Chapter 11

1. Chapter 11 Corporate Income Tax

2. Objective Understand the basic tax rules for the operation of a corporation

3. Corporate Tax Rates • Corporate rates are progressive from 15% to 39% depending on taxable income • For corporations with large income (> $18.333 million) the rate is a flat 35%

4. Personal Service Corporations • A corporation where the majority of the shareholder-employees are engaged in providing service is called a Personal Service Corporation. Personal services include • health care • law, engineering or architecture • accounting or consulting • Taxable income is taxed at a flat 35% rate

5. Corporate Capital Gains • Corporation can chose from two alternative tax treatments on capital gains • taxed at ordinary rates, or • elect to pay an alternative tax (35%) on the net long-term capital gain • Law basically taxes the income at the same rates; therefore, no difference in tax on the income • Short term capital gains considered ordinary income

6. Corporate Capital Losses • On corporate tax returns, capital losses may only be netted against capital gains • They are not allowed against ordinary income • Carry forward is allowed for five years, and carry back is allowed for three years

7. Dividends Received Deduction • Corporations are allowed a deduction for a percentage of the dividends received from other corporations • Attempt to alleviate triple taxation • Dividends received deduction is allowed Percent ownershipDRD percentage < 20% 70% > 20% to < 80% 80% > 80% 100% • Deduction limited to DRD % times taxable before DRD, NOL, and capital loss carrybacks. • Limitation does not apply if corporation has an NOL after subtracting the regular DRD %

8. Amortization of Organizational Expenditures • Examples of organizational expenses • legal/accounting services • temporary director fees • incorporation fees • These fees are capitalized and then amortized over sixty months if proper election made on initial tax return • If no election, then capitalize and do NOT amortize • Expenses involved in transferring assets to the corporation are not considered organizational expenses

9. Corporate Charitable Contributions Deduction • Corporations are allowed a deduction for charitable contributions • Cash basis taxpayers can deduct when paid • Accrual basis taxpayers have until the 15th day of the third month following year-end to pay (as long as pledge is made by year end) • Limited to 10% of taxable income before any loss carry-backs or the Dividend Received Deduction • Any unused amounts may be carried-forward for five years

10. Reconciliation of Tax to Accounting Income • Schedule M-1 of Form 1120 reconciles book to tax income • Computed before NOLs and special deductions • Amounts added to book income • Federal tax expense • Capital losses • Income recorded on tax return but not on books • Expenses recorded on books but not on tax return • Amounts deducted from book income • Income recorded on books but not on tax return • Expenses recorded on tax return but not on books

11. Filing Requirements • Regular corporation files a Form 1120 • S Corporation files a Form 1120S • Form 1120-A, a short form tax return, may be used if the corporation has • total gross revenue less than $500,000 • total income less than $500,000 and • total assets less than $500,000 • Returns are due by the 15th day of the 3rd month after year-end

12. Objective Know how an S Corporation is taxed and the requirements for operating as an S Corporation

13. S Corporation • Qualified small corporation may elect S status, if it • Is a domestic corporation • Has 75 or fewer shareholders • They cannot be corporations or partnerships • Has only one class of stock • Has only shareholders that are US citizens or resident aliens

14. S Corporations (continued) • Corporation must make election of S status in a prior year or within 2-1/2 months of the current tax year • S Corp status stays in effect until revocation • S Corp status can be voluntarily revoked • voluntary consent of shareholders • Or involuntarily revoked • if corporation ceases to qualify (e.g., 76 shareholders), or • if corporate passive income exceeds 25% for 3 consecutive years

15. Income Reporting • S Corporations do not pay tax themselves (generally), income flows through to each shareholder • Based upon shareholder’s % ownership • Each shareholder’s share of various items is included in shareholder’s tax return • Like a partnership, the S Corporation must file an informational return (Form 1120S)

16. Loss Reporting • Each shareholder of an S Corp can also report their respective share of losses • They cannot take a loss in excess of their adjusted basis in stock • If loss exceeds basis, shareholder can carry it forward • If shareholder entered S Corp midyear, or departed midyear, must allocate on a daily basis

17. S Corporation Pass Through Items • Many items retain their “character” when they pass through to S Corp shareholders on each K-1 • Examples • Capital gains/losses • §1231 gains/losses • Charitable contributions • §179 deduction • Tax-exempt interest • Most credits

18. S Corp “Special Taxes” • S Corps may be subject to tax attributable to gains on assets that have appreciated prior to electing S Corp status • Tax may also be imposed if passive investment income is “excessive”

19. Objective Understand the basic tax rules for the formation of a corporation

20. Corporate Formation • Shareholders often transfers assets to a corporation in exchange for stock • No tax is due on gain from transfer of appreciated assets, if: • All shareholders involved • Transfer property or cash solely in exchange for stock (not be providing a service), and • Own at least 80% of stock after transaction

21. Basis • A shareholder’s initial basis is the same as the basis in the property transferred in exchange for the stock (a carry-over basis) • Unlike partnerships, liabilities do not affect shareholder basis • The corporation has a carry-over basis in the property contributed equal to the basis in the hands of the shareholder

22. Objective Understand the operation of special corporation taxes

23. Accumulated Earnings Tax (AET) • Penalty tax designed to prevent a corporation from avoiding tax by retaining earnings • Tax is imposed at 38.6% on “unreasonable” accumulation of earnings • Corporation may accumulate up to $250,000 a year ($150,000 for a service corporation) • May accumulate more if can prove a valid business purpose

24. Personal Holding Company Tax (PHCT) • Penalty tax designed to encourage Personal Holding Companies to distribute earnings to shareholders • Tax is 38.6% on undistributed earnings • Corporation is not liable for both the PHCT and the AET in the same year

25. Corporate AMT • The corporate AMT is calculated in a similar manner to the individual AMT • AMT is 20% of AMTI • AMTI = Taxable Income +/- adjustments + preferences - exemption • Exemption is $40,000, but is phased out when AMTI > $150,000 • Phase out = .25(AMTI - $150,000) • Small corporations are not subject to the AMT • Defined as corporations with average annual gross receipts < $5 million over a three-year period

26. End of Chapter 11