Chapter 9 Taxation of Corporations 2005 Prentice Hall

Chapter 9 Taxation of Corporations © 2005 Prentice Hall, Inc. 9 -1

Corporation l l l l A business entity created under the laws of state of incorporation Owns property and can be sued directly Shareholders own part of corporation, but no interest in individual assets Shareholders have limited liability Corporation has unlimited life Ownership interests are freely transferable Management is centralized © 2005 Prentice Hall, Inc. 9 -2

Advantages l l Easier to raise capital than other business forms Corporations that reinvest their income rather than paying dividends could have lower tax bills than flow-through entities Shareholders can be employees and participate in tax-free employee fringe benefits that are deductible by the corporation Corporation can select calendar or fiscal year © 2005 Prentice Hall, Inc. 9 -3

Disadvantages l Double taxation Ø The 2003 Tax Act reduced the tax rate on dividend income to 15% (5% for individuals in 10% or 15% tax bracket) l Shareholders cannot deduct losses of the C corporation Ø Corporation can only offset NOLs against operating income in carryover years Ø Capital losses can only offset capital gains © 2005 Prentice Hall, Inc. 9 -4

Capital Structure l Equity Ø Common stock – shareholders have last claim on income and assets in liquidation but are entitled to all residual income when corporation is profitable Ø Preferred stock – claims take precedence over claims of common stockholders for dividends (preferred dividends must be paid before common dividends permitted) and assets in liquidation l Debt Ø Interest on debt is deductible (but dividends are not deductible) © 2005 Prentice Hall, Inc. 9 -5

Dividend Received Deduction l l To relieve burden of multiple taxation on corporate income DRD based on percentage of ownership in the distributing corporation Ø 100% DRD for 80% or more owned affiliate Ø 80% DRD for ownership of 20% up to 80% Ø 70% DRD for ownership less than 20% l DRD limited to percentage times lesser of taxable income or dividend income Ø Unless deducting DRD % x dividend income creates or increases NOL © 2005 Prentice Hall, Inc. 9 -6

Charitable Contributions l Overall limit 10% of taxable income before Ø Charitable contribution deduction Ø Dividend received deduction Ø NOL or capital loss carrybacks l l Excess carried forward up to 5 years Accrual basis corporation can deduct contributions in year accrued if Ø Payment authorized by board before year end Ø Payment made by 15 th day of 3 rd month following close of tax year in which accrued © 2005 Prentice Hall, Inc. 9 -7

Charitable Contributions l l l Deduction for ordinary income property usually limited to basis Deduction for LTCG property is FMV Deduction for inventory (if donated for care of infants, poor or ill) increased by 50% of difference between basis and FMV (not to exceed twice basis) Ø Similar exception for gifts of scientific property given to universities and research organizations © 2005 Prentice Hall, Inc. 9 -8

Capital Gains and Losses l l All capital gains taxed as ordinary income Capital losses can only offset capital gains Ø Net loss carried back 3 years as short-term capital loss and forward up to 5 years in sequence Ø Losses not used in the carryover periods are lost © 2005 Prentice Hall, Inc. 9 -9

Net Operating Losses l l NOL can be carried back 2 years Remaining NOL carried forward 20 years Ø Can elect to forgo carryback and carry forward only © 2005 Prentice Hall, Inc. 9 - 10

Computing Corporate Taxable revenues Less: Deductible expenses Equals: Taxable income Times: Corporate tax rate Equals: Corporate tax Plus: Additions to tax Less: Tax credits Equals: Net corporate tax © 2005 Prentice Hall, Inc. 9 - 11

Corporate Tax Rates Corporates: 1. 15% on first $50, 000 2. 25% on $50, 001 - $75, 000 3. 34% on $75, 001 - $100, 000 4. 39% (34% + 5% surtax) on $100, 001 $335, 000 5. 34% on $335, 001 - $10, 000 6. 35% on $10, 001 - $15, 000 7. 38% (35% + 3%) on $15, 000, 001 $18, 333 © 2005 Prentice Hall, Inc. 1. 9 - 12

