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Chapter Corporations: Introduction and Operating Rules (2009) Learning Objectives:
updated: August 15, 2008
Identify some of the advantages and disadvantages of various forms of conducting a business Compare the taxation of individuals and corporations (similarities & differences) Review the tax rules unique to corporations Understand the corporate income tax formula & compute the corporate income tax
I. Business Entity Choices A. Sole proprietorship B. Partnership 1. 2. 3. 4. General Limited Limited liability partnership (LLP) Limited liability company (LLC)
C. Corporation 1. Regular C corporations 2. Subchapter S corporations (S-corps) Note: For more information see Business Entities Matrix (chapter 2 web page). D. The choice of entity should be based on a combination of tax and nontax factors. 1. tax factors include: Is it a tax-paying or tax-reporting entity? Can the owner be treated as an employee? When is income taxed? (when earned or when distributed) The top corporate rate is 35% (39% on a limited range of taxable income), as is the top rate for individuals. However, for a specified level of income the corporate or individual tax rate can be higher because their tax rate schedules are different. The tax rate on qualified dividends must also be considered. Character. With pass-through entities, items of income, expenses, and losses retain their character for the owner. C corporation items do not pass through (especially losses).
2. nontax factors may override tax considerations: limited liability ability to raise larger amounts of capital continuity of life for the entity free transferability of ownership interests centralized management
II. Sole proprietorship A. Advantages: 1. entity not subject to separate tax (income reported on owners Schedule C which is attached to owners Form 1040) 2. owner can contribute/withdraw assets without tax consequence 3. losses can be used to offset other sources of income (subject to some limitations) B. Disadvantages: 1. all profits taxed at individual level to owner when earned even if not distributed 2. sole proprietor cannot be an employee of the business 3. unlimited liability 4. earnings subject to self-employment tax as well as federal income taxes (and most likely state income taxes) III. Partnership A. Advantages: 1. are not subject to separate tax (files an information return Form 1065 and Schedule K, and provides K-1 to each partner) 2. withdrawals generally are not taxed 3. pass-thru losses can be used to offset other income 4. pass-thru capital gains taxed at individual rates (15%/0%) 5. basis of partnership interest increases when partnership reports income B. Disadvantages: 1. 2. 3. 4. profits taxed to partners when earned even if not distributed partners cannot be treated as employees of the business general partners have unlimited liability ordinary income of general partners (and guaranteed payments) are subject to self-employment taxes 5. basis of partnership interest decreases when partnership reports loss
C. A note on LLCs LLCs have proliferated since 1988 when the IRS ruled it would treat qualifying LLCs as partnerships 1. major nontax advantage allows entity to avoid unlimited liability 2. major tax advantage allows qualifying business to be treated as a partnership for tax purposes, avoiding double taxation associated with C corps IV. C Corporation A. Advantages: 1. progressive tax rates starting at 15% 2. shareholders can be employees (corp. can deduct salary & most nontaxable fringe benefits) 3. special rules for small business stock 4. limited liability B. Disadvantages: 1. double taxation although somewhat mitigated by the 2003 Tax Act which reduced the tax rate on LTCGs and most qualified dividends to 15%/5% (now 15%/0%) 2. reports income and expenses on Form 1120 3. shareholders can not withdraw assets without tax consequences 4. losses cannot be used to offset other shareholder income Note: The TIPRA of 2005 (signed into law on May 17, 2006) extend the reduced rates to 2010 (the lower tax rates were set to expire in 2008)
V. S Corporation A. Advantages: 1. are not subject to tax (files an information return Form 1120S and Schedule K, and provides K-1 to each shareholder) 2. pass-thru losses can be used by shareholders to offset other income 3. pass-thru capital gains taxed at individual rates (15%/0%) 4. shareholders can generally withdraw assets without tax consequences 5. basis in stock increases when S-corporation reports income 6. limited liability 7. ordinary S corporation income is not subject to self-employment tax B. Disadvantages: 1. profits taxed whether distributed to shareholder or not 2. tax-free fringe benefits are not available to most shareholder/employees 3. basis in stock decreases when S-corporation reports loss 4. limitations on stock ownership (number and type of shareholders)
