Chapter 11 Corporate Income Tax

Chapter 11Corporate Income Tax Income Tax Fundamentals 2010 Gerald E. Whittenburg & Martha Altus-Buller 2010 Cengage Learning

Corporate Tax Rates • Corporate rates are progressive • Marginal rates are from 15% to 39%, depending on taxable income • There are eight brackets • There are a number of ‘tax bubbles’ - occurs when tax rate schedules recaptures savings from prior brackets • For corporations with large income (more than $18.33 million) the rate is a flat 35% • Qualified personal service corps taxed at flat 35% • Architects, CPAs, consultants, etc. 2010 Cengage Learning

Example Corporate Tax Rates Example Johnson & Kelby Inc. (a dental products wholesaler) has taxable income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services? 2010 Cengage Learning

Solution Example Johnson & Kelby Inc. (a dental products wholesaler) has taxable income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services? Solution Corporate tax = $100,250 $22,250 + (39%)(300,000 – 100,000) If Johnson & Kelby is a qualified personal service corporation, corporate tax = $105,000 ($300,000 x 35%) 2010 Cengage Learning

Corporate Capital Gains • A corporation can choose from two alternative tax treatments on capital gains • Taxed at ordinary rates or • Elect to pay an alternative tax (35%) on net long-term capital gain (LTCG) • Essentially equivalent to maximum regular corporate tax (no tax benefit to LTCG) • Bottom line: there is no difference in tax on ordinary vs. capital income 2010 Cengage Learning

Dividends Received Deduction • Corporations are allowed a deduction for a % of the dividends received from other corporations • Attempt to alleviate triple taxation • Dividends received deduction is allowed based upon ownership • Percentage Ownership Dividends Received % Deduction < 20% 70% • 20% or more, less than 80% 80% • > 80% 100% • Deductions limited by % and other items 2010 Cengage Learning

Amortization of Organizational Expenditures • Examples of organizational expenditures • Legal/accounting services incidental to organization • Incorporation fees • Organizational expenditures are capitalized and then amortized over 180 months • However, can make election to deduct up to $5,000 of organization costs in year corporation begins business • $5,000 amount is reduced $1 for each $1 that organizational expenses exceed $50,000 2010 Cengage Learning

Charitable Contributions • 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 contribute • As long as pledge is made by year-end • Limited to 10% of taxable income* • Carry forward unused deduction for five years *Calculated before any loss carrybacks, NOLS or the dividend received deduction 2010 Cengage Learning

Example Charitable Contributions Example Ferndale Corp. had net operating income of $400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is its charitable contribution carryforward? 2010 Cengage Learning

Solution Example Ferndale Corp. had net operating income of $400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction (DRD) of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is the carryforward? Solution The charitable contribution deduction is $48,000 ($400,000 + 80,000) x 10% = $48,000 limit* Therefore, carryforward is $32,000 ($80,000 – 48,000) *Note: had to add back DRD first!! 2010 Cengage Learning

Reconciliation of Tax to Book Income: Schedule M-1 • 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 See chapter for other items included on Schedule M-1 2010 Cengage Learning

Filing Requirements & Estimated Tax • Form 1120 - regular corporation • Form 1120S - S Corporation • Returns are due by the 15th day of the third month after year-end • Can file Form 7004 and receive automatic 6-month extension • Corporations must make estimated tax payments in similar manner as self-employed taxpayers 2010 Cengage Learning

S Corporations • Certain corporations may elect to be taxed in a manner similar to partnerships • Qualified small business corporation may elect S Corporation status if several criteria apply • Operates as a domestic corporation • Has 100 or fewer shareholders • Shareholders may not be corporations or partnerships • Has only one class of stock • Has only shareholders that are U.S. citizens or resident aliens 2010 Cengage Learning

S Corporations • 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 • Status can be voluntarily revoked by consent of shareholders or • Involuntarily revoked • If corporation ceases to be a small business corporation or • If corporate passive income is 25% or more for 3 consecutive years and corporation has accumulated earnings and profits at the end of each of those years 2010 Cengage Learning

Example S Corporation Election Example Swannak Electronics Corporation is a calendar year corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation? 2010 Cengage Learning

Solution Example Swannak Electronics Corporation is a calendar year corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation? Solution Since Swannak did not make its election within the first 2-1/2 months of the tax year, it will be treated as a regular corporation for the current year, and will become an S Corporation for tax year 2010. 2010 Cengage Learning

Income Reporting • Must report all elements of income and expense separately on Form 1120S • Then each shareholder reports his/her share of these items of corporate income/expense on personal return • K-1 takes total shareholder income/expenses and allocates each item to each shareholder based upon his/her ownership percentage 2010 Cengage Learning

Loss Reporting • Each shareholder of an S Corp may also report his/her respective share of loss • Cannot take a loss in excess of adjusted basis in stock • If loss exceeds adjusted basis in stock plus loans, shareholder can carry it forward • If shareholder entered/departed S Corp midyear, must allocate losses on a daily basis 2010 Cengage Learning

S Corporation Pass Through Items • Many items retain tax character when passing through to the S Corporation’s shareholders on individual K-1 • Examples of such items include • Capital gains/losses • §1231 gains/losses • Dividend Income • Charitable contributions • Tax-exempt interest • Most credits 2010 Cengage Learning

Corporate Formation • Shareholders often transfer assets to a corporation in exchange for stock • No tax is due on gain from transfer of appreciated assets if conditions met • Shareholder transferred cash or property and • Shareholder made transfer solely in exchange for stock* • Shareholder is not providing a service and all taxpayers together own at least 80% of stock after transaction *If shareholder receives boot in addition to stock, transaction may qualify for partial nonrecognition of gain 2010 Cengage Learning

Shareholder Basis in Stock • A shareholder’s initial basis in his/her stock is calculated as follows Basis of property transferred Less Boot received Plus Gain recognized Less Liabilities transferred Basis in stock • The corporation has a carry-over basis in the property contributed equal to the basis in the hands of the shareholder, increased by any gain recognized by shareholder on the transfer Note: generally assumption of shareholder liabilities that are attached to property are not considered boot received. 2010 Cengage Learning

Accumulated Earnings Tax (AET) • Penalty tax designed to prevent a corporation from avoiding tax by retaining earnings • 15% AET imposed on “unreasonable” accumulation of earnings in addition to corporate tax • Corporation may accumulate up to $250,000 a year that is exempt from AET tax or $150,000 for a service corporation • May accumulate more if can prove a valid business purpose 2010 Cengage Learning

Example Accumulated Earnings Tax Example Xinix Corporation (a medical device manufacturing firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be? 2010 Cengage Learning

Solution Example Xinix Corporation (a medical device manufacturing firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be? Solution Its AET = $45,000 (in addition to regular tax) ($800,000 – 500,000) x 15% 2010 Cengage Learning

Personal Holding Company Tax • Penalty tax designed to encourage Personal Holding Companies to distribute earnings to shareholders • Tax is 15% on undistributed earnings • Corporation is not liable for both the personal holding company tax and the AET in the same year 2010 Cengage Learning

Corporate AMT • Corporate AMT - calculated similar to the individual AMT • AMT is 20% of Alternative Minimum Taxable Income Taxable Income +/- Adjustments + Preferences - Exemption* Alternative Minimum Taxable Income (AMTI) • Small corporations are not subject to the AMT • Defined as having average annual gross receipts < $7.5 million over a three-year period *Exemption is $40,000, but is phased out when AMTI > $150,000 2010 Cengage Learning

You’re Done with Chapter 11 2010 Cengage Learning

Chapter 11 Corporate Income Tax