PSC l Personal service corporation is a corporation Ø that provides service in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or performing arts and Ø is substantially owned by its employees l l A flat 35% tax rate applies to its entire taxable income The PSC provisions encourage owneremployees to take earnings out of corporation as salary © 2005 Prentice Hall, Inc. 9 - 13

Reconciling Book/Tax Income l Form 1120 is the corporate tax return Ø Schedule L – beginning and ending financial accounting balance sheet Ø Schedule M-1 – reconciliation of after-tax net income on books with taxable income before DRD and NOL carryover Ø Schedule M-2 – reports changes in unappropriated retained earnings © 2005 Prentice Hall, Inc. 9 - 14

Schedule M-1 © 2005 Prentice Hall, Inc. 9 - 15

Tax Credits l l Can reduce tax liability but not below zero General business credit – a group of credits aggregated into one credit Ø Cannot exceed $25, 000 plus 75% of tax liability in excess of $25, 000 Ø Unused credits carried back 1 year and forward 20 years © 2005 Prentice Hall, Inc. 9 - 16

Alternative Minimum Tax l l AMT is a parallel tax that broadens the regular income tax base to ensure some taxes are paid Small corporation are exempt Ø Average annual receipts less than $5 million in each of prior taxable years Ø Remain exempt until average annual gross receipts exceed $7. 5 million © 2005 Prentice Hall, Inc. 9 - 17

Calculating AMT Corporate taxable income Plus/minus Plus: Equals: Less: Equals: Times: Equals: © 2005 Prentice Hall, Inc. AMT adjustments Preference items AMT income Exemption AMTI base AMT rate Gross AMT 9 - 18

Calculating AMT Less: Equals: Gross AMT Regular corporate tax Alternative minimum tax Credits Net AMT Ø Corporation only pays AMT if gross AMT is greater that its regular corporate income tax © 2005 Prentice Hall, Inc. 9 - 19

AMT Adjustments l Timing differences Ø Difference between regular tax depreciation and AMT depreciation Ø Difference between gain reported for AMT by percentage-of-completion method over gain reported using completed contract method for regular tax Ø 75% of difference between adjusted current earnings (ACE) and gross AMTI before this adjustment © 2005 Prentice Hall, Inc. 9 - 20

AMT l $40, 000 Exemption Ø Phased out at rate of $1 for every $4 AMTI exceeds $150, 000 (completely phased out at $310, 000 AMTI) l Credit – equal to AMT paid in prior years Ø Carried forward indefinitely but can only offset regular tax in excess of AMT © 2005 Prentice Hall, Inc. 9 - 21

Filing and Payment l Form 1120 is due on 15 th day of 3 rd month following close of tax year Ø File Form 7004 for 6 month automatic extension l Quarterly estimated tax payments due on 15 th day of 4 th, 6 th, 9 th, and 12 th months of tax year Ø Underpayment penalty assessed if liability $500 more than estimated payments Ø If taxable income less than $1 million in each of 3 preceding years, no penalty if each estimated payment equals 25% of prior year’s tax liability © 2005 Prentice Hall, Inc. 9 - 22

Consolidated Returns l Affiliated group – parent corporation must own directly 80% or more of subsidiary’s stock (by voting and value) Ø Can include more than 2 corporations if 80% of stock owned by one or more corporations that are part of affiliated group l Consolidated return reports combined results of operations of all corporations in the group Ø All subsidiaries must consent and must have or change to same tax year as parent © 2005 Prentice Hall, Inc. 9 - 23

Consolidated Net Income l l Affiliated corporations viewed as divisions of parent requiring modification for deferred intercompany transactions and intercompany dividends Items subject to limitations and netting are determined on a consolidated basis Ø Capital gains and losses Ø Section 1231 gains and losses Ø Charitable contributions deductions © 2005 Prentice Hall, Inc. 9 - 24

