1. The Corporate Taxpayer
Chapter 11
The Corporate Taxpayer
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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

3. 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

4. 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

5. 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”

6. 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
Corporations entitled to dividends-received deduction
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

7. Dividends-Received Deduction
Corporations receiving dividends from other taxable domestic corporations are entitled to this deduction
Ownership % Deduction
% < 20% of stock % DRD
20%<= % < 80% % DRD
80%<= % % DRD
What was Congress’ reasoning behind the DRD?
To mitigate “triple” taxation

8. Dividends-Received Deduction Example
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

9. 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

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

11. Example: Schedule M-1
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 ,500
- MACRS over SL ,000
Taxable Income $200,000

12. 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

13. Domestic Production Activities Deduction
Available to US taxpayers deriving income from domestic production activities
For 2013, deduction is equal to 9% 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

14. 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)

15. 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

16. 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

17. 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

18. Example: AMT Exemption
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

19. 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)

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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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