1. Welcome Back
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2. Welcome Back
Time for Any Question
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3. CHAPTER # 17
REVIEW
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4. Accounting for Tax Income
Chapter 17
Accounting for Tax Income
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5. Objectives of “Accounting for Income Taxes”
The income tax provision includes
Current year taxes payable or refundable
Any changes to future income taxes payable or refundable that result from differences in the timing of when an item is reported on the tax return compared to the financial statement
A company records these future income taxes payable or refundable on its balance sheet as
Deferred tax liability
Deferred tax asset
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6. Objectives of “Accounting for Income Taxes”
Objectives of ASC 740
ASC 740 applies only to:
Income taxes levied by the U.S. federal government
U.S. state and local governments
Non-U.S. (“foreign”) governments
The FASB defines an income tax as a tax based on income, which excludes property taxes, excise taxes, sales taxes, and value-added taxes.
Companies report non-income taxes as expenses in the computation of their net income before taxes
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7. Objectives of “Accounting for Income Taxes”
Two objectives
Recognize the amount of income taxes payable or refundable in the current year
Recognize deferred tax liabilities and assets for the (expected) future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns
Both objectives relate to reporting a company’s income tax amounts on the balance sheet, not the income statement
Asset and liability approach
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8. Objectives of “Accounting for Income Taxes”
A “book-tax” difference can occur for several reasons:
1) Different accounting methods are used in the computation.
Straight-line depreciation is used for book, accelerated depreciation is used for tax.
2) The book-tax “rules” are different.
Not all book income is taxable.
Not all book deductions reduce taxable income.
Not all tax deductions reduce book income.
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9. Objectives of “Accounting for Income Taxes”
3) The timing of when income and deductions are reported on the two statements may differ (prepayments).
4) Different entities may appear on the two statements.
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10. Objectives of “Accounting for Income Taxes”
To compute the deferred tax liability or asset, a company must calculate the future tax effects attributable to temporary differences and tax carry forwards
Temporary differences that are initially favorable (unfavorable) create deferred tax liabilities (assets)
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11. Objectives of “Accounting for Income Taxes” and Income Tax Provision Process
Steps in determining the income tax provision
Adjust pretax income for permanent differences
Identify all temporary differences and carryforwards
Calculate the current income tax expense or benefit
Recognize deferred tax assets and liabilities
Evaluate the need for a valuation allowance for deferred tax assets
Calculate the deferred income tax expense or benefit
Determine changes to liabilities for uncertain tax positions
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12. Objectives of “Accounting for Income Taxes” and Income Tax Provision Process
Compute the two components of the income tax provision
Current
Deferred
Combine the two components to produce the total income tax provision
Formula
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13. Calculate Current and Deferred Income Tax Expense or Benefit Component
1) Adjust Pretax Net Income for All Permanent Differences
Permanent differences - Differences that appear only on the income statement or tax return, but not on both
A company does not take permanent differences into account in computing its deferred tax assets and liabilities
Permanent differences usually affect a company’s effective tax rate and appear as part of its reconciliation of its effective tax rate with the statutory U.S. tax rate
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14. Calculate Current and Deferred Income Tax Expense or Benefit Component
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15. Calculate Current and Deferred Income Tax Expense or Benefit Component
2) Identify All Temporary Differences and Tax Carryforward Amounts
Temporary differences commonly arise in four instances
Revenues or Gains that are taxable after they are recognized in Financial Income
Expenses or Losses that are deductible after they are recognized in Financial Income
Revenues or Gains that are taxable before they are recognized in Financial Income
Expenses or Losses that are deductible before they are recognized in Financial Income
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16. Calculate Current and Deferred Income Tax Expense or Benefit Component
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17. Calculate Current and Deferred Income Tax Expense or Benefit Component
Identifying Taxable and Deductible Temporary Differences
Taxable Temporary Difference
Initially favorable gives rise to a taxable temporary difference
Taxable temporary differences generally arise when
Revenues or gains are taxable after they are recognized in net income
Expenses or losses are deductible on the tax return before they reduce net income
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18. Calculate Current and Deferred Income Tax Expense or Benefit Component
From a balance sheet perspective
A taxable temporary difference generally arises when the financial reporting basis of an asset exceeds its corresponding tax basis, or the financial reporting basis of a liability is less than its corresponding tax basis
The future tax cost associated with a taxable temporary difference is recorded on the balance sheet as a deferred tax liability
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19. Calculate Current and Deferred Income Tax Expense or Benefit Component
Deductible Temporary Difference
A temporary difference that initially is unfavorable gives rise to a deductible temporary difference
Deductible temporary differences generally arise when
Revenues or gains are taxable before they are recognized in net income
Expenses or losses are deductible on the tax return after they reduce net income
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20. Calculate Current and Deferred Income Tax Expense or Benefit Component
From a balance sheet perspective
A deductible temporary difference generally arises when the financial reporting basis of an asset is less than its corresponding tax basis or the financial reporting basis of a liability exceeds its corresponding tax basis
The future tax benefit associated with a deductible temporary difference is recorded on the balance sheet as a deferred tax asset
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21. Calculate Current and Deferred Income Tax Expense or Benefit Component
3) Compute the Current Income Tax Expense or Benefit
ASC 740 defines the current income tax expense or benefit as “The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year”
The major component of a company’s current income tax expense or benefit is
income tax liability or
refund from its current year operations
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22. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
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23. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
Tax-exempt interest income (book, not tax) 50
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24. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
Tax-exempt interest income (book, not tax) P
Accrued warranty (book, not tax) (200)
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25. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
Tax-exempt interest income (book, not tax) P
Accrued warranty (book, not tax) (200) T
Nondeductible fine (book, not tax) (150)
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26. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
Tax-exempt interest income (book, not tax) P
Accrued warranty (book, not tax) (200) T
Nondeductible fine (book, not tax) (150) P
Tax depreciation in excess of book depreciation (100)
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27. The Current Tax Provision Example
Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year.
