Welcome Back Atef Abuelaish

Welcome Back Time for Any Question Atef Abuelaish

CHAPTER # 15 REVIEW Atef Abuelaish

Chapter 15 Entities Overview Atef Abuelaish

Entity Legal Classification and Nontax Characteristics Corporation, limited liability company (LLC), general partnership (GP), limited partnership (LP), sole proprietorship Business owners legally form Corporation – file articles of incorporation LLC – file articles of organization GP – written agreement called partnership agreement LP – written agreement and file a certificate of limited partnership Sole proprietors are not required to formally organize their business with the state Atef Abuelaish

Entity Legal Classification and Nontax Characteristics Responsibility for Liabilities Corporations and LLCs are solely responsible Partnerships – GPs are ultimately responsible and LPs are not responsible Sole proprietorships – Individual owners are responsible (unless single member LLC) Rights, Responsibilities, and Legal Arrangement among Owners Atef Abuelaish

Entity Legal Classification and Nontax Characteristics Atef Abuelaish

Entity Tax Classification Business entities classification for tax purposes Check the box regulations Taxpaying entities Flow-through entities Corporations are C corporations unless shareholders make a valid S election Unincorporated entities taxed as partnerships if they have more than one owner taxed as sole proprietorships if owned by an individual or as disregarded entities if held by some other entity may elect to be taxed as C corporations Atef Abuelaish

Entity Tax Classification Check the box regulations summary Atef Abuelaish

Entity Tax Characteristics Double Taxation Income generated by flow-through entities is taxed only once while income of C corporations is taxed twice Flow-through entity owners pay tax on their share of income as if they had earned it themselves Corporations pay first level of tax on their taxable income at the corporate marginal tax rate Current marginal tax rate Lowest – 15 percent and highest – 39 % - Individual. Most profitable corporations – 35 % Shareholders are subject to double taxation when second level of tax is paid Atef Abuelaish

Entity Tax Characteristics After-Tax Earnings Distributed 1) Individual Shareholders Pay second tax at 0, 15, or 20 percent depending on taxpayers income level May also pay 3.8 net investment income tax, depending on income level Individual shareholders’ overall tax rates will be higher with a corporation when the corporation’s marginal tax rate is expected to be greater than or equal to the shareholders’ marginal tax rates Atef Abuelaish

Double Tax Example Assume that Nicole did some income projections to help her determine the taxable form of her business. She makes the following assumptions: CCS earns taxable income of $350,000. CCS will pay out all of its after-tax earnings annually as a dividend. Her ordinary marginal tax rate is 33 % and her dividend tax rate is 18.8 % (including 3.8% net investment income tax). Given these assumptions, if Nicole organizes CCS as a corporation, what would be the overall tax rate on CCS’s income (corporate-level tax + shareholder-level tax)/taxable income)? Atef Abuelaish

Entity Tax Characteristics After-Tax Earnings Distributed 2) Corporate Shareholders Dividends are subject to corporate ordinary rates Corporations receiving dividends are potentially subject to third level of tax Dividend received deduction (DRD) can be claimed for dividends DRD percentage is 70, 80, or 100% depending on the extent of recipient corporation’s ownership in the dividend-paying corporation Atef Abuelaish

Entity Tax Characteristics After-Tax Earnings Distributed 3) Institutional Shareholders Do not pay shareholder-level tax on dividends 4) Tax- Exempt and Foreign Shareholders Organizations like churches and universities are exempt from tax on investment income including dividend income Atef Abuelaish 14

Entity Tax Characteristics Mitigating the Double Tax Strategies for reducing the corporate-level tax Paying salaries to shareholders Paying fringe benefits to shareholders Leasing property to shareholders Pay interest on loans to shareholders Strategies for reducing the shareholder-level tax Retain earnings Hold stock before selling Atef Abuelaish

Entity Tax Characteristics Deductibility of Entity Losses C corporations with NOL for the year can carry back the loss to offset taxable income reported in the two preceding years and carry it forward for up to 20 years Losses from C corporations are not available to offset their shareholders’ personal income Atef Abuelaish

