Digging Deeper s1

Chapter 9 Digging Deeper

Contents:

| ENTITY CLASSIFICATION | DIVIDENDS RECEIVED DEDUCTION | CONTROLLED GROUPS | RECONCILIATION OF TAXABLE INCOME AND FINANCIAL NET INCOME | SCHEDULE
M–3—NET INCOME (LOSS) RECONCILIATION FOR CORPORATIONS WITH TOTAL ASSETS OF $10 MILLION OR MORE | CONSOLIDATED RETURNS |

ENTITY CLASSIFICATION

1. Prior to the issuance of the check-the-box Regulations, taxpayers had to deal with the following question: Can an organization not qualifying as a corporation under state law still be treated as such for Federal income tax purposes? Unfortunately, the tax law defines a corporation as including “. . . associations, joint stock companies, and insurance companies.”1 As the Code contains no definition of what constitutes an association, the issue became the subject of frequent litigation.

It was finally determined that an entity would be treated as a corporation if it had a majority of characteristics common to corporations. For this purpose, relevant characteristics were:

· Continuity of life.

· Centralized management.

· Limited liability.

· Free transferability of interests.

These criteria did not resolve all of the problems that continued to arise over corporate classification. When a new type of business entity—the limited liability company—was developed, the IRS was deluged with inquiries regarding its tax status. As LLCs became increasingly popular with professional groups, all states enacted statutes allowing some form of this entity. Invariably, the statutes permitted the corporate characteristic of limited liability and, often, that of centralized management. Because continuity of life and free transferability of interests were absent, partnership classification was hoped for. This treatment avoided the double taxation inherent in the corporate form.

DIVIDENDS RECEIVED DEDUCTION

2. Another restriction applies to the dividends received deduction when the underlying stock is debt financed. Like the holding period restriction, this provision also was enacted to close a tax loophole. A corporation that finances the purchase of dividend-paying stock receives an interest expense deduction from such financing, but would report only a small amount of the related income if the dividends received deduction was allowed unabated. In general, the debt-financed stock restriction reduces the dividends received deduction with respect to any dividend-paying stock by the percentage of the investment in the stock that is debt financed.2 For instance, if a stock purchase is financed 50 percent by debt, the dividends received deduction for dividends on such stock is reduced by 50 percent. However, the reduction in the dividends received deduction cannot exceed the amount of the interest deduction allocable to the dividend.

CONTROLLED GROUPS

3. Brother-Sister Corporations. A brother-sister controlled group may exist if two or more corporations are owned by five or fewer persons (individuals, estates, or trusts). 3 The ownership test is met if the shareholder group possesses stock representing more than 50 percent of the total combined voting power of all classes of stock entitled to vote or more than 50 percent of the total value of shares of all classes of stock of each corporation.

In applying the more than 50 percent ownership tests, the stock held by each person is considered only to the extent that the stock ownership is identical for each corporation. That is, if a shareholder owns 30 percent of Silver Corporation and 20 percent of Gold Corporation, that shareholder has identical ownership of 20 percent of each corporation.

Example: The outstanding stock of Hawk, Eagle, Crane, and Dove Corporations, each of which has only one class of stock outstanding, is owned by the following unrelated individuals:

Corporations Identical

Shareholders Hawk Eagle Crane Dove Ownership*

Allen 10% 20% 30% 25% 20%

Barton 20% 20% 15% 20% 15%

Carter 10% 15% 10% 10% 10%

Dixon 10% 10% 15% 10% 10%

Total 50% 65% 70% 65% 55%

*For Eagle, Crane, and Dove.

In determining whether a brother-sister controlled group exists, a corporation is considered only if the shareholder group of five or fewer persons owns more than 50% of the stock of the corporation. Therefore, Hawk Corporation is not considered as a potential member of the brother-sister group because the shareholder group does not own more than 50% of that corporation. It is then necessary to apply the identical ownership test to the shareholders’ ownership in the remaining corporations. Under the identical ownership test, five or fewer persons (Allen, Barton, Carter, and Dixon) own 55% of all classes of stock in Eagle, Crane, and Dove Corporations. Consequently, Eagle, Crane, and Dove are regarded as members of a brother-sister controlled group.

RECONCILIATION OF TAXABLE INCOME AND FINANCIAL NET INCOME

4. Corporations with less than $250,000 of gross receipts and less than $250,000 in assets do not have to complete Schedule L (balance sheet) and Schedules M-1 and M-2 of Form 1120. Similar rules apply to Form 1120S. These rules are intended to ease the compliance burden on small business.

SCHEDULE M-3—NET INCOME (LOSS) RECONCILIATION FOR CORPORATIONS WITH TOTAL ASSETS OF $10 MILLION OR MORE

5. Part I—Financial Information and Net Income (Loss) Reconciliation. Part I requires the following financial information about the corporation.

· The source of the financial net income (loss) amount used in the reconciliation—SEC Form 10–K, audited financial statements, prepared financial statements, or the corporation’s books and records.

· Any restatements of the corporation’s income statement for the filing period, as well as any restatements for the past five filing periods.

· Any required adjustments to the net income (loss) amount referred to above (see Part I, lines 5 through 10).

The adjusted net income (loss) amount must be reconciled with the amount of taxable income reported on the corporation’s Form 1120.

Because of Schedule M–3’s complexity, the coverage in this chapter will be limited to some of the more important concepts underlying the schedule. A series of examples adapted from the instructions for Schedule M–3 will be used to illustrate these concepts.

