3-1 ©2008 Prentice Hall, Inc.

3-2 ©2008 Prentice Hall, Inc. THE CORPORATE INCOME TAX (1 of 2)  Corporate elections  Computing corporation’s taxable income  Computing a corporation’s income tax liability

3-3 ©2008 Prentice Hall, Inc. THE CORPORATE INCOME TAX (2 of 2)  Controlled groups of corporations  Tax planning considerations  Compliance and procedural considerations  Financial statement implications

3-4 ©2008 Prentice Hall, Inc. Corporate Elections Tax Year (1 of 2)  New corp elects tax year by filing return  First return may be for short-period  Some corporations restricted  S-corporation uses calendar year  Affiliated group member must be same as parent  PSCs usually calendar year

3-5 ©2008 Prentice Hall, Inc. Corporate Elections Tax Year (2 of 2)  Changing the tax year  Usually requires IRS approval  Automatic approval if  Annualizes short-period income  Keeps books based on new year  Short period does not have a NOL  No change in accounting period for 48 mo  No interest in flow-through entities  Not a specialized corporation

3-6 ©2008 Prentice Hall, Inc. Corporate Elections Accounting Methods  Accrual  GAAP: generally required for C corps  Cash  Qualified PSC, or C corp w/ gross receipts < $5M  Inventories cannot be significant  If inventories significant, must use accrual method for sales, COGS, inventories, accts. rec., & accts. pay. (the hybrid method)  Family farm w/ gross receipts < $25M

3-7 ©2008 Prentice Hall, Inc. Computing a Corporation’s Taxable Income  Sales and exchanges of property  Business expenses  Special deductions  Exceptions for closely held corporations

3-8 ©2008 Prentice Hall, Inc. Sales and Exchanges of Property Capital Gains and Losses  Net capital gain taxed at ordinary income rates  Net capital losses cannot offset ordinary income  Net capital losses  Carryback 3 years and forward 5 years  Carryovers classified as short-term  Expired losses are lost forever

3-9 ©2008 Prentice Hall, Inc. Sales and Exchanges of Property §291 Tax Benefit Recapture Rule  §1250 property sold at a gain  Amount of depreciation in excess of straight line is characterized as ordinary income plus  An additional 20% of all depreciation characterized as ordinary income under §291

3-10 ©2008 Prentice Hall, Inc. Business Expenses  General rule  Organizational expenditures  Start-up expenditures  Limitations on deductions for accrued compensation  Charitable contributions

3-11 ©2008 Prentice Hall, Inc. General Rule  All ordinary and necessary expenses reasonable in amount  No deductions for  Interest on loans to buy tax exempts  Illegal bribes or kickbacks  Fines or penalties  Insurance premiums if corp is beneficiary

3-12 ©2008 Prentice Hall, Inc. Organizational Costs (1 of 2)  Expenses incident to creating corp  §248 election filed w/ first tax return  May expense first $5K of org costs  $5K reduced $ for $ when org costs > $50K  Amortize remainder over  180 months

3-13 ©2008 Prentice Hall, Inc. Organizational Costs (2 of 2)  Expenditures must be incurred before end of first year of business  Failure to file election  Capitalize with no amortization

3-14 ©2008 Prentice Hall, Inc. Start-up Expenditures (1 of 3)  Non-organizational  Ordinary and necessary expenses  Paid or incurred BEFORE the actual start of business operations

3-15 ©2008 Prentice Hall, Inc. Start-up Expenditures (2 of 3)  Examples of include expenses to:  Investigate creation or acquisition of an active trade or business  Create an active trade or business  Conduct an activity engaged in for profit or production of income before business operations begin

3-16 ©2008 Prentice Hall, Inc. Start-up Expenditures (3 of 3)  Election to expense first $5K of org costs  $5K reduced $ for $ when org costs > $50K  Remainder amortized over  180 months Election must be made by due date for filing tax return for first year of operation or ownership  Failure to file election  Capitalize with no amortization

3-17 ©2008 Prentice Hall, Inc. Limitation on Deductions for Accrued Compensation  Accrued bonuses/compensation must be paid within 2-1/2 months after close of tax year  If paid after 2-1/2 months, payment deemed deferred compensation and is deductible in year paid

3-18 ©2008 Prentice Hall, Inc. Charitable Contributions (1 of 4)  Timing of deduction  Deducted in the year paid  Accrual basis corps may elect to include payment made w/in 2-1/2 months following the end of tax year  Board of directors must have authorized contribution during year it was accrued  Must meet substantiation requirements to deduct contribution