Tax-exempt interest income (book, not tax) P
Accrued warranty (book, not tax) (200) T
Nondeductible fine (book, not tax) (150) P
Tax depreciation in excess of book depreciation (100)T
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28. The Current Tax Provision
Compute taxable income
Book income $1,000
Tax-exempt interest income (50)
Accrued warranty
Nondeductible fine
Tax depreciation in excess of book
depreciation (100)
Taxable income $1,200
Compute the current tax provision (assume tax R = 35%)
$1,200 × 35% = $420
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29. Calculate Current and Deferred Income Tax Expense or Benefit Component
4) Determine the Ending Balances in the Balance Sheet Deferred Tax Asset and Liability Accounts
The deferred income tax expense or benefit portion of a company’s income tax provision reflects the change in a company’s deferred tax liabilities or assets that relate to continuing operations
The deferred tax accounts provide investors and other interested parties with a measure of a company’s expected future income tax related cash inflows (outflows) resulting from book-tax differences that are temporary in nature or from tax carryover
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30. Calculate Current and Deferred Income Tax Expense or Benefit Component
ASC 740 takes a “liability” or balance sheet approach for the computation of the deferred tax expense or benefit
The computations are based on the change in the cumulative differences between the financial accounting basis of an asset or liability and its corresponding tax basis from the beginning of the year to the end of the year
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31. Calculate Current and Deferred Income Tax Expense or Benefit Component
5) Determining Whether a Valuation Allowance is Needed
Evaluate the Need for a Valuation Allowance for Gross Deferred Tax Assets
A valuation allowance is required if it is more likely than not some or all of the deferred tax asset will not be realized in the future
ASC 740 identifies four sources of potential future taxable income, two of which are objective and other two are subjective
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32. Calculate Current and Deferred Income Tax Expense or Benefit Component
A. Objective sources
1) Future Reversals of Existing Taxable Temporary Differences
If the reversing taxable temporary differences provide sufficient future taxable income to absorb the reversing deductible temporary differences, the company does not record a valuation allowance against the deferred tax asset
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33. Calculate Current and Deferred Income Tax Expense or Benefit Component
2) Taxable Income in Prior Carryback Years
Company does not record a valuation allowance if the tax benefit from the realization of a deferred tax asset can be carried back to a prior year that has sufficient taxable income to absorb the realized tax benefit.
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34. Calculate Current and Deferred Income Tax Expense or Benefit Component
B. Subjective sources
1) Expected future taxable income exclusive of reversing temporary differences and carryforwards
A company might support its predictions of future taxable income with evidence of existing contracts or a sales backlog that will produce enough taxable income to realize the deferred tax asset when it reverses
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35. Calculate Current and Deferred Income Tax Expense or Benefit Component
2) Tax Planning Strategies
Includes sale and leaseback of operating assets
Changing inventory accounting methods
Refraining from making voluntary contributions to the company pension plan
Electing to capitalize certain expenditures rather than deduct them currently
Sale of noncore assets
Electing the alternative depreciation system
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36. Calculate Current and Deferred Income Tax Expense or Benefit Component
Negative Evidence That a Valuation Allowance Is Needed
ASC 740 requires that a company consider negative as well as positive evidence in determining whether it is more likely that a deferred tax asset will not be realized in the future.
