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CHAPTER # 17 REVIEW Atef Abuelaish

Accounting for Tax Income Chapter 17 Accounting for Tax Income Atef Abuelaish

Objectives of “Accounting for Income Taxes” The income tax provision includes Current year taxes payable or refundable Any changes to future income taxes payable or refundable that result from differences in the timing of when an item is reported on the tax return compared to the financial statement A company records these future income taxes payable or refundable on its balance sheet as Deferred tax liability Deferred tax asset Atef Abuelaish

Objectives of “Accounting for Income Taxes” Objectives of ASC 740 ASC 740 applies only to: Income taxes levied by the U.S. federal government U.S. state and local governments Non-U.S. (“foreign”) governments The FASB defines an income tax as a tax based on income, which excludes property taxes, excise taxes, sales taxes, and value-added taxes. Companies report non-income taxes as expenses in the computation of their net income before taxes Atef Abuelaish

Objectives of “Accounting for Income Taxes” Two objectives Recognize the amount of income taxes payable or refundable in the current year Recognize deferred tax liabilities and assets for the (expected) future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns Both objectives relate to reporting a company’s income tax amounts on the balance sheet, not the income statement Asset and liability approach Atef Abuelaish

Objectives of “Accounting for Income Taxes” A “book-tax” difference can occur for several reasons: 1) Different accounting methods are used in the computation. Straight-line depreciation is used for book, accelerated depreciation is used for tax. 2) The book-tax “rules” are different. Not all book income is taxable. Not all book deductions reduce taxable income. Not all tax deductions reduce book income. Atef Abuelaish

Objectives of “Accounting for Income Taxes” 3) The timing of when income and deductions are reported on the two statements may differ (prepayments). 4) Different entities may appear on the two statements. Atef Abuelaish

Objectives of “Accounting for Income Taxes” To compute the deferred tax liability or asset, a company must calculate the future tax effects attributable to temporary differences and tax carry forwards Temporary differences that are initially favorable (unfavorable) create deferred tax liabilities (assets) Atef Abuelaish

Objectives of “Accounting for Income Taxes” and Income Tax Provision Process Steps in determining the income tax provision Adjust pretax income for permanent differences Identify all temporary differences and carryforwards Calculate the current income tax expense or benefit Recognize deferred tax assets and liabilities Evaluate the need for a valuation allowance for deferred tax assets Calculate the deferred income tax expense or benefit Determine changes to liabilities for uncertain tax positions Atef Abuelaish

Objectives of “Accounting for Income Taxes” and Income Tax Provision Process Compute the two components of the income tax provision Current Deferred Combine the two components to produce the total income tax provision Formula Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 1) Adjust Pretax Net Income for All Permanent Differences Permanent differences - Differences that appear only on the income statement or tax return, but not on both A company does not take permanent differences into account in computing its deferred tax assets and liabilities Permanent differences usually affect a company’s effective tax rate and appear as part of its reconciliation of its effective tax rate with the statutory U.S. tax rate Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 2) Identify All Temporary Differences and Tax Carryforward Amounts Temporary differences commonly arise in four instances Revenues or Gains that are taxable after they are recognized in Financial Income Expenses or Losses that are deductible after they are recognized in Financial Income Revenues or Gains that are taxable before they are recognized in Financial Income Expenses or Losses that are deductible before they are recognized in Financial Income Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Identifying Taxable and Deductible Temporary Differences Taxable Temporary Difference Initially favorable gives rise to a taxable temporary difference Taxable temporary differences generally arise when Revenues or gains are taxable after they are recognized in net income Expenses or losses are deductible on the tax return before they reduce net income Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component From a balance sheet perspective A taxable temporary difference generally arises when the financial reporting basis of an asset exceeds its corresponding tax basis, or the financial reporting basis of a liability is less than its corresponding tax basis The future tax cost associated with a taxable temporary difference is recorded on the balance sheet as a deferred tax liability Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Deductible Temporary Difference A temporary difference that initially is unfavorable gives rise to a deductible temporary difference Deductible temporary differences generally arise when Revenues or gains are taxable before they are recognized in net income Expenses or losses are deductible on the tax return after they reduce net income Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component From a balance sheet perspective A deductible temporary difference generally arises when the financial reporting basis of an asset is less than its corresponding tax basis or the financial reporting basis of a liability exceeds its corresponding tax basis The future tax benefit associated with a deductible temporary difference is recorded on the balance sheet as a deferred tax asset Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 3) Compute the Current Income Tax Expense or Benefit ASC 740 defines the current income tax expense or benefit as “The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year” The major component of a company’s current income tax expense or benefit is income tax liability or refund from its current year operations Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Tax-exempt interest income (book, not tax) 50 Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Tax-exempt interest income (book, not tax) 50 P Accrued warranty (book, not tax) (200) Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Tax-exempt interest income (book, not tax) 50 P Accrued warranty (book, not tax) (200) T Nondeductible fine (book, not tax) (150) Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Tax-exempt interest income (book, not tax) 50 P Accrued warranty (book, not tax) (200) T Nondeductible fine (book, not tax) (150) P Tax depreciation in excess of book depreciation (100) Atef Abuelaish