3-19 ©2008 Prentice Hall, Inc. Charitable Contributions (2 of 4)  Donated money  Deduction equals amount donated  Non-cash property  Amount USUALLY equal to FMV of property donated  Ordinary income property  Deduction limited to FMV less Ord Inc or STCG that would have been recognized if property were sold (includes recapture)

3-20 ©2008 Prentice Hall, Inc. Charitable Contributions (3 of 4)  Non-cash property (continued)  Certain inventory related to exempt function  Deduction = adjusted basis + 1/2 gain  Similar rule for computer technology donated for educational purposes

3-21 ©2008 Prentice Hall, Inc. Charitable Contributions (4 of 4)  Max deduction is 10% of “adjusted taxable income” (ATI)  ATI is taxable income before NOL carryback, capital loss carryback, dividend received deduction or charitable contribution  Excess carried forward for 5 yrs  Creates a deferred tax asset

3-22 ©2008 Prentice Hall, Inc. Special Deductions  U.S. Production activities deduction  Dividends-received deduction  Net operating losses  Sequencing of the deduction calculations

3-23 ©2008 Prentice Hall, Inc. U.S. Production Activities Deduction (1 of 3)  Deduction is lesser of a % times  Qualified production activities income OR  Taxable income before the U.S. production activities deduction  Phased-in percentages  6% for  9% for 2010 and thereafter

3-24 ©2008 Prentice Hall, Inc. U.S. Production Activities Deduction (2 of 3)  Qualified production activities income  Domestic production gross receipts from lease, rental, sale, or exchange, of tangible property manufactured in the U.S. LESS  Expenses related to qualified income including CoGS, & indirect allocable expenses

3-25 ©2008 Prentice Hall, Inc. U.S. Production Activities Deduction (3 of 3)  Deduction limited to 50% of W-2 wages  Not an expense for financial accounting  Creates a permanent difference

3-26 ©2008 Prentice Hall, Inc. Dividends Received Deduction (1 of 2)  Corps owning < 20% of a domestic corporation deduct lesser of  70% of Dividends Received or  70% of taxable income before NOL, capital loss carryback or DRD  Exception to taxable income limitation  If 70% of dividend received creates an NOL, then the full DRD is deductible

3-27 ©2008 Prentice Hall, Inc. Dividends Received Deduction (2 of 3)  Corps owning  20% and < 80% of a domestic corp  80% deduction instead of 70%  Corps owning  80% of domestic corp  Member of affiliated group  100% deduction

3-28 ©2008 Prentice Hall, Inc. Dividends Received Deduction (3 of 3)  No deduction is allowed if :  Paying corp is a foreign corp  Stock purchased w/borrowed money  Stock of paying corp held for < 46 days  Results in a permanent difference  Affects effective tax rate, but not deferred taxes

3-29 ©2008 Prentice Hall, Inc. Net Operating Losses (NOL)  Deductions exceed gross income for the year before NOL carrybacks  NOL may be carried back 2 yrs & then forward 20 yrs  Corp may elect to forgo carryback & only carry NOL forward 20 yrs  Creates a deferred tax asset

3-30 ©2008 Prentice Hall, Inc. Sequencing of the Deduction Calculations  Charitable contributions, DRD, NOL, and all other deductions must be taken in the following order  1. All other deductions  2. Charitable contributions  3. DRD  4. NOL  5. U.S. production activities deduction

3-31 ©2008 Prentice Hall, Inc. Exceptions for Closely-Held Corporations (1 of 3)  Special rules apply to shareholders who own >50% of corp  §1239 sale of depreciable property to corp causes gain to be ordinary income to the controlling shareholder  §267 disallows loss on sale of property by corp to controlling shareholder  Loss may be recovered by shareholder if later sells prop at a gain

3-32 ©2008 Prentice Hall, Inc. Exceptions for Closely-Held Corporations (2 of 3)  Special rules apply to shareholder who own >50% of corp (continued)  Corporation and shareholder using different accounting methods  Defers deduction for accrued expenses owed by accrual-method corp to cash- method controlling shareholder until income recognized by cash-method shareholder

3-33 ©2008 Prentice Hall, Inc. Exceptions for Closely-Held Corporations (3 of 3)  Loss limitation rules  If 5 or fewer s/hs own > 50% of the stock, the corp’s losses are limited to amount corp has “at risk”  Losses not currently deductible are carried over to be used in a later year  May also be subject to passive activity rules  PSCs and closely held corps subject to passive activity limitation rules

