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Taxation of Corporations. Chapter 9. Corporation. A business entity created under the laws of state of incorporation Owns property and can be sued directly Shareholder’s own part of corporation but no interest in individual assets Shareholders have limited liability

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  • A business entity created under the laws of state of incorporation
  • Owns property and can be sued directly
  • Shareholder’s own part of corporation but no interest in individual assets
  • Shareholders have limited liability
  • Corporation has unlimited life
  • Free transferability of ownership interest
  • Centralized management
  • Easier to raise capital than other business forms
  • Corporations that reinvest their income rather than paying dividends could have lower tax bill than flow-through entities
  • Shareholder can be employee and participate in tax-free employee fringe benefits that are deductible by the corporation
  • Corporation can select calendar or fiscal year
  • Double taxation
    • Minimized by 2003 Tax Act reduction in tax rate on dividend income to 15% (5% for individuals in 10% or 15% tax bracket)
  • C corporation cannot deduct losses of the corporation
    • Offset NOL against operating income
    • Offset capital losses against capital gains
capital structure
Capital Structure
  • Equity
    • Common stock – shareholders have last claim on income and assets in liquidation but no limit on sharing in income when profitable
    • Preferred stock – claims take precedence over claims of common stockholders for dividends (paid stated dividend rate first) and assets in liquidation
  • Debt
    • Interest on debt is deductible (but dividends are not deductible)
dividend received deduction
Dividend Received Deduction
  • To relieve burden of multiple taxation on corporate income
  • DRD based on percentage of ownership in the distributing corporation
    • 100% DRD for 80% or more owned affiliate
    • 80% DRD for ownership of 20% up to 80%
    • 70% DRD for ownership less than 20%
  • DRD limited to percentage times lesser of taxable income or dividend income
    • Unless deducting DRD % x dividend income creates or increases NOL
charitable contributions
Charitable Contributions
  • Overall limit 10% of taxable income before
    • Charitable contribution deduction
    • Dividend received deduction
    • NOL or capital loss carrybacks
  • Excess carried forward up to 5 years
  • Accrual basis corporation can deduct in year accrued if
    • Payment authorized by board before year end
    • Payment made by 15th day of 3rd month following close of tax year in which accrued
charitable contributions8
Charitable Contributions
  • Deduction for ordinary income property usually limited to basis
  • Deduction for LTCG property is FMV
  • Deduction for inventory (if donated for care of infants, poor or ill) increased by 50% of difference between basis and FMV (not to exceed twice basis)
    • Similar exception for gifts of scientific property given to universities and research organizations
capital gains and losses
Capital Gains and Losses
  • All capital gains taxed as ordinary income
  • Capital losses can only offset capital gains
    • Net loss carried back 3 years as short-term capital loss and forward up to 5 years in sequence
    • Losses not used in this period are lost
net operating losses
Net Operating Losses
  • NOLs incurred in 2001 and 2002 can be carried back 5 years
  • NOLs incurred after 2002 can be carried back 2 years
  • Remaining NOL carried forward 20 years
    • Can elect to forgo carryback and carry forward only
computing corporate tax
Computing Corporate Tax

Taxable revenues

Less: Deductible expenses

Equals: Taxable income

Times: Corporate tax rate

Equals: Corporate tax

Plus: Additions to tax

Less: Tax credits

Equals: Net corporate tax

corporate tax rates
Corporate Tax Rates
  • Corporate rates not affected by 2003 Tax Act
    • 15% on first $50,000
    • 25% on $50,001 - $75,000
    • 34% on $75,001 - $100,000
    • 39% (34% + 5% surtax) on $100,001 - $335,000
    • 34% on $335,001 - $10,000,000
    • 35% on $10,000,001 - $15,000,000
    • 38% (35% + 3%) on $15,000,001 - $18,333,333
    • 35% on over $18,333,333
  • Personal service corporation is a corporation
    • Providing service in the field of accounting, actuarial science, architecture, consulting, engineering, health, law, or performing arts and
    • Employees own substantially all of the corporation
  • Flat 35% tax rate applies on entire taxable income
  • Encourages owner-employees to take earnings out of corporation as salary
reconciling book tax income
Reconciling Book/Tax Income
  • Form 1120 corporate tax return
    • Schedule L – beginning and ending financial accounting balance sheet
    • Schedule M-1 – reconciliation of after-tax net income on books with taxable income before DRD and NOL carryover
    • Schedule M-2 – reports changes in unappropriated retained earnings
tax credits
Tax Credits
  • Can reduce tax liability but not below zero
  • General business credit – a group of credits aggregated into one credit
    • Cannot exceed $25,000 plus 75% of tax liability in excess of $25,000
    • Unused credits carried back 1 year and forward 20 years
alternative minimum tax
Alternative Minimum Tax
  • AMT is a parallel tax that broadens the regular income tax base to ensure some taxes are paid
  • Small corporation are exempt
    • Average annual receipts less than $5 million in each of prior taxable years
    • Remain exempt until average annual gross receipts exceed $7.5 million
calculating amt
Calculating AMT

