a consolidated return  Disadvantages of filing a consolidated return ©2014 Pearson Education, Inc. 3-50 Affiliated Groups (1 of 2)  One or more chains of includible corps connected through stock ownership to a common parent  Common parent directly owns 80% of voting power AND value of at least one includible corporation ©2014 Pearson Education, Inc. 3-51 Affiliated Groups (2 of 2)  Each corp owned at least 80/80 by another member of the group  An affiliated group MAY file a consolidated return Capital losses offset capital gains from other group members Operating losses reduce operating income from other group members ©2014 Pearson Education, Inc. 3-52 Consolidated Return Advantages  Losses of one member offset gains of another member  Cap. losses of one member offset cap. gains of another member  Profits and gains from intercompany transactions deferred until sale outside of group ©2014 Pearson Education, Inc. 3-53 Consolidated Return Disadvantages  Election binding on all subsequent tax years Unless IRS grants permission  Losses from intercompany transactions deferred until sale outside of group  Additional administrative costs ©2014 Pearson Education, Inc. 3-54 Tax Planning Considerations  Compensation planning for shareholder-employees  Special election to allocate reduced tax rate benefits  Using NOL carryovers and carrybacks ©2014 Pearson Education, Inc. 3-55 Compensation Planning  Salary payments Reduce double taxation if paid to shareholder-employees  Fringe benefits Deducted by corporation and certain benefits are not to be taxable to shareholder-employee ©2014 Pearson Education, Inc. 3-56 Allocating Reduced Tax Rate Benefits A controlled group may apportion lower tax rates in any manner to member corporations Reduce benefits to members with little or no income Increase benefits to members with the highest income ©2014 Pearson Education, Inc. 3-57 Using NOL Carryovers and Carrybacks  Two options Carryback to 2nd previous year, then 1st previous year, then forward Forgo carrybacks and carry forward  Maximize tax benefits Examine prior and expected future marginal tax rates ©2014 Pearson Education, Inc. 3-58 Compliance & Procedural Considerations Estimated Taxes  Estimated taxes required if corp owes >$500 for current year  Pay in four installments Each installment 25% of annual liability  Underpayment of est. tax penalty Small corps exemption if pay lesser of 100% of prior or current year’s liability ©2014 Pearson Education, Inc. 3-59 Compliance & Procedural Considerations Filing Requirements (1 of 2)  Return always required each year  Use Form 1120 Use Form 1120A if gross receipts, total income & total assets each < $500K  Large corps (assets>$10M) must fill out more detailed schedule M-3 ©2014 Pearson Education, Inc. 3-60 Compliance & Procedural Considerations Filing Requirements (2 of 2) ©2014 Pearson Education, Inc. 3-61 Financial Statement Implications  ASC 740 - Income Taxes  Temporary differences  Deferred tax assets and the valuation allowance  ASC 740 - Uncertain Tax Positions  Balance sheet classification  Tax provision process ©2014 Pearson Education, Inc. 3-62 ASC 740 - Income Taxes Scope  Establishes principles of accounting for current and deferred taxes Arising from temporary differences ©2014 Pearson Education, Inc. 3-63 ASC 740 - Income Taxes Objectives  Recognize current year taxes payable or refundable  Recognize deferred tax liabilities and assets for future tax consequences of events on financial statements or tax return ©2014 Pearson Education, Inc. 3-64 ASC 740 - Income Taxes Principles  Addresses financial statement consequences of Rev, exp, gains/losses recognized in different years for tax and financial statement purposes Events affecting book/tax differences in bases of assets and liabilities Loss & credit carrybacks/carryforwards ©2014 Pearson Education, Inc. 3-65 Temporary Differences Deferred Tax Liabilities  Rev/gains recognized earlier for book than tax  Exp/losses deducted earlier for tax than book  Tax basis of asset < book basis  Tax basis of liability > book basis ©2014 Pearson Education, Inc. 3-66 Temporary Differences Deferred Tax Assets  Rev/gains recognized earlier for tax than book  Exp/losses deducted earlier for book than tax  Tax basis of asset > book basis  Tax basis of liability < book basis  Loss/credit carryforwards exist ©2014 Pearson Education, Inc. 3-67 Deferred Tax Assets and the Valuation Allowance  Deferred tax asset Firm will realize tax benefit of event in the future Valuation allowance used for portion of benefit not likely to be realized Use “more likely than not” standard ©2014 Pearson Education, Inc. 3-68 ASC 740 - Uncertain Tax Positions  