Corporations, Partnerships, Copyright ©2010 Cengage Learning Chapter 3 Corporations: Special Situations Corporations, Partnerships, Estates & Trusts Copyright ©2010 Cengage Learning

Domestic Production Activities Deduction (slide 1 of 5) The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities The domestic production activities deduction (DPAD) is based on the following formula: 6% × Lesser of Qualified production activities income Taxable income (or modified AGI) or AMTI The deduction cannot exceed 50% of an employer’s W–2 wages properly allocable to domestic production gross receipts

Domestic Production Activities Deduction (slide 2 of 5) A phase-in provision increases the applicable rate for the production activities deduction as follows: Rate Years 3% 2005-2006 6% 2007-2009 9% 2010 and thereafter

Domestic Production Activities Deduction (slide 3 of 5) Eligible taxpayers include: Individuals, partnerships, S corporations, C corporations, cooperatives, estates, and trusts For a pass-through entity (e.g., partnerships, S corporations), the deduction flows through to the individual owners For sole proprietors, a deduction for AGI results For C corporations, the deduction is included with other expenses in computing corporate taxable income

Domestic Production Activities Deduction (slide 4 of 5) Qualified production activities income is the excess of domestic production gross receipts over: Cost of goods sold (CGS) Direct costs Allocable indirect costs

Domestic Production Activities Deduction (slide 5 of 5) Domestic production gross receipts (DPGR) include receipts from: Lease, rental, license, sale, exchange, or other disposition of qualified production property (QPP) that was manufactured, produced, grown, or extracted in the U.S. Qualified films largely created in the U.S. Production of electricity, natural gas, or potable water Construction performed in the U.S. Engineering and architectural services for domestic construction

Alternative Minimum Tax (slide 1 of 3) Designed to ensure that corporations with substantial economic income pay at least a minimum amount of federal taxes Essentially, a separate tax system with a quasi-flat tax rate applied to a corporation’s economic income

Alternative Minimum Tax (slide 2 of 3) If tentative alternative minimum tax > regular corporate income tax, corporation must pay regular tax plus the excess, the alternative minimum tax (AMT)

Alternative Minimum Tax (slide 3 of 3) For tax years beginning after 1997, many small corporations are not subject to AMT A small corporation has average annual gross receipts of $5 million or less for the preceding three-year period Small corporation continues to qualify as long as average gross receipts for the preceding three-year period do not exceed $7.5 million

AMT Formula for Corporations (slide 1 of 2) Regular Taxable Income Before NOL Deduction ± AMT Adjustments (except ACE adjustment) + Tax preferences = AMTI before AMT NOL deduction and ACE adjust. ± ACE adjustment = AMTI before AMT NOL – AMT NOL (limited to 90% of above amount) = Alternative minimum taxable income (AMTI)

AMT Formula for Corporations (slide 2 of 2) Alternative minimum taxable income (AMTI) – Exemption = Tentative minimum tax base × 20% rate = Tentative minimum tax before AMT foreign tax credit – AMT foreign tax credit = Tentative minimum tax – Regular tax liability before credits minus reg FTC = Alternative minimum tax (AMT) if positive

Adjustments for AMT (slide 1 of 2) A portion of depreciation on property placed in service after 1986 Difference between gain(loss) on sale of property for regular tax and AMT purposes Passive activity losses of certain closely held corporations and personal service corporations Mining exploration and development costs in excess of allowed AMT 10 year amortization

Adjustments for AMT (slide 2 of 2) Adjustments for AMT (cont’d): Difference between percentage of completion and completed contract income Amortization claimed on certified pollution control facilities Difference between installment gain and total gain on certain dealer sales A portion of the difference between “ACE” and unadjusted AMTI

Tax Preference Items Accelerated depreciation on real property in excess of straight-line for property placed in service before 1987 Tax-exempt interest on “private activity bonds” Percentage depletion in excess of the adjusted basis of property Certain intangible drilling costs for “integrated oil companies”

ACE Adjustment (slide 1 of 3) Ace adjustment = 75% of difference between unadjusted AMTI and ACE Can be positive or negative Negative adjustment is limited to aggregate positive adjustments less previous negative adjustments

ACE Adjustment (slide 2 of 3) Starting point for determining ACE is AMTI AMTI is defined as regular taxable income after AMT adjustments and tax preferences (other than the NOL and ACE adjustments)

ACE Adjustment (slide 3 of 3) AMTI is adjusted to arrive at ACE These adjustments include: Exclusion items—Income items that will never be included in regular taxable income or AMTI Disallowed items – e.g., dividends received deduction of 70% (less than 20% ownership) Other adjustments items including, for example, intangible drilling costs, circulation expenditures, organization expense amortization, LIFO inventory adjustments, installment sales, other items