Corporate taxable income

Plus/minus AMT adjustments

Plus: Preference items

Equals: AMT income

Less: Exemption

Equals: AMTI base

Times: AMT rate

Equals: Gross AMT

calculating amt19
Calculating AMT

Gross AMT

Less: Regular corporate tax

Equals: Alternative minimum tax

Less: Credits

Equals: Net AMT

  • Corporation only pays AMT if gross AMT is greater that its regular corporate income tax
amt adjustments
AMT Adjustments
  • Timing differences
    • Difference between regular tax depreciation and AMT depreciation
    • Difference between gain reported for AMT by percentage-of-completion method over gain reported on completed contract method for regular tax
    • 75% of difference between adjusted current earnings (ACE) and gross AMTI before this adjustment
  • $40,000 Exemption
    • Phased out at rate of $1 for every $4 AMTI exceeds $150,000 (completely phased out at $310,000 AMTI)
  • Credit – equal to AMT paid in prior years
    • Carried forward indefinitely but can only offset regular tax in excess of AMT
filing and payment
Filing and Payment
  • Form 1120 due on 15th day of 3rd month following close of tax year
    • File Form 7004 for 6 month automatic extension
  • Quarterly estimated tax payments due on 15th day of 4th, 6th, 9th, and 12th months of tax year
    • Underpayment penalty assessed if liability $500 more than estimated payments
    • If taxable income less than $1 million in each of 3 preceding years, no penalty if each estimated payment equals 25% of prior year’s tax liability
consolidated returns
Consolidated Returns
  • Affiliated group – parent corporation must directly own 80% or more stock of subsidiary
    • Can have more than 2 corporations if 80% of stock owned by one or more corporations that are part of affiliated group
  • Consolidated return reports combined results of operations of all corporations in the group
    • All subsidiaries must consent and must have or change to same tax year as parent
consolidated net income
Consolidated Net Income
  • Affiliated corporations viewed as divisions of parent requiring modification for deferred intercompany transactions and intercompany dividends
  • Items subject to limitations and netting are determined on a consolidated basis
    • Capital gains and losses
    • Section 1231 gains and losses
    • Charitable contributions deductions
consolidated tax returns
Consolidated Tax Returns
  • Advantages
    • Intercompany dividends are eliminated from taxation
    • Gains on intercompany transactions are eliminated
    • Deductions subject to limitation may be allowed when consolidated
    • Losses of one corporation can offset gains of another
    • Income from one corporation can offset losses of another
    • Limitations based on consolidated income permit greater use of deductions or credits
corporate distributions
Corporate Distributions
  • Dividend – a distribution of corporate earnings and profits (E&P) that is taxable income to shareholders but not deductible by the corporation
    • 2003 Tax Act lowed rates on dividend income to 15% (5% for individuals in 10% or 15% tax brackets) – same rates as LTCG
  • Dividends in excess of E&P
    • Tax free return of capital to extent of shareholder’s stock basis (reducing basis)
    • Excess distribution is capital gain
  • E&P measures how much a corporation can distribute as dividends and leave contributed capital intact
    • Starts with taxable income but is adjusted for positive and negative adjustments
computing current e p
Computing Current E&P
  • DRD, loss carryovers, and tax-exempt income are added back
  • Federal income taxes paid are deductible
  • Charitable contributions are deductible without regard to the 10% limit
  • 20% of Section 179 expensing allowed
  • Also deductible for E&P are life insurance premiums on key employees, capital losses in excess of capital gains, nondeductible expenses related to tax-exempt income, disallowed losses on related party sales, and nondeductible fines
  • Current earnings and profits (CE&P) - the current year’s taxable income (as adjusted)
  • Accumulated earnings and profits (AE&P) – accumulations of CE&P for all prior years that has not been distributed as dividends
  • Dividends are first paid from CE&P then AE&P
  • Property distributions – corporation recognizes gain on distribution of appreciated property (but not loss)
    • Value of distribution is net FMV (net of any liabilities assumed) and basis to shareholder is FMV
stock dividends and rights
Stock Dividends and Rights
  • Stock dividend – distribution of stock giving shareholder a greater number of shares
    • Nontaxable if proportionate distribution (unless given choice of cash or stock)