Consolidated Tax Returns l Advantages Ø Intercompany dividends are eliminated from taxation Ø Gains on intercompany transactions are eliminated Ø Deductions subject to limitation may be allowed when consolidated Ø Losses of one corporation can offset gains of another Ø Income from one corporation can offset losses of another Ø Limitations based on consolidated income permit greater use of deductions or credits © 2005 Prentice Hall, Inc. 9 - 25

Dividend Distributions l Dividend – a distribution of corporate earnings and profits (E&P) that is taxable income to shareholders but not deductible by the corporation Ø 2003 Tax Act lowered rates on dividend income to 15% (5% for individuals in 10% or 15% tax brackets) – same rates as LTCG © 2005 Prentice Hall, Inc. 9 - 26

Earnings and Profits l l E&P measures how much a corporation can distribute as a dividend and leave contributed capital intact Dividends in excess of E&P Ø Tax free return of capital to extent of shareholder’s stock basis (reducing basis) Ø If shareholder’s basis is reduced to zero, excess distribution is capital gain © 2005 Prentice Hall, Inc. 9 - 27

Earnings and Profits l l l Current earnings and profits (CE&P) - the current year’s taxable income (as adjusted) Accumulated earnings and profits (AE&P) – accumulations of CE&P for all prior years that has not been distributed as dividends Dividends are first paid from CE&P then AE&P © 2005 Prentice Hall, Inc. 9 - 28

Computing Current E&P l Starts with taxable income, but is subject to for positive and negative adjustments Ø DRD, loss carryovers, and tax-exempt income are added back Ø Federal income taxes paid are deducted Ø Charitable contributions are deducted without regard to the 10% limit Ø Only 20% of Section 179 expensing allowed Ø Also deductible for E&P are life insurance premiums on key employees, capital losses in excess of capital gains, nondeductible expenses related to tax-exempt income, disallowed losses on related party sales, and nondeductible fines © 2005 Prentice Hall, Inc. 9 - 29

Property Distributions l Property distributions – corporation recognizes gain on distribution of appreciated property (but not loss) Ø Value of distribution is net FMV (net of any liabilities assumed) and basis to shareholder is FMV Ø Like cash dividends, property dividends taxable only to extent of E&P © 2005 Prentice Hall, Inc. 9 - 30

Stock Dividends and Rights l Stock dividend – distribution of stock that gives shareholder a greater number of shares Ø Nontaxable if proportionate distribution (unless given choice of cash or stock) Ø Shareholder allocates basis among all shares of stock l Stock rights – the right to purchase additional stock at a set price Ø If value of rights is less than 15% of value of stock, then no basis must be allocated to rights © 2005 Prentice Hall, Inc. 9 - 31

Redemptions l l Redemption – a repurchase of stock from a shareholder by the issuing corporation that may result in either sale or dividend treatment to the redeeming shareholder Sale treatment allowed if Ø The redemption is substantially disproportionate (ownership after redemption is less 50% and also less than 80% of ownership before redemption or Ø Shareholder completely terminates interest in the corporation © 2005 Prentice Hall, Inc. 9 - 32

Redemptions l l If treated as a sale, shareholder recognizes capital gain (or loss) on the difference between the proceeds received and the basis of the stock surrendered If not a sale, the amount the shareholder receives is taxed as a dividend to the extent of the corporation’s E&P © 2005 Prentice Hall, Inc. 9 - 33

Redemptions l Attribution rules apply in determining ownership Ø Family attribution – includes stock owned by spouse, parent, child, grandchild Ø Entity to owner – attributed proportionately from partnership to partners, from estate or trust to beneficiaries, from corporation to 50% or greater shareholders Ø Owner to entity – attributed from partner to partnership, from beneficiary to estate or trust, from 50% or greater shareholder to corporation © 2005 Prentice Hall, Inc. 9 - 34

Partial Liquidation l Partial liquidation – the significant reduction in a corporation’s operations or a termination of one of its qualifying businesses with a distribution of property or cash to its shareholders Ø Corporation recognizes gain (but not loss) on distribution of appreciated property Ø Noncorporate shareholders receive sale treatment Ø Corporate shareholders receive dividend treatment with dividend amount eligible for DRD © 2005 Prentice Hall, Inc. 9 - 35

