Chapter 3: The Corporate Income Tax - Pearson Education

Chapter 3: The Corporate Income Tax - Pearson Education

Chapter 3 The Corporate Income Tax 2011 Pearson Education, Inc. Publishing as Prentice 3-1 THE CORPORATE INCOME TAX (1 of 2) Corporate elections Computing corporations taxable income Computing a corporations income tax liability 2011 Pearson Education, Inc. Publishing as Prentice

3-2 THE CORPORATE INCOME TAX (2 of 2) Controlled groups of corporations Tax planning considerations Compliance and procedural considerations Financial statement implications 2011 Pearson Education, Inc. Publishing as Prentice 3-3 Corporate Elections Tax Year (1 of 2)

New corp elects tax year by filing return First return may be for shortperiod Some corporations restricted S-corporation uses calendar year Affiliated group member must be same as parent PSCs usually calendar year 2011 Pearson Education, Inc. Publishing as Prentice 3-4 Corporate Elections Tax Year (2 of 2) Changing

the tax year Usually requires IRS approval Automatic approval if Annualizes short-period income Keeps books based on new year Short period does not have a NOL No change in accounting period for 48 mo No interest in flow-through entities Not a2011 3-5 Pearson Education, Inc. Publishing as Prentice specialized

corporation Corporate Elections Accounting Methods Accrual GAAP: generally required for C corps Cash Qualified PSC, or C corp w/ gross receipts < $5M Inventories If cannot be significant

inventories significant, must use accrual method for sales, COGS, inventories, accts. rec., & accts. pay. (the hybrid method) 3-6 2011 Pearson Education, Inc. Publishing as Prentice Computing a Corporations Taxable Income Sales and exchanges of property Business expenses Special deductions Exceptions for closely held corporations

2011 Pearson Education, Inc. Publishing as Prentice 3-7 Sales and Exchanges of Property Capital Gains and Losses Net capital gain taxed at ordinary income rates Net capital losses cannot offset ordinary income Net capital losses Carryback 3 years and forward 5 years Carryovers classified as shortterm 2011 Pearson Education, Inc. Publishing as Prentice

3-8 Sales and Exchanges of Property 291 Tax Benefit Recapture Rule 1250 property sold at a gain Amount of depreciation in excess of straight line is characterized as ordinary income plus An additional 20% of all depreciation characterized as ordinary income under 291 No

1250 recapture under MACRS 2011 Pearson Education, Inc. Publishing as Prentice 3-9 Business Expenses General rule Organizational expenditures Start-up expenditures Limitations on deductions for accrued compensation Charitable contributions 2011 Pearson Education, Inc. Publishing as Prentice 3-10

General Rule All ordinary and necessary expenses reasonable in amount No deductions for Interest on loans to buy tax exempts Illegal bribes or kickbacks Fines or penalties Insurance premiums if corp is beneficiary 2011 Pearson Education, Inc. Publishing as Prentice 3-11 Organizational Expenditures (1 of 2)

Expenses incident to creating corp E.g., legal, accounting, temporary director fees, state incorporation fees 248 election deemed to be made No need to filed election w/ 1st return 2011 Pearson Education, Inc. Publishing as Prentice

3-12 Organizational Expenditures (2 of 2) Amortize remainder over 180 months Expenditures must be incurred before end of first year of business May elect to capitalize and not amortize Election irrevocable

2011 Pearson Education, Inc. Publishing as Prentice 3-13 Start-up Expenditures (1 of 3) Non-organizational Ordinary and necessary expenses Paid or incurred BEFORE the actual start of business operations 2011 Pearson Education, Inc. Publishing as Prentice 3-14 Start-up Expenditures

(2 of 3) Examples of include expenses to: Investigate creation or acquisition of an active trade or business Create an active trade or business Conduct an activity engaged in for profit or production of income before business operations begin 2011 Pearson Education, Inc. Publishing as Prentice 3-15 Start-up Expenditures

(3 of 3) Election to expense first $5K of org costs $5K reduced $ for $ when org costs > $50K Remainder amortized over 180 months Election must be made by due date for filing tax return for first year of operation or ownership Election deemed to be made w/ 1st 3-16 2011 Pearson Education, Inc. Publishing as Prentice Limitation on Deductions for Accrued Compensation

Accrued bonuses/compensation must be paid within 2-1/2 months after close of tax year If paid after 2-1/2 months, payment deemed deferred compensation and is deductible in year paid 2011 Pearson Education, Inc. Publishing as Prentice 3-17 Charitable Contributions (1 of 4) Timing

of deduction Deducted in the year paid Accrual basis corps may elect to include payment made w/in 2-1/2 months following the end of tax year Board of directors must have authorized contribution during year it was accrued Must meet substantiation 2011 Pearson Education, Inc. Publishing as Prentice

