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

 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 Cengage Learning

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

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

 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

 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 2010 Cengage Learning Percentage Ownership Dividends Received % Deduction < 20% 70% 20% or more, less than 80% 80% > 80% 100% Deductions limited by % and other items

 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, Cengage Learning

 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 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

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) x 10% = $48,000 limit* Therefore, carryforward is $32,000 ($80,000 – 48,000) *Note: had to add back DRD first!! 2010 Cengage Learning

 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 Cengage Learning

 Form 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

 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

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

Example Swannak Electronics Corporation is a calendar year corporation that makes an S Corporation election on May 25, 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 Cengage Learning

 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

 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

 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

 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

 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 2010 Cengage Learning Note: generally assumption of shareholder liabilities that are attached to property are not considered boot received.

 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 o r $150,000 for a service corporation  May accumulate more if can prove a valid business purpose 2010 Cengage Learning

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

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

 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 - 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, Cengage Learning