3-1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-2 THE CORPORATE INCOME TAX (1 of 2)  Corporate elections  Computing corporation’s taxable income  Determining a corporation’s income tax liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-3 THE CORPORATE INCOME TAX (2 of 2)  Controlled groups of corporations  Tax planning considerations  Compliance and procedural considerations  Financial statement implications Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-4 Corporate Elections Initial Tax Year  New corp elects tax year by filing return  First return may be for short period  Some corporate restrictions  S corporation uses calendar year  Affiliated group member same as parent  PSCs usually calendar year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-5 Corporate Elections Changing Tax Year  Usually requires IRS approval  Automatic approval if  Annualizes short-period income  Keeps books based on new year  Short period does not have a NOL  No change in acctg period for 48 mo.  No interest in flow-through entities  Not a specialized corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-6 Corporate Elections Accounting Methods  Accrual  GAAP generally required for C corps  Cash  PSC, or C corp w/ gross receipts < $5M  Inventories cannot be significant  If inventories significant, must use accrual method for sales, COGS, inventories, accts. rec., & accts. pay. (the hybrid method)  Family farm w/ gross receipts < $25M Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-7 Determining a Corporation’s Taxable Income  Sales and exchanges of property  Business expenses  Special deductions  Exceptions for closely held corporations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-8 Sales and Exchanges of Property Capital Gains and Losses  Net capital gain taxed at ordinary income rates  Net capital losses cannot offset ordinary income  Net capital losses  Carryback 3 years and forward 5 years  Carryovers classified as short-term  Expired losses are lost forever Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-9 Sales and Exchanges of Property §291 Tax Benefit Recapture Rule  §1250 property sold at a gain  Ordinary income portion  Depreciation in excess of straight line plus  20% of all depreciation characterized as ordinary income under §291  No §1250 recapture under MACRS Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-10 Business Expenses  General rule  Organizational expenditures  Start-up expenditures  Limitations on deductions for accrued compensation  Charitable contributions Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-11 General Rule  All ordinary and necessary expenses reasonable in amount  No deductions for  Interest on loans to buy tax exempts  Illegal bribes or kickbacks  Fines or penalties  Insurance premiums if corp is beneficiary Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-12 Organizational Expenditures (1 of 2)  Expenses incident to creating corp  E.g., legal, accounting, temporary director fees, state incorporation fees  §248 election deemed to be made  No need to file election w/ 1 st return  May expense first $5K of org costs  $5K reduced $ for $ in excess of $50K Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-13 Organizational Expenditures (2 of 2)  Amortize remainder over 180 months  Expenditures must be incurred before end of first year of business  May elect to capitalize and not amortize  Election irrevocable Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-14 Start-Up Expenditures Basic Concepts  Non-organizational  Ordinary and necessary expenses  Paid or incurred BEFORE the actual start of business operations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-15 Start-Up Expenditures Types of Expenditures  Investigate creation or acquisition of an active trade or business  Create an active trade or business  Conduct an activity engaged in for profit or production of income before business operations begin Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-16 Start-Up Expenditures Election  $5K reduced $ for $ in excess of $50K  Remainder amortized over 180 months  Election must be made by due date for 1 st year tax return or 1 st year of ownership  Election deemed made w/ 1 st return  May elect to capitalize w/o amortization Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-17 Limitation on Deductions for Accrued Compensation  Accrued bonuses/compensation must be paid within 2-1/2 months after close of tax year  If paid after 2-1/2 months, payment deemed deferred compensation and is deductible in year paid Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-18 Charitable Contributions Timing  Deducted in year paid  Accrual basis corp. election  Include payments w/in 2 ½ months after year-end  Contribution authorized by BoD during year accrued  Must meet substantiation requirements to deduct contribution Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-19 Charitable Contributions Types of Contributions (1 of 2)  Donated money  Non-cash property  USUALLY FMV of property donated  Ordinary income property  Deduction limited to FMV less Ord Inc or