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Principles of Taxation

Principles of Taxation. Chapter 10 The Corporate Taxpayer. The Corporate Taxpayer. Legal characteristics Dividends-received deduction Schedule M-1 reconciliation Regular tax, credits, AMT Payment and filing requirements Double taxation Tax incidence. Corporation Legal Characteristics.

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Principles of Taxation

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  1. Principles of Taxation Chapter 10 The Corporate Taxpayer

  2. The Corporate Taxpayer • Legal characteristics • Dividends-received deduction • Schedule M-1 reconciliation • Regular tax, credits, AMT • Payment and filing requirements • Double taxation • Tax incidence

  3. Corporation Legal Characteristics • Limited liability of shareholders • Owners of closely-held corporations often are required to sign personal liability on bank debt. • Unlimited life • Free transferability • Closely-held corporations:buy-sell agreement may prevent transferability. • Centralized management

  4. Affiliated Groups and Consolidations. • Parent + all >= 80% domestic subsidiaries. • Affiliated groups may elect to file a consolidated tax return - applies to all members of affiliated group. • Advantage: losses and profits of affiliated members offset. Like financial accounting, intercompany transactions are eliminated. • If the same individual(s) own 80% or more of more than one corporation, these corporations may not filed a consolidated return, but the tax bracket benefits are limited.

  5. Nonprofit Corporations • Section 501(c)(3) organizations require IRS recognition of tax-exempt status. • Nevertheless, tax-exempt organizations may pay tax on “unrelated business taxable income.” • Thinking question: what types of business activities do tax-exempt organizations do that put them in competition with for-profit taxpayers?

  6. Computing Corporate Taxable Income • Page 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return (Ch 9). • Use chapters 5, 6, 7 and 8 for general rules on business income. • Deduct only 50% of meals and entertainment expenses. • Deduct charitable contributions up to 10% of taxable income BEFORE charity and before dividends-received deduction.

  7. Dividends-Received Deduction • Ownership Deduction • < 20% of stock 70% DRD • 20%<= own < 80% 80% DRD • 80%<= own 100% DRD • Reason for DRD? Mitigate “triple” taxation. • Additional details: DRD can’t create loss - tricky computations not in this text.

  8. Book Versus Taxable Income - Schedule M-1 • This schedule reconciles book income to taxable income. • net book income - line 1 • federal tax expense for books - line 2 • lines 3 - 6 explain increases in taxable income relative to books. • lines 7 - 9 explain decreases in taxable income relative to books. • line 10 = taxable income before NOLD and DRD = line 28 form 1120 • Try problem AP7.

  9. Book Versus Taxable Income • Book-tax differences are scrutinized by IRS. Mills (1998 Journal of Accounting Research) shows that IRS audit adjustments are related to M-1 difference). • The Schedule M-1 contains permanent and temporary items. • The tax footnote in the financial statement contains numerous estimates of amounts that are finalized by the time the return is filed. Thus, Schedule M-1 will not exactly = amounts in F/S footnotes.

  10. Computing Regular Tax • The surtax rates of 39% and 38% eliminate progressivity at high levels of corporate income. • Corporations with taxable income > $18.33 million just pay a flat rate of 35% on all income. • Personal service corporations are taxed at a flat 35% rate.

  11. Tax Credits • Credits directly reduce computed tax. Deductions only reduce the income subject to tax. Thus, $1 of credit provides $1 of benefit. $1 of deduction only provides $1 x the tax rate. • Tax credits are generally limited to some % of tax before credits. Often a provision permits carry back or carry forward of excess credits. • Biggest credits: R&D credit, foreign tax credit (see Chapter 12).

  12. Alternative Minimum Tax - Who is Subject? • New corporation exempt in year 1. • Exempt in year 2 if year 1 sales <=$5 million • Exempt in year 3 if average (sales1+sales2) <= $7 million • Exempt in subsequent years if average gross receipts for three prior years <= $7 million. • Once corporation fails to be exempt, it is ineligible for AMT exemption for all subsequent tax years.

  13. AMT Exemption Example • Year 1 sales = $4 million (exempt because it’s year 1) • Year 2 sales = $8 million (exempt because year 1 sales <=$5 million) • Year 3 sales = $10 million (exempt because average years 1 and 2 = $6 million, <= $7 million) • Year 4 sales = $2 million (subject to AMT because average 1, 2, 3 = $7.33 million, > $7 million) • Subject to AMT all subsequent years.

  14. Alternative Minimum Tax - Overview • 20% of income under an alternative definition of taxable income that has fewer loopholes. • Alternative minimum taxable income • less (exemption) • = AMTI in excess of exemption • x 20% • Tentative minimum tax (TMT) • less (regular tax) • Alternative minimum tax (AMT)

  15. Alternative Minimum Tax - AMTI • Start with regular taxable income • Adjustments and preferences include: • Accelerated depreciation - AMT depreciation using slower methods. • Excess of % depletion > cost depletion. • Deduction for NOL carryforward is limited to 90% of AMTI. • Other differences between book and taxable income may create adjustments.

  16. AMT - more details • Exemption = $40,000 - 25% (AMTI - $150,000). • Minimum tax credit. • In future year(s), when regular tax exceeds TMT, corporation may subtract a credit equal to prior year(s) AMT. See AP16.

  17. Payment and Filing Requirements • Tax return due 15th day of 3rd month, may extend to 15th day of 9th month. • Estimated payments are due on the 15th day of 4th, 6th, 9th, and 12th months. • Must pay 100% of tax due (small corporations may use safe-harbor rule of paying 100% of prior year tax). • Underpayment penalty is computed like interest expense but is nondeductible.

  18. Distributions to Investors • Interest payments are deductible. • Payments on stock are non-deductible. • Payments on stock are taxable dividends to the shareholder if the corporation has either current or cumulative earnings and profits. • Payments in excess of earnings and profits are first a return of capital and then a gain to the shareholder.

  19. Distributions to Investors • Nondeductibility of dividends makes paying dividends hard to explain. • One result is the high leverage of many corporations, because interest expense is deductible. • Investors may prefer that the corporation keep the funds and reinvest them; sell stock for a capital gain in future. • Double taxation unlikely to change in near future.

  20. Incidence of the Corporate Tax • Corporations do not pay taxes - people do. • What are examples of ways that the incidence of the corporate tax could be born by individual taxpayers in the U.S.? • higher consumer prices • lower employee wages • lower dividends

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