Negative evidence includes
Cumulative (book) losses in recent years (usually 36 quarters)
A history of net operating (capital) losses and credits expiring unused
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37. Calculate Current and Deferred Income Tax Expense or Benefit Component
An expectation of losses in the near future
Unsettled circumstances that, if resolved unfavorably, will result in losses from continuing operations in future years
Calculate the Deferred Income Tax Expense or Benefit
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38. Calculate Current and Deferred Income Tax Expense or Benefit Component
6) Accounting for Uncertainty in Income Tax Positions
FAS 109 provided no specific guidance on how to deal with uncertain tax positions.
Companies generally applied the principles of FAS 5, Accounting for Contingencies, to uncertain tax positions.
The objective of FIN 48 (codified in ASC ) was to provide a uniform approach to recording and disclosing tax benefits resulting from tax positions that are considered to be uncertain.
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39. Calculate Current and Deferred Income Tax Expense or Benefit Component
ASC applies to all tax positions accounted for in accordance with ASC 740, including:
Previously filed positions
Expected filing positions
Decisions not to file tax returns in a particular jurisdiction
Decisions to exclude potentially taxable income
Choices made in classifying a transaction as tax-exempt or taxable
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40. Calculate Current and Deferred Income Tax Expense or Benefit Component
ASC applies a two step process in evaluating tax positions
1) Recognition process
Company first determines if it is more likely than not that its tax position on a particular account will be sustained on IRS examination based on its technical merits
Company then determines the amount it expects to be able to recognize
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41. Calculate Current and Deferred Income Tax Expense or Benefit Component
2) Measurement process
Requires the company to make a cumulative probability assessment of all likely outcomes of the audit and litigation process
A company recognizes the amount that has a greater than 50 percent probability of being sustained on examination and subsequent litigation
The amount not recognized is recorded as a liability on the balance sheet
Interest and Penalties – may be included in the provision or reported as a deduction in computing pretax income
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42. Calculate Current and Deferred Income Tax Expense or Benefit Component
Disclosures of Uncertain Tax Positions
Specific line items should disclose
Gross amounts of increases and decreases in liabilities related to uncertain tax positions as a result of tax positions taken during a prior period and current year
Amounts of decreases in liabilities related to uncertain tax positions relating to settlements with taxing authorities
Reductions in liabilities related to uncertain tax positions as a result of a lapse of the applicable statute of limitations
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43. Financial Statement Disclosure and Corporation's Effective Tax Rate
1) Balance Sheet Classification
ASC 740 requires companies (public and private) to disclose their deferred tax assets and liabilities on their balance sheets and classify them as either current or noncurrent (all are noncurrent beginning in 2016).
ASC 740 permits companies to net deferred tax assets and liabilities based on their classification and present the net amount on the balance sheet
ASC 740 does not permit netting of deferred tax assets and liabilities that are attributable to different tax jurisdictions
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44. Financial Statement Disclosure and Corporation's Effective Tax Rate
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45. Financial Statement Disclosure and Corporation's Effective Tax Rate
2) Income Tax Footnote Disclosure
ASC 740 mandates that a company disclose
Components of the net deferred tax assets and liabilities reported on its balance sheet
Total valuation allowance recognized for deferred tax assets
3) ASC 740 also requires publicly traded companies to disclose these components
Current tax expense or benefit
Deferred tax expense or benefit
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46. Financial Statement Disclosure and Corporation's Effective Tax Rate
Benefits of operating loss carryforwards
Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates
Adjustments to the beginning of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in management’s judgment about the realizability of the recognized deferred tax assets
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47. Financial Statement Disclosure and Corporation's Effective Tax Rate
4) Computation and Reconciliation of the Income Tax Provision with a Company’s Hypothetical Tax Provision
ASC 740 requires a company to reconcile its
Reported income tax provision attributable to continuing operations with
Amount of income tax expense that would result from applying its U.S. statutory tax rate to its pretax net income or loss from continuing operations
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48. Financial Statement Disclosure and Corporation's Effective Tax Rate
5) Importance of a Company’s Effective Tax Rate
The tax rate that backs out one-time and nonrecurring (discrete) events is referred to as the company’s structural tax rate
The structural effective tax rate often is viewed as more representative of the company’s effective tax rate from its normal (recurring) operations
The cash tax rate is used by analysts to compute a company’s tax status excluding deferred taxes
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49. Break for Minutes
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50. Chapter 18
Corporate Taxation:
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51. Corporate Taxation: Nonliquidating Distributions
Chapter 18
Corporate Taxation: Nonliquidating Distributions
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52. Learning Objectives
Explain the framework that applies to the taxation of property distributions from a corporation to a shareholder.