VI. Check-the-Box Regulations A. The check-the-box regulations allow most unincorporated businesses to choose whether to be taxed as a proprietorship, a partnership, or a corporation B. Prior to 1997 and the check-the-box regulations this was a subjective test, and it was the subject of much controversy and litigation (see text page 2-8) C. Election is made without regard to corporate or noncorporate characteristics 1. entities with > 1 owner can elect to be classified as a partnership (the default), or as a corporation 2. entities with only 1 owner can elect to be classified as a sole proprietorship (the default), or as a corporation D. The business cannot be: 1. an organization actually incorporated under state law, or 2. an organization required to be treated as corporation (e.g. corporations, associations, joint-stock companies, insurance companies, and banks) 3. a trust 4. subject to special rules (e.g. REIT, REMIC)
VII. Corporate Tax Year A. Corporations generally have the same choices as individual taxpayers calendar year or fiscal year B. Some corporations choices are restricted: 1. S-Corporations generally must use calendar year 2. affiliated group members must use same year as the parent 3. personal service corporations (PSCs) usually must use calendar year C. Changing the tax year usually requires IRS approval VIII. Accounting Methods A. Accrual used by most corporations, exceptions include: 1. S corporations 2. corporations engaged in trade or business of farming/timber 3. qualified personal service corporations (PSCs) principal activity is performance of personal services service substantially performed by owner/employees
4. corporations with 3-year average annual gross receipts of $5 million or less B. Cash an option for: 1. any entity with 3-year average annual gross receipts of $1 million or less (even if buy & sell inventory) 2. some entities with 3-year average annual gross receipts between $1$10 million C. Hybrid required for corporations who would otherwise qualify for cash method but have significant inventories 1. accrual for sales/cost of goods sold, recognize A/R & A/P 2. cash for other income and expense items
IX. Gross Income A. General definition from Sec. 61(a): Except as otherwise provided in this subtitle, gross income means all income from whatever source derived B. Some exclusions also apply to corporations 1. life insurance proceeds 2. municipal bond interest C. There are some opportunities for deferral 1. involuntary conversions 2. like-kind exchanges D. Prepaid rent and interest is included in income in the year received regardless of method of accounting E. For more information see CCHs gross income checklist (chapter 2 web page) X. Overview of Business Deductions for an expense to be deductible it must be . . . ordinary, necessary and reasonable in amount A. An expense is ordinary if it is: 1. 2. 3. 4. normal, usual, or customary in the type of business run by taxpayer NOT capital in nature based on common and accepted business practice an expense need not be recurring to be deductible
B. An expense is necessary if: 1. a prudent businessperson would incur the same expense 2. the expense is expected to be appropriate and helpful in the business (not synonymous with indispensable) C. An expense must be reasonable in amount 1. while the Code refers solely to salary & other compensation, the Courts have expanded the scope to include all other business expenses 2. not excessive in the specific circumstances 3. expenses in excess of reasonable amounts are NOT deductible 4. the taxpayer has the burden of proof for substantiating expenses and must retain adequate records; otherwise, IRS can disallow any deductions
D. New domestic production activities deduction (was originally called the domestic manufacturing deduction) is available to all business entities, not just corporations. The DPAD is equal to 6% of the lesser of: 1. qualified production activities income (see chapter 2 web page for more information), or 2. taxable income NOT to exceed 50% of W-2 wages paid Note1: The deduction is aimed at a broad range of industries, and replaces our unfair export subsidies. Note2: Deduction was 3% in 2005-2006, and increases to 9% in 2010. E. No deductions for: 1. 2. 3. 4. interest on loans to buy tax-exempt securities illegal bribes or kickbacks fines or penalties insurance premiums paid if the corporation is the beneficiary of the life insurance policy 5. dividends paid to shareholders 6. estimated expenses bad debts & product warranty costs (can only deduct actual write-offs and actual warranty costs incurred) F. 50% of meals and entertainment expenses are disallowed (the cutback adjustment) G. Corporation does not 1. compute AGI (no distinction between deductions FOR and deductions FROM AGI) 2. deduct standard or itemized deductions 3. deduct personal/dependency exemptions H. For more information see CCHs deduction checklist (chapter 2 web page)
