Taxation of Individuals and Business Entities 2019 Edition Chapter 16 Corporate Operations

Corporate Taxable Income Formula (Exhibit 16-1) Corporate Tax Formula Individual Tax Formula Gross income Minus: Deductions For AGI deductions Equals Adjusted gross income From AGI deductions Deduction for qualified business income, and Greater of: Standard deduction or Itemized deductions and Taxable income Times Tax rate (21%) Tax rates Regular income tax liability Add Other taxes Total tax Minus Credits Prepayments Taxes due (or refund)

Book–Tax Differences (1 of 2) Financial income often is the starting point for computing taxable income. Reconcile to taxable income Book–tax adjustments for differences between financial accounting rules Companies preparing financial statements with tax accounting methods won’t have book–tax differences.

Book–Tax Differences (2 of 2) Unfavorable differences Add-back to book income to compute taxable income. Favorable differences Subtract from book income to compute taxable income. Permanent differences (never “reverse”) Temporary differences (reverse over time)

Common Permanent Book–Tax Differences Interest income from municipal bonds (Fav) Death benefit from life insurance on key employees (Fav) Life insurance premiums (Unfav) Half of business-related meals (Unfav) 100% of entertainment expenses (Unfav) Fines and penalties and political contributions (Unfav) Excess compensation to executives (Unfav) Federal income taxes (Unfav) Dividends received deduction (Fav)

Common Temporary Book–Tax Differences (1 of 2) Equity income Depreciation Gain/loss on sale of depreciable asset Bad debt expense §263A uniform inventory capitalization costs See #34 Organizational or start-up costs Unearned rent revenue Deferred compensation

Common Temporary Book–Tax Differences (2 of 2) Non-qualified stock option compensation expense Net capital loss Carry back three years and forward five years Net operating loss carryover #39 & #45 Goodwill acquired in an asset acquisition (goodwill with a book and tax basis) #36

Book–Tax Differences from Dividends (1 of 3) Included in gross income for tax purposes if received from a domestic corporation Eligible for a 100% dividends received deduction if received from a 10%-or-more owned foreign corporation and previously deferred from U.S. taxation

Book–Tax Differences from Dividends (2 of 3) Income included in book income depends on ownership. If ownership < 20%, unrealized gain or loss included in income for book purposes; dividends reported for book and tax purposes. If ownership is at least 20% but not more than 50%, the shareholder corporation reports its share of joint venture’s income under the equity method; dividends reported for tax, but not book purposes.

Book–Tax Differences from Dividends (3 of 3) If ownership > 50%, consolidated financial reporting; intercompany dividends are eliminated for book purposes. If ownership ≥80%, consolidated tax reporting; dividends are eliminated for tax purposes.

Dividends Book–Tax Difference Example PCC owns 30% of the stock of BCS corporation. During 2018, BCS distributed a $40,000 dividend to PCC. BCS reported $100,000 of net income for 2018. Based on this information, what is PCC’s 2018 book–tax difference relating to the dividend and its investment in BCS (ignore the dividends received deduction)? Is the difference favorable or unfavorable?

Dividends Book–Tax Difference Example Solution Answer: $10,000 unfavorable book-tax difference, computed as follows: Description Amount Explanation Dividend received in 2018 (included in 2018 taxable income but not in book income) $40,000 BCS 2018 net income $100,000 PCC’s ownership in BCS stock 30% PCC’s book income from BCS investment under the equity method of accounting $30,000 (2) × (3) Unfavorable book-tax difference associated with dividend $10,000 (1) – (4)

Limitation on Net Interest Expense Corporate net interest expense deductions are limited to 30% of taxable income before interest income or deductions (called adjusted taxable income, ATI). Deductions disallowed are carried forward indefinitely. This limitation does not apply to taxpayers with annual average gross receipts (AGR) less than $25 million for the prior three years.

