1. Copyright © 2016 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13 Corporate Formations and Operations

2. 222 Learning Objectives 1. Compute the tax consequences of transactions in which shareholders transfer property or services to corporations in exchange for stock of the corporation. 2. Describe the corporate income tax formula, compare and contrast the corporate tax formula to the individual tax formula, and discuss tax considerations relating to corporations’ accounting periods and accounting methods

3. 333 Learning Objectives 3. Identify common book-tax differences, distinguish between permanent and temporary differences, and compute a corporation’s taxable income and regular tax liability 4. Describe a corporation’s tax return reporting and estimated tax payment obligations 5. Calculate a corporation’s alternative minimum tax liability

4. 4 §351 facilitates corporate formations by providing for gain and loss deferral on property transfers that meet its requirements. §351 contemplates a transfer of property by a person or persons who maintain a “continuity of proprietary interest” in the assets transferred (through stock ownership in the corporation now holding the assets). Tax-Deferred Transfers of Property to a Corporation

5. 555 Section 351 Tax Deferral Requirements Transfer of property to the corporation (not services) In exchange for stock of the corporation Receipt of boot will cause the transferor to recognize gain, but not loss, realized on the exchange Boot is nonqualifying property received by the shareholder Transferor(s) of property must be in control, in aggregate, of the corporation immediately after the transfer Control = Ownership of 80 percent or more of the corporation’s voting stock and each class of nonvoting stock Tax-Deferred Transfers of Property to a Corporation

6. 666 Tax consequences when a shareholder receives other property (boot) A shareholder recognizes gain (but not loss) in an amount not to exceed the lesser of Gain realized or The fair market value of the boot received Gain is determined on an asset by asset basis Boot in a §351 transaction must be allocated to the property exchanged on a pro rata basis using the relative fair market values of the properties. Tax-Deferred Transfers of Property to a Corporation

7. 7 The character of gain recognized depends on the nature of the asset transferred on which gain is recognized. Capital gain §1231 gain §1245 depreciation recapture Ordinary income Boot received has a tax basis equal to its fair market value. Tax-Deferred Transfers of Property to a Corporation

8. 8 Example 1 Suppose Sarah received 25 percent of the CCS stock in exchange for services, Nicole received 50 percent of the CCS stock in exchange for appreciated land, and Chanzz Inc. received 25 percent of the CCS stock in exchange for cash. Must Nicole recognize the gain she realized on her transfer of appreciated land?

9. 9 Tax-Deferred Transfers of Property to a Corporation Example 1 Answer: Yes. Because Nicole and Chanzz Inc. are the only transferors of property to CCS, only their stock counts for purposes of the 80 percent control test. Because Nicole and Chanzz Inc. together own less than 80 percent of the CCS stock (they own 75 percent) immediately after the transfer, Nicole’s transfer does not qualify under § 351, and she must recognize the gain on the appreciated land.

10. 10 Tax-Deferred Transfers of Property to a Corporation Example 2 When incorporating CCS, Nicole transferred a parcel of land (held as an investment for five years) to CCS in exchange for 50 percent of the corporation’s stock (50 shares valued at $100,000). The land’s fair market value was $100,000, and its tax basis to Nicole was $40,000. Assuming the transfer qualifies under § 351, what gain or loss does Nicole recognize on the transfer? What is her basis in the stock she received on the exchange? What is her holding period in the stock?

11. 11 Tax-Deferred Transfers of Property to a Corporation Example 2 Answer: $0 gain recognized and $40,000 basis in the stock with a five-year holding period. Nicole realizes a $60,000 gain on the exchange ($100,000 stock received minus $40,000 basis in property transferred) but does not recognize any gain because she meets the § 351 requirements and she did not receive boot. Her basis in the stock is the same as the basis she had in the land she transferred to CCS. Finally, Nicole’s holding period in the stock includes the five years she owned the land because the land was a capital asset to Nicole.