XI. Some Corporate & Individual Differences A. Deductions and losses 1. 2. 3. 4. 5. 6. not subject to hobby loss limitations of Sec. 183 not subject to investment interest limit of Sec. 163(d) publicly held corps not subject to passive loss limitations can amortize organizational and start-up costs are allowed a special dividends received deduction casualty losses are fully deductible no $100 per event & 10% of AGI floor 7. lower limitations (10%) apply to charitable contributions 8. NOL carry back & carry forward provisions B. Sales and exchanges of property 1. net capital gains are taxed as ordinary income 2. capital losses may only be used to offset capital gains 3. unused net capital losses subject to 3 year carryback and 5 year carryforward (lose their identity all are considered short term) 4. are also subject to Sec. 291 recapture on Sec. 1250 property C. Different tax rates apply to different income levels D. Related corporations or controlled groups - two or more corporations that are owned directly, or indirectly, by the same shareholder or group of shareholders 1. the following must be allocated among the members of the controlled group: the benefit of the graduated corporate tax rates (the first $50,000 taxed at 15%) the $250,000 minimum accumulated earnings credit (which is designed to prevent companies from retaining excessive amounts of income in the corporation) the $40,000 AMT exemption amount (a separate parallel tax system to ensure that corporations pay their fair share of taxes) the Sec. 179 expense amount
2. no loss on sale of assets between members may be recognized
XII. Organizational Costs A. Organizational costs (defined) incident to creation of corporation, chargeable to corporations capital account and of a character that, if expended incident to the creation of a corporation having a limited life, would be amortizable over that life (see text page 2-19) B. Requirements for deductibility: 1. election be must made under Sec. 248 and filed with the FIRST tax return 2. first year deduction of $5,000, remaining amount amortized over 15 years effective for expenses incurred after October 23, 2004 prior rules required amortization of all expenses over period not less than 60 months first-year expensing reduced on a dollar-for-dollar basis when these expenses exceed $50,000
3. expenditures must be incurred before the end of the first year of business 4. does not include expenditure related to issuing/selling securities 5. failure to file the election requires capitalization of the costs until the business liquidates XIII. Start-up Expenditures A. Start-up Costs (defined) Non-organizational; ordinary and necessary; paid or incurred BEFORE the actual start of business operations to: 1. investigate the creation or acquisition of an active trade or business 2. create an active trade or business 3. conduct an activity engaged in for profit or the production of income before the time the activity becomes an active trade or business
B. Requirements for deductibility: 1. first year deduction of $5,000, remaining amount amortized over 15 years effective for expenses incurred after October 23, 2004 prior rules required amortization of all expenses over period not less than 60 months first-year expensing reduced on a dollar-for-dollar basis when these expenses exceed $50,000
2. election is to be made not later than the date for filing tax return for the first year of operation or ownership
XIV. Charitable Contributions A. Generally deductible in the year paid; exception an accrual-basis corporation may deduct charitable contribution in year of accrual if: 1. authorized by the board of directors, and 2. actually paid within 21/2 months of end of year B. If cash is donated; the contribution equals the amount of cash donated C. If non-cash property is donated and: 1. it is LTCG property, then, the amount of the charitable contribution is generally equal to the fair market value of the property 2. however, if it is tangible personal property and the organizations use of the property is unrelated to its tax-exempt purpose (or charity is a non-operating foundation), then, the deduction is usually limited to the adjusted basis of the property 3. the deduction for ordinary income property is limited to fair value minus the amount of ordinary income or short-term gain that would have been recognized if the property had been sold (usually the adjusted basis of the property) 4. for certain inventory (defined in Sec. 170 (e)), the allowable deduction is equal to the adjusted basis of the inventory plus 1/2 the gain that would have been recognized if the inventory had been sold. (However, the deduction cannot exceed 2 x adjusted basis) D. Limitations on charitable contributions 1. maximum deduction is computed as 10% of adjusted taxable income 2. adjusted taxable income is the corporations taxable income before any deduction for: NOL carryback, capital loss carry back, dividend received deduction, or the charitable contribution itself BUT after any NOL carryforward
3. excess CC can be carried forward 5 years, but can only be used after current-year contributions are deducted.