Corporate Liquidation l Corporation adopts a plan of liquidation and ceases operations Ø Sells assets recognizing both gains and losses on asset sales Ø Distributes cash from sales and any remaining assets to shareholders in exchange for their stock © 2005 Prentice Hall, Inc. 9 - 36

Liquidating Distributions to Shareholders l l Corporation recognizes loss as well as gain on distribution of property in liquidation Shareholders recognize gain or loss on difference between FMV received and basis of stock surrendered Ø Basis of property to shareholders is FMV l Parent corporation can liquidate a subsidiary tax free (but basis of assets carries over) © 2005 Prentice Hall, Inc. 9 - 37

Constructive Dividends l Shareholder of closely held corporation receives informal economic benefit Ø Examples include rents in excess of property’s FMV, use of corporate property for personal use, loans to shareholder at no interest, payment of personal expenses by corporation, and excessive compensation l Any benefit reclassified by IRS as dividend is taxable to shareholder but not deductible by corporation Ø Benefit to a related party can also be reclassified as dividend to shareholder © 2005 Prentice Hall, Inc. 9 - 38

Penalty Taxes l There is a 15% penalty tax, in addition to the regular corporate tax, to encourage payment of dividends to shareholders Ø Personal holding company – closely held corporation with more than 60% AOGI from passive sources Ø Accumulated earnings tax – assessed when corporation accumulates more than $250, 000 ($150, 000 if service business) without valid business purpose © 2005 Prentice Hall, Inc. 9 - 39

Controlled Groups l l Controlled groups must apportion lower tax rates to members of group Parent-subsidiary group – 2 or more corporations with a common parent Ø Parent directly owns 80% of stock of subsidiary Ø 80% or more of stock must be jointly or separately owned of all other corporations by parent and subsidiaries l Brother-sister group Ø 2 or more corporations have 80% of more of each corporation’s stock owned by 5 or few individuals and sum of lowest common ownership of each shareholder is 50% or more © 2005 Prentice Hall, Inc. 9 - 40

Exempt Organizations Appendix 9 A © 2005 Prentice Hall, Inc. 9 - 41

Exempt Organizations l l Organizations whose purpose is to serve the public are classified as tax-exempt organizations Persons who donate to exempt organizations may be permitted a charitable contribution deduction Exempt organizations do not pay tax on their income if they qualify under Section 501(c) If it fails to meet the requirements on a continuing basis, it may either lose its status or be assessed an income or excise tax © 2005 Prentice Hall, Inc. 9 - 42

Exempt Organizations l l Exempt organizations normally operate as corporations or as trusts An exempt organization can be assessed taxes when it engages in prohibited transactions Ø Unrelated businesses Ø Transactions that benefit disqualified persons © 2005 Prentice Hall, Inc. 9 - 43

UBIT l An exempt organization is assessed the unrelated business income tax if it regularly carries on a trade or business that is substantially unrelated to the organization’s exempt purpose Ø A business is substantially unrelated to the exempt purpose if the sales of goods or services do not make a significant contribution to its exempt purpose © 2005 Prentice Hall, Inc. 9 - 44

UBIT l l UBIT is assessed when the exempt organization regularly carries on a business that competes with for-profit businesses UBIT is assessed on the net unrelated business income at the regular corporate tax rates Ø $1, 000 exemption is allowed © 2005 Prentice Hall, Inc. 9 - 45

UBIT Gross unrelated business income Less: Deductions Plus/minus: Modifications Less: $1, 000 exemption Equals: Unrelated business income Times: Corporate tax rates Equals: Unrelated business income tax © 2005 Prentice Hall, Inc. 9 - 46

Filing l l Form 990: Return of Organizations Exempt from Income Tax is due on the 15 th day of the 5 th month after the close of the organization’s tax year If UBIT must be paid, then it must also file Form 990 -T: Exempt Organization’s Business Income Tax Return © 2005 Prentice Hall, Inc. 9 - 47