3-18 Charitable Contributions (2 of 4) Donated money Deduction Non-cash equals amount donated property Amount USUALLY equal to FMV of

property donated Ordinary income property Deduction limited to FMV less Ord Inc or STCG that would have been recognized if property were sold 3-19 2011 Pearson Education, Inc. Publishing as Prentice (includes recapture) Charitable Contributions (3 of 4) Non-cash property (continued)

Certain inventory related to exempt function Deduction = adjusted basis + 1/2 gain Similar rule for computer technology donated for educational purposes Special rules pertaining to contributions of computer equipment, book inventory, and 2011 Pearson Education, Inc. Publishing as Prentice 3-20 Charitable Contributions (4 of 4)

Max deduction is 10% of adjusted taxable income (ATI) ATI is taxable income before NOL carryback, capital loss carryback, dividend received deduction or charitable contribution deduction Excess carried forward for 5 yrs Creates a deferred tax asset

2011 Pearson Education, Inc. Publishing as Prentice 3-21 Special Deductions U.S. Production activities deduction Other names for the deduction Domestic production activities deduction Manufacturing deduction Dividends-received

deduction Net operating losses Sequencing of the deduction calculations 2011 Pearson Education, Inc. Publishing as Prentice 3-22 U.S. Production Activities Deduction (1 of 3) Deduction is lesser of a % times Qualified production activities income OR

Taxable income before the U.S. production activities deduction Phased-in percentages 6% for 2007-2009 9% for 2010 and thereafter 2011 Pearson Education, Inc. Publishing as Prentice 3-23 U.S. Production Activities Deduction (2 of 3) Qualified

production activities income Domestic production gross receipts from lease, rental, sale, or exchange, of tangible property manufactured in the U.S. LESS Expenses related to qualified income including CoGS, & indirect allocable expenses 3-24 2011 Pearson Education, Inc. Publishing as Prentice U.S. Production Activities Deduction (3 of 3) Deduction

limited to 50% of W-2 wages Not an expense for financial accounting Creates a permanent difference 2011 Pearson Education, Inc. Publishing as Prentice 3-25 Dividends Received Deduction (1 of 3) Corps owning < 20% of a

domestic corporation deduct lesser of 70% of Dividends Received or 70% of taxable income before NOL, capital loss carryback or DRD Exception to taxable income limitation 2011 Pearson Education, Inc. Publishing as Prentice 3-26 Dividends Received Deduction (2 of 3) Corps owning 20% and < 80%

of a domestic corp 80% Corps deduction instead of 70% owning 80% of domestic corp Member of affiliated group 100% deduction 2011 Pearson Education, Inc. Publishing as Prentice 3-27 Dividends Received Deduction (3 of 3)

No deduction is allowed if : Paying corp is a foreign corp Stock purchased w/borrowed money Stock of paying corp held for < 46 days Results in a permanent difference 2011 Pearson Education, Inc. Publishing as Prentice

3-28 Net Operating Losses (NOL) Deductions exceed gross income for the year before NOL carrybacks NOL may be carried back 2 yrs & then forward 20 yrs Corp may elect to forgo carryback & only carry NOL forward 20 yrs Creates 2011 Pearson Education, Inc. Publishing as Prentice a deferred tax asset

3-29 Sequencing of the Deduction Calculations Charitable contributions, DRD, NOL, and all other deductions must be taken in the following order 1. All other deductions 2. Charitable contributions 3. DRD 4. NOL 2011 Pearson Education, Inc. Publishing as Prentice 3-30

Exceptions for Closely-Held Corporations (1 of 3) Special rules apply to shareholders who own >50% of corp 1239 sale of depreciable property to corp causes gain to be ordinary income to the controlling shareholder 267 disallows loss on sale of property by corp to controlling 3-31 2011 Pearson Education, Inc. Publishing as Prentice Exceptions for Closely-Held

Corporations (2 of 3) Special rules apply to shareholder who own >50% of corp (continued) Corporation and shareholder using different accounting methods Defers deduction for accrued expenses owed by accrual-method corp to cash-method controlling 2011 Pearson Education, Inc. Publishing as Prentice shareholder until income recognized3-32

Exceptions for Closely-Held Corporations (3 of 3) Loss limitation rules If 5 or fewer s/hs own > 50% of the stock, the corps losses are limited to amount corp has at risk Losses not currently deductible are carried over to be used in a later year May also be subject to passive activity rules PSCs and closely held corps subject

to passive activity limitation rules3-33 2011 Pearson Education, Inc. Publishing as Prentice Computing a Corporations Income Tax Liability General rules Regular income tax formula Personal service companies 2011 Pearson Education, Inc. Publishing as Prentice 3-34 General Rules The tax rates are graduated