Two-step to account for uncertain tax positions Determine if position exceeds “more likely than not” (>50%) probability of being sustained on its merits by IRS If not, corp cannot recognize tax benefit  Records If liability for unrecognized tax benefits yes, measure amount of benefit ©2014 Pearson Education, Inc. 3-69 Balance Sheet Classification  Classify as current or noncurrent  If related to another asset or liability use classification of related asset/liab  Net current assets and liabilities  Net noncurrent assets and liabilities ©2014 Pearson Education, Inc. 3-70 Tax Provision Process (1 of 3) Identify temporary differences and tax carryforwards 2. Prepare “roll forward” schedules 3. Apply appropriate tax rates in roll forward schedules to determine deferred tax asset/liability balances 4. Adjust deferred tax assets by valuation allowance if necessary 1. ©2014 Pearson Education, Inc. 3-71 Tax Provision Process (2 of 3) Adjust income tax expense for uncertain tax positions under ASC 740 6. Determine current federal income taxes payable (current tax expense) 7. Determine total federal income tax expense (benefit) 5. ©2014 Pearson Education, Inc. 3-72 Tax Provision Process (3 of 3) Prepare and record tax journal entries 9. Prepare tax provision reconciliation 10. Prepare tax rate reconciliation 11. Prepare financial statements 8. ©2014 Pearson Education, Inc. 3-73 END Chapter 3 ©2014 Pearson Education, Inc. 3-74 Corporate Nonliquidating Distributions Chapter 4 ©2014 Pearson Education, Inc. 4-1 NONLIQUIDATING DISTRIBUTIONS (1 of 2)  Nonliquidating distributions in general  Earnings and profits (E&P)  Nonliquidating property distributions  Stock dividends and stock rights  Stock redemptions ©2014 Pearson Education, Inc. 4-2 NONLIQUIDATING DISTRIBUTIONS (2 of 2)  Preferred stock bailouts  Stock redemptions by related corporations  Tax planning  Compliance and procedural considerations ©2014 Pearson Education, Inc. 4-3 Nonliquidating Distributions Dividend Distributions in General A distribution of property based on corporation’s earnings & profits (E&P)  Property includes Money, securities, and other assets Not stock/stock rights of distrib. corp  Dividends treated as ordinary income by shareholder (15% LTCG rate) ©2014 Pearson Education, Inc. 4-4 Nonliquidating Distributions Earnings & Profits (E&P) in General  E&P not defined in the Code  Consists of current & accumulated  Distributions are based upon current E&P first & accumulated E&P second  Distributions in excess of E&P are considered a return of capital ©2014 Pearson Education, Inc. 4-5 Earnings and Profits Current E&P Basic Concepts  E&P computed on annual basis at end of tax year  Generally E&P based on corp’s economic income instead of TI  Adjustments to taxable income for permanent & timing differences including use of different depr methods  Refer to Table 1 ©2014 Pearson Education, Inc. 4-6 Earnings and Profits Current E&P Computation Taxable income + Excluded taxable income + Taxable income deferred to another year +/- Inc & deduct recomputed under E&P rules + Deductions disallowed for E&P - Nondeductible items that reduce E&P Current E&P (or current E&P deficit) ©2014 Pearson Education, Inc. 4-7 Earnings and Profits Current vs. Accumulated E&P (1 of 3)  Current E&P (CE&P) computed on last day of the corp’s tax year Distributions  Distributions first from CE&P greater than CE&P CE&P allocated to distributions pro rata regardless of payment date Then AE&P (only if positive) allocated to distributions in chronological order ©2014 Pearson Education, Inc. 4-8 Earnings and Profits Current vs. Accumulated E&P (2 of 3)  Distributions Cannot greater than E&P create an E&P deficit Distributions in excess of all E&P are a return of capital to shareholders and reduce shareholders’ basis in stock Distributions in excess of basis result in a gain (usually capital gain) ©2014 Pearson Education, Inc. 4-9 Earnings and Profits Current vs. Accumulated E&P (3 of 3)  If CE&P is positive and beginning AE&P is a deficit Distributions will produce ordinary income to shareholder until CE&P reaches zero CE&P allocated on a pro-rata basis  Deficit in CE&P transferred to AE&P before classifying distributions ©2014 Pearson Education, Inc. 4-10 Nonliquidating Property Distributions  Shareholder consequences  Corporation’s consequences Example 15 Example 16 Distribution’s  Constructive effect on E&P dividends ©2014 Pearson Education, Inc. 4-11 Shareholder Consequences  Non-cash distributions Income equal to FMV of property received minus liabilities assumed  Amount of distribution cannot  Basis in non-cash property FMV be
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