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Chapter 3

Chapter 3. Corporations: Special Situations. Domestic Production Activities Deduction (slide 1 of 5). The American Jobs Creation Act of 2004 created a new deduction, the domestic production activities deduction (DPAD) Based on income from manufacturing activities

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Chapter 3

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  1. Chapter 3 Corporations: Special Situations

  2. Domestic Production Activities Deduction (slide 1 of 5) • The American Jobs Creation Act of 2004 created a new deduction, the domestic production activities deduction (DPAD) • Based on income from manufacturing activities • Calculated using the following formula: • 9% × Lesser of • Qualified production activities income • Taxable income (or modified AGI) or AMTI • The deduction cannot exceed 50% of an employer’s W–2 wages properly allocable to domestic production gross receipts

  3. A phase-in provision increased the applicable rate for the production activities deduction as follows: RateYears 3% 2005-2006 6% 2007-2009 9% 2010 and thereafter Domestic Production Activities Deduction (slide 2 of 5)

  4. Domestic Production Activities Deduction (slide 3 of 5) • Eligible taxpayers include: • Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts • For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners • For sole proprietors, a deduction for AGI results • For C corporations, the deduction is included with other expenses in computing corporate taxable income

  5. Domestic Production Activities Deduction (slide 4 of 5) • Qualified production activities income is the excess of domestic production gross receipts over: • Cost of goods sold (CGS) • Direct costs • Allocable indirect costs

  6. Domestic Production Activities Deduction (slide 5 of 5) • Domestic production gross receipts (DPGR) include receipts from: • Lease, rental, license, sale, exchange, or other disposition of qualified production property (QPP) that was manufactured, produced, grown, or extracted in the U.S. • Qualified films largely created in the U.S. • Production of electricity, natural gas, or potable water • Construction performed in the U.S. • Engineering and architectural services for domestic construction

  7. Alternative Minimum Tax (slide 1 of 3) • Designed to ensure that corporations with substantial economic income pay at least a minimum amount of federal taxes • Essentially, a separate tax system with a quasi-flat tax rate applied to a corporation’s economic income

  8. Alternative Minimum Tax (slide 2 of 3) • If tentative alternative minimum tax > regular corporate income tax, corporation must pay regular tax plus the excess, the alternative minimum tax (AMT)

  9. Alternative Minimum Tax (slide 3 of 3) • For tax years beginning after 1997, many small corporations are not subject to AMT • A small corporation has average annual gross receipts of $5 million or less for the preceding three-year period • Small corporation continues to qualify as long as average gross receipts for the preceding three-year period do not exceed $7.5 million

  10. AMT Formula for Corporations

  11. AMT Adjustments (slide 1 of 2) • The starting point for computing AMTI is taxable income before any NOL deduction • Certain adjustments must be made to this amount • Tax preference items are always additions to taxable income • AMT adjustments may either positive or negative • Positive adjustments result from timing differences • Added to taxable income in computing AMTI • When AMT adjustments reverse, they are deducted from taxable income to arrive at AMTI

  12. AMT Adjustments for (slide 2 of 2) • AMT adjustments may either increase or decrease taxable income • e.g., The deduction for domestic manufacturing activities (DPAD) is available for AMT purposes • DPAD for AMT is limited to the smaller of qualified production income as determined for the regular income tax or for AMTI before the manufacturing deduction

  13. Adjustments for AMT (slide 1 of 2) • A portion of depreciation on property placed in service after 1986 • Difference between gain (loss) on sale of property for regular tax and AMT purposes • Passive activity losses of certain closely held corporations and personal service corporations • Mining exploration and development costs in excess of allowed AMT 10 year amortization

  14. Adjustments for AMT (slide 2 of 2) • Difference between percentage of completion and completed contract income • Amortization claimed on certified pollution control facilities • Difference between installment gain and total gain on certain dealer sales • A portion of the difference between “ACE” and unadjusted AMTI

  15. Tax Preference Items • Accelerated depreciation on real property in excess of straight-line for property placed in service before 1987 • Tax-exempt interest on “private activity bonds” • Percentage depletion in excess of the adjusted basis of property • Certain intangible drilling costs for “integrated oil companies”

  16. ACE Adjustment (slide 1 of 3) • Ace adjustment = 75% of difference between unadjusted AMTI and ACE • Can be positive or negative • Negative adjustment is limited to aggregate positive adjustments less previous negative adjustments

  17. ACE Adjustment (slide 2 of 3) • Starting point for determining ACE is AMTI • AMTI is defined as regular taxable income after AMT adjustments and tax preferences (other than the NOL and ACE adjustments)

  18. ACE Adjustment (slide 3 of 3) • AMTI is adjusted to arrive at ACE • These adjustments include: • Exclusion items—Income items that will never be included in regular taxable income or AMTI • Disallowed items – e.g., dividends received deduction of 70% (less than 20% ownership) • Other adjustments items including, for example, intangible drilling costs, circulation expenditures, organization expense amortization, LIFO inventory adjustments, installment sales, other items

