Accounting 331
Course Outline—Fall 2004
Chapter 2
Introduction to Income Taxation of Corporations
· Differences and similarities to individual income taxation. Corporation has no deduction for itemized deductions (as all of its expenses are business deductions) plus there is no standard deduction or personal/dependency exemption. Corporate income tax model is much more straightforward.
Gross Income (generally apply to all business entities)
-Trade or Business Deductions (generally apply to all business entities)
= Taxable Income before NOL and Special (Dividends Received) Deductions
- NOL & Dividends Received Deductions
= Taxable Income
Note: No AGI for Corporations
· Accounting Periods and Methods
C Corporations may choose a calendar year or a fiscal year for reporting purposes, but S corporations and personal service corporations are subject to restrictions on the choice of a fiscal year. Consequently S & PSC normally choose a calendar year.
The cash method is often not available to C corporations. S Corporations and qualified PSC’s are excluded from this rule; C corporations with average gross receipts $ 5 million or less for the past three years are also excluded.
IRS Notice 2001-76 permits qualified service providers with average annual gross receipts of not more than $ 10 million for the most recent three year period to use the cash method. This applies even if the taxpayer is buying and selling inventory.
· Do Q 2-13
· Comparison of a proprietorship (flow-through entity) with a corporation. Proprietorship profits subject to SE tax, no salary for the proprietor. C corporations taxed on the net income and the shareholders taxed on the dividends received. Shareholders of C corporations can be subject to treatment of part of their salaries as dividends under the doctrine of “unreasonable compensation”.
· § 267 Related party issues—an accrual basis taxpayer cannot claim a deduction for an accrual owed to a related party until the recipient reports that amount as income.
Capital gains and Losses—Comparison with Individuals
· Net capital gains for corporations are not subject to lower rates as are gains for individuals.
· Corporate capital losses may only offset capital gains.
· Excess capital losses are carried back three years and forward five years to offset capital gains, while capital gains for individuals are carried forward indefinitely. Further for corporations capital loss carry-backs or carryovers become short-term capital losses. For individuals they retain their original status as short term and long term.
· Do P 2-39, 40
Passive Activity Losses
Passive Loss Limitations apply to closely held C corporations (>50% ownership, 5 or fewer individuals) and to PSC’s, but do not apply to regular C corporations.
Closely held C corporations may offset passive losses against active income.
Do Q 2-18
Charitable Contributions
General Observations—Rules parallel to a large extent those for individuals. For long-term capital gain property the amount of the deduction is the fair market value on the date of the donation. A contribution of tangible personal property that is put to an unrelated use by the charity is limited to the adjusted basis at the date of donation.
For contributions of ordinary income-producing property, the deduction is limited to the lower of adjusted basis or fair market value. Corporate contributions of ordinary income property to charities that use the property in a manner related to the exempt purpose and solely for the care of the ill, needy or infants or where the property is used for research purposes (under special rules):
1. The deduction is measured by the adjusted basis of the property plushalf of the appreciation of the property.
2. However, the deduction cannot exceed twice the basis of the property.
A corporate taxpayer is limited to 10% or taxable income computed without regard to the charitable contribution deduction, any net operating loss carry-back, and the dividends received deduction. Any contribution in excess of the 10% limitation may be carried forward for five succeeding tax years.
For accrual basis corporations there is an exception to the rule that deductions for charitable contributions are allowed only for the year in which payment is made. A corporation may deduct a charitable contribution in the year preceding payment if the contribution is authorized by the board of directors by the end of that year and is paid on or before the 15th day of the third month of the next year.
Review Problems 2-42, 43, 44
Net Operating Losses
A net operating loss of a corporation is not subject to the adjustments required for individual taxpayers (capital gains/losses & non-business income)
A corporation is allowed to include a dividends received deduction in computing its net operating loss (See White Corporation example in P 2-47)
Generally NOL’s are carried back 2 years and forward 20 years. The corporation may also elect to forgo the carry back and simply carry forward.
Deductions Available Only to Corporations—Dividends Received Deduction
A corporation is allowed a dividends-received deduction for distributions received from other domestic corporations.
The amount is limited as follows (page 2-18)
Ownership Level / PercentageLess than 20% / 70%
20% or more but less than 80% / 80
80% or more / 100
The dividends received deduction is limited to a percent of taxable income of the corporation computed without regard to the net operating loss, the dividends received deduction and any capital loss carry-back for the current tax year. The percentage of taxable income corresponds to the deduction percentage. The taxable income limitation does not apply if the corporate shareholder has a NOL for the current year.
Review Problems 2-46 & 47
Organization and Start Up Expenses
Qualifying expenses under § 248:
Legal services incident to organization
Necessary accounting services
Expenses of temporary directors and organizational meetings of directors or shareholders
Fees paid to the state of incorporation
Such expenses may be amortized over a 60 month (or greater) period. To qualify for the election must be incurred before the end of the taxable year in which the corporation begins business. If a timely election is not made the organizational expenses cannot be deducted until the corporation ceases to do business and liquidates.
The election is made in a statement attached to the corporation’s return for its first taxable year. A cash basis corporation can include cost that incurred (although unpaid) as long as the liability arises in the first year.
Under § 195 start-up costs can also be amortized over a period of 60 months. These costs include investigation expense involved in entering a new business as well as operating expenses incurred before the corporation actually begins producing gross income (e.g. rent, payroll, travel, market surveys, financial audits, legal fees).
Review Problem 2-48, 49
Corporate Income Tax Rates
Corporations compute their Federal income tax liability using the rate structure contained in § 11(b). Tax savings at lower rates, favors small businesses, PSC rate is 35%, we will use 34% for most illustrations.
