Taxation of Corporations

Taxation ofCorporations Chapter9

Corporation • A business entity created under the laws of state of incorporation • Owns property and can be sued directly • Shareholders own part of corporation, but no interest in individual assets • Shareholders have limited liability • Corporation has unlimited life • Ownership interests are freely transferable • Management is centralized

Advantages • Easier to raise capital than other business forms • Corporations that reinvest their income rather than paying dividends could have lower tax bills than flow-through entities • Shareholders can be employees and participate in tax-free employee fringe benefits that are deductible by the corporation • Corporation can select calendar or fiscal year

Disadvantages • Double taxation • The 2003 Tax Act reduced the tax rate on dividend income to 15% (zero rate for individuals in 10% or 15% tax brackets for 2008-2010) • Shareholders cannot deduct losses of the C corporation • Corporation can only offset NOLs against operating income in carryover years • Capital losses can only offset capital gains

Capital Structure • Equity – dividends paid are not deductible • Common stock – shareholders have last claim on income and assets in liquidation but are entitled to all residual income when corporation is profitable • Preferred stock – claims take precedence over claims of common stockholders for dividends (preferred dividends must be paid before common dividends permitted) and assets in liquidation • Debt – interest paid on debt is deductible

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 • 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 contributions 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 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 • 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 the carryover periods are lost

Qualified U.S. Production Activities Deduction • Deduction for domestic production activities for most manufacturing, leasing, and construction (including architectural & engineering) that take place in the U.S. • Receipts from sale of food or beverages prepared at a retail establishment are not eligible

Qualified U.S. Production Activities Deduction • Deduction equals 6% of the lesser of: • Qualified production activities income or • Taxable income before deduction • Deduction cannot exceed 50% of wages paid during the year

Qualified U.S. ProductionActivities Income • Qualified production activities income (QPAI) is domestic production gross receipts (DPGR) less the sum of: • Cost of goods sold & other deductions related to these gross receipts and • A ratable share of other deductions not specifically related to any income source

Net Operating Losses • NOL can be carried back 2 years • Remaining NOL carried forward 20 years • Can elect to forgo carryback and carry forward only

Corporate Tax Model Gross revenues Less: Cost of goods sold Equals: Gross income Plus: Other includible income items Less: Deductions Equals: Taxable income (loss)

Corporate Tax Model (continued) Taxable income Times: Tax rates Equals: Gross income tax liability Plus: Additions to tax Less: Tax credits or prepayments Equals: Tax owed or refund due

Corporate Tax Rates • Corporate rates: • 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

PSC • Personal service corporation is • a corporation that provides service in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or performing arts and • is substantially owned by its employees • A flat 35% tax rate applies to its entire taxable income • The PSC provisions encourage owner-employees to take earnings out of corporation as salary

Reconciling Book/Tax Income • Form 1120 is the 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 • Schedule M-3 – reconciliation of net income (loss) for corporations with total assets of $10 million or more

Schedule M-1

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 • AMT is a parallel tax that broadens the regular income tax base to ensure some taxes are paid • Small corporations 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 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 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 than its regular corporate income tax

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 using completed contract method for regular tax • 75% of difference between adjusted current earnings (ACE) and gross AMTI before this adjustment

AMT • $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 • Form 1120 is 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 • Affiliated group – parent corporation must directly own 80% or more of subsidiary’s stock (by voting rights and value) • Can include 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 • 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 contribution deductions

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

Dividend 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 lowered rates on dividend income to 15% (zero rate for individuals in 10% or 15% tax brackets) – same rates as LTCG

Earnings and Profits • E&P measures how much a corporation can distribute as a dividend and leave contributed capital intact • Dividends in excess of E&P • Tax free return of capital to extent of shareholder’s stock basis (reducing basis) • If shareholder’s basis is reduced to zero, excess distribution is capital gain

Property Distributions • 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 • Like cash dividends, property dividends taxable only to extent of E&P

Stock Dividends and Rights • Stock dividend – distribution of stock that gives 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 – the right to purchase additional stock at a set price • If value of rights is less than 15% of value of stock, then no basis must be allocated to rights

Redemptions • Redemption – a repurchase of stock from a shareholder by the issuing corporation that may result in either sale or dividend treatment to the redeeming shareholder • Sale treatment allowed if • The redemption is substantially disproportionate (ownership after redemption is less 50% and also less than 80% of ownership before redemption or • Shareholder completely terminates interest in the corporation

Redemptions • If treated as a sale, shareholder recognizes capital gain (or loss) on the difference between the proceeds received and the basis of the stock surrendered • If not a sale, the amount the shareholder receives is taxed as a dividend to the extent of the corporation’s E&P

Redemptions • Attribution rules apply in determining ownership • Family attribution – includes stock owned by spouse, parent, child, grandchild • Entity to owner – attributed proportionately from partnership to partners, from estate or trust to beneficiaries, from corporation to 50% or greater shareholders • Owner to entity – attributed from partner to partnership, from beneficiary to estate or trust, from 50% or greater shareholder to corporation

Partial Liquidation • Partial liquidation – the significant reduction in a corporation’s operations or a termination of one of its qualifying businesses with a distribution of property or cash to its shareholders • Corporation recognizes gain (but not loss) on distribution of appreciated property • Noncorporate shareholders receive sale treatment • Corporate shareholders receive dividend treatment with dividend amount eligible for DRD

Corporate Liquidation • Corporation adopts a plan of liquidation and ceases operations • Sells assets recognizing both gains and losses on asset sales • Distributes cash from sales and any remaining assets to shareholders in exchange for their stock

Liquidating Distributions to Shareholders • Corporation recognizes loss as well as gain on distribution of property in liquidation • Shareholders recognize gain or loss on difference between FMV of property received and basis of stock surrendered • Basis of property to shareholders is FMV • No loss recognized until final distribution received • Parent corporation can liquidate a subsidiary tax free (but basis of assets carries over)

Constructive Dividends • Shareholder of closely held corporation receives informal economic benefit • 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 • Any benefit reclassified by IRS as dividend is taxable to shareholder but not deductible by corporation • Benefit to a related party can also be reclassified as dividend to shareholder

Penalty Taxes • There is a 15% penalty tax, in addition to the regular corporate tax, to encourage payment of dividends to shareholders • Personal holding company tax – applies to closely held corporations with more than 60% AOGI from passive sources • Accumulated earnings tax – assessed when corporation accumulates more than $250,000 ($150,000 if service business) without valid business purpose

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

Controlled Groups • Brother-sister group • 2 or more corporations have 80% or more of each corporation’s stock owned by 5 or fewer individuals and • Sum of lowest common ownership of each shareholder is 50% or more

Computing Current E&P • Starts with taxable income, but is subject to positive and negative adjustments • DRD, loss carryovers, and tax-exempt income are added back • Federal income taxes paid are deducted • Charitable contributions are deducted without regard to the 10% limit • Only 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

Earnings and Profits • Current earnings and profits (CE&P) • Current year’s taxable income (as adjusted) • Accumulated earnings and profits (AE&P) • Accumulations of CE&P for all prior years that have not been distributed as dividends • Dividends are first paid from CE&P then AE&P • Dividends in excess of E&P • Tax free return of capital to extent of shareholder’s stock basis (reducing basis) • If shareholder’s basis is reduced to zero, excess distribution is capital gain

Exempt Organizations Appendix 9A

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 they fail to meet the requirements on a continuing basis, they may either lose their status or be assessed an income or excise tax

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

UBIT • 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 • 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

Taxation of Corporations