The Current Tax Provision Example Green, Inc. computed its pretax book income to be $1,000. Green identified the following four book/tax differences that it will report on Schedule M-1 when it files Form 1120 later in the year. Tax-exempt interest income (book, not tax) 50 P Accrued warranty (book, not tax) (200) T Nondeductible fine (book, not tax) (150) P Tax depreciation in excess of book depreciation (100)T Atef Abuelaish

The Current Tax Provision Compute taxable income Book income $1,000 Tax-exempt interest income (50) Accrued warranty 200 Nondeductible fine 150 Tax depreciation in excess of book depreciation (100) Taxable income $1,200 Compute the current tax provision (assume tax R = 35%) $1,200 × 35% = $420 Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 4) Determine the Ending Balances in the Balance Sheet Deferred Tax Asset and Liability Accounts The deferred income tax expense or benefit portion of a company’s income tax provision reflects the change in a company’s deferred tax liabilities or assets that relate to continuing operations The deferred tax accounts provide investors and other interested parties with a measure of a company’s expected future income tax related cash inflows (outflows) resulting from book-tax differences that are temporary in nature or from tax carryover Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component ASC 740 takes a “liability” or balance sheet approach for the computation of the deferred tax expense or benefit The computations are based on the change in the cumulative differences between the financial accounting basis of an asset or liability and its corresponding tax basis from the beginning of the year to the end of the year Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 5) Determining Whether a Valuation Allowance is Needed Evaluate the Need for a Valuation Allowance for Gross Deferred Tax Assets A valuation allowance is required if it is more likely than not some or all of the deferred tax asset will not be realized in the future ASC 740 identifies four sources of potential future taxable income, two of which are objective and other two are subjective Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component A. Objective sources 1) Future Reversals of Existing Taxable Temporary Differences If the reversing taxable temporary differences provide sufficient future taxable income to absorb the reversing deductible temporary differences, the company does not record a valuation allowance against the deferred tax asset Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 2) Taxable Income in Prior Carryback Years Company does not record a valuation allowance if the tax benefit from the realization of a deferred tax asset can be carried back to a prior year that has sufficient taxable income to absorb the realized tax benefit. Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component B. Subjective sources 1) Expected future taxable income exclusive of reversing temporary differences and carryforwards A company might support its predictions of future taxable income with evidence of existing contracts or a sales backlog that will produce enough taxable income to realize the deferred tax asset when it reverses Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 2) Tax Planning Strategies Includes sale and leaseback of operating assets Changing inventory accounting methods Refraining from making voluntary contributions to the company pension plan Electing to capitalize certain expenditures rather than deduct them currently Sale of noncore assets Electing the alternative depreciation system Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Negative Evidence That a Valuation Allowance Is Needed ASC 740 requires that a company consider negative as well as positive evidence in determining whether it is more likely that a deferred tax asset will not be realized in the future. Negative evidence includes Cumulative (book) losses in recent years (usually 36 quarters) A history of net operating (capital) losses and credits expiring unused Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component An expectation of losses in the near future Unsettled circumstances that, if resolved unfavorably, will result in losses from continuing operations in future years Calculate the Deferred Income Tax Expense or Benefit Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 6) Accounting for Uncertainty in Income Tax Positions FAS 109 provided no specific guidance on how to deal with uncertain tax positions. Companies generally applied the principles of FAS 5, Accounting for Contingencies, to uncertain tax positions. The objective of FIN 48 (codified in ASC 740-10) was to provide a uniform approach to recording and disclosing tax benefits resulting from tax positions that are considered to be uncertain. Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component ASC 740-10 applies to all tax positions accounted for in accordance with ASC 740, including: Previously filed positions Expected filing positions Decisions not to file tax returns in a particular jurisdiction Decisions to exclude potentially taxable income Choices made in classifying a transaction as tax-exempt or taxable Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component ASC 740-10 applies a two step process in evaluating tax positions 1) Recognition process Company first determines if it is more likely than not that its tax position on a particular account will be sustained on IRS examination based on its technical merits Company then determines the amount it expects to be able to recognize Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component 2) Measurement process Requires the company to make a cumulative probability assessment of all likely outcomes of the audit and litigation process A company recognizes the amount that has a greater than 50 percent probability of being sustained on examination and subsequent litigation The amount not recognized is recorded as a liability on the balance sheet Interest and Penalties – may be included in the provision or reported as a deduction in computing pretax income Atef Abuelaish