  19. Impact of CertainTransactions on ACE

  20. Exemption • Exemption amount for a corp = $40,000 • Reduced by 25% of excess of AMTI over $150,000 • Exemption is totally phased-out when AMTI reaches $310,000

  21. Minimum Tax Credit (slide 1 of 2) • AMT paid in one year can be used as a credit against future regular tax liability that exceeds its tentative minimum tax • Indefinite carryforward • Cannot be carried back • Cannot offset any future minimum tax liability

  22. Minimum Tax Credit (slide 2 of 2) • Small corporations (no longer subject to AMT) with unused minimum tax credits after 1997 may use them against regular tax liability • Limit = regular tax – [25% × (regular tax – $25,000)]

  23. Moreland Co. has the following income, etc. in 2010: Taxable income $100,000 Depreciation adjustment 18,000 Installment gain (not on inventory sale) 80,000 Federal income tax provision on financial stmts. 75,000 Penalties and fines 2,000 Private activity bond interest income 25,000 Other tax-exempt interest 20,000 The depreciation adjustment is an AMT adjustment and the private activity bond interest is a tax preference for AMTI. AMT Example (slide 1 of 4)

  24. Calculation of AMTI before ACE: Taxable income $100,000 Plus: private activity bond income 25,000 Plus: depreciation adjustment 18,000 AMTI $143,000 AMT Example (slide 2 of 4)

  25. Calculation of ACE Adjustment: AMTI before ACE $143,000 Plus: deferred installment gain 80,000 Plus: other tax-exempt income 20,000 Adjusted current earnings $243,000 Less: AMTI 143,000 Base amount for Ace Adjustment $100,000 Times rate: 75% ACE Adjustment (positive) $75,000 AMT Example (slide 3 of 4)

  26. Calculation of AMT: AMTI before ACE $143,000 Plus: ACE Adjustment 75,000 AMTI $218,000 Less: Exemption 23,000 Tentative minimum tax base $195,000 20% rate × 20% Tentative minimum tax $ 39,000 Less: regular tax (22,250) AMT(TMT-Regular tax) $ 16,750 Total cash paid = Regular tax + AMT = $ 39,000 AMT Example (slide 4 of 4)

  27. Accumulated Earnings Tax(slide 1 of 5) • Penalty tax designed to discourage the retention of corporate earnings unrelated to the business needs of the company

  28. Accumulated Earnings Tax(slide 2 of 5) • Tax of 15% is imposed on accumulated taxable income (ATI), determined as follows: • ATI = Taxable income ± Adjustments - Dividends paid - Accumulated earnings credit • Adjustments to taxable income generally pertain to a corporation’s ability to pay a dividend • Thus, deductions include the corporate income tax and excess charitable contributions, while additions include the NOL and dividends received deductions

  29. Accumulated Earnings Tax(slide 3 of 5) • An accumulated earnings credit is allowed even when accumulations are beyond reasonable business needs

  30. Accumulated Earnings Tax(slide 4 of 5) • The accumulated earnings credit is the greater of: • Current E&P needed to meet “reasonable needs” of the business, or • Amount by which $250,000 ($150,000 for service companies) exceeds Accumulated E&P as of close of preceding tax year (the minimum credit)

  31. Legitimate reasons Business expansion Capital asset replacement Working capital needs Product liability loss Loans to suppliers or customers Invalid Reasons Loans to shareholders Unrealistic contingencies Investment in unrelated business assets Accumulated Earnings Tax -Reasonable Needs Of The Business (slide 5 of 5)

  32. Personal Holding Company Tax • Personal Holding Company (PHC) tax is designed to discourage sheltering of certain types of passive income in corporations • Like the accumulated earnings tax, the purpose is to force the distribution of corporate earnings to shareholders

  33. Definition of PHC • A company is a PHC if: • More than 50% of the value of stock is owned by 5 or fewer individuals during the last half of the year • Broad constructive ownership rules apply in determining stock ownership • 60% or more of gross income (as adjusted) must consist of personal holding company income (PHCI) • Examples are dividends, interest, rents, royalties, and certain personal service income • Rents or royalties may be excluded if they are significant in amount (i.e., comprise more than 50% of the adjusted gross income)

  34. Calculation of PHC Tax • Once classified as a PHC, the tax base must be calculated • Penalty tax rate = 15% • Tax base is undistributed Personal Holding Company income (UPHC income) • Amount is taxable income plus or minus certain adjustments, minus the dividends paid deduction

  35. Dividends Paid • Dividend payments reduce both ATI and undistributed PHCI • As these are the bases on which the § 531 tax or the § 541 tax is imposed, either tax can be completely avoided by paying sufficient dividends

  36. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: • Dr. Donald R. Trippeer, CPA • trippedr @oneonta.edu • SUNY Oneonta

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