Rate surcharges eliminate benefit of lower graduated tax rates from lower income brackets Corps with income >$18.33M pay a flat 35% on all income 2011 Pearson Education, Inc. Publishing as Prentice 3-35 Regular Tax Formula (1 of 3) Gross Income - Deductions and Losses - Special Deductions =Taxable Income x Appropriate Rate (or rates) =Regular Tax Liability before credits

2011 Pearson Education, Inc. Publishing as Prentice 3-36 Regular Tax Formula (2 of 3) Regular Tax Liability before credits - Foreign tax credit - Other Credits + Credit recapture =Regular tax liability 2011 Pearson Education, Inc. Publishing as Prentice 3-37 Regular Tax Formula (3 of 3)

Regular Tax Liability + AMT Liability + Special Taxes (if any) - Estimated Payments =Refund or tax due 2011 Pearson Education, Inc. Publishing as Prentice 3-38 Personal Service Corporations (1 of 2) PSCs taxed at a flat 35% PSC is defined as a corp that: Substantially

all of the activities involve services in the following fields: Health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting 2011 Pearson Education, Inc. Publishing as Prentice 3-39 Personal Service Corporations (2 of 2) Substantially all stock must be

owned by employees, former employees or survivors of employees 2011 Pearson Education, Inc. Publishing as Prentice 3-40 Controlled Groups Why special rules are needed What is a controlled group? Special rules applying to controlled groups Consolidated tax returns 2011 Pearson Education, Inc. Publishing as Prentice 3-41

Why Special Rules are Needed Prevent shareholders from using multiple corporations to avoid having income taxed at 35% Each corporation would be able to take advantage of lower graduated rates Lower graduated rates must be spread among all corporations 2011 Pearson Education, Inc. Publishing as Prentice

3-42 What Is a Controlled Group? Two or more corps owned directly or indirectly by same shareholder or group of shareholders Types of controlled groups Parent-subsidiary Brother-sister Combined 2011 Pearson Education, Inc. Publishing as Prentice 3-43 Parent-Subsidiary Controlled Group One

corp directly owns at least: 80% of voting power of all classes of voting stock OR 80% of total value of all classes of stock of subsidiary corporation 2011 Pearson Education, Inc. Publishing as Prentice 3-44 Brother-Sister Controlled Group 50%-80% definition

Five or fewer individuals, trusts or estates own: At least 80% of voting power or at least 80% of value of stock of two or more corporations AND > 50% of the voting power or value is held by identical owners (common ownership) nd 50%-only definition isas2 2011 Pearson Education, Inc. Publishing Prentice

test 3-45 Combined Controlled Groups Three or more corps which meet the following criteria: Each corporation is a member of a parent-subsidiary or brother-sister group At least one is both a parent and a member of a brother-sister group 2011 Pearson Education, Inc. Publishing as Prentice 3-46

Special Rules Applying to Controlled Groups (1 of 2) Benefits allocated among members 5% and 3% surcharge 50%-only test for brother-sister groups $40,000 AMT exemption amount 50%-only

test for brother-sister groups The $250,000 minimum 2011 Pearson Education, Inc. Publishing as Prentice 3-47 Special Rules Applying to Controlled Groups Benefits 179 (2 of 2)

allocated (continued) expense amount 50%-80% test for brother-sister groups 50% used for parent-sub test instead of 80% The $25,000 general business credit limit 50%-80% No test for brother-sister groups

loss on sale of assets between 3-48 2011 Pearson Education, Inc. Publishing as Prentice Consolidated Tax Returns Affiliated groups Advantages of filing a consolidated return Disadvantages of filing a consolidated return 2011 Pearson Education, Inc. Publishing as Prentice 3-49 Affiliated Groups (1 of 2) One

or more chains of includible corps connected through stock ownership to a common parent Common parent directly owns 80% of voting power AND value of at least one includible corporation 2011 Pearson Education, Inc. Publishing as Prentice 3-50 Affiliated Groups (2 of 2) Each corp owned at least 80/80 by another member of the group

An affiliated group MAY file a consolidated return Capital losses offset capital gains from other group members Operating losses reduce operating 2011 Pearson Education, Inc. Publishing as Prentice 3-51 Consolidated Return Advantages Losses of one member offset gains of another member Capital losses of one member offset capital gains of another member

Profits and gains from intercompany transactions deferred until sale outside the 2011 Pearson Education, Inc. Publishing as Prentice 3-52 Consolidated Return Disadvantages Election binding on all subsequent tax years Unless IRS grants permission otherwise Losses

from intercompany transactions deferred until sale outside the group Additional administrative costs 2011 Pearson Education, Inc. Publishing as Prentice 3-53 Tax Planning Considerations Compensation planning for shareholder-employees Special election to allocate reduced tax rate benefits Using NOL carryovers and carrybacks 2011 Pearson Education, Inc. Publishing as Prentice