Calculate Current and Deferred Income Tax Expense or Benefit Component Disclosures of Uncertain Tax Positions Specific line items should disclose Gross amounts of increases and decreases in liabilities related to uncertain tax positions as a result of tax positions taken during a prior period and current year Amounts of decreases in liabilities related to uncertain tax positions relating to settlements with taxing authorities Reductions in liabilities related to uncertain tax positions as a result of a lapse of the applicable statute of limitations Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate 1) Balance Sheet Classification ASC 740 requires companies (public and private) to disclose their deferred tax assets and liabilities on their balance sheets and classify them as either current or noncurrent (all are noncurrent beginning in 2016). ASC 740 permits companies to net deferred tax assets and liabilities based on their classification and present the net amount on the balance sheet ASC 740 does not permit netting of deferred tax assets and liabilities that are attributable to different tax jurisdictions Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate 2) Income Tax Footnote Disclosure ASC 740 mandates that a company disclose Components of the net deferred tax assets and liabilities reported on its balance sheet Total valuation allowance recognized for deferred tax assets 3) ASC 740 also requires publicly traded companies to disclose these components Current tax expense or benefit Deferred tax expense or benefit Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate Benefits of operating loss carryforwards Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates Adjustments to the beginning of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in management’s judgment about the realizability of the recognized deferred tax assets Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate 4) Computation and Reconciliation of the Income Tax Provision with a Company’s Hypothetical Tax Provision ASC 740 requires a company to reconcile its Reported income tax provision attributable to continuing operations with Amount of income tax expense that would result from applying its U.S. statutory tax rate to its pretax net income or loss from continuing operations Atef Abuelaish

Financial Statement Disclosure and Corporation's Effective Tax Rate 5) Importance of a Company’s Effective Tax Rate The tax rate that backs out one-time and nonrecurring (discrete) events is referred to as the company’s structural tax rate The structural effective tax rate often is viewed as more representative of the company’s effective tax rate from its normal (recurring) operations The cash tax rate is used by analysts to compute a company’s tax status excluding deferred taxes Atef Abuelaish

Break for 10 Minutes Atef Abuelaish

Chapter 18 Corporate Taxation: Atef Abuelaish

Corporate Taxation: Nonliquidating Distributions Chapter 18 Corporate Taxation: Nonliquidating Distributions Atef Abuelaish

Learning Objectives Explain the framework that applies to the taxation of property distributions from a corporation to a shareholder. Compute a corporation's earnings and profits and a shareholder's dividend income. Identify when a corporation may be deemed to have paid a "constructive dividend" to a shareholder. Explain the taxation of stock dividends. Comprehend the tax consequences of stock redemptions. Describe the tax consequences of a partial liquidation to the corporation and its shareholders. Atef Abuelaish

Framework for Property Distributions Distributions to shareholders will be taxed in one of the following ways: Taxed as income (albeit at a lower tax rate) Return of capital Capital gains When distributions from corporations are taxed to shareholders, this creates double taxation of corporate income Atef Abuelaish

Framework for Property Distributions Some payments to shareholders are deductible by the corporation Examples are payments for services (salary), interest, and rent To be deductible, payments to shareholders must be reasonable in amount Unreasonable payments (e.g., excessive salary) are taxed as “constructive” dividends to shareholders Atef Abuelaish