Impact of Certain Transactions on ACE (slide 1 of 2)

Impact of Certain Transactions on ACE (slide 2 of 2)

Exemption Exemption amount for a corp = $40,000 Reduced by 25% of excess of AMTI over $150,000 Exemption is totally phased-out when AMTI reaches $310,000

Minimum Tax Credit (slide 1 of 2) AMT paid in one year can be used as a credit against future regular tax liability that exceeds its tentative minimum tax Indefinite carryforward Cannot be carried back Cannot offset any future minimum tax liability

Minimum Tax Credit (slide 2 of 2) Small corporations (no longer subject to AMT) with unused minimum tax credits after 1997 may use them against regular tax liability Limit = regular tax – [25% × (regular tax – $25,000)]

AMT Example (slide 1 of 4) Moreland Co. has the following income, etc. in 2009: Taxable income $100,000 Depreciation adjustment 18,000 Installment gain (not on inventory sale) 80,000 Federal income tax provision on financial stmts. 75,000 Penalties and fines 2,000 Private activity bond interest income 25,000 Other tax-exempt interest 20,000 The depreciation adjustment is an AMT adjustment and the private activity bond interest is a tax preference for AMTI.

AMT Example (slide 2 of 4) Calculation of AMTI before ACE: Taxable income $100,000 Plus: private activity bond income 25,000 Plus: depreciation adjustment 18,000 AMTI $143,000

AMT Example (slide 3 of 4) Calculation of ACE Adjustment: AMTI before ACE $143,000 Plus: deferred installment gain 80,000 Plus: other tax-exempt income 20,000 Adjusted current earnings $243,000 Less: AMTI 143,000 Base amount for Ace Adjustment $100,000 Times rate: 75% ACE Adjustment (positive) $75,000

AMT Example (slide 4 of 4) Calculation of AMT: AMTI before ACE $143,000 Plus: ACE Adjustment 75,000 AMTI $218,000 Less: Exemption 23,000 Tentative minimum tax base $195,000 20% rate × 20% Tentative minimum tax $ 39,000 Less: regular tax (22,250) AMT(TMT-Regular tax) $ 16,750 Total cash paid = Regular tax + AMT = $ 39,000

Accumulated Earnings Tax (slide 1 of 5) Penalty tax designed to discourage the retention of corporate earnings unrelated to the business needs of the company

Accumulated Earnings Tax (slide 2 of 5) Tax of 15% is imposed on accumulated taxable income (ATI), determined as follows: ATI = Taxable income ± Adjustments - Dividends paid - Accumulated earnings credit Adjustments to taxable income generally pertain to a corporation’s ability to pay a dividend Thus, deductions include the corporate income tax and excess charitable contributions, while additions include the NOL and dividends received deductions

Accumulated Earnings Tax (slide 3 of 5) An accumulated earnings credit is allowed even when accumulations are beyond reasonable business needs

Accumulated Earnings Tax (slide 4 of 5) The accumulated earnings credit is the greater of: Current E&P needed to meet “reasonable needs” of the business, or Amount by which $250,000 ($150,000 for service companies) exceeds Accumulated E&P as of close of preceding tax year (the minimum credit)

Accumulated Earnings Tax - Reasonable Needs Of The Business (slide 5 of 5) Legitimate reasons Business expansion Capital asset replacement Working capital needs Product liability loss Loans to suppliers or customers Invalid Reasons Loans to shareholders Unrealistic contingencies Investment in unrelated business assets

Personal Holding Company Tax Personal Holding Company (PHC) tax is designed to discourage sheltering of certain types of passive income in corporations Like the accumulated earnings tax, the purpose is to force the distribution of corporate earnings to shareholders

Definition of PHC A company is a PHC if: More than 50% of the value of stock is owned by 5 or fewer individuals during the last half of the year Broad constructive ownership rules apply in determining stock ownership 60% or more of gross income (as adjusted) must consist of personal holding company income (PHCI) Examples are dividends, interest, rents, royalties, or certain personal service income Rents or royalties may be excluded if they are significant in amount (i.e., comprise more than 50% of the adjusted gross income)

Calculation of PHC Tax Once classified as a PHC, the tax base must be calculated Penalty tax rate = 15% Tax base is undistributed Personal Holding Company income (UPHC income) Amount is taxable income plus or minus certain adjustments, minus the dividends paid deduction

Dividends Paid Dividend payments reduce both ATI and undistributed PHCI As these are the bases on which the § 531 tax or the § 541 tax is imposed, either tax can be completely avoided by paying sufficient dividends

Dr. Donald R. Trippeer, CPA If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr @oneonta.edu SUNY Oneonta