Example: Southwest Sportsman’s Corporation (SSC) sells hunting and fishing equipment to sportsmen. SSC has several stores in Texas, New Mexico, and Arizona. It also has a subsidiary in Mexico, which is organized as a Mexican corporation. SSC, which does not file a Form 10–K with the SEC, reports income from its Mexican subsidiary on its audited financial statements, which show net income of $45 million in 2009. The Mexican corporation, which is not consolidated by SSC for tax purposes and is therefore not an includible corporation, had net income of $7 million. SSC must enter $7 million on Part I, line 5a of Schedule M–3, resulting in net income per income statement of includible corporations of $38 million.

A situation similar to that described in the previous example could result in additional entries in Part I of Schedule M–3. For example, if SSC engaged in transactions with its nonincludible Mexican subsidiary, an entry would be required on line 8 (adjustment to eliminations of transactions between includible corporations and nonincludible entities).

Part II—Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations with Taxable Income per Return. Part II reconciles income and loss items of includible corporations, while Part III reconciles expenses and deductions. As indicated in the previous example, corporations included in a financial reporting group may differ from corporations in a tax reporting group. Corporations may also be partners in a partnership, which is a flow-through entity. The following example illustrates the adjustments that are required in this situation.

Example: Southwest Sportsman’s Corporation also owns an interest in a U.S. partnership, Southwest Hunting Lodges (SHL). On its audited financial statements, SSC reported net income of $10 million as its distributive share from SHL. SSC’s Schedule K–1 from SHL reports the following amounts:

Ordinary income $5,000,000

Long-term capital gain 7,000,000

Charitable contributions 4,000,000

Section 179 expense 100,000

In order to adjust for the flow-through items from the partnership, SSC must report these items on Schedule M–3, Part II, line 9 [Income (loss) from U.S. partnerships]. The corporation reports $10 million (book income) on line 9, column (a). SSC reports income per tax return of $7.9 million ($5,000,000 + $7,000,000 – $4,000,000 – $100,000) in column (d) of line 9, and a permanent difference of $2.1 million in column (c).

Part III—Reconciliation of Expense/Deduction Items. Part III lists 35 reconciling items relating to expenses and deductions. For these items, taxpayers must reconcile differences between income statement amounts (column a) and tax return amounts (column d), then classify these differences as temporary (column b) or permanent (column c) differences. The totals of the reconciling items from Part III are transferred to Part II, line 27, and are included with other items required to reconcile financial statement net income (loss) to tax return net income (loss).

Example: Southwest Sportsman’s Corporation acquired intellectual property in 2009 and deducted amortization of $20,000 on its financial statements, which were prepared according to GAAP. For Federal income tax purposes, SSC deducted $30,000. The corporation must report the amortization on line 27, Part III as follows: $20,000 book amortization in column (a), $10,000 temporary difference in column (b), and $30,000 tax return amortization in column (d).

Example: In January 2009, Southwest Sportsman’s Corporation established an allowance for uncollectible accounts (bad debt reserve) of $35,000 on its books and increased the allowance by $65,000 during the year. As a result of a client’s bankruptcy, SSC decreased the allowance by $25,000 in November 2009. The corporation deducted the $100,000 of increases to the allowance on its 2009 income statement but was not allowed to deduct that amount on its tax return. On its 2009 tax return, the corporation was allowed to deduct the $25,000 actual loss sustained because of its client’s bankruptcy. These amounts must be reported on line 32, Part III as follows: $100,000 book bad debt expense in column (a), $75,000 temporary difference in column (b), and $25,000 tax return bad debt expense in column (d).

The previous two examples illustrate the Schedule M–3 reporting when book expenses are different than tax return deductions. Both examples illustrate the reporting of temporary differences. The amounts from both examples are included in the totals derived in Part III and are carried to Part II, line 27. The reconciliation of book income and taxable income occurs in lines 26 through 30. The reconciled amount on Part II, line 30, column (a) must be equal to the net income per income statement of includible corporations on Part I, line 11. The reconciled amount on Part II, line 30, column (d) must be equal to the taxable income reported on Form 1120.

CONSOLIDATED RETURNS

6. Corporations that are members of a parent-subsidiary affiliated group may be able to file a consolidated income tax return for a taxable year. Filing a consolidated return offers distinct advantages. Income of a profitable company is offset by losses of another. Capital losses of one corporation can offset capital gains of another. Without this possibility, net capital losses cannot be deducted in the year incurred. Further, there is no § 482 problem. Section 482 permits the IRS to reallocate income and deductions among related organizations, trades, or businesses. The allocation is permitted when it is necessary to prevent evasion of taxes or to reflect income correctly.

Filing a consolidated return also has certain disadvantages. Losses on intercompany transactions must be deferred. Accounting for consolidated taxable income and deferral of intercompany transactions can be perplexing. Another problem is that the consolidated returns filed for tax purposes and the consolidated financial statements may not include the same corporations. For example, most foreign corporations cannot be consolidated for Federal income tax purposes but should be consolidated when preparing financial statements. This variance will cause some compliance problems in computing the taxable income and the AMT of the group.

Sections 1501-1504 and 1552 and the related Regulations, prescribing the manner of computing consolidated income, are quite complex.

Notes:

1 § 7701(a)(3).

2 § 246A.

3 § 1563(a)(2). Legislation in 2004 changed the definition of brother-sister controlled groups only with respect to computing the corporate income tax, accumulated earnings credit, and AMT exemption. For other purposes, an 80% total ownership test and the 50% identical ownership test apply.