12. 12 Tax-Deferred Transfers of Property to a Corporation Example 3 What if: Suppose Nicole contributed land she held as an investment (fair market value $90,000; basis $40,000) and inventory (fair market value $30,000; basis of $26,000) to CCS in exchange for 50 percent of the CCS stock (50 shares valued at $100,000) and $20,000 cash in a qualifying § 351 exchange. What percentage of the $120,000 value received by Nicole was received for the land and the inventory, respectively?

13. 13 Tax-Deferred Transfers of Property to a Corporation Example 3 What amount of gain does Nicole recognize on the exchange? What is the character of the gain?

14. 14 Tax-Deferred Transfers of Property to a Corporation Example 3 continued

15. 15 Assumption of shareholder liabilities by the corporation General rule- a shareholder’s liability attached to property transferred is not treated as boot received. Exceptions- Liability assumption has tax avoidance purpose Liability assumption has no business purpose Tax-Deferred Transfers of Property to a Corporation

16. 16 Liabilities in excess of basis Shareholder recognizes gain to extent liabilities assumed by corporation exceed aggregate basis of property contributed Tax-Deferred Transfers of Property to a Corporation

17. 17 Tax-Deferred Transfers of Property to a Corporation Example 4 What if: Suppose that when forming CCS, Nicole transferred a parcel of land (held as an investment) to CCS in exchange for 50 percent of the CCS stock (50 shares valued at 100,000). The land’s fair market value was $150,000 and its adjusted tax basis to Nicole was $40,000. The land was subject to a $50,000 mortgage that CCS assumed on the transfer (not treated as boot). Assuming the transfer qualifies under §351, what is the amount and character of the gain Nicole recognizes on the exchange?

18. 18 Tax-Deferred Transfers of Property to a Corporation Example 4 Answer: $10,000 capital gain. Even though Nicole did not receive boot on the exchange she still must recognize a $10,000 gain because the $50,000 mortgage assumed by CCS on the exchange exceeds the $40,000 basis of the property Nicole transferred by $10,000 ($50,000 liabilities minus $40,000 adjusted basis transferred = $10,000 recognized gain). The gain is a capital gain because the land was a capital asset to her.

19. 19 Tax-Deferred Transfers of Property to a Corporation Shareholder’s basis in stock received

20. 20 Tax-Deferred Transfers of Property to a Corporation Corporation’s basis in assets received from shareholder Same basis shareholder had plus gain recognized by shareholder

21. 21 Contributions to Capital Transfer of property but no stock or other property is received in return Corporation takes a carryover tax basis in property contributed by a shareholder Corporation takes a zero tax basis in property contributed by a nonshareholder Shareholder making a capital contribution increases the tax basis in existing stock by the tax basis of the property contributed Tax-Deferred Transfers of Property to a Corporation

22. Corporate Taxable Income Formula 22

23. 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. 23

24. 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 24

25. Common Permanent Book-Tax Differences Interest income from municipal bonds (Fav) Death benefit from life insurance on key employees (Fav) Life insurance premiums to cover lives of key employees (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 production activities deduction (Fav) 25

26. 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 Purchased goodwill 26

27. Stock Option-related book-tax differences 27 Incentive stock options Not deductible for tax Unfavorable permanent book-tax difference when vests Nonqualified stock options Deduct as vest for books Deduct bargain element when exercise for tax Permanent difference to extent estimated value for books is different from bargain element for tax

28. Stock Option Example 1 28 Assume that last year CCS issued 1,000 incentive stock options (ISOs) to Nicole. The options were valued at $6 each and were scheduled to vest in 2014 (the current year). Each option entitled Nicole to purchase one share of CSS stock for $15 a share (the per share price of CSS stock when the stock was granted). Nicole exercised the options in 2014 when they vested. The CCS stock was valued at $22 per share on the date of exercise. For book purposes, CCS reported compensation expense in 2014 from the incentive stock options in the amount of $6,000. What would be CCS’s 2014 book-tax difference associated with the incentive stock options? Would the difference be favorable or unfavorable? Would the difference be permanent or temporary?

