McGraw-Hill Education Copyright © 2015 by the McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website in whole or part. Chapter 15 Corporate Taxation “Corporations don’t pay taxes, they collect them.” -- Paul H. O’Neill

15-2 LO #1 Corporate Formation and Filing Requirements Corporations are legal entities formed under the laws of a state. Corporations can use the cash-basis of accounting if average gross receipts <= $5 million or if inventory is not a material factor.

15-3 LO #1 Corporate Formation and Filing Requirements Corporations are not limited to a calendar year fiscal year. They can choose any fiscal year in their first year of operation. Corporations file a Form Tax returns are due 2.5 months after the fiscal year-end –Can obtain an automatic 6-month extension using Form 7004.

15-4 LO #1 Corporate Formation and Filing Requirements – Concept Check A corporation can use either the cash or accrual method of accounting. True or False? False 2. Corporate tax returns are due ________ if no extension is requested. 2.5 months after the end of the fiscal year 3. The tax year of a corporation must end on December 31. True or False? False

15-5 LO # 2 - Basis On formation of a corporation, transferors are exchanging cash and/or property for stock. Generally, on corporate formation, no gain is recognized by the transerors if, immediately after the transfer, the transferors control 80% or more of the corporation.

15-6 LO # 2 - Basis Two cases in which gain may be recognized by the transferor(s): –1. If shareholder contributes an asset subject to a liability and the relief of liability is greater than basis then the gain recognized will be equal to the excess. –2. Cash or other property received (boot) triggers gain equal to the lesser of the boot received or the gain

15-7 LO # 2 - Basis Basis of the contributed property to the corporation (inside basis) –Equal to the basis in the hands of the shareholder plus any gain recognized by the shareholder

15-8 LO # 2 - Basis Basis of the stock to the shareholder (outside basis) –Equal to the basis of the property contributed, plus any gain recognized, minus any boot received (boot includes any relief of liability). Unless shareholder increases or decreases his or her proportionate ownership, outside basis generally does not change.

15-9 LO # 2 – Basis Concept Check When forming a corporation, if the transferors control at least 80% of the corporate entity, then the formation will generally be tax free. True or False? True 2. The basis to the corporation of property received is equal to _______________. Shareholder basis plus gain recognized by shareholder. 3. Arturo contributed land with a fair value of $100,000 and basis of $40,000 to a newly-formed corporation in exchange for 90% of the stock. Arturo’s basis in the stock is ______________. $40,000

15-10 LO #3 – Taxable Income & Tax Liability Determination of taxable income generally follows the rules associated with a trade or business (Chapter 6). –For corporations, the notion of AGI does not exist.

15-11 LO #3 – Taxable Income & Tax Liability Capital gains and losses are netted together. Net capital losses are not permitted. –If a corporation has a net capital loss, it can carry it back three years and then forward five years. Only offsets net capital gains in the carryback or carryforward periods. Net capital gains are included in income and are taxed at ordinary rates.

15-12 LO #3 – Taxable Income & Tax Liability Charitable contributions are limited to 10% of taxable income before charitable contributions, DRD, and carrybacks. –Excess is carried forward five years. Contribution amount for “ordinary income property,” such as inventory, is limited to basis.

15-13 LO #3 – Taxable Income & Tax Liability Corporations receive a Dividends Received Deduction (DRD) for dividends from other domestic corporations. –DRD is 70% if ownership is < 20% –DRD is 80% if ownership => 20% or < 80% –DRD is 100% ownership => 80% DRD may be limited.

15-14 LO #3 – Taxable Income & Tax Liability Organizational expenses and start-up expenses can be amortized and deducted over 180 months –Corporation must make affirmative election. –Some org expenses and/or startup expenses may be immediately deductible.

15-15 LO #3 – Taxable Income & Tax Liability Taxable income is subject to tax rates of up to 35%. –Tax rate schedule is progressive, but the benefit of lower rates for lower income is recaptured as taxable income increases.

15-16 LO #3 – Taxable Income & Tax Liability Corporations must make estimated payments –Payment is lesser of 100% of tax due for the year or 100% of the tax for the prior year. –Due on 15 th day of fourth, sixth, ninth, and twelfth months of fiscal year. –Underpayment penalty applies if payments are not sufficient.

15-17 LO #3 – Taxable Income & Tax Liability If a corporation has a net operating loss, it can be carried back two years and then carried forward 20. –Corporations can make an irrevocable affirmative election to carry the NOL only forward.

15-18 LO #3 – Taxable Income & Tax Liability – Concept Check Corporations follow the same tax rules for capital gains as do individuals. True or False? False 2. The tax liability of a corporation with taxable income of $520,000 is ___________. $176,800

15-19 LO #3 – Taxable Income & Tax Liability – Concept Check A corporation reported taxable income of $390,000 before charitable contributions. The corporation made charitable contributions of $50,000. Its permitted deduction for charitable contributions in the current tax year is ________. $39,000

15-20 LO #3 – Taxable Income & Tax Liability – Concept Check Organizational expenses are automatically deductible over 180 months. True or False? False 5. Corporate net operating losses from 2012 can be carried back ____ years and forward ____ years. 2 years, 20 years

15-21 LO #4 – Transactions with Shareholders Corporations have earnings and profits (E&P). It is similar, but not identical, to retained earnings –E&P is based on tax law, not accounting rules Distributions of cash or property from E&P are dividends –Taxable to shareholders –Not deductible by the corporation

15-22 LO #4 – Transactions with Shareholders Distributions in excess of E&P –Nontaxable to shareholder to the extent of shareholder basis in the stock –A capital gain to the extent the distribution exceeds basis.