3-54 Compensation Planning Salary payments Reduce double taxation if paid to shareholder-employees Fringe benefits Deducted by corporation and certain benefits are not be taxable

to shareholder-employee 2011 Pearson Education, Inc. Publishing as Prentice 3-55 Allocating Reduced Tax Rate Benefits A controlled group may apportion lower tax rates in any manner to member corporations Reduce benefits to members with little or no income Increase benefits to members with the highest income 2011 Pearson Education, Inc. Publishing as Prentice

3-56 Using NOL Carryovers and Carrybacks Two options Carryback to 2nd previous year, then 1st previous year, then forward Forgo the carrybacks and carry forward Examine marginal tax rates in prior years and expected marginal tax rates in future

2011 Pearson Education, Inc. Publishing as Prentice 3-57 Compliance and Procedural Considerations Estimated Taxes Estimated taxes required if corp owes >$500 for current year. Pay in four installments Each installment 25% of annual liability Underpayment of estimated tax

penalty Small corps exempt from penalty if 2011 Pearson Education, Inc. Publishing as Prentice 3-58 Procedural Considerations Filing Requirements Return is required each year regardless of income

Use form 1120 Use form 1120A if gross receipts, total income & total assets each < $500K Large corps (assets>$10M) must fill out more detailed schedule M3-59 2011 Pearson Education, Inc. Publishing as Prentice Financial Statement Implications ASC 740 - Income Taxes (SFAS 109) Temporary differences Deferred tax assets and the valuation allowance ASC 740 - Uncertain Tax Positions (FIN 48)

Balance sheet classification 2011 Pearson Education, Inc. Publishing as Prentice 3-60 ASC 740 - Income Taxes Scope Establishes principles of accounting for current and deferred taxes Arising from temporary differences 2011 Pearson Education, Inc. Publishing as Prentice

3-61 ASC 740 - Income Taxes Principles Addresses financial statement consequences of Rev, exp, gains/losses recognized in different years for tax and financial statement purposes Events affecting book/tax differences in bases of assets and liabilities Loss & credit carrybacks or 3-62 2011 Pearson Education, Inc. Publishing as Prentice

ASC 740 - Income Taxes Objectives Recognize current yr taxes payable or refundable Recognize deferred tax liabilities and assets for future tax consequences of events on fin stmts or tax return 2011 Pearson Education, Inc. Publishing as Prentice 3-63 Temporary Differences (1 of 2)

Deferred tax liabilities occur when Rev/gains recognized earlier for book than tax Exp/losses deducted earlier for tax than book Tax basis of asset < book basis Tax basis of liability > book basis 2011 Pearson Education, Inc. Publishing as Prentice 3-64 Temporary Differences (2 of 2) Deferred

tax assets occur when Rev/gains recognized earlier for tax than book Exp/losses deducted earlier for book than tax Tax basis of asset > book basis Tax basis of liability < book basis Loss/credit carryforwards exist 2011 Pearson Education, Inc. Publishing as Prentice 3-65 Deferred Tax Assets and the Valuation Allowance Deferred

tax asset Firm will realize tax benefit of event in the future Valuation allowance used for portion of benefit not likely to be realized Use more likely than not standard 2011 Pearson Education, Inc. Publishing as Prentice 3-66 ASC 740 - Uncertain Tax Positions

Formerly FIN 48 Two-step to account for uncertain tax positions Determine if position exceeds more likely than not (>50%) probability of being sustained on its merits by IRS If not, corp cannot recognize tax benefit Records liability for unrecognized tax

2011 Pearson Education, Inc. Publishing as Prentice benefits 3-67 Balance Sheet Classification Classify as current or noncurrent If related to another asset or liability use classification of related asset/liab Net current assets and liabilities Net noncurrent assets and liabilities 2011 Pearson Education, Inc. Publishing as Prentice 3-68 Tax Provision Process

(1 of 3) Identify temporary differences and tax carryforwards 2. Prepare roll forward schedules 3. Apply appropriate tax rates in roll forward schedules to determine deferred tax asset/liability balances 4. Adjust deferred tax assets by 1. 2011 Pearson Education, Inc. Publishing as Prentice 3-69 Tax Provision Process (2 of 3) Adjust income tax expense for

uncertain tax positions under FIN 48 6. Determine current federal income taxes payable (current tax expense) 7. Determine total federal income tax expense (benefit) 3-70 5. 2011 Pearson Education, Inc. Publishing as Prentice Tax Provision Process (3 of 3) Prepare and record tax journal entries 9. Prepare tax provision reconciliation 10. Prepare tax rate reconciliation

11. Prepare financial statements 8. 2011 Pearson Education, Inc. Publishing as Prentice 3-71 End Chapter 3 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorados Kenneth W. Monfort College of Business [email protected] 2011 Pearson Education, Inc. Publishing as Prentice 3-72

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