CHAPTER 2
CORPORATIONS: INTRODUCTION, OPERATING RULES, AND RELATED CORPORATIONS
Based on West Federal Taxation, Corporations, Partnerships, Estates, and Trusts, 2001 ed.
I.
TAX TREATMENT OF VARIOUS BUSINESS FORMS
A.
B.
C.
SOLE PROPRIETORSHIPS p.2-2
1.
A sole proprietorship is subject to income tax on the owner’s individual 1040.
2.
Owner reports all net profit from business (regardless of actual amount withdrawn during the year).
PARTNERSHIPS p.2-3
1.
A partnership is not subject to a separate income tax. It is a “pass through” entity and must file Form 1065
on its business activity for the year.
2.
Any income and expense not reported on Form 1065 are reported separately to the partners.
3.
Net profit (loss) and other separately reported items are allocated to each partner according to profit
sharing agreements and the partners receive separate K-1 schedules.
4.
Each partner reports these items on his or her tax returns according the the K-1 breakdown.
REGULAR CORPORATIONS p.2-3
1.
2.
Two types of corporations:
a.
S-Corporation (governed by Subchapter S)
(1)
“pass-through” entity (like a partnership). Net profit or loss flows through to the
shareholders to be reported.
(2)
do not aggregate all income and expense items in computing net profit and loss.
b.
C-Corporation (governed by Subchapter C)
(1)
Separate taxpaying entity (result is known as double tax effect) and report their income
on Form 1120.
(2)
Tax computed using the corporate tax tables and rates.
Comparison of Corporations and Other Forms of Doing Business p.2-4
a.
b.
c.
3.
D.
Tax rate – Corporate rates are lower than individual rates.
Income & expenses – Retain their character (ordinary vs. capital) on a proprietorship return but
not on corporate returns.
Losses – Proprietorship can deduct loss on his individual return. Not so w/ corporate losses.
Nontax Considerations p.2-6
a.
Liability – Sole proprietors and general partnerships face unlimited personal liability while
corporate shareholders are shielded from personal liability.
b.
Raising capital – Much easier with corporation because stock ownership can be widespread.
c.
Transfer of ownership – Much easier with corporation (i.e., sell stock vs. selling assets.
d.
Life - Corporations are perpetual. Proprietorships & partnerships die with owner/partner.
e.
Management – More structure in a corporation than other business forms.
LIMITED LIABILITY COMPANIES (LLC) p. 2-7
Tax advantage of LCCs is that qualifying businesses may be treated as partnerships for tax purposes, there by
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E.
avoiding the problem of double taxation associated with regular corporations plus limited liability for owners.
ENTITY CLASSIFICATION PRIOR TO 1997 p.2-8
Entity would be treated as a corporation if it has the following characteristics common to corporations:
1.
Continuity of life
2.
Centralized management
3.
Limited liability
4.
Free transferability of interests
F.
ENTITY CLASSIFICATION AFTER 1996 p.2-8
Check-the-box Regulations enables a taxpayer to elect an unincorporated business entity’s tax status by filing
Form 8832. (Election is not available to entities incorporated under state law or required to be corporations under
Federal laws.)
1.
More than one owner entities – can elect partnership or a corporation
2.
One owner entities can elect corporation or sole proprietorship.
II.
AN INTRODUCTION TO THE INCOME TAXATION OF CORPORATIONS
A.
AN OVERVIEW OF CORPORATE VERSUS INDIVIDUAL INCOME TAX TREATMENT P. 2-9
1.
Similarities between corporate taxpayers and individual taxpayers:
a.
Both determine gross income the same and recognize exclusions from gross income.
b.
Gains and losses from property transactions are handled similarly.
c.
Both may defer tax on like-kind exchanges and on involuntary conversions of property.
d.
Both may be disallowed a loss on a related-party sale or on a wash sales of securities.
e.
Both can claim foreign tax credits.
f.
Both may take business deductions for all ordinary and necessary expenses paid or incurred in
carrying on a trade or business.