    • Shareholder allocates basis among all shares of stock
  • Stock rights – if value of rights is less than 15% of value of stock, then no basis need be allocated to rights
  • Redemption – a repurchase of stock from a shareholder by the issuing corporation
    • If treated as sale, shareholder recognizes capital gain on difference between FMV received and basis of stock surrendered
      • Sale treatment if complete termination of interest or if substantially disproportionate (ownership after redemption less than 80% of before redemption ownership and less than 50% ownership)
    • If not a sale, then taxed as dividend on full amount received (to extent of E&P) and basis transfers to other shares of stock owned
  • Attribution rules apply in determining ownership
    • Family attribution – includes stock owned by spouse, parent, child, grandchild
    • Entity to owner – proportionately from partnership to partners, from estate or trust to beneficiaries, from corporation to 50% or greater shareholders
    • Owner to entity – from partner to partnership, from beneficiary to estate or trust, from 50% or greater shareholder to corporation
partial liquidation
Partial Liquidation
  • Partial liquidation – similar to redemption when corporation significantly reduces its operations or terminates one of its qualifying businesses
    • Corporation recognizes gain on distribution of appreciated property (but not loss)
    • Sale treatment for noncorporate shareholders
    • Dividend to corporate shareholders (eligible for DRD)
liquidating distributions
Liquidating Distributions
  • Corporations can recognize loss as well as gain on distribution of property in liquidation
  • Shareholders recognize gain or loss on difference between FMV received and basis of stock surrendered
    • Basis of property to shareholders is FMV
  • Parent corporation can liquidate a subsidiary tax free (but basis of assets carries over)
constructive dividends
Constructive Dividends
  • Shareholders receiving informal economic benefits
    • Examples include rents in excess of property’s FMV, use of corporate property for personal use, loans to shareholder at no interest, payment of personal expenses by corporation, and excessive compensation
  • Benefit reclassified by IRS as dividend is taxable to shareholder and not deductible by corporation
    • Benefits to related parties can also be reclassified as dividend to shareholder
penalty taxes
Penalty Taxes
  • Penalty taxes to encourage payment of dividends to shareholders
    • Personal holding company – closely held corporation with more than 60% AOGI from passive sources
    • Accumulated earnings tax – assessed when corporation accumulates more than $250,000 ($125,000 if service business) without valid business needs
    • 2003 Tax Act lowed these penalty tax rates to 15%
controlled groups
Controlled Groups
  • Controlled groups must apportion lower tax rates to members of group
  • Parent-subsidiary group – 2 or more corporations with a common parent
    • Parent directly owns 80% of stock of subsidiary
    • 80% or more of stock must be jointly or separately owned of all other corporations by parent and subsidiaries
  • Brother-sister group
    • 2 or more corporations have 80% of more of each corporation’s stock owned by 5 or few individuals and sum of lowest common ownership of each shareholder is 50% or more
exempt organizations39
Exempt Organizations
  • Organizations whose purpose is to serve the public are classified as tax-exempt organizations
  • Persons who donate to exempt organizations may be permitted a charitable contribution deduction
  • Exempt organizations do not pay tax on their income if they qualify under Section 501(c)
  • If it fails to meet the requirements on a continuing basis, it may either lose its status or be assessed an income or excise tax
exempt organizations40
Exempt Organizations
  • Exempt organizations normally operate as corporations or as trusts
  • An exempt organization can be assessed taxes when it engages in prohibited transactions
    • Unrelated businesses
    • Transactions that benefit disqualified persons
  • An exempt organization is assessed the unrelated business income tax if it regularly carries on a trade or business that is substantially unrelated to the organization’s exempt purpose
    • A business is substantially unrelated to the exempt purpose if the sales of goods or services do not make a significant contribution to its exempt purpose
  • UBIT is assessed when the exempt organization regularly carries on a business that competes with for-profit businesses
  • UBIT is assessed on the net unrelated business income at the regular corporate tax rates
    • $1,000 exemption is allowed