Tax Liability of Related Corporations
Related corporations are subject to special rules for computing the income tax, the accumulated earnings credit, and the AMT exemption. Without these rules the shareholders of corporations could gain significant tax advantages by splitting a single corporation into multiple corporations. Hamburgers York Road 41 TC 78 (1964) and examples 30 & 31 page 2-22 give illustrations.
To preclude the advantages that could be gained by the use of multiple corporations the tax law requires special treatment for controlled groups of corporations. To eliminate the advantages of using multiple corporations to achieve lower rates the law limits a controlled group’s taxable income in the tax brackets below 35%. As a group they are limited to the amount they would have if they were one corporation. The allocation of the lower brackets is equal unless all members consent to an apportionment.
Controlled Groups
Controlled groups are generally parent-subsidiary or brother-sister groups. A parent-subsidiary group exists if:
stock possessing at least 80% of the total combined voting power of all classes of stock or at least 80% of the total value of shares of all classes of stock in each of the corporations, except the common parent, is owned by one or more of the other corporations and
the common parent owns stock possessing at least 80% of the total value of shares of all classes of stock of at least one of the other corporations.
A brother-sister controlled group exists if:
two or more corporations are owned by five or fewer persons (individuals, estates or trusts) who possess stock representing at least 80% of the total voting power of all classes entitled to vote or at least 80% of the total value of shares of all classes of each corporation and who have a common ownership of more than 50% of the total combined voting powers of all classes of stock entitled to vote or more than 50% of the total value of shares of all classes of stock of each corporation.
A combined controlled group (parent-subsidiary and brother-sister) exists when each corporation is a member of some group and at least one member is a parent and that parent is also a brother or sister.
See US vs Vogel Fertilizer 102 S. Ct. 821 (1982) for the treatment of the common ownership test under the 80% rule. Brother-Sister must shareholder must have ownership in more than 1 corporation.
Review P 2-52,53,54
Filing Requirements
Corporations must file a tax return (Form 1120, Form 1120S or Form 1120A on or before the 15th day of the 3rd month following the close of the tax year. A corporation is entitled to an automatic extension of six months provided that it timely and properly files Form 7004 and deposits the full amount of the tax due with Form 8109.
The abbreviated 1120A can only be used in certain circumstances (see pages 2-27 & 28.)
A corporation must make payments of estimated tax liability unless the tax liability less than $ 500. Payment dates for calendar year corporations are: 4/15, 6/15, 9/15 and 12/15.
Reconciliation of Taxable Income and Financial Net Income
Schedule M-1—Reconciliation of Income per Books with Income per Return. Adjustments will generally be the same as those on the tax trial balance. Note that taxable income per return will be net income before special deductions. See page 2-28 for illustration
Schedule M-2 is an analysis of unappropriated retained earnings. Watch for corrections of errors that have income tax implications.
Review Problem 2-57
Review of Form 1120 on pages 2-31 thru 2-35:
Page 1—Computation of Taxable Income/Balance Due-Refund
Page 2—Cost of Sales, Dividends Received & Special Deductions and Compensation of Officers
Page 3—Tax Computations, Questions
Page4—Book Balance Sheets, Schedules M-1 & M-2
Chapter 3
I. Organization of a Corporation
Under § 351 no gain or loss is recognized upon the transfer by one or more persons of property to a corporation solely in exchange for stock in that corporation if, immediately after the exchange, such persons are in control of the corporation to which the property was transferred.
“Property” is broadly construed. The term includes unrealized receivables, installment obligations, secret processes, formulas and patents.
“Stock” under § 351 includes common or preferred stock. It does not include stock rights, stock warrants, and long-term debt (securities). Mortgages and liabilities related to business do not taint the transaction.
“Control” means at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock.
Control (80%) may apply to a single person or to several individuals, if they are all parties to an integrated transaction.
The exchange does not necessarily require simultaneous exchanges by two or more persons, but it does require that the rights of the parties have been previously defined and that the execution of the agreement proceeds “with an expedition consistent with orderly procedure”.
If the property of money, other than stock, is received from the corporation, gain will be recognized to the extent of the lesser of the gain realized or the boot received. Note that losses are never recognized.
SEE FIGURES 3-1 & 3-2 on page 3-12. Non recognition of gain or loss is accomplished by a carryover of basis. § 358 provides that the basis of the stock received in a § 351 transfer is the same as the basis taxpayers had in the property transferred increased by gain recognized and decreased by the boot received.
Services
§ 351 treatment will be lost if the stock is transferred to a person who did not contribute property, causing those who did to lack control immediately after the exchange. Services are not considered property under § 351. If a person performs services for the corporation in exchange for stock and also transfers some property (a significant amount), her or she is treated as a member of the transferring group.
Other Points
§ 351 is mandatory. It applies to later transfers to an existing corporation by either new or former shareholders. This provision commonly prevents new shareholders from receiving tax-free treatment.
Illustrative Problems:
Q 3-8
P 3-27, 28, 31
Assumption of Liabilities by the Acquiring Corporation
Under § 357 (a) the assumption of a liability by the acquiring corporation taking property will not produce boot to the transferor shareholder in a § 351 transaction. Liabilities assumed by the transferee corporation are treated as “other property” or money as far as the basis of the stock received in the transfer is concerned. The basis of the stock received must be reduced by the amount of liabilities assumed by the corporation.
Review Q 3-12
Exceptions: § 357(b)—if the principal purpose of the assumption of liabilities is to avoid tax or there is no bona fide business purpose behind the exchange, the liabilities in total will treated as money received and taxed as boot.
§ 357(c)—provides that if the sum of the liabilities exceeds the adjusted basis of the properties transferred, the excess is taxable gain.
Accounts payable for a cash basis taxpayer that give rise to a deduction are not considered liabilities for the purposes of § 357 (c).