(1)
No deductions for interest paid or incurred on amounts borrowed to purchase or carry
tax-exempt securities.
(2)
No deductions for expenses contrary to public policy and certain unpaid expenses and
interest between related parties.
2.
Dissimilarities between corporate taxpayers and individual taxpayers:
a.
Different tax rates apply.
b.
Determination of adjusted gross income has no relevance to corporations.
c.
Corporations are not concerned with itemized deductions or standard deduction.
d.
Personal and dependency exemptions are not available to corporations.
e.
$100 floor for personal casualty and theft losses not applicable to corporations.
f.
No deduction of nonbusiness casualty losses to the amount in excess of 10% of AGI.
B.
SPECIFIC PROVISIONS COMPARED 2-10 – Discussed in these next six sections.
C.
ACCOUNTING PERIODS AND METHODS 2-10
1.
Accounting Periods
a.
Corporations may use a calendar year or a fiscal year for reporting purposes.
b.
Corporations may have different tax years than their shareholders.
c.
Newly formed corporations can choose any approved period without IRS’s consent.
d.
Personal service corporations (PSC) and S corporations are subject to restrictions.
(1)
PSC’s must generally use a calendar year.
(2)
PSC’s can elect a fiscal year under certain conditions.
(a)
Business purpose for the year can be demonstrated.
(b)
PSC year results in deferral of not more than three month’s income.
(c)
PSC retains the same year that was used for its fiscal year ending 1987,
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provided latter 2 requirements applicable to the preceding condition are
satisfied.
2.
D.
E.
CAPITAL GAINS AND LOSSES p.2-11
1.
There are several combinations possible regarding capital gains and capital losses.
a.
NLTCG + NSTCL = either a NCG or a NCL.
b.
NLTCL + NSTCG = either NCG or NCL
c.
NLTCG and NSTCG (These are not combined. Taxed separately)
d.
NLTCL and NSTCL (These are not combined. Benefits are derived separately)
2.
Capital gains – Corporations must include net capital gain, in full, in taxable income
3.
Capital losses – Corporations cannot claim any capital loss as deduction against ordinary income but can:
a.
carry back a net capital loss to 3 prior years beginning with the earliest year.
b.
carry forward a net capital loss for 5 years term.
PASSIVE LOSSES 2-12
1.
2.
3.
4.
F.
Accounting Methods
a.
Cash method of accounting is unavailable to regular corporations. Exceptions include:
(1)
S Corporations
(2)
Corporations engaged in the trade or business of farming and timber.
(3)
Corporations with average annual gross receipts of $5 million or less.
b.
If inventory for customer sales is stocked, accrual method is required for sales and COGS.
Passive loss rules apply to unincorporated taxpayers, closely held C corporations, and PSCs.
Passive loss rules are applied at the owner level for S corporations.
For PSC’s, passive activity losses cannot be offset against either active or portfolio income.
For closely held corporations they may be offset against active income, but not against portfolio income.
CHARITABLE CONTRIBUTIONS 2-13
1.
Corporate and unincorporated taxpayers may deduct charitable contributions if recipient is qualified
charitable organization.
a.
Deduction only allowed for year payment is made.
b.
Exception for accrual basis corporations – Can claim deduction in year preceding payment if
(1)
the contribution is authorized by the board of directors by the end of year AND
(2)
paid on or before the fifteenth day of the third month of the next year.
2.
Property contributions
a.
Property must be identified as long-term capital gain property or ordinary income property.
b.
Long-term capital gain property generally measured by FMV. Exceptions:
(1)
Tangible personal property contribution.
(2)
Charitable organization puts property to unrelated use.
c.
3.
G.
Deduction for ordinary income property generally limited to basis of property. Two exceptions
where 50 percent of appreciation is allowed on certain contributions.
(1)
Inventory property is used in manner related to the exempt purpose of the charity, and
the charity uses it solely for the care of the ill, needy, or infants.
(2)
Gifts of scientific property for research.