Excise Taxes l An excise tax is levied on any excess benefit transaction in which a disqualified person participates (bargain purchase or personal use of assets) Ø Disqualified person – anyone who can substantially influence the activities of an exempt organization Ø Excise tax is 25% of the excess benefit (up to $10, 000 maximum) for the disqualified person (200% if they fail to correct the transaction) and 10% for the exempt organization’s manager © 2005 Prentice Hall, Inc. 9 - 48

Private Foundations l l Exempt organizations are classified as private foundations if they are not supported by or operated for the general public as a whole but have a more narrow focus for their activities Private foundations exclude 501(c)(3) organizations that receive a major part of their support from the public or government Ø To be excluded from private foundation designation, an organization must meet both an external and internal support test © 2005 Prentice Hall, Inc. 9 - 49

Private Foundations l External support test – must receive more than one-third of its annual support from the general public, governments, or other exempt organizations Ø Support includes membership fees, contributions, and grants l Internal support test – limits interest, dividends, rent, royalty, and unrelated business income (net of tax) to one-third of its total support © 2005 Prentice Hall, Inc. 9 - 50

Private Foundations l Subject to taxes on investment income, for failure to distribute its income, for excess business holdings, for investing in speculative assets, and for participating in transactions with disqualified persons Ø Excise tax on investment income is 2% Ø Taxes on other activities range from 5% to 15% Ø Second round of excise taxes of up to 200% if corrective actions are not taken © 2005 Prentice Hall, Inc. 9 - 51

Multistate Issues Appendix 9 B © 2005 Prentice Hall, Inc. 9 - 52

State Income Taxes l 45 states assess some type of income tax on corporations Ø Franchise tax – an excise tax based on the right to do business or own property in the state l l Rates typically range from 4% to 10% Most states piggyback on the federal system by beginning their computations with the corporation's federal taxable income © 2005 Prentice Hall, Inc. 9 - 53

State Income Taxes l Typical modifications of federal taxable income include Ø State and local income taxes Ø Interest income earned on state and local bonds Ø Interest income on federal notes or bonds Ø Dividends received deduction Ø Net operating losses © 2005 Prentice Hall, Inc. 9 - 54

State Income Taxes l Nexus – the connection between a state and the business that the state is seeking to tax Ø Nexus can be established through physical presence of corporate property or employees in the state l When there is nexus in several states, each state can tax only the percentage of income based on the business allocated to that state Ø Most states use three-factor allocation formula of sales, payroll costs, and tangible property © 2005 Prentice Hall, Inc. 9 - 55

State Income Taxes l Nonbusiness income (interest, dividends, rent) is taxed in one state only Ø Usually the in which the corporation is domiciled or where property is located or used l l Income tax planning usually involves shifting income from high-tax states to low-tax states by eliminating nexus in a state through the outsourcing of functions or shifting assets A few states subject S corporations to the corporate income tax © 2005 Prentice Hall, Inc. 9 - 56

Sales Taxes l 45 states charge sales taxes that typically range from 3% to 7% Ø Many local governments impose local sales taxes resulting in more than 7, 400 different taxing jurisdictions l Sales taxes are imposed on gross receipts from retail sales or leases of tangible personalty Ø Retailer is responsible for collecting © 2005 Prentice Hall, Inc. 9 - 57

Sales Taxes l Multistate retailers must determine not only the appropriate tax rate but also which items are subject to tax in each location Ø Exempt items typically include food, prescription drugs, realty, intangible property, and most services l A state can require an out-of-state business to collect sales tax only if it has nexus with the state © 2005 Prentice Hall, Inc. 9 - 58

Use Tax l Use tax – imposed on the use of property brought into a state that levies a sales tax when sales tax was not paid in the state of purchase Ø A use tax is self-assessed and usually has the same rate as the sales tax © 2005 Prentice Hall, Inc. 9 - 59

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