The Corporate Taxpayer Chapter 11 The Corporate Taxpayer McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

The Corporate Taxpayer Identify legal characteristics of corporations Compute the dividends-received deduction Prepare a Schedule M-1 reconciliation Compute regular tax on corporate income Discuss corporate AMT Describe payment and filing requirements Explain why dividends are taxed twice Discuss the incidence of the corporate income tax

Corporation Legal Characteristics Limited liability of shareholders Owners of closely-held corporations often are required to personally guarantee repayment of debt Licensed professionals must still carry malpractice insurance Unlimited life Legal existence not affected by changes in ownership Free transferability of interests Through regulated markets with maximum convenience and minimal transaction cost For closely-held corporations, a buy-sell agreement may prevent transferability Centralized management

Affiliated Groups and Consolidations Affiliated groups = a parent corporation that directly owns at least 80% of at least one domestic subsidiary + all other domestic subsidiaries that are 80% owned within the group Affiliated groups may elect to file a consolidated tax return - applies to all members of affiliated group Advantage: losses and profits of affiliated members offset each other

Nonprofit Corporations Includes corporations formed exclusively for “religious, charitable, scientific, literary, educational purposes, etc.” Section 501(c)(3) organizations require IRS recognition of tax-exempt status Nevertheless, tax-exempt organizations may pay tax on “unrelated business taxable income”

Thinking Question What types of business activities do tax-exempt organizations perform that put them in competition with for-profit taxpayers?

Computing Corporate Taxable Income Page 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return (Ch 10) See Chapters 6, 7, 8 and 9 for general rules on business income Deduct only 50% of meals and entertainment expenses Deduct charitable contributions up to 10% of taxable income BEFORE charitable deductions and before dividends-received deduction Excess contributions can be carried forward for 5 years

Dividends-received Deduction Corporations receiving dividends from other taxable domestic corporations are entitled to this deduction Ownership % Deduction % < 20% of stock 70% DRD 20%<= % < 80% 80% DRD 80%<= % 100% DRD What was Congress’ reasoning behind the DRD? To mitigate “triple” taxation Additional details: DRD can’t create loss

Dividends Received Deduction Aragorn Corp. owns 35% of Ent Corp. and 88% of Legolas Corp. If Aragorn receives dividends of $10,000 from Ent and $15,000 from Legolas, calculate Aragorn’s DRD. $10,000 x 80% = $ 8,000 $15,000 x 100% = $15,000 Total DRD $23,000

Book Versus Taxable Income - Schedule M-1 & M-3 Schedules M-1 and M-3 reconcile book income to taxable income The M-1 was used by all corporations until 2004 and can still be used by corporations with total assets less than $10 million In 2004, the IRS developed the M-3 for use by large corporations (assets > $10 million); it requires more detailed information than the M-1 and enhances the transparency of book/tax differences

Schedule M-1 Net book income - line 1 Federal tax expense for books - line 2 Lines 3 - 6 explain increases in taxable income relative to books Lines 7 - 9 explain decreases in taxable income relative to books Line 10 = taxable income before NOL and DRD = Line 28, page 1, form 1120

Schedule M-1 Example Wilson Inc. reported $149,250 of net income after tax on its financial statements Wilson reported federal income tax expense of $61,250 Meals and entertainment expense = $15,000 MACRS depreciation = $60,000; book depreciation = $42,000 Prepare Wilson Inc.’s M-1 Net book income $149,250 + Federal tax expense + 61,250 + 50% of meals & ent. + 7,500 - MACRS over SL - 18,000 Taxable Income $200,000

Computing Regular Tax The surtax rates of 39% and 38% eliminate bracket benefits for ‘rich’ corporations Corporations with taxable income Between $335,000 and $10 million actually pay a flat rate of 34% Greater than $18.33 million pay a flat rate of 35% Personal service corporations are taxed at a flat 35% rate Includes health, law, engineering, architecture, accounting, actuarial science, performing arts, & consulting professionals

Domestic Production Activities Deduction Available to US taxpayers deriving income from domestic production activities For 2007 and 2008, deduction is equal to 6% of the lesser of net production income or taxable income before the deduction Deduction can’t exceed 50% of US compensation expense Deduction is equivalent to a reduced tax rate on domestic production income

Tax Credits Credits directly reduce computed tax $1 of credit provides $1 of benefit $1 of deduction only provides ($1 x the tax rate) of benefit Tax credits are generally limited to some % of tax before credits. Often a provision permits carry back or carry forward of excess credits Biggest credits: R&D credit, foreign tax credit (see Chapter 13)