Constructive Dividends Examples of constructive dividends Unreasonable compensation Shareholder use of corporate assets without an arm’s-length payment Interest paid to shareholder at excessive interest rates Payments made by the corporation on behalf of a shareholder Atef Abuelaish

Computing Earnings and Profits Overview of distributions: Dividend distributions are included in the shareholder’s gross income Non-dividend distributions are a return of capital (reduce the shareholder’s tax basis in the corporation’s stock) Non-dividend distributions in excess of the shareholder’s stock tax basis constitute a gain from sale or exchange of the stock Atef Abuelaish

Determining the Dividend A “dividend” for tax purposes is: any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P) Two separate E&P accounts to be maintained Current earnings and profits (CE&P) Accumulated earnings and profits (AE&P) Undistributed current E&P is added to the balance of accumulated E&P on the first day of the next tax year Atef Abuelaish

Determining the Dividend Computing Earnings and Profits begins with taxable income Taxable income is adjusted as follows: Income that is excluded from taxable income Disallowed deductions that do not require an economic outflow Deduction of expenses that require an economic outflow but are not deducted for computing taxable income Adjustment of timing for deductions or income because of accounting methods required for E&P computation Atef Abuelaish

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Determining the Dividend Ordering of E&P Distributions Positive Current E&P and Positive Accumulated E&P Positive current E&P, negative accumulated E&P Negative current E&P, positive accumulated E&P Negative current E&P, negative accumulated E&P Atef Abuelaish

Determining the Dividend Example 1 Current E&P = $1,000,000 Accumulated E&P = ($500,000) The corporation distributes $1,000,000 on July 1. The entire distribution is deemed to come from current E&P and is a dividend to the shareholders. Atef Abuelaish

Determining the Dividend Example 2 Current E&P = ($1,000,000) Accumulated E&P = $1,000,000 The corporation distributes $1,000,000 on July 1. Current E&P is apportioned on a per day basis AE&P as of July 1 = $1M − ½($1M) = $500,000 $500,000 is a treated as a dividend. Atef Abuelaish

Determining the Dividend Distributions of Noncash Property to Shareholders Atef Abuelaish

Determining the Dividend Tax Consequences to a Corporation Paying Noncash Property as a Dividend The corporation recognizes gains (but not losses) on the distribution of noncash property as a dividend Gain is recognized to the extent of fair market value in excess of tax basis in the property Liabilities If the property’s fair market value is less than liabilities assumed by the shareholder, the fair market value is deemed to be the liability Atef Abuelaish

Determining the Dividend Example 3 Cher Holder receives a property distribution from Sunny Corporation with a fair value of $200. Cher assumes a $100 mortgage attached to the property. Sunny’s basis in the property distributed is $100. Sunny Corporation reports a gain of $100 on the distribution ($200 − $100). Atef Abuelaish

Determining the Dividend Example 4 Cher Holder receives a property distribution from Sunny Corporation with a fair value of $200. Cher assumes a $300 mortgage attached to the property. Sunny’s basis in the property distributed is $100. Sunny Corporation reports a gain of $200 on the distribution ($300 − $100). The property’s FMV is deemed to be the amount of the liability assumed because it exceeds the property’s fair market value. Atef Abuelaish

Determining the Dividend Noncash Property Distributions affect E&P Atef Abuelaish

Stock Dividends A stock dividend increases the number of shares outstanding Stock dividends can also take the form of a stock split (e.g., 2-for-1 stock split) Stock dividends are nontaxable to shareholders if two conditions are met: Made with respect to common stock and Pro rata (proportionate interests maintained) Atef Abuelaish

Stock Dividends Non-pro rata stock dividends usually are taxable as dividends Atef Abuelaish

Stock Redemptions Form of a Stock Redemption A redemption occurs when a corporation acquires its stock from a shareholder in exchange for property A redemption results in either a dividend or a sale of the redeemed shares Individuals prefer exchange treatment because of the preferential tax rates for capital gains Corporate shareholders prefer dividend treatment because of the dividends received deduction Atef Abuelaish

Stock Redemptions Three types of redemptions are treated as exchanges: Redemptions that are Substantially Disproportionate are treated as sales Redemptions in Complete Redemption of all of the Stock of the Corporation Owned by the Shareholder Redemptions that are not Essentially Equivalent to a Dividend Atef Abuelaish