Entity Tax Characteristics Deductibility of Entity Losses Losses generated by flow-through entities are generally available to offset the owners’ personal income, subject to certain restrictions Ability to deduct flow-through losses against other sources of income can be a significant issue for owners of new businesses as they tend to report losses early on as they get established Atef Abuelaish

Entity Loss Example 1 Assume that Nicole will organize CCS as a C corporation and that in spite of her best efforts as CEO of the company, CCS reports a tax loss of $50,000 in its first year of operation (year 1). Also, recall Nicole’s marginal tax rate is 33 % and assume she will have ordinary taxable income of $200,000 from her husband’s salary in year 1. How much tax will CCS pay in year 1 and how much tax will Nicole (and her husband) pay on the $200,000 of other taxable income if CCS is organized as a C corporation? Atef Abuelaish

Entity Loss Example 1 Solution Answer: CCS will pay $0 in taxes because it reports a loss for tax purposes. Because Nicole may not use the CCS loss to offset her other income, she must pay $66,000 in taxes ($200,000 × 33%). Atef Abuelaish 19

Entity Loss Example 2 Suppose CCS is organized as an S corporation and Nicole’s basis in CCS before the year 1 loss is $50,000. How much tax will CCS pay in year 1, and how much tax will Nicole (and her husband) pay on the $200,000 of other income? Atef Abuelaish

Entity Loss Example 2 Solution Answer: CCS pays $0 taxes (S corporations are not taxpaying entities) and Nicole pays $49,500 in taxes. Atef Abuelaish 21

Entity Loss Examples 1 and 2 Summary Atef Abuelaish

Entity Loss Example 3 Suppose CCS is organized as an S corporation and Nicole’s basis before the $50,000 year 1 loss is $100,000. Further, assume that Nicole does not participate in CCS’s business activities; that is, assume she is a passive investor in the business entity. How much tax will Nicole (and her husband) pay on the $200,000 of other income? Atef Abuelaish 23

Entity Loss Example 3 Solution Answer: $66,000. Because Nicole is a passive investor, she is not allowed to deduct the loss allocated to her this year. She must carry it over and use it in future years (this assumes neither Nicole nor her husband have income from other investments in which they are passive investors). Atef Abuelaish 24

Entity Tax Characteristics Converting to Other Entity Types C corporations Make election to S corporation May not qualify to make S election May liquidate and form as entity taxed as a partnership but tax cost of liquidation prohibitive Entities taxed as partnerships or sole proprietorships Generally tax free to form as a corporation Very common in advance of IPO Atef Abuelaish 25

Chapter 16 Corporate Operations Atef Abuelaish

Learning Objectives Describe the corporate income tax formula, compare and contrast the corporate to the individual tax formula, and discuss tax considerations relating to corporations’ accounting periods and accounting methods. Identify common book-tax differences, distinguish between permanent and temporary differences, and compute a corporation’s taxable income and regular tax liability. Describe a corporation’s tax return reporting and estimated tax payment obligations. Calculate a corporation’s alternative minimum tax liability. Atef Abuelaish 16-27

Corporate Taxable Income Formula Gross Income – Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Other Taxes = Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Other Taxes = Total Taxes – Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Other Taxes = Total Taxes – Credits – Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Other Taxes = Total Taxes – Credits – Prepayments = Atef Abuelaish

Corporate Taxable Income Formula Gross Income – Deductions = Taxable Income X Tax Rates = Regular Income Tax Liabilities + Other Taxes = Total Taxes – Credits – Prepayments = Tax Due/Refund Atef Abuelaish

Corporate Taxable Income Formula Atef Abuelaish 16-38

Book-Tax Adjustments Financial income typically is the starting point for computing taxable income Reconcile to taxable income Book-tax adjustments for differences between financial accounting rules Companies preparing financial statements with tax accounting methods won’t have book-tax differences Atef Abuelaish 16-39

Book-Tax Adjustments Unfavorable Adjustments: Add back to book income to compute taxable income Favorable Adjustments: Subtract from book income to compute taxable income Permanent differences Temporary differences Atef Abuelaish 16-40

