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Chapter 14 Taxation of Corporations —Basic Concepts

Chapter 14 Taxation of Corporations —Basic Concepts. ©2008 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com. Chapter 14 Exhibits. 1. Selecting an Entity (Table 1)—Nontax Differences Among Entities

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Chapter 14 Taxation of Corporations —Basic Concepts

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  1. Chapter 14Taxation of Corporations—Basic Concepts ©2008 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

  2. Chapter 14 Exhibits 1. Selecting an Entity (Table 1)—Nontax Differences Among Entities 2. Selecting an Entity (Table 2)—General Tax Differences Among Entities 3. Selecting an Entity (Table 3)—Differences in Eligibility Among Entities 4. Selecting an Entity (Table 4)—Differences in Tax Treatment Among Entities 5. Corporation Defined 6. C Corporations—Special Types 7. C Corporations—Tax Years 8. C Corporations—Accounting Methods 9. C Corporations—Tax Formula 10. C Corporations—Comparison with Individual Taxpayers 11. Income Items Requiring Special Treatment 12. Exclusions Requiring Special Treatment 13. Deductions Requiring Special Treatment—Organizational Expenditures 14. Dividends Received Deduction—Example 1 15. Dividends Received Deduction—Example 2 Chapter 14, Exhibit Contents A CCH Federal Taxation Comprehensive Topics

  3. Chapter 14 Exhibits 16. Deductions Requiring Special Treatment—Charitable Contributions 17. Charitable Contributions—Example 18. Deductions Requiring Special Treatment—Interest Expense and Original Issue Discount 19. Interest Expense and Original Issue Discount—Example 20. Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium 21. Deductions Requiring Special Treatment—Compensation and Educational Reimbursement 22. Deductions Requiring Special Treatment—Rules for Net Operating Losses (NOLs) 23. Net Operating Losses (NOLs)—Example 24. Deductions Requiring Special Treatment—Capital Gains and Losses 25. Deductions Requiring Special Treatment—Depreciation Expense 26. Depreciation Expense—Example 27. Reconciling Book and Taxable Income 28. Corporate Tax Rates Chapter 14, Exhibit Contents B CCH Federal Taxation Comprehensive Topics

  4. Chapter 14 Exhibits 29. Corporate Tax Credits 30. Corporate Tax Credits—Example 31. Consolidated Returns 32. Consolidated Returns—Example 33. Estimated Taxes 34. Accumulated Earnings Tax (AET) 35. Personal Holdings Tax (PHC) 36. Formation of C Corps, S Corps and Partnerships—Owner Perspective 37. Formation of C Corps, S Corps and Partnerships—Entity Perspective 38. Formation of Corporations—Overview of Code Sec. 351 39. Code Sec. 351 Contribution of Part Property/Part Services—Example 40. Code Sec. 351 Contributions—Tax Effect on Shareholders 41. Code Sec. 351 Contributions—Tax Effect on Corporations 42. Code Sec. 351 Contributions—Example 1 43. Code Sec. 351 Contributions—Example 2 Chapter 14, Exhibit Contents C CCH Federal Taxation Comprehensive Topics

  5. Selecting an Entity (Table 1)—Nontax Differences Among Entities What entity form is best for a new business? General rules for small businesses: 1. Taxes should not be a motivator unless there are no nontax differences. 2.  If no need to incorporate, generally better to be a limited liability company taxed as a partnership. 3.  If there is a need to incorporate, generally better to be an S corporation. 4.  If there is a need to go public, a C corporation is usually the only choice. Chapter 14, Exhibit 1a CCH Federal Taxation Comprehensive Topics

  6. Nontax Differences C Corp S Corp General Partnerships (G P/Ss) Exposure of owners Limited liability to extent of investment. Same as C corp Each general partner (GP) has personal liability for P/S debt, & a direct interest in the P/S assets. Owners of LLCs have limited liability; but may not appoint 3rd parties to board of directors. Continuity of ownership Going concern Same as C corp P/S dissolves after • Departure of 50% GP(s); or • Operations cease. Rights of owners Rights to investment in stock, but not corporate asset; cannot bind corp. Same as C corp Actual rights to individual P/S assets; can bind partnership; each GP has equal right to run business. Selecting an Entity (Table 1)—Nontax Differences Among Entities Chapter 14, Exhibit 1b CCH Federal Taxation Comprehensive Topics

