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Chapter 11
- 1. Income Tax Fundamentals 2010 Gerald E. Whittenburg & Martha Altus-Buller 2010 Cengage Learning
- 2. Corporate rates areprogressive Marginal rates are from 15% to 39%, depending on taxable income There are eight brackets There are a number of ‘tax bubbles’ - occurs when tax rate schedules recaptures savings from prior brackets For corporations with large income (more than $18.33 million) the rate is a flat 35% Qualified personal service corps taxed at flat 35% Architects, CPAs, consultants, etc. 2010 Cengage Learning
- 3. Example Johnson &Kelby Inc. (a dental products wholesaler) has taxable income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services? 2010 Cengage Learning
- 4. Example Johnson &Kelby Inc. (a dental products wholesaler) has taxable income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services? Solution Corporate tax = $100,250 $22,250 + (39%)(300,000 – 100,000) If Johnson & Kelby is a qualified personal service corporation, corporate tax = $105,000 ($300,000 x 35%) 2010 Cengage Learning
- 5. A corporation canchoose from two alternative tax treatments on capital gains Taxed at ordinary rates or Elect to pay an alternative tax (35%) on net long-term capital gain (LTCG) Essentially equivalent to maximum regular corporate tax (no tax benefit to LTCG) Bottom line: there is no difference in tax on ordinary vs. capital income 2010 Cengage Learning
- 6. Corporations are alloweda deduction for a % of the dividends received from other corporations Attempt to alleviate triple taxation Dividends received deduction is allowed based upon ownership 2010 Cengage Learning Percentage Ownership Dividends Received % Deduction < 20% 70% 20% or more, less than 80% 80% > 80% 100% Deductions limited by % and other items
- 7. Examples of organizationalexpenditures Legal/accounting services incidental to organization Incorporation fees Organizational expenditures are capitalized and then amortized over 180 months However, can make election to deduct up to $5,000 of organization costs in year corporation begins business $5,000 amount is reduced $1 for each $1 that organizational expenses exceed $50,000 2010 Cengage Learning
- 8. Corporations are alloweda deduction for charitable contributions Cash basis taxpayers can deduct when paid Accrual basis taxpayers have until the 15th day of the third month following year-end to contribute As long as pledge is made by year-end Limited to 10% of taxable income * Carry forward unused deduction for five years *Calculated before any loss carrybacks, NOLS or the dividend received deduction 2010 Cengage Learning
- 9. Example Ferndale Corp.had net operating income of $400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is its charitable contribution carryforward? 2010 Cengage Learning
- 10. Example Ferndale Corp.had net operating income of $400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction (DRD) of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is the carryforward? Solution The charitable contribution deduction is $48,000 ($400,000 + 80,000) x 10% = $48,000 limit * Therefore, carryforward is $32,000 ($80,000 – 48,000) *Note: had to add back DRD first!! 2010 Cengage Learning
- 11. Schedule M-1 ofForm 1120 reconciles book to tax income Computed before NOLs and special deductions Amounts added to book income Federal tax expense Capital losses Income recorded on tax return but not on books Expenses recorded on books but not on tax return Amounts deducted from book income Income recorded on books but not on tax return Expenses recorded on tax return but not on books See chapter for other items included on Schedule M-1 2010 Cengage Learning
- 12. Form 1120 -regular corporation Form 1120S - S Corporation Returns are due by the 15th day of the third month after year-end Can file Form 7004 and receive automatic 6-month extension Corporations must make estimated tax payments in similar manner as self-employed taxpayers 2010 Cengage Learning
- 13. Certain corporations mayelect to be taxed in a manner similar to partnerships Qualified small business corporation may elect S Corporation status if several criteria apply Operates as a domestic corporation Has 100 or fewer shareholders Shareholders may not be corporations or partnerships Has only one class of stock Has only shareholders that are U.S. citizens or resident aliens 2010 Cengage Learning
- 14. Corporation must makeelection of S status in a prior year Or within 2-1/2 months of the current tax year S Corp status stays in effect until revocation Status can be voluntarily revoked b y consent of shareholders or Involuntarily revoked If corporation ceases to be a small business corporation or If corporate passive income is 25% or more for 3 consecutive years and corporation has accumulated earnings and profits at the end of each of those years 2010 Cengage Learning
- 15. Example Swannak ElectronicsCorporation is a calendar year corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation? 2010 Cengage Learning
- 16. Example Swannak ElectronicsCorporation is a calendar year corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation? Solution Since Swannak did not make its election within the first 2-1/2 months of the tax year, it will be treated as a regular corporation for the current year, and will become an S Corporation for tax year 2010. 2010 Cengage Learning
- 17. Must report allelements of income and expense separately on Form 1120S Then each shareholder reports his/her share of these items of corporate income/expense on personal return K-1 takes total shareholder income/expenses and allocates each item to each shareholder based upon his/her ownership percentage 2010 Cengage Learning
- 18. Each shareholder ofan S Corp may also report his/her respective share of loss Cannot take a loss in excess of adjusted basis in stock If loss exceeds adjusted basis in stock plus loans, shareholder can carry it forward If shareholder entered/departed S Corp midyear, must allocate losses on a daily basis 2010 Cengage Learning
- 19. Many items retaintax character when passing through to the S Corporation’s shareholders on individual K-1 Examples of such items include Capital gains/losses §1231 gains/losses Dividend Income Charitable contributions Tax-exempt interest Most credits 2010 Cengage Learning
- 20. Shareholders often transferassets to a corporation in exchange for stock No tax is due on gain from transfer of appreciated assets if conditions met Shareholder transferred cash or property and Shareholder made transfer solely in exchange for stock* Shareholder is not providing a service and all taxpayers together own at least 80% of stock after transaction * If shareholder receives boot in addition to stock, transaction may qualify for partial nonrecognition of gain 2010 Cengage Learning
- 21. A shareholder’s initialbasis in his/her stock is calculated as follows Basis of property transferred Less Boot received Plus Gain recognized Less Liabilities transferred Basis in stock The corporation has a carry-over basis in the property contributed equal to the basis in the hands of the shareholder, increased by any gain recognized by shareholder on the transfer 2010 Cengage Learning Note: generally assumption of shareholder liabilities that are attached to property are not considered boot received.
- 22. Penalty tax designedto prevent a corporation from avoiding tax by retaining earnings 15% AET imposed on “unreasonable” accumulation of earnings in addition to corporate tax Corporation may accumulate up to $250,000 a year that is exempt from AET tax o r $150,000 for a service corporation May accumulate more if can prove a valid business purpose 2010 Cengage Learning
- 23. Example Xinix Corporation(a medical device manufacturing firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be? 2010 Cengage Learning
- 24. Example Xinix Corporation(a medical device manufacturing firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be? Solution Its AET = $45,000 (in addition to regular tax) ($800,000 – 500,000) x 15% 2010 Cengage Learning
- 25. Penalty tax designedto encourage Personal Holding Companies to distribute earnings to shareholders Tax is 15% on undistributed earnings Corporation is not liable for both the personal holding company tax and the AET in the same year 2010 Cengage Learning
- 26. Corporate AMT -calculated similar to the individual AMT AMT is 20% of Alternative Minimum Taxable Income Taxable Income +/- Adjustments + Preferences - Exemption* Alternative Minimum Taxable Income (AMTI) Small corporations are not subject to the AMT Defined as having average annual gross receipts < $7.5 million over a three-year period *Exemption is $40,000, but is phased out when AMTI > $150,000 2010 Cengage Learning
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Editor's Notes
- #3 Section 11.1 Corporate Tax Rates Corporate tax rates have eight tax brackets with marginal tax rates from 15 percent to 39 percent. The following table shows the corporate tax rates for 2006 Qualified personal service corporation are taxed at a flat 35 percent tax rate on all taxable income. Qualified personal service corporations are substantially employee-owned and engaged in one of the following activities: Health Law Engineering Architecture Accounting Actuarial science Performing arts Consulting
- #6 Section 11.2 Corporate Capital Gains and Losses Corporations with net long-term capital gains have two alternative tax treatments. The net long-term capital gain can be included in ordinary income or an alternative tax can be paid. The alternative rate is 35 percent, the same as the maximum regular corporate rate. Net short-term capital gains of a corporation are taxed as ordinary income. Corporations may not deduct capital losses against ordinary income. Capital losses may be carried back three year and forward five years
- #7 Section 11.3 Special Deductions and Limitations Corporations are allowed special deductions. The first is a deduction for dividends received from another corporation, since the dividends would be taxed three times without the provision. The amount of deduction is based on the overall percentage of ownership of the corporation paying the dividend. If the corporation makes an election, expenses of organization may be amortized. The election must be made on the tax return of the corporation for the first taxable year. Examples of qualifying organization expenses include legal and accounting services to initiate the organization, fees paid for corporate filings, and organizational meetings. Corporations are also allowed a deduction for contributions to qualified charitable organizations. The deduction is limited to 10 percent of taxable income, computed before the deduction for charitable deductions. Excess contributions may be carried forward for five years, but are still subject to 10 percent of taxable income for that year.
- #12 Section 11.4 Schedule M-1 Because tax laws and accounting rules are not the same, a corporation’s taxable income is rarely equal to the net income per the financial statements. Schedule M-1 is a reconciliation of the two income amounts. Examples of differences included depreciation expenses, entertainment expenses and net capital losses deducted for book but not tax purposes.
- #13 Section 11.5 Filing Requirements and Estimated Tax The tax return for regular corporations is a Form 1120; for an S Corporation, the tax return is filed on a Form 1120S; a small corporation may file a Form 1120-A. Corporate tax returns are due on the fifteenth day of the third month following the tax year-end. A Form 7004 can be filed for an automatic six-month extension to file, but not an extension to pay. Corporations make estimated tax payments in a manner similar to those made by self-employed individual taxpayers.
- #14 Section 11.6 S Corporations An S Corporation does not generally pay tax, but rather each shareholder reports his or her share of corporate income. The S Corporation election is designed to relieve small corporations of certain corporate tax disadvantages, such as double taxation of income. To elect S Corporation status, the following conditions must be met: The corporation must be a domestic corporation The corporation must have 100 or fewer shareholders, who are all individuals, estates, certain trusts, certain financial institutions or certain exempt organizations The corporation must have only one class of stock All shareholders must be U.S. citizens or resident aliens The corporation remains an S Corporation until changes are made, such as additional stockholders increase the total stockholders to more than 100 or various classes of stock are offered. Upon consent of shareholders owning a majority of the voting stock, an S Corporation may revoke the status voluntarily.
- #15 The shareholders of S Corporations receive a Schedule K-1 from Form 1120S for their allocation of ordinary income or loss. Losses from an S Corporation pass through to the shareholders; however the losses are limited to the adjusted basis in the corporation’s stock and any loans to the corporation from the shareholder. Pass-through items from an S Corporation to shareholders included capital gains and losses, Section 1231 gains and losses, dividend income, charitable contributions, tax-exempt interest and most credits. S Corporations may have to pay taxes on certain items such as passive investment income.
- #21 Section 11.7 Corporate Formation Since many taxpayers exchange high-value, low-basis property in exchange for stock in a newly formed corporation, tax laws were established to defer the gain. The requirements necessary for the deferral include: The taxpayer must transfer property or money to the corporation The transfer must be solely in exchange for stock of the corporation, and The shareholder(s) qualifying for nonrecognition must own at least 80 percent of the corporation’s stock after the transfer. If all requirements are met, losses and gains are not recognized on the formation of the corporation. Typically, when a corporation takes over shareholder liabilities, the assumption is not considered to be boot. However, if the corporation takes over the liability for no business purpose or to avoid paying taxes, the recognition of any realized gain is required. After the transfer, the shareholder’s basis in stock is determined as follows: Basis of the property transferred $XXX Less boot received (XXX) Plus gain recognized XXX Less liabilities transferred (XXX) Basis in the stock $ XXX
- #23 Section 11.8 Corporate Accumulations In some cases, individuals have established corporations to avoid paying individual income taxes. Congress has enacted two special taxes to discourage these practices. The first tax is the accumulated earnings tax. This tax is designed to prevent shareholders from retaining earnings in a corporation rather than paying taxes on the earnings. The tax is imposed at 15 percent for any unreasonable accumulation of earnings. For most corporations, the first $250,000 is exempt from tax. The second tax is the personal holding company tax. Personal holding companies are corporations with few shareholders and income primarily from investments
- #27 Section 11.9 The Corporate Alternative Minimum Tax The corporate alternative minimum tax is calculated like the individual alternative minimum tax. The tax is imposed at a 20 percent rate on the alternative minimum tax base (regular taxable income plus corporate tax preferences less exemptions). Common corporate tax adjustments and preferences include accelerated depreciation on real estate, accelerated deprecation on personal property, tax-exempt bond interest, percentage depletion in excess of the property’s adjusted basis and seventy-five percent of the difference between adjusted current earnings and alternative minimum taxable income determined before this adjustment and the alternative tax net operating loss deduction.