Common Permanent Book-Tax Differences Interest income from municipal bonds (Fav) Death benefit from life insurance on key employees (Fav) Life insurance premiums (UnFav) Half of meals and entertainment expense (UnFav) Fines and penalties and political contributions (UnFav) Excess compensation to executives (UnFav) Federal income taxes (UnFav) Dividends received deduction (Fav) Domestic manufacturing deduction (Fav) Atef Abuelaish 16-41

Common Temporary Book-Tax Differences Dividends Depreciation Gain/loss on sale of depreciable asset Bad debt expense §263A uniform inventory capitalization costs Organizational or start-up costs Unearned rent revenue Deferred compensation Stock options Net capital loss Carry back three years and forward five years Net operating loss carryover Goodwill acquired in an asset acquisition Atef Abuelaish 16-42

Book-Tax Differences from Dividends Included in gross income for tax purposes Under the general rule, income included in financial income depends on ownership If ownership < 20%, no book tax difference If ownership is at least 20% but not more than 50%, the receiving corporation does not include the dividend in book income but includes a pro-rata share of the distributing corporation’s income in its income If ownership > 50%, consolidated financial reporting Atef Abuelaish 16-43

Dividends Book-Tax Difference Example Assume that PCC owned 30 % of the stock of BCS corporation. During 2016, BCS distributed a $40,000 dividend to PCC. BCS reported $100,000 of net income for 2016. Based on this information, what is PCC’s 2016 book-tax difference relating to the dividend and its investment in BCS (ignore the dividends received deduction)? Is the difference favorable or unfavorable? Atef Abuelaish 16-44

Dividends Book-Tax Difference Example Solution Atef Abuelaish 16-45

Stock Option-Related Book-Tax Differences Atef Abuelaish 16-46

Stock Option Example 1 On January 1, 2016, PCC granted 20,000 nonqualified options with an estimated $5 value per option ($100,000 total value). Each option entitled the owner to purchase one share of PCC stock for $15 a share (the per share price of PCC stock on January 1, 2016, when the options were granted). The options vested at the end of the day on December 31, 2016 (employees could not exercise options in 2016). What is PCC’s book-tax difference associated with the nonqualified options in 2016? Is the difference favorable or unfavorable? Is it permanent or temporary? Atef Abuelaish 16-47

Stock Option Example 1 Solution Answer: $100,000 unfavorable, temporary book-tax difference. PCC amortizes the compensation expense ratably over the vesting period (2016). PCC expenses $100,000 for book purposes in 2016 and reports a $0 compensation deduction for tax purposes (the options were not exercised). Atef Abuelaish 16-48

Stock Option Example 2 Assume the same facts in Example 1 and that on March 1, 2017, employees exercised all 20,000 options at a time when the PCC stock was trading at $20 per share. What is PCC’s book-tax difference associated with the stock options in 2017? Is it a permanent difference or a temporary difference? Is it favorable or unfavorable? Atef Abuelaish 16-49

Stock Option Example 2 Solution Answer: $100,000 favorable, temporary book-tax difference in 2017. The favorable book-tax difference is a complete reversal of the unfavorable book-tax difference in 2016. The 2016 and 2017 book-tax differences completely offset each other because the estimated value of $5 per option is equal to the bargain element ($20 FMV minus $15 exercise price per share). Atef Abuelaish 16-50

Stock Option Example 3 Assume that on March 1, 2017, employees exercised all 20,000 options at a time when the PCC stock was trading at $24 per share. What is PCC’s book-tax difference associated with the stock options in 2017? Is it a permanent difference or a temporary difference? Is it favorable or unfavorable? Atef Abuelaish 16-51

Stock Option Example 3 Solution Answer: $180,000 favorable book-tax difference in 2017. The $180,000 difference consists of a $100,000 favorable, temporary difference (the reversal of the prior year unfavorable, temporary difference) and an $80,000 permanent, favorable difference. The permanent difference is the bargain element on the 20,000 options in excess of the estimated value of the options for book purposes [($24 − $20) × 20,000 options]. Atef Abuelaish 16-52