Gross unrelated business income

Less: Deductions

Plus/minus: Modifications

Less: $1,000 exemption

Equals: Unrelated business income

Times: Corporate tax rates

Equals: Unrelated business income tax

  • Form 990: Return of Organizations Exempt from Income Tax is due on the 15th day of the 5th month after the close of the organization’s tax year
  • If UBIT must be paid, then it must also file Form 990-T: Exempt Organization’s Business Income Tax Return
excise taxes
Excise Taxes
  • An excise tax is levied on any excess benefit transaction in which a disqualified person participates (bargain purchase or personal use of assets)
    • Disqualified person – anyone who can substantially influence the activities of an exempt organization
    • Excise tax is 25% of the excess benefit (up to $10,000 maximum) for the disqualified person (200% if they fail to correct the transaction) and 10% for the exempt organization’s manager
private foundation
Private Foundation
  • Exempt organizations are classified as private foundations if they are not supported by or operated for the general public as a whole but have a more narrow focus for their activities
  • Private foundations exclude 501(c)(3) organizations that receive a major part of their support from the public or government
    • To be excluded, an external support test and internal support test must be met
private foundations
Private Foundations
  • External support test – must receive more than one-third of annual support from the general public, governments, or other exempt organizations
    • Support includes membership fees, contributions, and grants
  • Internal support test – limits interest, dividends, rent, royalty, and unrelated business income (net of tax) to one-third of the total support
private foundations48
Private Foundations
  • Subject to taxes on investment income, for failure to distribute its income, for excess business holdings, for investing in speculative assets, and for participating in transactions with disqualified persons
    • Excise tax on investment income is 2%
    • Taxes on other activities range from 5% to 15%
    • Second round of excise taxes of up to 200% if corrective actions are not taken
income taxes
Income Taxes
  • 46 states assess some type of income tax on corporations
    • Franchise tax – an excise tax based on the right to do business or own property in the state
  • Rates typically range from 4% to 10%
  • Most states piggyback on the federal system by beginning their computations with the corporation's federal taxable income
income taxes51
Income Taxes
  • Typical modifications of federal taxable income include
    • State and local income taxes
    • Interest income earned on state and local bonds
    • Interest income on federal notes or bonds
    • Dividends received deduction
    • Net operating losses
income taxes52
Income Taxes
  • Nexus – the connection between a state and the business that the state is seeking to tax
    • Nexus can be established through physical presence of corporate property or employees in the state
  • When there is nexus in several states, each state can tax only the percentage of income based on the business allocated to that state
    • Most states use the three-factor allocation formula of sales, payroll costs, and tangible property
income taxes53
Income Taxes
  • Nonbusiness income (interest, dividends, rent) is taxed in one state only
    • Usually where corporation is domiciled or where property is located or used
  • Income tax planning usually involves shifting income from high-tax states to low-tax states by outsourcing some functions to eliminate nexus in a state or shifting assets
  • A few states subject S corporations to their corporate income tax
sales taxes
Sales Taxes
  • 45 states charge sales taxes that typically range from 3% to 7%
    • Many local governments impose local sales taxes resulting in more than 7,400 different taxing jurisdictions
  • Sales taxes are imposed on gross receipts from retail sales or leases of tangible personalty
    • Retailer is responsible for collecting
sales taxes55
Sales Taxes
  • Multistate retailers must determine not only the appropriate tax rate but also which items are subject to tax in each location
    • Exempt items typically include food, prescription drugs, realty, intangible property, and most services
  • A state can require an out-of-state business to collect sales tax only if it has nexus with the state
sales taxes56
Sales Taxes
  • Use tax – imposed on the use of property brought into a state when sales tax was not paid in the state of purchase
    • A use tax is self-assessed and usually has the same rate as the sales tax