Tax Credits To be eligible, taxpayers must engage in specific activities that Congress believes are worthy of government support The list of credits changes as Congress experiments with new credits and discards those that fail to produce the intended behavioral result

Alternative Minimum Tax A second federal tax system parallel to the regular income tax Created to ensure that every corporation pays a “fair share” of taxes

Alternative Minimum Tax - Who is Subject? New corporation is exempt in Year 1 Exempt in Year 2 if Year 1 sales <=$5 million Exempt in Year 3 if average sales in years 1 and 2 <= $7.5 million Exempt in subsequent years if average gross receipts for three prior years <= $7.5 million Once a corporation fails to be exempt, it is ineligible for AMT exemption for all subsequent tax years

AMT Exemption Example Year 1 sales = $4 million Exempt from AMT because it’s year 1 Year 2 sales = $8 million Exempt because Year 1 sales <=$5 million Year 3 sales = $12 million Exempt because average of years 1 and 2 = $6 million, which is <= $7.5 million Year 4 sales = $2 million Subject to AMT because average of years 1, 2 & 3 = $8 million, which is > $7.5 million Thus, the firm is subject to AMT in all subsequent years

Alternative Minimum Tax - Overview Alternative minimum taxable income (AMTI) less Exemption = AMTI in excess of Exemption x 20% = Tentative minimum tax (TMT) less Regular Tax = Alternative minimum tax (AMT)

Alternative Minimum Taxable Income (AMTI) Starts with regular taxable income Add AMT preferences Add or subtract AMT adjustments Subtract AMT NOL

AMT Preferences Preferences are always positive additions to AMTI Examples Tax-exempt interest income from private activity bonds - municipal bonds issued to fund non-government activities Percentage depletion in excess of cost basis

AMT Adjustments Represent timing differences between regular taxable income and alternative minimum taxable income - will eventually reverse, perhaps over several periods Examples Differences between MACRS and ADS depreciation amounts Completed-contract method Amortization of pollution control facilities ACE adjustment

ACE Adjustment Adjustment equals 75% of difference between ‘adjusted current earnings’ and AMTI before ACE adjustment and AMT NOL Adjusted current earnings an economic measure of earnings that approximates financial statement net income Any negative ACE adjustment (ACE > AMTI before ACE and AMT NOL) limited to cumulative positive ACE adjustments from prior years

AMT NOL Deduction AMT NOL amount computed using alternative taxable income approach Deduction limited to 90% of AMTI before the AMT NOL Example: If AMTI before consideration of any NOL is $100,000, the maximum allowable AMT NOL deduction is $90,000

AMT - More Details Exemption = $40,000 but is reduced by 25% of the amount that AMTI exceeds $150,000 AMTI in excess of the Exemption is multiplied by 20% = Tentative Minimum Tax (TMT) If TMT > Regular tax, then TMT less Regular Tax = Alternative Minimum Tax (AMT) If TMT < Regular tax, AMT = 0 Corporations with modest AMT adjustments and preferences avoid AMT

AMT Timing Minimum tax credit Results when AMT is paid Reduces regular tax in subsequent year Can’t reduce regular tax to less than TMT Carries forward indefinitely Corporate AMT is not designed as a permanent tax increase, but only accelerates the payment of tax Eliminating the AMT is a frequent tax debate in the news

Payment and Filing Requirements Tax return due 15th day of 3rd month, may extend to 15th day of 9th month However, the extension does not extend the payment deadline Estimated payments are due on the 15th day of 4th, 6th, 9th, and 12th months Must pay 100% of tax due; Small corporations (TI < $1 million) may use safe-harbor rule of paying 100% of prior year tax Underpayment penalty is computed like interest expense but is nondeductible

Distributions to Investors (Creditors & Shareholders) Interest payments are deductible, while payments on stock (i.e., dividends) are non-deductible This creates a bias in favor of debt financing Non-tax costs associated with debt financing include large cash flow commitments and a greater risk of insolvency The non-tax costs often outweigh the tax savings associated with debt

Alternatives to Double Taxation of Dividends Treat corporations as pass-through entities Administratively cumbersome, if not impossible Make dividends nontaxable Current policy of taxing dividends to individuals at 15% is a step in this direction Tax credit for individuals for the corporate tax attributable to dividends included in individual taxpayers’ income All of these alternatives would result in significant revenue loss to the Treasury

Incidence of the Corporate Tax Corporations do not pay taxes - people do What are examples of ways that the incidence of the corporate tax could be born by individual taxpayers in the U.S.? Higher consumer prices Lower employee wages Lower dividends