Net Capital Losses No current deduction for net capital losses (capital losses in excess of capital gains) Carry back net capital losses three years and carry forward five years. Use carryover amounts on FIFO basis Unfavorable, temporary book-tax difference in year of net capital loss Favorable, temporary book-tax difference in year carryback or carryover is utilized Atef Abuelaish 16-53

Net Operating Loss Deduction No current benefit from current year loss (NOL) Carry NOL back two years and forward 20 to offset taxable income in those years May elect to forgo carry back Why would a corporation do this? Atef Abuelaish 16-54

Net Operating Loss Deduction To compute NOL for year no deduction for NOL carrybacks or carryovers from other years Capital loss carrybacks (carryovers are allowed) Atef Abuelaish 16-55

NOL Example XYZ Inc. has a net operating loss of $20,000 for the 2016 tax year. XYZ reported the following taxable income from 2013 through 2015: 2013: $10,000 2014: $17,000 2015: $8,000 What options does XYZ have with respect to the current year NOL? Atef Abuelaish 16-56

NOL Example Solution Could carry back $17,000 to 2014, then $3,000 to 2015. Immediate refund (file Form 1139) Or, could forgo carryback and carry loss forward 20 years Atef Abuelaish 16-57

Charitable Contributions Amount of deduction Capital gain property Generally fair market value Ordinary income property Generally adjusted basis Accrual method corporation Deduct when accrue if Approved by board of directors before year end Paid within 3 ½ months after end of year (beginning in 2016) Atef Abuelaish 16-58

Charitable Contributions Deduction limited to 10% of taxable income before deducting Any charitable contribution deduction The dividends received deduction (DRD) NOL carrybacks Domestic production activities deduction (DPAD) Capital loss carrybacks Carry forward excess contributions for five years Atef Abuelaish 16-59

Charitable Contribution Example In 2016, PCC donated a total of $700,000 of cash to the American Red Cross. PCC’s taxable income before the charitable contribution deduction, NOL carryover ($24,000), DRD ($21,000), and DPAD ($465,000) was $6,287,000. What is PCC’s charitable contribution deduction for the year? What is its charitable contribution carryover to next year, if any? Atef Abuelaish 16-60

Charitable Contribution Example Solution Atef Abuelaish 16-61

Dividends Received Deduction Deduction to mitigate more than two levels of tax Own less than 20%: 70% DRD Own at least 20% but less than 80%: 80% DRD Own 80% or more: 100% DRD Limitation: Deduction is limited to the lesser of (1) Dividend × DRD % or (2) DRD modified taxable income × DRD % Modified taxable income = taxable income before DRD, any NOL, DPAD, and capital loss carrybacks If full DRD extends or creates NOL, this limit does not apply Creates favorable, permanent book-tax difference Atef Abuelaish 16-62

Dividends Received Deduction Example Atef Abuelaish 16-63

Regular Tax Liability Marginal tax rates range from 15% to 39%. Larger corporations generally pay flat 34% or 35% rate Controlled groups Group of corporations treated as one for determining certain tax benefits Parent-Subsidiary Brother-Sister Combined Atef Abuelaish 16-64

Compliance Corporations report taxable income on Form 1120. Small corporations complete Schedule M-1 Large corporations complete Schedule M-3 Book-tax differences referred to as M adjustments Corporate returns are due 3½ months after the close of the tax year (June 30 year-end exception). Automatic six month extension for filing (10/15 for calendar year) Consolidated tax returns Affiliated groups essentially treated as one corporation Atef Abuelaish 16-65

Form 1120 Schedule M-1 Atef Abuelaish 16-66

Estimated Payments Corporations with a federal income tax liability of $500 or more are required to pay their estimated income tax in four monthly installments. Installments due on the 15th day of: 4th month (25% of required annual payment) 6th month (50% of required annual payment) 9th month (75% of required annual payment) 12th month (100% of required annual payment) Corporations may owe a penalty for underpayment Payments based on required annual payment Atef Abuelaish 16-67