Book and Tax Treatment of Stock Options (1 of 2) EXHIBIT 16-5 Book and Tax Treatment on Stock Options Description Book Deduction Tax Deduction Book-Tax Difference Incentive stock option Initial estimated fair value of stock options/requisite service period No deduction Unfavorable, permanent Nonqualified stock option (in years before exercise) No deduction until exercise Unfavorable, temporary

Book and Tax Treatment of Stock Options (2 of 2) Description Book Deduction Tax Deduction Book-Tax Difference Nonqualified stock option (in year of exercise) Initial estimated fair value of stock options/requisite service period Bargain element* Favorable, temporary (reversing unfavorable, temporary difference in prior years) Favorable, permanent difference if the bargain element exceeds the initial estimated value of stock options; unfavorable permanent difference otherwise *The bargain element is the difference between the fair market value of the stock and the exercise price on the date the employee exercises the stock options.

Net Capital Losses #39 No current deduction for net capital losses (capital losses in excess of capital gains) Carry back net capital losses three years and carry forward five years Use carryover amounts on FIFO basis Unfavorable, temporary book-tax difference in year of net capital loss Favorable, temporary book-tax difference in year carryback or carryover is utilized

Net Operating Loss Deduction No current benefit from current year loss (NOL) NOLs from tax years beginning after 12/31/17 can be carried forward indefinitely; offset is limited to 80% of taxable income. NOLs from pre-2018 tax years can be carried back 2 years and forward 20 years. To compute NOL for year, no deduction for: NOL carrybacks or carryovers from other years. Capital loss carrybacks (carryovers are allowed).

NOL Example XYZ Inc. has a net operating loss of $200,000 for the 2018 tax year. XYZ reported taxable income in 2019 of $200,000. How much of the 2018 NOL can XYZ offset against its 2019 taxable income?

NOL Example Solution XYZ can offset the lesser of the 1) NOL carryover of $200,000 or 2) 80% of taxable income in 2019. XYZ can use $160,000 of the 2018 NOL carryover to offset taxable income in 2019. The remaining $40,000 of unused NOL from 2018 can be carried forward to 2020 (indefinitely).

Charitable Contributions (1 of 2) #47 Amount of deduction Capital gain property Generally fair market value Ordinary income property Generally adjusted basis Accrual method corporation Deduct when accrue if Approved by board of directors before year-end Paid within 3½ months after end of year

Charitable Contributions (2 of 2) Deduction is limited to 10% of taxable income before deducting: Any charitable contributions. The dividends received deduction (DRD). NOL carrybacks. Domestic production activities deduction (DPAD). Capital loss carrybacks. Carry forward excess contributions for 5 years.

Charitable Contribution Example In 2018, PCC donated a total of $700,000 of cash to the American Red Cross. PCC’s taxable income before the charitable contribution deduction, NOL carryover ($24,000), and DRD ($15,000) was $6,287,000. What is PCC’s charitable contribution deduction for the year? What is its charitable contribution carryover to next year, if any?

Charitable Contribution Example Solution Answer: $626,300 charitable contribution deduction and $73,700 charitable contribution carryover, computed as follows: Description Amount Explanation Taxable income before any charitable contribution, NOL carryover from previous year, and DRD $6,287,000 Exhibit 16-7. NOL carryover from previous year (24,000) Deductible in determining taxable income limit. Charitable contribution limit modified taxable income $6,263,000 (1) + (2). Total charitable contributions for year $ 700,000 Tax deduction limitation percentage 10% §170(b)(2)(A) Charitable contribution deduction limitation $ 626,300 (3) × (5). Charitable contribution deduction for year Lesser of (4) or (6). Charitable contribution carryover* $ 73,700 (4) – (7). *The carryover expires if it has not been used during the five- year period after the current year.