STCG that would have been recognized if property were sold (includes recapture) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-20 Charitable Contributions Types of Contributions (2 of 2)  Non-cash property (continued)  Inventory related to exempt function  Deduction = adjusted basis + 1/2 gain  Similar rule for computer technology donated for educational purposes  Special rules for contributions of computer equipment, book inventory, and wholesale food inventory Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-21 Charitable Contributions Limitations  Max deduction is 10% of “adjusted taxable income” (ATI)  ATI - taxable income before charitable contribution deduction, NOL carryback, capital loss carryback, dividend-received deduction, & U.S. prod. activities ded.  Excess carried forward for 5 yrs  Creates a deferred tax asset Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-22 Special Deductions  U.S. production activities deduction  Dividends-received deduction  Net operating losses  Sequencing of the deduction calculations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-23 U.S. Production Activities Deduction Basic Concepts  Deduction is lesser of 9% times  Qualified production activities income OR  Taxable income before the U.S. production activities deduction  Limited to 50% of W-2 wages  Not an expense for financial accounting  Creates a permanent difference Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-24 U.S. Production Activities Deduction Qualified Production Activities Income  Domestic production gross receipts from lease, rental, sale, or exchange, of tangible property manufactured in the U.S. LESS  Expenses related to qualified income, including CoGS, & indirect allocable expenses Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-25 Dividends-Received Deduction (1 of 3)  Corps owning < 20% of a domestic corporation deduct lesser of  70% of Dividends Received or  70% of taxable income before NOL, capital loss carryback or DRD  Exception to taxable income limitation  If 70% of dividend received creates an NOL, then the full DRD is deductible Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-26 Dividends-Received Deduction (2 of 3)  Corps owning  20% and < 80% of a domestic corp  80% deduction instead of 70%  Corps owning  80% of domestic corp  Member of affiliated group  100% deduction Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-27 Dividends-Received Deduction (3 of 3)  No deduction is allowed if:  Paying corp is a foreign corp  Stock purchased w/borrowed money  Stock of paying corp held for < 46 days  Results in a permanent difference  Affects effective tax rate, but not deferred taxes Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-28 Net Operating Losses (NOL)  Deductions exceed gross income for the year before NOL carrybacks  NOL may be carried back 2 yrs & then forward 20 yrs  Corp may elect to forgo carryback & only carry NOL forward 20 yrs  Creates a deferred tax asset Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-29 Sequencing of the Deduction Calculations  Charitable contributions, DRD, NOL, and all other deductions must be taken in the following order  1. All other deductions  2. Charitable contributions  3. DRD  4. NOL  5. U.S. production activities deduction Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-30 Exceptions for Closely-Held Corps Shareholders Owning > 50% of Corp. (1 of 2)  §1239  Sale of depreciable property to corp.  Causes gain to be ordinary income to the controlling shareholder  §267  Disallows loss on sale of property by corp. to controlling shareholder  Loss may be recovered by shareholder if later sells prop at a gain Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-31 Exceptions for Closely-Held Corps Shareholders Owning > 50% of Corp. (2 of 2)  Corporation and shareholder using different accounting methods  Defers deduction for accrued expenses owed by accrual-method corp to cash- method controlling shareholder until income recognized by cash-method shareholder Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-32 Exceptions for Closely-Held Corps Loss Limitation Rules  > 50% ownership by ≤ 5 s/h’s  Corp’s losses limited to “at risk” amount  Losses not currently deductible  Carried over to be used in a later year  May be subject to passive activity rules  PSCs and closely held corps subject to passive activity limitation rules Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-33 Computing a Corporation’s Income Tax Liability  General rules  Regular income tax formula  Personal service companies Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-34 General Rules  The tax rates are graduated  Rate surcharges eliminate benefit of lower graduated tax rates from lower income brackets  Corps with income >$18.33M pay a flat 35% on all income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-35 Regular Tax Formula Regular Tax Liability before Credits Gross Income -Deductions and Losses -Special Deductions Taxable Income xAppropriate Rate (or rates) Regular Tax Liability before credits Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-36 