Compute a corporation's earnings and profits and a shareholder's dividend income.
Identify when a corporation may be deemed to have paid a "constructive dividend" to a shareholder.
Explain the taxation of stock dividends.
Comprehend the tax consequences of stock redemptions.
Describe the tax consequences of a partial liquidation to the corporation and its shareholders.
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53. Framework for Property Distributions
Distributions to shareholders will be taxed in one of the following ways:
Taxed as income (albeit at a lower tax rate)
Return of capital
Capital gains
When distributions from corporations are taxed to shareholders, this creates double taxation of corporate income
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54. Framework for Property Distributions
Some payments to shareholders are deductible by the corporation
Examples are payments for services (salary), interest, and rent
To be deductible, payments to shareholders must be reasonable in amount
Unreasonable payments (e.g., excessive salary) are taxed as “constructive” dividends to shareholders
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55. Constructive Dividends
Examples of constructive dividends
Unreasonable compensation
Shareholder use of corporate assets without an arm’s-length payment
Interest paid to shareholder at excessive interest rates
Payments made by the corporation on behalf of a shareholder
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56. Computing Earnings and Profits
Overview of distributions:
Dividend distributions are included in the shareholder’s gross income
Non-dividend distributions are a return of capital (reduce the shareholder’s tax basis in the corporation’s stock)
Non-dividend distributions in excess of the shareholder’s stock tax basis constitute a gain from sale or exchange of the stock
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57. Determining the Dividend
A “dividend” for tax purposes is:
any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P)
Two separate E&P accounts to be maintained
Current earnings and profits (CE&P)
Accumulated earnings and profits (AE&P)
Undistributed current E&P is added to the balance of accumulated E&P on the first day of the next tax year
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58. Determining the Dividend
Computing Earnings and Profits begins with taxable income
Taxable income is adjusted as follows:
Income that is excluded from taxable income
Disallowed deductions that do not require an economic outflow
Deduction of expenses that require an economic outflow but are not deducted for computing taxable income
Adjustment of timing for deductions or income because of accounting methods required for E&P computation
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61. Determining the Dividend
Ordering of E&P Distributions
Positive Current E&P and Positive Accumulated E&P
Positive current E&P, negative accumulated E&P
Negative current E&P, positive accumulated E&P
Negative current E&P, negative accumulated E&P
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62. Determining the Dividend
Example 1
Current E&P = $1,000,000
Accumulated E&P = ($500,000)
The corporation distributes $1,000,000 on July 1.
The entire distribution is deemed to come from current E&P and is a dividend to the shareholders.
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63. Determining the Dividend
Example 2
Current E&P = ($1,000,000)
Accumulated E&P = $1,000,000
The corporation distributes $1,000,000 on July 1.
Current E&P is apportioned on a per day basis
AE&P as of July 1 = $1M − ½($1M) = $500,000
$500,000 is a treated as a dividend.
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64. Determining the Dividend
Distributions of Noncash Property to Shareholders
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65. Determining the Dividend
Tax Consequences to a Corporation Paying Noncash Property as a Dividend
The corporation recognizes gains (but not losses) on the distribution of noncash property as a dividend
Gain is recognized to the extent of fair market value in excess of tax basis in the property
Liabilities
If the property’s fair market value is less than liabilities assumed by the shareholder, the fair market value is deemed to be the liability
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66. Determining the Dividend
Example 3
Cher Holder receives a property distribution from Sunny Corporation with a fair value of $200. Cher assumes a $100 mortgage attached to the property. Sunny’s basis in the property distributed is $100.
Sunny Corporation reports a gain of $100 on the distribution ($200 − $100).
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67. Determining the Dividend
Example 4
Cher Holder receives a property distribution from Sunny Corporation with a fair value of $200. Cher assumes a $300 mortgage attached to the property. Sunny’s basis in the property distributed is $100.
Sunny Corporation reports a gain of $200 on the distribution ($300 − $100).
The property’s FMV is deemed to be the amount of the liability assumed because it exceeds the property’s fair market value.