Dividends Received Deduction Deduction to mitigate more than two levels of tax Own less than 20%: 50% DRD Own at least 20% but less than 80%: 65% DRD Own 80% or more: 100% DRD Limitation: deduction is limited to the lesser of: Dividend × DRD%, or DRD modified taxable income × DRD%. Modified taxable income = taxable income before DRD, any NOL, and capital loss carrybacks. If full DRD increases or creates an NOL, this limit does not apply. Creates favorable, permanent book–tax difference

Dividends Received Deduction Example Description Scenario A Scenario B Explanation Taxable income before the dividends received deduction (includes dividend income) $50,000 $25,000 NOL carryover 3,000 DRD modified taxable income $53,000 $28,000 (1) + (2). Dividend income $30,000 Dividends received deduction percentage based on ownership 50% §243(a). Dividends received deduction before limitation $15,000 (4) × (5). Dividends received deduction limitation $26,500 $13,500 (3) × (5). DRD deductible Lesser of (6) or (7).

Regular Tax Liability For taxable years beginning after 12/31/18 Flat tax rate of 21% (blended for corporations with fiscal years beginning before 12/31/18 and ending in 2019) Apple, Inc. has a September 30, 2018 year-end (92 days in 2017, 273 days in 2018). Blended rate for 2018 = 92/365 x 35% + 273/365 x 21% = 24.52%

Compliance Corporations report taxable income on Form 1120. Small corporations complete Schedule M-1. Large corporations complete Schedule M-3. Book–tax differences referred to as M adjustments. Corporate returns are due 3½ months after the close of the tax year (June 30 year-end exception). Automatic five month extension for filing (September 15 for calendar-year corporations) Consolidated tax returns Affiliated groups essentially treated as one corporation.

EXHIBIT 16-9 Form 1120, Schedule M-1

Estimated Payments (1 of 4) Corporations with a federal income tax liability of $500 or more are required to pay their estimated income tax in four monthly installments. Installments due on the 15th day of 4th month (25% of required annual payment) 6th month (50% of required annual payment) 9th month (75% of required annual payment) 12th month (100% of required annual payment) Corporations may owe a penalty for underpayment. Payments based on required annual payment.

Estimated Payments (2 of 4) Required annual payment 100% of tax liability on prior-year return Doesn’t apply if no liability in prior year 100% of current-year tax liability 100% of estimated current-year tax liability using annualized method Rules for large corporations $1,000,000 of taxable income in prior three years May use prior-year liability for first quarter payment only

Estimated Payments (3 of 4) EXHIBIT 16-10 Estimated Taxable Income Computation under Annualized Income Method Installment (1) Taxable Income (first_months of year) (2) Annualization Factor × (2) Annual Estimated Taxable Income First quarter 3 12/3 = 4 Second quarter Third quarter 6 12/6 = 2 Fourth quarter 9 12/9 = 1.3333

Estimated Payments (4 of 4) EXHIBIT 16-11 Estimated Taxable Income Computation under Annualized Income Method Installment (1) Annual Estimated Taxable Income (2) Tax on Estimated Taxable Income (3) Percentage of Tax Required to Be Paid (4) (2) × (3) Required Cumulative Payment (5) Prior Cumulative Payment (4) – (5) Required Estimated Tax Payment First quarter 25% Second quarter 50 Third quarter 75 Fourth quarter 100

Alternative Minimum Tax (1 of 3) Tax paid in addition to regular tax liability Repealed for tax years beginning after 12/31/17

Alternative Minimum Tax (2 of 3) EXHIBIT 16-12 Corporate AMT Formula

Alternative Minimum Tax (3 of 3) AMTI × 20% = tentative minimum tax AMT = tentative minimum tax minus regular tax liability Minimum tax credit Amount of AMT creates credit Carry forward indefinitely When regular tax > tentative minimum tax, credit can offset regular tax down to tentative minimum tax amount

Minimum Tax Credit Example Corporations with a MTC carryover can offset regular tax liability for any taxable year to which the AMT no longer applies. For tax years beginning in 2018, 2019, and 2020, 50 percent of the minimum tax credit in excess of the regular tax liability is refundable. Any remaining credit is fully refundable in 2021.

End of Presentation