XV. Dividends Received Deduction (DRD) A. Objective of the DRD to alleviate (but not eliminate) multiple taxation on dividends paid between domestic corporations B. If a corporation owns stock in a domestic corporation and receives dividends; a portion of the dividends may be deducted (or permanently excluded) from income: If the ownership % is: less than 20% more than 20% but less than 80% 80% or more (an affiliated group) (to be covered in chapter 8) Then the DRD % is: 70% 80% 100%
C. Corporations owning less than 20% (between 20%-80%) of a domestic corporation may deduct the lesser of: Step 1: 70% (80%) of the dividends received (often called the full DRD), or Step 2: 70% (80%) of taxable income before deducting any NOL, any capital loss carry back, or the DRD Note: This limit does not apply if, after taking the full DRD, the corporation would have an NOL for the year (often referred to as the NOL rule) D. Members of an affiliated group (more than 80% ownership) can claim a 100% deduction with respect to dividends received from other members of the group E. No DRD is allowed if: 1. the corporation paying the dividend is a foreign corporation 2. the stock was purchased with borrowed money 3. taxpayer holds stock for fewer than 46 days during the 90 day period beginning 45 days before taxpayer became entitled to dividend
XVI. Net Operating Loss A. A net operating loss results when deductions exceed gross income for the year B. The current year NOL is computed WITHOUT any deduction for NOL carryforwards or NOL carryback C. An NOL may be carried back 2 years and carried forward 20 years (1997 Tax Act). The old 3-year carryback and 15-year carryforward rules still apply in special circumstances.
XVII. Sequencing of Deductions A. The computation of special deductions requires proper sequencing. Correct order for taking deductions: Gross income (including 100% of any dividends received) Less: All ordinary, necessary & reasonable deductions except: charitable contributions dividends received deduction NOLs STCL carryback Taxable income for charitable contribution limitation Less: Charitable contributions (must be < = 10% of above) Taxable income for dividends received deduction Less: Dividends received deduction (lesser of step 1 or step 2) Taxable income before carryforwards & carrybacks Less: NOLs carryforwards & carrybacks and STCL carryback Taxable income before DPAD Less: Domestic production activities deduction (DPAD) TAXABLE INCOME
Income tax liability Less: Tax credits Less: Estimated (quarterly) tax payments Equals: Tax due or refund
XVIII. Shareholder Transactions A. Special rules apply to transactions between a corporation and a controlling shareholder (i.e., the related party rules under Sec. 267) 1. controlling shareholder (defined) a controlling shareholder is one who owns more than 50% of the corporations stock B. Transactions that are affected by the related party rules 1. sale of depreciable property at a gain gain is ordinary income 2. sale of depreciable property at a loss (disallowed/deferred) loss is disallowed in year of sale disallowed loss may reduce gain on subsequent sale
3. accrued but unpaid expenses (disallowed/deferred) expense may not be deducted by one member (usually an accrual-basis taxpayer) until cash payment is included in other members income (usually a cash-basis taxpayer)
XIX. Loss Limitations A. If five or fewer shareholders own more than 50% of a corporations stock it is considered a closely-held corporation 1. the corporations losses are limited to the amount the corporation has at risk 2. losses not currently deductible must be carried over and used as a deduction in a later year B. Passive activity loss limitations apply to: 1. individuals and personal service corps cannot offset passive losses against active, or portfolio income 2. S corps and partnerships passive income and loss flows through to owners and rules applied at owner level 3. closely held C corps may offset passive losses against active income, but not portfolio income
XX. Corporate Tax Rates A. Corporate tax rates are 15%-39% Base rate for first $10 million is 34% Base rate for taxable income > $10 million is 35% Reduced rates (15 & 25%) apply to the first $100,000 Recapture of lower rates occurs when: o $100,000 < taxable income < $335,000 (+5%) o $15M < taxable income < $18.33M (+3%)