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68. Determining the Dividend
Noncash Property Distributions affect E&P
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69. Stock Dividends
A stock dividend increases the number of shares outstanding
Stock dividends can also take the form of a stock split (e.g., 2-for-1 stock split)
Stock dividends are nontaxable to shareholders if two conditions are met:
Made with respect to common stock and
Pro rata (proportionate interests maintained)
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70. Stock Dividends
Non-pro rata stock dividends usually are taxable as dividends
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71. Stock Redemptions Form of a Stock Redemption
A redemption occurs when a corporation acquires its stock from a shareholder in exchange for property
A redemption results in either a dividend or a sale of the redeemed shares
Individuals prefer exchange treatment because of the preferential tax rates for capital gains
Corporate shareholders prefer dividend treatment because of the dividends received deduction
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72. Stock Redemptions Three types of redemptions are treated as exchanges:
Redemptions that are Substantially Disproportionate are treated as sales
Redemptions in Complete Redemption of all of the Stock of the Corporation Owned by the Shareholder
Redemptions that are not Essentially Equivalent to a Dividend
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73. Stock Redemptions
Stock ownership tests are required for treatment as substantially disproportionate:
Shareholder does not control the corporation after the exchange (less than 50 percent of voting power)
Shareholder’s percentage of voting stock and aggregate value is less than 80 percent of the percentage before the redemption
Constructive ownership rules must be considered:
Family attribution
Attribution from entities to owners or beneficiaries
Attribution from owners or beneficiaries to entities
Option attribution
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74. Stock Redemptions
Example 5 Tom owns 60 of the corporation’s 100 shares of voting common stock. 1. What percentage ownership test(s) must be met for the Tom to receive exchange treatment? 2. How many shares of stock must the corporation redeem to have Tom treat the redemption as an exchange?
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75. Stock Redemptions
Example 5 Solution Part 1: Two tests must be met: First, after the redemption Tom must own less than 50% of the outstanding shares. Second, Tom’s percentage ownership after the redemption must be less than 80 % of his percentage ownership before the redemption. In this case, Tom ’s 60 percent ownership must drop to less than 48% (80% × 60% = 48%).
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76. Stock Redemptions
Example 5 Solution Part 2: To determine the minimum number of shares to be redeemed, solve the following inequality where x=number of redeemed shares: This reduces to the following expression: Hence, by redeeming 24 of Tom’s shares his ownership interest in the corporation will drop to 47.4% ([60-24] / [100 − 24] = 36/76).
(60 – x) / (100 – x) < .48
.52x > 12 and x > 24 shares
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77. Stock Redemptions
If the redemption is treated as an exchange the shareholder tax consequences are:
Gain is always recognized
Loss is recognized unless the shareholder is a related person to the corporation
The redeemed shareholder may be related if they owns more than 50% of the stock’s value
Note that ownership is determined using the §267(c) attribution rules
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78. Stock Redemptions Tax Consequences to the Distributing Corporation
Current E&P is reduced by dividend distributions (cash and fair market value of other property adjusted for gain recognized and liabilities distributed)
For an exchange, current and accumulated E&P is reduced by the percentage of stock redeemed (limited to the fair market value of the property distributed)
Current E&P is reduced by dividends before reducing its current E&P for redemptions treated as exchanges
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79. Stock Redemptions
Example 6 Acme Inc. has AE&P at 1/1/16 of $100,000 and CE&P for 2016 is $75,000. Acme redeems all of Bill’s stock on July 1 for $60,000. The stock redeemed represents 25% of Acme stock. On December 31, Acme pays its remaining shareholders dividends of $25,000. Bill treats the redemption as an exchange. What is the effect on Acme’s AE&P and CE&P?
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80. Stock Redemptions
Example 6 What is the effect on Acme’s AE&P and CE&P? 1. CE&P after the dividends is $50,000 ($75,000 − $25,000) 2. AE&P at 7/01/14 is $100,000 + ½($50,000) = $125, Acme reduces AE&P to the lesser of: 25% × $125,000 = $31,250 or $60,000 (fair value of the distribution)
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81. Partial Liquidations Corporations can contract either by:
Distributing stock of a subsidiary to shareholders
Selling a business and distributing the proceeds to shareholders in partial liquidation
Distributions may require the shareholders to exchange some shares of stock or may be pro rata to all the shareholders without an actual exchange of stock
Noncorporate shareholders receive exchange treatment
Corporate shareholders determine their tax consequences using the change-in-stock ownership rules that apply to stock redemptions
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82. Happiness is having all homework up to date
Homework assignment
Using Connect – 6 Questions for 60 Points for Chapter 18.
Tax Return; Course Project: Corporation Tax Return Problem # 2 “Blue Catering Service Inc.'s (BCS) 2016 Form 1120” on Pages C-16 till C-18.
Complete the “Connect Orientation” at Connect web site for 5 points, before 03/26/2017.
Quiz # 1 is Available from today till 2/19/2017 at 11:59 PM.
Prepare chapter 19 “Corporate Formation, Reorganization, and Liquidation.” for meeting on 2/27/2017; no Class on 2/20 for “Presidents Day.”
Happiness is having all homework up to date
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83. Thank you and See You On 2/27/2017 at the Same Time, Take Care
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