3-34 ©2008 Prentice Hall, Inc. Computing a Corporation’s Income Tax Liability  General rules  Regular income tax formula  Personal service companies

3-35 ©2008 Prentice Hall, Inc. General Rules  The tax rates are graduated  Rate surcharges eliminate benefit of lower graduated tax rates from lower income brackets  Corps with income >$18.33M pay a flat 35% on all income

3-36 ©2008 Prentice Hall, Inc. Regular Tax Formula (1 of 3) Gross Income -Deductions and Losses -Special Deductions =Taxable Income xAppropriate Rate (or rates) =Regular Tax Liability before credits

3-37 ©2008 Prentice Hall, Inc. Regular Tax Formula (2 of 3) Regular Tax Liability before credits -Foreign tax credit -Other Credits +Credit recapture =Regular tax liability

3-38 ©2008 Prentice Hall, Inc. Regular Tax Formula (3 of 3) Regular Tax Liability +AMT Liability +Special Taxes (if any) -Estimated Payments =Refund or tax due

3-39 ©2008 Prentice Hall, Inc. Personal Service Corporations (1 of 2)  PSCs taxed at a flat 35%  PSC is defined as a corp that:  Substantially all of the activities involve services in the following fields:  Health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting

3-40 ©2008 Prentice Hall, Inc. Personal Service Corporations (2 of 2)  Substantially all stock must be owned by employees, former employees or survivors of employees

3-41 ©2008 Prentice Hall, Inc. Controlled Groups  Why special rules are needed  What is a controlled group?  Special rules applying to controlled groups  Consolidated tax returns

3-42 ©2008 Prentice Hall, Inc. Why Special Rules are Needed  Prevent shareholders from using multiple corporations to avoid having income taxed at 35%  Each corporation would be able to take advantage of lower graduated rates  Lower graduated rates must be spread among all corporations in a controlled group

3-43 ©2008 Prentice Hall, Inc. What Is a Controlled Group?  Two or more corps owned directly or indirectly by same shareholder or group of shareholders  Types of controlled groups  Parent-subsidiary  Brother-sister  Combined

3-44 ©2008 Prentice Hall, Inc. Parent-Subsidiary Controlled Group  One corp directly owns at least:  80% of voting power of all classes of voting stock OR  80% of total value of all classes of stock of subsidiary corporation

3-45 ©2008 Prentice Hall, Inc. Brother-Sister Controlled Group  80%-50% definition  Five or fewer individuals, trusts or estates own:  At least 80% of voting power or at least 80% of value of stock of two or more corporations AND  > 50% of the voting power or value is held by identical owners  50%-only definition is 2 nd test above

3-46 ©2008 Prentice Hall, Inc. Combined Controlled Groups  Three or more corps which meet the following criteria:  Each corporation is a member of a parent-subsidiary or brother-sister group  At least one is both a parent and a member of a brother-sister group

3-47 ©2008 Prentice Hall, Inc. Special Rules Applying to Controlled Groups (1 of 2)  Benefits allocated among members  5% and 3% surcharge  50%-only test for brother-sister groups  $40,000 AMT exemption amount  50%-only test for brother-sister groups  The $250,000 minimum accumulated earnings credit  50%-only test for brother-sister groups

3-48 ©2008 Prentice Hall, Inc. S pecial Rules Applying to Controlled Groups (2 of 2)  Benefits allocated (continued)  $112,000 §179 expense amount  80%-50% test for brother-sister groups  The $25,000 general business credit limitation  80%-50% test for brother-sister groups  No loss on sale of assets between members

3-49 ©2008 Prentice Hall, Inc. Consolidated Tax Returns  Affiliated groups  Advantages of filing a consolidated return  Disadvantages of filing a consolidated return

3-50 ©2008 Prentice Hall, Inc. Affiliated Groups (1 of 2)  One or more chains of includible corps connected through stock ownership to a common parent  Common parent directly owns  80% of voting power & value of at least one includible corporation

3-51 ©2008 Prentice Hall, Inc. Affiliated Groups (2 of 2)  Each corp owned at least 80/80 by another member of the group  An affiliated group MAY file a consolidated return  Capital losses offset capital gains from other group members  Operating losses reduce operating income from other group members

3-52 ©2008 Prentice Hall, Inc. Consolidated Return Advantages  Losses of one member offset gains of another member  Capital losses of one member offset capital gains of another member  Gains from intercompany transactions deferred until sale outside the group