B. Corporations (other than small corporations) are subject to an alternative minimum tax (AMT) that is similar to the AMT of individuals. Most adjustments and preferences are the same as for individuals, but the rates and exemption amounts are different. C. Personal Service Corporations (PSCs) are taxed at a flat rate of 35%. PSCs (defined): 1. a corporation that substantially all of the activities involve services in the following fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting AND 2. substantially all of the stock is owned by employees, former employees, or survivors of employees D. Corporations are subject to the alternative minimum tax (AMT) The AMT is a separate and parallel federal income tax system with different tax rates, different definitions of income, deductions and credits designed to measure the taxpayers economic income. It is an alternative tax because the AMT rules constitute a complete, alternative set of rules & minimum tax because taxpayer must pay the larger of its AMT or its regular income tax liabilities. 1. Taxpayers are first required to compute their regular income tax liability and then compute their tax under the AMT system. The AMT system requires taxpayers to adjust their regular taxable by a number of adjustments and preferences, and then subtract an exemption amount to arrive at the AMT base. 2. The AMT base is multiplied by the special AMT rate (26 or 28% for individuals and 20% for corporations) to compute their tentative minimum tax (TMT). 3. Taxpayers are required to pay the greater of (1) the regular income tax, or (2) the TMT.
XXI. Filing Requirements A. A tax return is required each year regardless of income B. Most use Form 1120 C. Can use form 1120A if gross receipts, total income and total assets are each under $500,000 D. Corporations have to make estimated tax payments (for most corps: 100% of liability, or 100% of last years tax liability) (see text page 2-21) 1. payments of a calendar year corporation are due April 15, June 15, September 15, and December 15 2. penalties apply to underpayments
XXII. Schedule M-1& M-3 Reconciliations A. Corporations must reconcile financial accounting income with taxable income on Schedule M-1, Form 1120 B. Two reasons why financial accounting (book income) is different than taxable income 1. permanent differences which will never reverse and will have no deferred tax consequences/benefit. Permanent differences result from items that (a) enter into pretax financial income but never into taxable income, or (b) enter into taxable income but never into pretax financial income. 2. temporary (or timing) differences which will reverse over time and will have future tax consequences/benefit; one of two relationships can occur: current period book income > taxable income book income < taxable income C. Some common reconciling items include: 1. 2. 3. 4. Federal tax liability net capital losses income reported for tax but not book income (e.g., prepaid income) income reported for books but not tax (e.g., municipal bond income, life insurance proceeds) 5. expenses deducted for book income but not tax (e.g., excess charitable contributions, 50% disallowance on meals/entertainment, lobbying expenses, expenses associated with tax-exempt income) 6. expenses deducted for tax but not for book (e.g., accelerated depreciation) 7. differences in gains/losses on sale of property due to differences in book and tax depreciation methods future period(s) book income < taxable income book income > taxable income .
D. Beginning in 2004, corporations with total assets > $10 million must use Schedule M-3 (with much greater disclosure requirements). Schedule M3 should: 1. create greater transparency between corporate financial statements and tax returns 2. help the IRS identify corporations that engage in aggressive tax practices E. Financial accounting considerations Financial Accounting Standard No. 109 (FAS 109) and Interpretation 48 (FIN 48) are used to reconcile book income and taxable income in the external financial statements. F. See Schedule M-1 and Schedule M-3 (chapter 2 web page)
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