Stock Redemptions Stock ownership tests are required for treatment as substantially disproportionate: Shareholder does not control the corporation after the exchange (less than 50 percent of voting power) Shareholder’s percentage of voting stock and aggregate value is less than 80 percent of the percentage before the redemption Constructive ownership rules must be considered: Family attribution Attribution from entities to owners or beneficiaries Attribution from owners or beneficiaries to entities Option attribution Atef Abuelaish

Stock Redemptions Example 5 Tom owns 60 of the corporation’s 100 shares of voting common stock. 1. What percentage ownership test(s) must be met for the Tom to receive exchange treatment? 2. How many shares of stock must the corporation redeem to have Tom treat the redemption as an exchange? Atef Abuelaish

Stock Redemptions Example 5 Solution Part 1: Two tests must be met: First, after the redemption Tom must own less than 50% of the outstanding shares. Second, Tom’s percentage ownership after the redemption must be less than 80 % of his percentage ownership before the redemption. In this case, Tom ’s 60 percent ownership must drop to less than 48% (80% × 60% = 48%). Atef Abuelaish

Stock Redemptions Example 5 Solution Part 2: To determine the minimum number of shares to be redeemed, solve the following inequality where x=number of redeemed shares: This reduces to the following expression: Hence, by redeeming 24 of Tom’s shares his ownership interest in the corporation will drop to 47.4% ([60-24] / [100 − 24] = 36/76). (60 – x) / (100 – x) < .48 .52x > 12 and x > 24 shares Atef Abuelaish

Stock Redemptions If the redemption is treated as an exchange the shareholder tax consequences are: Gain is always recognized Loss is recognized unless the shareholder is a related person to the corporation The redeemed shareholder may be related if they owns more than 50% of the stock’s value Note that ownership is determined using the §267(c) attribution rules Atef Abuelaish

Stock Redemptions Tax Consequences to the Distributing Corporation Current E&P is reduced by dividend distributions (cash and fair market value of other property adjusted for gain recognized and liabilities distributed) For an exchange, current and accumulated E&P is reduced by the percentage of stock redeemed (limited to the fair market value of the property distributed) Current E&P is reduced by dividends before reducing its current E&P for redemptions treated as exchanges Atef Abuelaish

Stock Redemptions Example 6 Acme Inc. has AE&P at 1/1/16 of $100,000 and CE&P for 2016 is $75,000. Acme redeems all of Bill’s stock on July 1 for $60,000. The stock redeemed represents 25% of Acme stock. On December 31, Acme pays its remaining shareholders dividends of $25,000. Bill treats the redemption as an exchange. What is the effect on Acme’s AE&P and CE&P? Atef Abuelaish

Stock Redemptions Example 6 What is the effect on Acme’s AE&P and CE&P? 1. CE&P after the dividends is $50,000 ($75,000 − $25,000) 2. AE&P at 7/01/14 is $100,000 + ½($50,000) = $125,000 3. Acme reduces AE&P to the lesser of: 25% × $125,000 = $31,250 or $60,000 (fair value of the distribution) Atef Abuelaish

Partial Liquidations Corporations can contract either by: Distributing stock of a subsidiary to shareholders Selling a business and distributing the proceeds to shareholders in partial liquidation Distributions may require the shareholders to exchange some shares of stock or may be pro rata to all the shareholders without an actual exchange of stock Noncorporate shareholders receive exchange treatment Corporate shareholders determine their tax consequences using the change-in-stock ownership rules that apply to stock redemptions Atef Abuelaish

Happiness is having all homework up to date Homework assignment Using Connect – 6 Questions for 60 Points for Chapter 18. Tax Return; Course Project: Corporation Tax Return Problem # 2 “Blue Catering Service Inc.'s (BCS) 2016 Form 1120” on Pages C-16 till C-18. Complete the “Connect Orientation” at Connect web site for 5 points, before 03/26/2017. Quiz # 1 is Available from today till 2/19/2017 at 11:59 PM. Prepare chapter 19 “Corporate Formation, Reorganization, and Liquidation.” for meeting on 2/27/2017; no Class on 2/20 for “Presidents Day.” Happiness is having all homework up to date Atef Abuelaish

Thank you and See You On 2/27/2017 at the Same Time, Take Care Atef Abuelaish