  7. Selecting an Entity (Table 1)—Nontax Differences Among Entities Chapter 14, Exhibit 1c CCH Federal Taxation Comprehensive Topics

  8. Selecting an Entity (Table 1)—Nontax Differences Among Entities Only if nontax differences weigh equally should one weigh the tax difference. Chapter 14, Exhibit 1d CCH Federal Taxation Comprehensive Topics

  9. General Tax Differences C Corp S Corp Partnership Highest Marginal tax Rate 35% if income is not distributed (but 15% accumulated earnings tax or personal holding company penalty possible); 44.75% if income is distributed. (35% + 15% x 65%)  possibly higher if corporate shareholder receives dividends, then distributes them again Same as partnership 35% whether or not income is distributed Lowest Marginal Tax Rate 10% on taxable income (TI) up to $50,000 Same as partnership 10% on TI up to $7,300 in 2005 for individuals; $14,600 for joint filers Selecting an Entity (Table 2)—General Tax Differences Among Entities Chapter 14, Exhibit 2a CCH Federal Taxation Comprehensive Topics

  10. Selecting an Entity (Table 2)—General Tax Differences Among Entities Chapter 14, Exhibit 2b CCH Federal Taxation Comprehensive Topics

  11. Selecting an Entity (Table 2)—General Tax Differences Among Entities Chapter 14, Exhibit 2c CCH Federal Taxation Comprehensive Topics

  12. Eligibility Limitations: C Corp S Corp Partnership # Owners No Limit 1 to 100 (family members may elect to be treated as one). At least 2 Owner identity limits None S corp. S/Hs NOT allowed: • Nonresident aliens • C Corporations • Partnerships • Banks • Insurance companies S corp. S/Hs allowed: • Individuals • Estates • Qualified trusts None Affiliate limits None None after 1996. Before 1997, could not own > 80% stock of another corporation None Capital structure limits None Only one class of common stock. Code Sec. 1361(b)(1)(D). However, differences in voting rights among common shares are OK None Selecting an Entity (Table 3)—Differences in Eligibility Among Entities Chapter 14, Exhibit 3 CCH Federal Taxation Comprehensive Topics

  13. Selecting an Entity (Table 4)—Differences in Tax Treatment Among Entities Chapter 14, Exhibit 4a CCH Federal Taxation Comprehensive Topics

  14. Selecting an Entity (Table 4)—Differences in Tax Treatment Among Entities Chapter 14, Exhibit 4b CCH Federal Taxation Comprehensive Topics

  15. Corporation Defined Either an organization incorporated under state law, or an unincorporated association that has “checked the box” for corporate tax treatment on Form 8832 (Entity Classification Election). (Code Sec. 7701; Reg. §301.7701-1 to 3.) Chapter 14, Exhibit 5a CCH Federal Taxation Comprehensive Topics

  16. Corporation Defined Two Classifications of Corporate Entities C Corporations. Taxpaying entities. (This results in what is known as a double tax effect. The corporation computes tax on the net income When a corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns.) S Corporations. Not subject to regular corporate income tax. They are treated in a manner similar to partnerships, i.e., as pass-through entities, in that net profit or loss flows through to the owners to be reported on their separate returns. Chapter 14, Exhibit 5b CCH Federal Taxation Comprehensive Topics

  17. C Corporations—Special Types Professional Association [PA].An association of professionals (e.g., accountants, doctors, lawyers) treated as a C corporation for tax purposes if it has: • Organized under a state’s Professional Association Act; AND • “Checked the box” on Form 8832 for corporate tax treatment. (One individual may be a professional association.) Chapter 14, Exhibit 6a CCH Federal Taxation Comprehensive Topics

  18. C Corporations—Special Types Personal Service Corporation [PSC]. C corporation whose shareholder-employee(s) owns over 10% of the stock and provides personal services (e.g., acting, entertainment, medical, legal, consulting, or other services performed through their personal efforts.) Generally, a PSC must use a calendar tax year. (Code Sec. 441(i)). PSCs are subject to a flat 35% tax rate. Chapter 14, Exhibit 6b CCH Federal Taxation Comprehensive Topics

  19. C Corporations—Special Types Personal Holding Company [PHC].A non-exempt, closely held corporation, with a significant portion of its income that is passive in nature (e.g., from dividends or interest). PHCs are subject to a 15% penalty tax on excess personal holding company income in addition to the regular corporate income tax. Chapter 14, Exhibit 6c CCH Federal Taxation Comprehensive Topics

  20. C Corporations—Special Types Q: When is a corporation deemed to be “closely held”? A: When more than 50% of the value of the outstanding stock was owned by five or fewer individuals during the second half of the year. Q: When is passive income deemed to be “significant”? A: When passive income is 60% or more of “adjusted ordinary gross income (AOGI).” AOGI is gross income less capital gains and section 1231 gains, less adjustments such as certain expenses connected with rental and royalty income. Chapter 14, Exhibit 6d CCH Federal Taxation Comprehensive Topics

  21. C Corporations—Tax Years Every newly organized corporation other than a personal service corporations (PSC) has the unrestricted right to select its annual tax year, regardless of the tax years employed by its shareholders. PSCs generally must use a calendar year-end. However, it may use a fiscal year-end under the same conditions as listed for S corporations. Chapter 14, Exhibit 7 CCH Federal Taxation Comprehensive Topics

  22. C Corporations—Accounting Methods Most corporations must use the accrual method. The cash method MAY be used by C corporations that have average annual gross receipts of $5 million or less in the 3 preceding years, or by PSCs. Chapter 14, Exhibit 8 CCH Federal Taxation Comprehensive Topics

  23. C Corporations—Tax Formula Chapter 14, Exhibit 9 CCH Federal Taxation Comprehensive Topics

  24. C Corporations—Comparison with Individual Taxpayers Chapter 14, Exhibit 10a CCH Federal Taxation Comprehensive Topics

  25. Exclusions Similar Tax Treatment Different Treatment Most exclusions receive the same tax treatment • Capital contributions • Gain/loss on sale treasury stock • Life Insurance Proceeds C Corporations—Comparison with Individual Taxpayers Chapter 14, Exhibit 10b CCH Federal Taxation Comprehensive Topics

  26. C Corporations—Comparison with Individual Taxpayers Chapter 14, Exhibit 10c CCH Federal Taxation Comprehensive Topics

  27. Income Items Requiring Special Treatment Bond Repurchases A corporation’s income INCLUDES the original issue price of its own bonds being repurchased, MINUS (i) The repurchase price, MINUS (ii) Any premium already recognized on the original issuance. PLUS (iii) Any discounts previously deducted. Sinking Fund Income Interest or other income from property in a sinking fund established to satisfy an obligation IS INCLUDED, even if in the hands of a trustee (since both funded and non-forfeitable). Chapter 14, Exhibit 11 CCH Federal Taxation Comprehensive Topics

  28. Exclusions Requiring Special Treatment Treasury Stock No gain or loss is recognized by a corporation on the sale or exchange of its own stock. Chapter 14, Exhibit 12a CCH Federal Taxation Comprehensive Topics

  29. Exclusions Requiring Special Treatment Capital Contributions Gifts from nonshareholders are excluded. · Noncash gifts. If a gift is property other than money, the corporation carries it with a zero basis. ·Cash gifts. When cash is contributed, reduce the basis of corporate property in the following order: (i) Property acquired within 1 year after the contribution; (ii) Then depreciable property in proportion to relative bases; (iii) Then, if there is a remaining balance, NON-depreciable property acquired over 1 year after the contribution. Chapter 14, Exhibit 12b CCH Federal Taxation Comprehensive Topics

  30. Exclusions Requiring Special Treatment Capital Contributions Pro rata contributions from shareholders are excluded.   Whether voluntary or by assessment, shareholder contributions are excluded from corporate income. The corporation carries the property at the same basis as had been reported by the contributing shareholder. That shareholder gets no deduction, but does get an increase in stock basis, equal to the basis in the property contributed. Chapter 14, Exhibit 12c CCH Federal Taxation Comprehensive Topics

  31. Deductions Requiring Special Treatment—Organizational Expenditures Organizational expenditures.Expenses qualify for amortization if: (a) = Incurred incidental to formation of the corporation (e.g., legal fees for drafting the charter, state incorporation fees, expenses for temporary directors and organizational meeting costs) and (b) = Incurred before the end of the tax year in which the corporation commences business. The first $5,000 of qualified expenditures are deductible in the year incurred (subject to a dollar-for-dollar phaseout once total expenses exceed $50,000). The remaining qualified expenditures must be amortized over 15 years, starting with the month that the corporation commences business. Chapter 14, Exhibit 13a CCH Federal Taxation Comprehensive Topics

  32. Deductions Requiring Special Treatment—Organizational Expenditures Nonamortizable expenditures. Organizationalexpenses DO NOT qualify for amortization if related to the transfer of assets to the corporation or the issuance and sale of stock. (e.g., printing stock certificates, professional fees for issuing stock and broker’s commission on the sales of stock). They are written off when the corporation completely liquidates. Chapter 14, Exhibit 13b CCH Federal Taxation Comprehensive Topics

  33. DIVIDENDS RECEIVED from other corporations are INCLUDED by both corporate and individual shareholders, but DEDUCTIBLE only by corporate shareholders within limits explained below. DIVIDENDS RECEIVED DEDUCTION (DRD) % Ownership (Value & Voting) Tentative* DRD: * (Subject to DRD limit if DRD would NOT create an NOL) Tentative* DRD Limit: * (Does not apply if DRD would create an NOL)  < 0% 20% 70% div. received 70% ATI 20% 80% 80% div. received 80% ATI 80% & affiliated --- 100% div. received 100% ATI ATI = Revenue – COGS – Operating expenses + Other income.(Another way to arrive at ATI is to start with taxable income and purge out three possible deductions: ATI = TI + (1) Actual DRD + (2) NOL carryover + (3) Capital loss carryback). “Affiliated” means owning  80% of both voting power and value of stock. Dividends Received Deduction—Example 1 Chapter 14, Exhibit 14a CCH Federal Taxation Comprehensive Topics

  34. Dividends Received Deduction—Example 1 FACTS: C Corp. has the following income and expenses: Operating Revenue $ 800,000 COGS (300,000) Operating expenses (520,000) Other income (dividends received from a 25%-owned corp.) 100,000 Chapter 14, Exhibit 14b CCH Federal Taxation Comprehensive Topics

  35. Dividends Received Deduction—Example 1 Chapter 14, Exhibit 14c CCH Federal Taxation Comprehensive Topics

  36. FACTS:Same as Example 1 except operating expenses are $520,001, not $520,000. (a) ATI = $79,999 [= $800,000 – $300,000 – $520,001 + $100,0000] (b) Tentative DRD Limit = $63,999 [= 80% ATI = 80% x $79,999 = $63,999] (c)  Tentative DRD = $80,000 [= 80% x $100,000] (d) Actual DRD = $80,000 [Same as tentative DRD, since $79,999 ATI - $80,000 Tentative DRD is < 0.] (e) TI = $(1), an NOL [= ATI – DRD = $79,999 - $80,000] Tax = $0 Note that in Example 1, the tentative DRD Limit applies since the DRD does not create an NOL. In Example 2, where operating expenses are $520,001 instead of $520,000, the tax results are much more favorable. An additional $1 of operating expenses saves $2,400 of taxes! Dividends Received Deduction—Example 2 Chapter 14, Exhibit 15 CCH Federal Taxation Comprehensive Topics

  37. Deductions Requiring Special Treatment—Charitable Contributions Charitable contributions. As with individuals, corporate charitable contributions are deductible if made to qualified organizations. [i.e., Code Sec. 501(c) organizations]. Also, as with individuals, corporate contributions in excess of deductions are carried forward 5 years. No carrybacks are allowed for corporations or individuals. Chapter 14, Exhibit 16a CCH Federal Taxation Comprehensive Topics

  38. Deductions Requiring Special Treatment—Charitable Contributions Chapter 14, Exhibit 16b CCH Federal Taxation Comprehensive Topics

  39. Deductions Requiring Special Treatment—Charitable Contributions 2 ½ Month Rule. If a charitable contribution is board-approved in the current year and paid within 2 ½ months of the subsequent year, then a deduction is allowed in the current year. Not so for individuals. Inventory.Generally, as with individuals, corporations may deduct only the basis of inventory contributed. However, corporations may deduct the adjusted basis plus 1/2 of the appreciation (not to exceed twice the adjusted basis) if the inventory is donated solely for care of infants, the ill, or the needy. Chapter 14, Exhibit 16c CCH Federal Taxation Comprehensive Topics

  40. FACTS: • C Corp.’s TI BEFORE the charitable deduction was $410,000. • C Corp. contributed $40,000 to a qualified charitable organization. • Included in the $410,000 is a $20,000 DRD. • C Corp. also has a $5,000 carryover contribution from a prior year (not part of the $410,000). QUESTION: How much is the charitable deduction? SOLUTION: $43,000 1. ATI = $430,000 [$410,000 + $20,000] 2.  10% ATI Limitation = $43,000 [10% x $430,000 = $43,000] 3.  Contribution = $45,000 [$40,000 currently + $5,000 carryover.] 4. Deduction = $43,000 [ < of 2. or 3.] Charitable Contributions—Example Chapter 14, Exhibit 17 CCH Federal Taxation Comprehensive Topics

  41. Deductions Requiring Special Treatment—Interest Expense and Original Issue Discount Interest Expense. Interest expense on a corporation’s own debt is fully deductible, even if in connection with the repurchase of its own stock. Recall that individuals’ investment interest deductions are limited to net investment income. Not so with corporations. Original Issue Discounts. OID is deductible as interest expense. (1) Pre-7/1/82 issue bonds. Discount may be amortized using the straight-line method over the life of the bonds. (2) Post-6/30/82 issue bonds. For bonds issued on or after 7/1/82, discounts from face value must be amortized using the effective yield method. Chapter 14, Exhibit 18 CCH Federal Taxation Comprehensive Topics

  42. Interest Expense and Original Issue Discount—Example Chapter 14, Exhibit 19a CCH Federal Taxation Comprehensive Topics

  43. Interest Expense and Original Issue Discount—Example Chapter 14, Exhibit 19b CCH Federal Taxation Comprehensive Topics

  44. Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium Repurchasing Bonds at a Premium. A corporation that repurchases its bonds may deduct as interest expense the excess of the repurchase price over the adjusted issue price. Chapter 14, Exhibit 20a CCH Federal Taxation Comprehensive Topics

  45. Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium Chapter 14, Exhibit 20b CCH Federal Taxation Comprehensive Topics

  46. Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium Repurchasing Stock at a Premium.Amounts paid to repurchase stock are not deductible. Both acquiring and target corporations may capitalize legal fees, invest banker fees and other cost associated with a takeover. Chapter 14, Exhibit 20c CCH Federal Taxation Comprehensive Topics

  47. Deductions Requiring Special Treatment—Compensation and Educational Reimbursement Compensation. Four independent rules: (1) Unreasonable compensation to a shareholder is generally treated as a dividend, to the extent of earnings and profits. (2) Informal short-term arrangements. Payments made by March 15 of the succeeding year may be accrued and expensed in the current year if related to services incurred in the current year. Chapter 14, Exhibit 21a CCH Federal Taxation Comprehensive Topics

  48. Deductions Requiring Special Treatment—Compensation and Educational Reimbursement (3) Executive Compensation Limitations. Deductible compensation for the top five executives of publicly traded companies is limited to $1,000,000 for each executive. Amounts exceeding this limit are deductible if determined via a performance-based compensation plan. (4) Restricted Stock. Compensation to an employee in the form of stock is deductible when the employee reports the amount as ordinary income. Employees must include the market value of stock received for services in GI when (i) it is not subject to a substantial risk of forfeiture and (ii) its value is ascertainable. Chapter 14, Exhibit 21b CCH Federal Taxation Comprehensive Topics

  49. Example on Restricted Stock Compensation FACTS: • 20x1: Employee purchases restricted stock (FMV = $1,000) from employer-corporation for $500. • The stock is forfeitable until the employee serves the employer 6 years. • 20x7: After 6 yrs., the restriction is lifted when the FMV = $2,000. QUESTION: What is the timing and amount of the employee’s taxable income and the corporate employer’s deduction? SOLUTION: 20x1: No TI to employee; no deduction to employer. 20x7: $1,500 ordinary income to employee; $1,500 corporate deduction $1,500 [$2,000 - $500] Deductions Requiring Special Treatment—Compensation and Educational Reimbursement Chapter 14, Exhibit 21c CCH Federal Taxation Comprehensive Topics

  50. Deductions Requiring Special Treatment—Compensation and Educational Reimbursement Educational Expenses. An employer’s expenditures for employee education are deductible as business expenses. An individual, in contrast, may deduct only educational expenses required to maintain or improve skills in a present position. Chapter 14, Exhibit 21d CCH Federal Taxation Comprehensive Topics

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