©2003 South-Western College Publishing, Cincinnati, Ohio Chapter 11 Corporate Income Tax

© 2003 South-Western College PublishingTransparency 11-2 Objective Understand the basic tax rules for the operation of a corporation

© 2003 South-Western College PublishingTransparency 11-3 Corporate Tax Rates rCorporate rates are progressive from 15% to 39% depending on taxable income rFor corporations with large income (> $ million) the rate is a flat 35%

© 2003 South-Western College PublishingTransparency 11-4 Personal Service Corporations rA corporation where the majority of the shareholder-employees are engaged in providing service is called a Personal Service Corporation. Personal services include <health care <law, engineering or architecture <accounting or consulting rTaxable income is taxed at a flat 35% rate

© 2003 South-Western College PublishingTransparency 11-5 Corporate Capital Gains rCorporation can chose from two alternative tax treatments on capital gains <taxed at ordinary rates, or <elect to pay an alternative tax (35%) on the net long-term capital gain rLaw basically taxes the income at the same rates; therefore, no difference in tax on the income rShort term capital gains considered ordinary income

© 2003 South-Western College PublishingTransparency 11-6 Corporate Capital Losses rOn corporate tax returns, capital losses may only be netted against capital gains <They are not allowed against ordinary income rCarry forward is allowed for five years, and carry back is allowed for three years

© 2003 South-Western College PublishingTransparency 11-7 Dividends Received Deduction rCorporations are allowed a deduction for a percentage of the dividends received from other corporations <Attempt to alleviate triple taxation rDividends received deduction is allowed Percent ownershipDRD percentage < 20%70% > 20% to < 80%80% > 80% 100% <Deduction limited to DRD % times taxable before DRD, NOL, and capital loss carrybacks. ÙLimitation does not apply if corporation has an NOL after subtracting the regular DRD %

© 2003 South-Western College PublishingTransparency 11-8 Amortization of Organizational Expenditures rExamples of organizational expenses <legal/accounting services <temporary director fees <incorporation fees rThese fees are capitalized and then amortized over sixty months if proper election made on initial tax return <If no election, then capitalize and do NOT amortize rExpenses involved in transferring assets to the corporation are not considered organizational expenses

© 2003 South-Western College PublishingTransparency 11-9 Corporate Charitable Contributions Deduction rCorporations are allowed a deduction for charitable contributions <Cash basis taxpayers can deduct when paid <Accrual basis taxpayers have until the 15th day of the third month following year-end to pay (as long as pledge is made by year end) rLimited to 10% of taxable income before any loss carry-backs or the Dividend Received Deduction <Any unused amounts may be carried-forward for five years

© 2003 South-Western College PublishingTransparency Reconciliation of Tax to Accounting Income rSchedule M-1 of Form 1120 reconciles book to tax income <Computed before NOLs and special deductions rAmounts added to book income <Federal tax expense <Capital losses <Income recorded on tax return but not on books <Expenses recorded on books but not on tax return rAmounts deducted from book income <Income recorded on books but not on tax return <Expenses recorded on tax return but not on books

© 2003 South-Western College PublishingTransparency Filing Requirements rRegular corporation files a Form 1120 rS Corporation files a Form 1120S rForm 1120-A, a short form tax return, may be used if the corporation has <total gross revenue less than $500,000 <total income less than $500,000 and <total assets less than $500,000 rReturns are due by the 15th day of the 3rd month after year-end

© 2003 South-Western College PublishingTransparency Objective Know how an S Corporation is taxed and the requirements for operating as an S Corporation

© 2003 South-Western College PublishingTransparency S Corporation rQualified small corporation may elect S status, if it <Is a domestic corporation <Has 75 or fewer shareholders ÙThey cannot be corporations or partnerships <Has only one class of stock <Has only shareholders that are US citizens or resident aliens

© 2003 South-Western College PublishingTransparency S Corporations (continued) rCorporation must make election of S status in a prior year or within 2-1/2 months of the current tax year rS Corp status stays in effect until revocation <S Corp status can be voluntarily revoked Ùvoluntary consent of shareholders <Or involuntarily revoked Ùif corporation ceases to qualify (e.g., 76 shareholders), or Ùif corporate passive income exceeds 25% for 3 consecutive years

© 2003 South-Western College PublishingTransparency Income Reporting rS Corporations do not pay tax themselves (generally), income flows through to each shareholder <Based upon shareholder’s % ownership <Each shareholder’s share of various items is included in shareholder’s tax return rLike a partnership, the S Corporation must file an informational return (Form 1120S)

© 2003 South-Western College PublishingTransparency Loss Reporting rEach shareholder of an S Corp can also report their respective share of losses <They cannot take a loss in excess of their adjusted basis in stock <If loss exceeds basis, shareholder can carry it forward rIf shareholder entered S Corp midyear, or departed midyear, must allocate on a daily basis

© 2003 South-Western College PublishingTransparency S Corporation Pass Through Items rMany items retain their “character” when they pass through to S Corp shareholders on each K-1 rExamples <Capital gains/losses <§1231 gains/losses <Charitable contributions <§179 deduction <Tax-exempt interest <Most credits

© 2003 South-Western College PublishingTransparency S Corp “Special Taxes” rS Corps may be subject to tax attributable to gains on assets that have appreciated prior to electing S Corp status rTax may also be imposed if passive investment income is “excessive”

© 2003 South-Western College PublishingTransparency Objective Understand the basic tax rules for the formation of a corporation

© 2003 South-Western College PublishingTransparency Corporate Formation rShareholders often transfers assets to a corporation in exchange for stock rNo tax is due on gain from transfer of appreciated assets, if: <All shareholders involved ÙTransfer property or cash solely in exchange for stock (not be providing a service), and ÙOwn at least 80% of stock after transaction

© 2003 South-Western College PublishingTransparency Basis rA shareholder’s initial basis is the same as the basis in the property transferred in exchange for the stock (a carry-over basis) <Unlike partnerships, liabilities do not affect shareholder basis rThe corporation has a carry-over basis in the property contributed equal to the basis in the hands of the shareholder

© 2003 South-Western College PublishingTransparency Objective Understand the operation of special corporation taxes

© 2003 South-Western College PublishingTransparency Accumulated Earnings Tax (AET) rPenalty tax designed to prevent a corporation from avoiding tax by retaining earnings rTax is imposed at 38.6% on “unreasonable” accumulation of earnings <Corporation may accumulate up to $250,000 a year ($150,000 for a service corporation) <May accumulate more if can prove a valid business purpose

© 2003 South-Western College PublishingTransparency Personal Holding Company Tax (PHCT) rPenalty tax designed to encourage Personal Holding Companies to distribute earnings to shareholders rTax is 38.6% on undistributed earnings rCorporation is not liable for both the PHCT and the AET in the same year

© 2003 South-Western College PublishingTransparency Corporate AMT rThe corporate AMT is calculated in a similar manner to the individual AMT rAMT is 20% of AMTI <AMTI = Taxable Income +/- adjustments + preferences - exemption $150,000 ÙPhase out =.25(AMTI - $150,000) rSmall corporations are not subject to the AMT <Defined as corporations with average annual gross receipts < $5 million over a three-year period

© 2003 South-Western College PublishingTransparency End of Chapter 11