3-53 ©2008 Prentice Hall, Inc. Consolidated Return Disadvantages  Election binding on all subsequent tax years  Unless IRS grants permission otherwise  Losses from intercompany transactions deferred until sale outside the group  Additional administrative costs

3-54 ©2008 Prentice Hall, Inc. Tax Planning Considerations  Compensation planning for shareholder-employees  Special election to allocate reduced tax rate benefits  Using NOL carryovers and carrybacks

3-55 ©2008 Prentice Hall, Inc. Compensation Planning  Salary payments  Reduce double taxation if paid to shareholder-employees  Fringe benefits  Deducted by corporation and certain benefits are not be taxable to shareholder-employee

3-56 ©2008 Prentice Hall, Inc. Allocating Reduced Tax Rate Benefits  A controlled group may apportion lower tax rates in any manner to member corporations  Reduce benefits to members with little or no income  Increase benefits to members with the highest income

3-57 ©2008 Prentice Hall, Inc. Using NOL Carryovers and Carrybacks  Two options  Carryback to 2 nd previous year, then 1 st previous year, then forward  Forgo the carrybacks and carry forward  Examine marginal tax rates in prior years and expected marginal tax rates in future years to maximize tax benefit

3-58 ©2008 Prentice Hall, Inc. Compliance Procedure Estimated Taxes  Estimated taxes required if corp owes >$500 for current year.  Pay in four installments  Each installment 25% of annual liability  Underpayment of estimated tax penalty  Small corps exempt from penalty if  Pay in lesser of 100% of prior or current year’s tax liability

3-59 ©2008 Prentice Hall, Inc. Compliance Procedure Filing Requirements  Return is required each year regardless of income  Use form 1120  Use form 1120A if gross receipts, total income & total assets each < $500K  Large corps (assets>$10M) must fill out more detailed schedule M-3

3-60 ©2008 Prentice Hall, Inc. Financial Statement Implications  Scope, objectives, & principles of SFAS No. 109  Temporary differences  Deferred tax assets and the valuation allowance  Balance sheet classification  Tax provision process

3-61 ©2008 Prentice Hall, Inc. Scope, Objectives, & Principles of SFAS No. 109 (Scope)  Establishes principles of accounting for current and deferred taxes  Arising from temporary and permanent differences

3-62 ©2008 Prentice Hall, Inc. Scope, Objectives, & Principles of SFAS No. 109 (Principles)  Addresses financial statement consequences of  Rev, exp, gains/losses recognized in different years for tax and financial statement purposes  Events affecting book/tax differences in bases of assets and liabilities  Loss & credit carrybacks or carryforwards

3-63 ©2008 Prentice Hall, Inc. Scope, Objectives, & Principles of SFAS No. 109 (Objectives)  Recognize current yr taxes payable or refundable  Recognize deferred tax liabilities and assets for future tax consequences of events on fin stmts or tax return

3-64 ©2008 Prentice Hall, Inc. Temporary Differences (1 of 2)  Deferred tax liabilities occur when  Rev/gains recognized earlier for book than tax  Exp/losses deducted earlier for tax than book  Tax basis of asset < book basis  Tax basis of liability > book basis

3-65 ©2008 Prentice Hall, Inc. Temporary Differences (2 of 2)  Deferred tax assets occur when  Rev/gains recognized earlier for tax than book  Exp/losses deducted earlier for book than tax  Tax basis of asset > book basis  Tax basis of liability < book basis  Loss/credit carryforwards exist

3-66 ©2008 Prentice Hall, Inc. Deferred Tax Assets and the Valuation Allowance  Deferred tax asset  Firm will realize tax benefit of event in the future  Valuation allowance used for portion of benefit not likely to be realized  Use “more likely than not” standard

3-67 ©2008 Prentice Hall, Inc. Balance Sheet Classification  Classify as current or noncurrent  If related to another asset or liability use classification of related asset/liab  Net current assets and liabilities  Net noncurrent assets and liabilities

3-68 ©2008 Prentice Hall, Inc. Tax Provision Process (1 of 2) 1. Determine pretax book income (PBI) 2. Identify perm diff, temp diff, & CF 3. Adjust PBI for perm differences 4. Step 3 amount x current tax rate 5. Adjust step 3 for temp diff to get tax income or NOL

3-69 ©2008 Prentice Hall, Inc. Tax Provision Process (2 of 2) 6. Step 5 x current rate to get tax liability or NOL benefit 7. Calculate def tax liab/asset by using current rate 8. Adjust def tax assets by valuation allowance if necessary

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 3-70 ©2008 Prentice Hall, Inc.