Estimated Payments Required annual payment 100% of tax liability on prior year return Doesn’t apply if no liability in prior year 100% of current year tax liability 100% of estimated current year tax liability using annualized method Rules for large corporations $1,000,000 of taxable income in prior three years May use prior year liability for first quarter payment only Atef Abuelaish 16-68

Estimated Payments Atef Abuelaish 16-69

Estimated Payments Atef Abuelaish 16-70

Alternative Minimum Tax Tax paid in addition to regular tax liability Does not apply to small corporations Average annual gross receipts < $7.5 million for three years prior to current taxable year Once fail small corporation test, subject to AMT for all subsequent years Atef Abuelaish 16-71

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Gross AMT – Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Gross AMT – AMT Foreign Tax Credit = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Gross AMT – AMT Foreign Tax Credit = TMT – Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Gross AMT – AMT Foreign Tax Credit = TMT – Regular Tax = Atef Abuelaish

Alternative Minimum Tax Formula Taxable income (before NOL DED) + Preference Items +- Adjustments = Preadjustement AMT Income +- ACE Adjustment – NOL Deduction = AMTI - Exemption = AMT Base X 20% = Gross AMT – AMT Foreign Tax Credit = TMT – Regular Tax = AMT Atef Abuelaish

Alternative Minimum Tax Atef Abuelaish 16-87

Alternative Minimum Tax Preference items Added to taxable income to determine AMTI Tax exempt interest income from private activity bond (issued in years other than 2009 or 2010) Percentage depletion in excess of cost basis Others Atef Abuelaish 16-88

Alternative Minimum Tax Adjustments Depreciation Gain or loss on disposition of depreciable assets Adjusted current earnings adjustment (ACE) 75% of difference between AMTI and adjusted current earnings (or 75% of net amount of modifications) Adjusted current earnings determined by making modifications to AMTI Adjustment can be positive or negative in a given year Negative adjustment limited to cumulative positive prior adjustments Atef Abuelaish 16-89

Alternative Minimum Tax Atef Abuelaish 16-90

Adjusted Current Earnings Example Assume PCC did not receive any dividends and that it received $12,000 in interest from a San Diego bond that is not a private activity bond and the bond was not issued in 2009 or 2010. Further, assume that PCC reported $5,000 of organizational expenses this year and it reported $20,000 of gain this year from an installment sale it executed two years ago. Assuming PCC’s cumulative ACE adjustment as of the beginning of the year is $100,000, what is its current year ACE adjustment under these circumstances? Atef Abuelaish 16-91

Adjusted Current Earnings Example Solution Atef Abuelaish 16-92

AMT Exemption Full exemption is $40,000 Phased out by 25% of AMTI in excess of $150,000 Fully phased out when AMTI reaches $310,000 Atef Abuelaish 16-93

Alternative Minimum Tax AMTI × 20% = Tentative minimum tax AMT = Tentative minimum tax minus regular tax liability Minimum tax credit Amount of AMT creates credit Carry forward indefinitely When regular tax > Tentative minimum tax, credit can offset regular tax down to tentative minimum tax amount Atef Abuelaish 16-94

Minimum Tax Credit Example Assume that in year 1, PCC has a TMT of $1,152,690 and a regular tax liability of $1,000,000. PCC would owe $152,690 of AMT and $1,000,000 of regular tax. It would also generate a $152,690 minimum tax credit. Further, assume that in year 2 PCC reports a tentative minimum tax of $900,000 and a regular tax liability of $1,000,000. What is PCC’s tax liability after applying the minimum tax credit? Atef Abuelaish 16-95

Minimum Tax Credit Example Solution Atef Abuelaish 16-96

Happiness is having all homework up to date Homework assignment Using Connect – 6 Questions for 60 Points for Chapter 16. Complete the “Connect Orientation” at Connect web site for 5 points, before 03/26/2017. Prepare chapter 17 “Accounting for Income Taxes.” Happiness is having all homework up to date Atef Abuelaish

Break for 10 Minutes Atef Abuelaish