Regular Tax Formula Regular Tax Liability Regular Tax Liability before credits -Foreign tax credit -Other Credits +Credit recapture Regular Tax Liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-37 Regular Tax Formula Refund or Tax Due Regular Tax Liability +AMT Liability +Special Taxes (if any) -Estimated Payments Refund or tax due Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-38 Personal Service Corporations (1 of 2)  Taxed at a flat 35%  Substantially all activities involve services in following fields:  Health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-39 Personal Service Corporations (2 of 2)  Substantially all stock must be owned by employees, former employees, or survivors of employees Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-40 Controlled Groups  Why special rules are needed  What is a controlled group?  Special rules applying to controlled groups  Consolidated tax returns Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-41 Why Special Rules are Needed  Prevent shareholders from using multiple corporations to avoid having income taxed at 35%  Each corporation would be able to take advantage of lower graduated rates  Lower graduated rates must be spread among all corporations in a controlled group Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-42 What Is a Controlled Group?  Two or more corps owned directly or indirectly by same shareholder or group of shareholders  Types of controlled groups  Parent-subsidiary  Brother-sister  Combined Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-43 Parent-Subsidiary Controlled Group (1 of 2)  One corp directly owns at least:  80% of voting power of all classes of voting stock OR  80% of total value of all classes of stock of subsidiary corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-44 Parent-Subsidiary Controlled Group (2 of 2)  Axle is a sub of Parent due to 80% direct ownership  Wheel is a member of same p-s group because of 80% owned by Parent & Axle Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-45 Brother-Sister Controlled Group (1 of 2)  50%-80% definition  ≤ 5 individuals, trusts or estates own:  ≥ 80% of voting power or ≥ 80% of value of stock of two or more corps AND  > 50% of voting power or value held by identical owners (common ownership)  50%-only definition is 2 nd test above Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-46 Brother-Sister Controlled Group (2 of 2)  80% Test  Walt & Gail own 100% of North and South  50% Test  Walt’s & Gail’s common ownership is 60% (30% of North & 30% of South) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-47 Combined Controlled Groups (1 of 2)  Three or more corps which meet the following criteria:  Each corp. is a member of a parent- subsidiary or brother-sister group  At least one corp. is both a parent and a member of a brother-sister group Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-48 Combined Controlled Groups (2 of 2)  Able & Coast are brother-sister controlled group  Able & Best are parent-subsidiary controlled group  Parent member of both groups Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-49 Items that Must be Apportioned within a Controlled Group Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall Brother-SisterParent-Subsidiary Item 50%- Only 50%- 80%≥ 80%≥ 50% Low-bracket tax ratesXXX AMT exemptionXXX Min accum. earnings creditXXX §179 expense limitXXX General business credit limitXX

3-50 Consolidated Tax Returns  Affiliated groups  Advantages of filing a consolidated return  Disadvantages of filing a consolidated return Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-51 Affiliated Groups (1 of 2)  One or more chains of includible corps connected through stock ownership to a common parent  Common parent directly owns  80% of voting power AND value of at least one includible corporation Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-52 Affiliated Groups (2 of 2)  Each corp owned at least 80/80 by another member of the group  An affiliated group MAY file a consolidated return  Capital losses offset capital gains from other group members  Operating losses reduce operating income from other group members Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-53 Consolidated Return Advantages  Losses of one member offset gains of another member  Capital losses of one member offset capital gains of another member  Profits and gains from intercompany transactions deferred until sale outside the group Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-54 Consolidated Return Disadvantages  Election binding on all subsequent tax years  Unless IRS grants permission otherwise  Losses from intercompany transactions deferred until sale outside the group  Additional administrative costs Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-55 Tax Planning Considerations  Compensation planning for shareholder-employees  Special election to allocate reduced tax rate benefits  Using NOL carryovers and carrybacks Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-56 Compensation Planning  Salary payments  Reduce double