15-23 LO #4 – Transactions with Shareholders Distribution of property with FMV in excess of basis –Corporation reports gain (write-up to FMV) –Amount of distribution to shareholder is based on FMV.

15-24 LO #4 – Transactions with Shareholders Distributions in full liquidation –Corporation records all assets and liabilities at FMV and records gain or loss –Shareholder reports capital gain or loss equal to the FMV of the distribution compared to stock basis.

15-25 LO #4 – Transactions with Shareholders – Concept Check Dividends are always taxable to a shareholder. True or False? True 2. If a corporation pays a dividend in property, the stockholder will have a dividend equal to the corporate basis in the property. True or False? False 3. A corporation has earnings and profits of $10,000 and makes a cash distribution to its sole shareholder in the amount of $11,000. The amount of taxable dividend to the shareholder is ______________. $10,000

15-26 LO #5 – Schedules L, M-1 and M-3 Schedules L, M-1, and M-2 are all on page 5 of the Form –Small corporations are not required to complete these schedules. Schedule L is a beginning and ending balance sheet reported in accordance with the financial accounting method of the corporation.

15-27 LO #5 – Schedules L, M-1 and M-3 Schedule M-1 is a reconciliation from book income to taxable income (not the other way around). Schedule M-1 sets forth all book/tax differences for the year, whether permanent or temporary.

15-28 LO #5 – Schedules L, M-1 and M-3 Some items that are a positive adjustment (added back) from book income to taxable income: –Income tax expense per books –Excess capital losses –Disallowed current year charitable contribution –Book depreciation in excess of tax depreciation –50% of travel and entertainment expense

15-29 LO #5 – Schedules L, M-1 and M-3 Some items that are a negative adjustment (subtracted) from book income to taxable income: –Life insurance proceeds –Tax exempt interest –Tax depreciation in excess of book depreciation –Charitable contributions in excess of 10% limit in prior year

15-30 LO #5 – Schedules L, M-1 and M-3 Schedule M-3 is a comprehensive book/tax reconciliation for large corporations. –Total assets of $10 million or more.

15-31 LO #5 – Schedules L, M-1 and M-3 – Concept Check Completion of Schedule L is required of all corporations. True or False? False 2. Schedule M-1 reconciles book income to taxable income. True or False? True 3. A corporation’s depreciation expense is lower on the financial statements than it is on the tax return. Would this difference be a negative or positive item on Schedule M-1? Negative

15-32 LO #6 – Other Corporate Issues Parent-subsidiary group –A common parent owns, directly or indirectly, at least 80% of one or more other corporations. –Can elect to file a consolidated return. –If elected, the election is irrevocable for all future tax years.

15-33 LO #6 – Other Corporate Issues Brother-sister group –Five or fewer persons own two or more corps Total ownership test – group owns at least 80% of the voting shares Common ownership test – group has common, identical, ownership of at least 50% of share value –Must disclose to IRS.

15-34 LO #6 – Other Corporate Issues Larger corporations are subject to AMT –Start with taxable income, add or subtract tax adjustments, add tax preference items, subtract exemption amount. –Preferences similar to individuals Additional corporate item is the adjusted current earnings (ACE) adjustment –Exemption amount is $40K Phased out 25 cents on the dollar for AMT income over $150K. Exemption is totally phased out for AMT income of $310K or more. –AMT rate is 20%

15-35 LO #6 – Other Corporate Issues Concept Check To be considered a parent/subsidiary group, the parent corporation must own, directly or indirectly, at least ____ percent of the subsidiary corporation. 80% 2. A brother-sister group may exist if ______ or fewer persons own two or more corporations. Five 3. For AMT purposes, the corporate exemption amount is $________. $40,000

15-36 LO #7 – Subchapter S Corporations Subchapter S corporations are “regular” corporations that affirmatively elect to be taxed in a manner similar to a partnership File a Form 1120S Filing deadlines and extension rules are the same as Subchapter C corporations

15-37 LO #7 – Subchapter S Corporations Must meet four tests to elect Sub S status: –Be a domestic corporation –Have 100 or fewer shareholders –Have one class of stock –Have shareholders who are U.S. citizens or resident aliens.

15-38 LO #7 – Subchapter S Corporations Sub S corporations report taxable income and separately stated items –Separately stated items are very similar to those reported by a partnership Sub S corporation does not pay tax. The shareholders do.

15-39 LO #7 – Subchapter S Corporations Shareholder basis is determined similar to a partnership except corporate debt does not affect shareholder basis. Basis increased by: –Net income –Separately stated positive items –Capital contributions –Loans from the shareholder to the corporation

15-40 LO #7 – Subchapter S Corporations Basis is decreased by: –Net losses –Separately stated negative items –Distributions from the corporation at FMV Basis cannot go below zero. –If negative basis is implied, the amount is carried forward.

15-41 LO #7 – Subchapter S Corporations Subchapter S distributions are not taxable to shareholders –Shareholders have already been taxed on the income –Similar to a partnership in that income is taxed and distributions are generally not taxed.

15-42 LO #7 – Subchapter S Corporations Concept Check Corporations with fewer than 100 shareholders are automatically considered Subchapter S corporations. True or False? False 2. A Subchapter S corporation is taxed in a manner similar to a partnership. True or False? True 3. Subchapter S corporations file a Form ______. 1120S

15-43 LO #7 – Subchapter S Corporations Concept Check Alyssa is a shareholder in a Subchapter S corporation and has a basis of $1,000 in her stock. The corporation gives her a $200 cash dividend. Is this dividend taxable or not taxable to Alyssa? Not taxable 5. Similar to a partnership, shareholders of a Subchapter S corporation increase the basis of their stock by their share of corporate debts. True or False? False