29. Stock Option Example 1 Solution Answer: $6,000 unfavorable permanent difference ($6,000 deductible for books; $0 deductible for tax). 29

30. Stock Option Example 2 30 Assume that last year CCS issued 1,000 nonqualified options (NQOs) to Nicole. The options were valued at $6 each and were scheduled to vest in 2014 (the current year). Each option entitled Nicole to purchase one share of CSS stock for $15 a share (the per share price of CSS stock when the stock was granted). Nicole exercised the options in 2014 when they vested. The CCS stock was valued at $22 per share on the date of exercise. For book purposes, CCS reported compensation expense in 2014 from the options in the amount of $6,000. What would be CCS’s 2014 book-tax difference associated with the nonqualified options? Would the difference be favorable or unfavorable? Would the difference be permanent or temporary?

31. Stock Option Example 2 Solution Answer: $1,000 favorable, permanent book-tax difference. The tax deduction for the options is the $7,000 bargain element (unfavorable permanent difference ($22 stock value per share minus $15 exercise price times 1,000 shares). The book deduction is $6,000. 31

32. 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 32

33. 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? 33

34. 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) 34

35. NOL Example CCS. has a net operating loss of $20,000 for the 2015 tax year. CCS reported the following taxable income from 2012 through 2014: 2012: $10,000 2013: $17,000 2014: $8,000 What options does CCS have with respect to the current year NOL? 35

36. NOL Example Solution Could carry back $17,000 to 2013, then $3,000 to 2014. Immediate refund (file Form 1139) Or, could forgo carryback and carry loss forward up to 20 years 36

37. 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 2 ½ months after end of year 37

38. Charitable Contributions Deduction limited to 10% of taxable income before deducting Any charitable contribution deduction The dividends received deduction (DRD) Domestic production activities deduction (DPAD) NOL and Capital loss carrybacks Carry forward excess contributions for five years. 38

39. Charitable Contribution Example Assume that CCS’s 2015 taxable income before considering the charitable contribution limitation was $40,000. The taxable income computation includes a $5,000 charitable contribution deduction, a $1,000 DRD, a $2,000 DPAD, and $12,000 of depreciation expense. Under these circumstances, what would be CCS’s 2015 deductible charitable contribution? What would be its charitable contribution carryover? When would the carryover expire? 39

40. Charitable Contribution Example Solution 40

41. 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 x DRD % or (2) DRD modified taxable income x 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 16-41

42. Dividends Received Deduction Example UPDATEXXX 42

43. 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 43

44. 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 2½ months after the close of the tax year. Automatic six month extension for filing (9/15 for calendar year) Consolidated tax returns Affiliated groups essentially treated as one corporation 44

45. Form 1120 Schedule M-1 45

46. 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 15 th day of: 4 th month (25% of required annual payment) 6 th month (50% of required annual payment) 9 th month (75% of required annual payment) 12 th month (100% of required annual payment) Corporations may owe a penalty for underpayment Payments based on required annual payment 46

47. 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 47

48. 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 48

49. Alternative Minimum Tax 49

50. 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 50

51. 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 51

52. Alternative Minimum Tax 52

53. Adjusted Current Earnings Example Assume CCS did not receive any dividends and that it received $300 in interest from a Salt Lake City bond issued in 2012 that is not a private activity bond. Further, assume that CCS reported $5,000 of organizational expenses this year and it reported $2,000 of gain this year from an installment sale it executed two years ago. Assuming CCS’s cumulative ACE adjustment as of the beginning of the year is $1,000, what is its current year ACE adjustment under these circumstances? 53

54. Adjusted Current Earnings Example Solution UPDATE### 54

55. 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 55

56. 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 56

57. Minimum Tax Credit Example Assume that in year 1, CCS has a TMT of $17,565 and a regular tax liability of $10,000. CCS would owe $7,565 of AMT and $10,000 of regular tax. It would also generate a $7,565 minimum tax credit. Further, assume that in year 2 CCS reports a tentative minimum tax of $9,000 and a regular tax liability of $10,000. What is CCS’s tax liability after applying the minimum tax credit? 57

58. Minimum Tax Credit Example Solution 58