taxation if paid to shareholder-employees  Fringe benefits  Deducted by corporation and certain benefits are not to be taxable to shareholder-employee Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-57 Allocating Reduced Tax Rate Benefits  A controlled group may apportion lower tax rates in any manner to member corporations  Reduce benefits to members with little or no income  Increase benefits to members with the highest income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-58 Using NOL Carryovers and Carrybacks  Two options  Carryback to 2 nd previous year, then 1 st previous year, then forward  Forgo the carrybacks and carry forward  Examine marginal tax rates in prior years and expected marginal tax rates in future years to maximize tax benefit Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-59 Compliance and Procedural Considerations Estimated Taxes  Estimated taxes required if corp owes >$500 for current year  Pay in four installments  Each installment 25% of annual liability  Underpayment of estimated tax penalty  Small corps exempt from penalty if  Pay in lesser of 100% of prior or current year’s tax liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-60 Compliance and Procedural Considerations Filing Requirements (1 of 2)  Return is required each year regardless of income  Use Form 1120  Use Form 1120A if gross receipts, total income & total assets each < $500K  Large corps (assets>$10M) must fill out more detailed Schedule M-3 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-61 Compliance and Procedural Considerations Filing Requirements (2 of 2) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-62 Financial Statement Implications  ASC Income Taxes  Temporary differences  Deferred tax assets and the valuation allowance  ASC Uncertain Tax Positions  Balance sheet classification  Tax provision process Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-63 ASC Income Taxes Scope  Establishes principles of accounting for current and deferred taxes  Arising from temporary differences Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-64 ASC Income Taxes Principles  Addresses financial statement consequences of  Rev, exp, gains/losses recognized in different years for tax and financial statement purposes  Events affecting book/tax differences in bases of assets and liabilities  Loss & credit carrybacks or carryforwards Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-65 ASC Income Taxes Objectives  Recognize current yr taxes payable or refundable  Recognize deferred tax liabilities and assets for future tax consequences of events on fin stmts or tax return Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-66 Temporary Differences Deferred Tax Liabilities  Rev/gains recognized earlier for book than tax  Exp/losses deducted earlier for tax than book  Tax basis of asset < book basis  Tax basis of liability > book basis Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-67 Temporary Differences Deferred Tax Assets  Rev/gains recognized earlier for tax than book  Exp/losses deducted earlier for book than tax  Tax basis of asset > book basis  Tax basis of liability < book basis  Loss/credit carryforwards exist Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-68 Deferred Tax Assets and the Valuation Allowance  Deferred tax asset  Firm will realize tax benefit of event in the future  Valuation allowance used for portion of benefit not likely to be realized  Use “more likely than not” standard Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-69 ASC Uncertain Tax Positions  Two-step to account for uncertain tax positions  Determine if position exceeds “more likely than not” (>50%) probability of being sustained on its merits by IRS  If not, corp cannot recognize tax benefit  Records liability for unrecognized tax benefits  If yes, measure amount of benefit Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-70 Balance Sheet Classification  Classify as current or noncurrent  If related to another asset or liability use classification of related asset/liab  Net current assets and liabilities  Net noncurrent assets and liabilities Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-71 Tax Provision Process (1 of 3) 1. Identify temporary differences and tax carryforwards 2. Prepare “roll forward” schedules 3. Apply appropriate tax rates in roll forward schedules to determine deferred tax asset/liability balances 4. Adjust deferred tax assets by valuation allowance if necessary Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-72 Tax Provision Process (2 of 3) 5. Adjust income tax expense for uncertain tax positions under ASC Determine current federal income taxes payable (current tax expense) 7. Determine total federal income tax expense (benefit) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3-73 Tax Provision Process (3 of 3) 8. Prepare and record tax journal entries 9. Prepare tax provision reconciliation 10. Prepare tax rate reconciliation 11. Prepare financial statements Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 3-74 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall