Chapter 2: The Corporate Income Tax 406 Ch02.PPTX Chapter 2: The Corporate Income Tax “C” Corporation is a regular corporation subject to laws in subchapter C of the Internal Revenue Code. Tax year must = financial accounting year. Fiscal year end is allowed. Elect on 1st return. text p 2-10 Exception: Special rules for Personal Service Corporations. See slide 21. Taxable entity. - File form 1120, due 3 1/2 months after year end. p 2-25 (Automatic 6 month extension if form 7004 is filed.) See pp 2-31 to 39 for filled in form 1120 example. 1

The Corporate Income Tax Accounting methods: Law change for 2018! - Old law: Accrual method required unless: text p 2-11 Average annual gross receipts < $5 million (Use 3 year average for test). or Farming or Personal Service Corporation (PSC) See later slide - New law: Same as above except the 3 year test is expanded to < $25 million. - New law: $25 million test also used to exempt taxpayers from using Uniform Capitalization rules for inventory and from using percentage of completion method for contracts. - New law: Amounts for accrual taxpayers must be included in taxable income no later than when they are included in income on their financial statements. 2

The Corporate Income Tax Double Taxation: Dividend distributions from profits taxed to corporation are also taxable to owners. - Individual shareholders maximum dividend tax rate = 20%, 15%, or 0% depending on marginal tax bracket. - Distribution of appreciated assets taxable to corporation and again to owners. Estimated Tax Payments required by the15th day of 4th , 6th , 9th and 12th months text p 2-25 - Penalty (form 2220)unless quarterly payments made equal to: (1/4)(Tax on last year tax return) or (1/4)(Tax on this year tax return) or (1/4)(Tax computed quarterly using annualized method) or Special seasonal method - Large corporations, ($1 million of taxable income in any of 3 preceeding years) must pay 100% of this year’s liability although 1st Quarter may be based on prior year. 3

VARIATIONS FROM INDIVIDUAL TAXATION Capital gains/losses text p. 2-11, 41 - Taxed at regular rates. No maximum rate. - Losses netted against gains only. No excess loss deductible. - Excess loss carried back 3 years, forward 5. Only used to offset gains in those years. Additional depreciation recapture - § 291 (only applies to C corporations) text p. 2-12 - Reclassifies §1231 gain to ordinary income on real estate gains. - Equals unrecaptured §1250 depreciation x 20% (§1245 calculation* - §1250 calculation**)(.2) * 1245 recap = lesser of gain OR Accumulated depreciation ** 1250 recap = lesser of gain OR Actual accumulated depreciation in excess of Straight line depreciation 4

Example: §291 depreciation recapture Facts: Office building sold. SL depreciation under MACRS used. Sale proceeds $2,000,000 Cost $2,500,000 SL Depreciation - 600,000 -1,900,000 Gain 100,000 How much gain is §1231? How much is recapture? §1250 recapture = If §1245 applied, recapture = §291 recapture = balance of is §1231 5

VARIATIONS FROM INDIVIDUAL TAXATION Charitable contributions text p 2-14, 40 - Limited to 10% of taxable income computed without regard to deductions for charity, dividends received deduction, DPAD, NOL carrybacks and capital loss carrybacks. - 5 year carry forward. Always use current contributions first, then apply FIFO. - Accrual basis allowed if BOD authorizes and paid within 3 1/2 months of year end, and election to deduct is made. - Special additional deduction for ordinary income property = 50% of appreciation (up to 2 times basis). Must be used for needy, ill, infants or college research. Same rules apply as individuals regarding FMV of property and reductions of deduction. See text for refresher. 6

Example: Charitable contribution income limit Facts: Gross profit $500,000 Dividend received 100,000 Operating expenses - 200,000 $400,000 Charitable contribution = $50,000. How much deductible? 7

Example: Property contributions – 405 refresher Konk Inc. donated items which each have a cost basis of $5k and had FMV of $100k. How much is deductible for each of the following? Land owned 20 years to a church. Painting (non depreciable) owned 20 years to a church. Painting (non depreciable) owned 20 years to an art museum. Stock investment owned 20 years to a church. Painting owned 6 months to an art museum. Inventory owned 2 years to an art museum. Inventory of medical supplies to a church used in mission work. Computer system to a church. They used it in their exempt purpose. Original cost was $100k. MACRS was $95k. Building to a church. They did not use it in exempt purpose. Original cost was $105k. SL depreciation was used. Accum = $100k. 8

VARIATIONS FROM INDIVIDUAL TAXATION Passive Activity Losses (PAL) text p 2-13 - If a PSC, rules are same as individuals (PAL only offsets passive income) - If Closely held (>50% stock owned by 5 or fewer shareholders) PAL can offset NON-PASSIVE but not portfolio income. - No limits on other C corporations Domestic Production Activities Deduction (DPAD) Law change for 2018! - Old Law: Same as individuals. text p 2-16, 3-2 to 3-10 - New Law: Repealed. Net Operating Losses (NOL) text p 2-16, 41 - Old Law: Carry over Back 2 years, forward 20, elect forward only. - New Law: Carryforward only. 9

VARIATIONS FROM INDIVIDUAL TAXATION Dividends Received Deduction (DRD) text p 2-17 Congress will double tax income of corporate owners (slide 2) but feels triple or more is too much. DRD mitigates this. - Not allowed for: - Stock owned <46 days during 90 day period spanning date of record p 2-19 - Debt financed stock - Foreign dividends (unless US taxes corp) - Deduction is - Old law: 70% of dividend if < 20% stock owned - Old law: 80% if 20% to < 80% stock owned - 100% if 80% or more stock owned - Exception: Limit DRD to above % times Taxable income computed without regard to DRD, NOL& CL carrybacks. - Exception to Exception: Limit N/A if NOL is created or increased by DRD. Law change for 2018! Change 70% to 50% and 80% to 65%. 10

Form 1120 page 2 11

Example: DRD Facts: Gross profit $500,000 Dividend received 100,000 Operating expenses - 200,000 Charity - 40,000 Taxable income before DRD $360,000 Assume < 20% stock owned. DRD? DRD is lesser or = $ . Taxable income = New law result: TI = What if gross profit = $200,000. Taxable income? Charity = ( + - )(.1) = ( )(.1) = DRD lesser of , or = New law: DRD = lesser of or = $ Taxable income = 12

Example: DRD Facts: Gross profit $500,000 Dividend received 100,000 Operating expenses - 200,000 Charity - 40,000 Taxable income before DRD $360,000 Assume < 20% stock owned. DRD? What if gross profit = $150,000. Taxable income? Charity = ( )(.1) = ( )(.1) = DRD lesser of or however since DRD = 70k. Taxable income = New law: DRD = lesser of ($ )(50%) or )(50%) = , however, <0, DRD = 13

VARIATIONS FROM INDIVIDUAL TAXATION Section 248 - Organization expenses text p 2-19 - Cost to form corporation, partnership or LLC. Legal, filing and other fees but NOT stock issue costs. - If capitalized, then no amortizing. If amortized on return, election is deemed automatically made. - Election allows first $5,000 as a deduction. - Balance is amortized over 180 months. Phase out $5,000 dollar-for-dollar as total costs exceed $50,000 - Deductions allowed in year business starts. Cost must be incurred in 1st year. If not, no amortization. Section 195 – Start-up expenses text p 2-21 - Pre-opening ordinary business expenses Marketing, training, HR, rent, etc - Similar $5,000 and phase-out as §248 costs 14

VARIATIONS FROM INDIVIDUAL TAXATION §267 - Related party rules text p 2-11 - More than 50% shareholder is a related party. - Attribution (see p 6-5) rules add indirect ownership shares from certain relatives and controlled entities. - Deduct accrued expenses in year paid if related party uses the cash basis method. Typically, deduction deferred until next year. - Loss not allowed on sale between related parties. - Deferred loss can be used to offset later gain. § 1239 not in text reclassifies capital gain as ordinary on sale of property which is depreciable in related parties hands. 15

VARIATIONS FROM INDIVIDUAL TAXATION Deferred Compensation Rules not in text - Accrued wage items must be paid within 2 1/2 months after year end to deduct. Otherwise, cash method required. Similar to related party accruals but applies to all employees. Applies to accrued regular wages, bonuses, vacation pay, etc - Rules don’t apply to qualified pension plan contributions. Reminder from Tax I, all accrual method taxpayers: - Can’t deduct reserves or allowances for expenses due to Economic Performance rule For example, only write off specific bad debts, actual warranty costs, etc 16

VARIATIONS FROM INDIVIDUAL TAXATION Law change in 2018 for all businesses Interest expense - Interest expense business deduction limited to 30% of “Adjusted taxable income”. Adjusted taxable income is basically net business income before interest, depreciation and amortization. - Rules not applicable if annual average gross receipts over last 3 years < $25 million. - Indefinite carry forward of excess interest. Law change in 2018 for all businesses Some business deductions discussed in Tax I are disallowed or modified starting in 2018 (or later for some). For example, entertainment, employer provided meals, non-cash employee achievement awards, R&D must be amortized, all lobbying expenses, bonus, §179 deduction, car depreciation increased 17

CALCULATING CORPORATE TAXABLE INCOME Tax Formula simpler than 1040 (See 1120 later slide) - No AGI or itemized vs standard or exemptions. Order by which the deduction limitations are calculated. Deduct: All deductions other than charity, DRD, NOL & DPAD. Charitable contributions. ** DRD. NOL. DPAD. ** NOL carryforward does reduce charity limit though. 18

CALCULATING CORPORATE TAXABLE INCOME Law change for 2018! Tax brackets p 2-4 - Old Law: - New Law: 21% flat rate 19

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Book to Tax reconciliation (schedule M-1) Highly tested on CPA exam. Left side: ↑Increases to book income to arrive at taxable income Claim more income or less expense on tax than on books. Right side: ↓Decreases to book income to arrive at taxable income Claim less income or more expense on tax than on books. Note line 10 is taxable income before special deductions Schedule M-2 = statement of retained earnings 22

Example: M-1 adjustments Indicate which side and amount of adjustment on schedule M-1. Consider each of these items on the books independently. Tax expense includes $500,000 of federal income tax. Interest income of $12,000 includes $1,000 from tax exempt muni bonds. Depreciation on books is $11,000. Tax return has $15,000. Income shows a net investment (capital) loss of $2,000. Insurance expense of $50,000 includes life insurance premiums of $2,500 (not deductible). Charity expense is $50,000. Amount deductible due to the 10% limitation is $48,400. Meals and entertainment expenses totaled $30,000. 50% of these are deductible. Penalty assessed by the EPA of $10,000 was recorded as a miscellaneous expense. This is not deductible. continued 23

Example: M-1 adjustments - continued Accrued wage bonuses of $300,000 were all paid in the first month of next year. Of these, $20,000 were paid to the sole shareholder. Accrued vacation pay of $40,000 was recorded. All of the vacations will be taken in the summer months (6 months after year end.) None relate to the sole shareholder. Similar amounts of vacation pay as #10 were recorded last year. DPAD deducted was 9% of US manufacturing income. The deduction was $58,000. Dividends totaling $10,000 received qualified for the 70% DRD. Net capital gains this year were $16,000. There is also an unused capital loss carry forward from last year of $2,000. Equipment was sold for $50,000 which had a book value of $15,000. The tax basis was $2,000. Bad debt expense was recorded as $35,000. The allowance account had a beginning balance of $40,000 and ending balance of $45,000. Specific accounts written off totaled $30,000. 24

SPECIAL CLASSIFICATION for some Corporations Personal Service Corporation (PSC) text p. 2-10, 42 - Old law: Undesirable classification. Flat 35% rate, other harsher rules. New law in 2018: flat 21%, same as other corporations. - C corporation with “service” type of business. law, health, consult, etc - More than 10% of stock owned by employees. - Generally cash basis OK, fiscal year end must have business purpose or minimum deferral potential. Controlled (related) Corporate Group text p. 2-24 - Multiple corps owned by the same shareholders. - Oftentimes undesirable since group gets one set of rates. Allocate brackets equally or elect different scheme. - Other items only allowed for the “group”. - Sometimes desirable since consolidated tax return allowed. 25