Limits imposed on charitable contribution deductions – Annual corporate contribution deduction limited
to 10% of taxable income. Excess may be carried forward 5 succeeding tax years.
NET OPERATING LOSSES 2-16
1.
NOL of corporation may be carried back 2 years and forward 20 years.
3
H.
III.
2.
Corporations do not adjust tax loss for year for capital losses.
3.
Corporations make no adjustment for nonbusiness deductions.
4.
Corporations are allowed to include dividends received deductions.
DEDUCTIONS AVAILABLE ONLY TO CORPORATIONS 2-16
1.
Dividends Received Deduction – Mitigates triple taxation.
a.
Deduction amount depends on the ownership percentage the recipient corporate shareholder has
in a domestic corporation making dividend distribution.
b.
Deduction is limited to a percentage of corporation’s taxable income.
2.
Deduction of organizational expenditures –
a.
Corporations may elect to amortize organizational expenditures over 60 months or more if those
expenses are incurred before the end of the taxable year the corporation begins business.
b.
Expenditures that quality:
(1)
Legal services incident to organization
(2)
Necessary accounting services
(3)
Expenses of temporary directors and organizational meetings of directors or
shareholders
(4)
Fees paid to state of incorporation
c.
Expenditures that do not qualify
(1)
Issuing or selling stocks or other securities
(2)
Transferring of assets to corporation.
DETERMINING THE CORPORATE INCOME TAX LIABILITY
A.
CORPORATE INCOME TAX RATES 2-19 – See table in front cover of text
1.
If taxable income exceeds $100,000 for any tax year, the tax is increased by the lesser of
a.
5% of the excess or
b.
$11,750.
2.
This additional tax means a 39% rate for every dollar of taxable income from $100,000 to $335,000.
3.
PSCs are taxed at a flat 35% rate on all taxable income.
B.
ALTERNATIVE MINIMUM TAX 2-20 – A corporation is required to pay AMT much like individuals.
C.
TAX LIABILITY OF RELATED CORPORATIONS
D.
2-20
1.
Related corporations are subject to special rules in computing income tax, accumulated earnings credit,
and AMT exemption. This prevents shareholders from splitting a single corporation into multiple
corporations.
2.
The law limits a controlled group’s taxable income in the tax brackets below 35% to the amount the
corporations in the group would have if they were one corporation.
CONTROLLED GROUPS p.2-21
1.
2.
Parent-subsidiary – consists of one or more chains of corporations connected through stock ownership
with a common parent corporation. The ownership connection can be established through:
a.
Voting power test – must own 80%+ of total voting power of all classes of stock entitled to vote
b.
Value test – must own 80%+ of total value of all shares of all classes of stock of each
corporations except the parent corporation, by one or more of the other corporations
Brother - Sister Corporations – may exist of two or more corporations are owned by five or fewer persons.
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Brother-sister status will apply if such a shareholder group meets and 80% total ownership test and a 50%
common ownership test.
a.
Total ownership test – met if shareholder group possesses stock representing at least 80% of the
total combined voting power of all classes of stock entitled to vote, or at least 80% of the total
value of shares of all classes of stock of each corporation
b.
Common ownership test met if shareholder group owns more than 50% of the total combined
voting power of all classes of stock entitled to vote, or more than 50% of the total value of shares
of all classes of stock of each corporation
c.
Combined Groups – combined controlled group exists if all of the following conditions are met
(1)
(2)
(3)
d.
IV.
Each corporation is a member of either a parent-subsidiary controlled group or a
brother-sister controlled group
At least one of the corporations is a parent of a parent-subsidiary controlled group
The parent corporation is also a member of a brother-sister controlled group
Application of Section 482 – parent corporation has power to shift income among its
subsidiaries – shareholders who control brother-sister groups can shift income and deductions
among related corporations – Section 482 permits the IRS to allocate gross income, deductions,
and credits between any two or more organizations, trades, or businesses that are owned or
controlled by the same interests
PROCEDURAL MATTERS
A.
B.
FILING REQUIREMENTS FOR CORPORATIONS p.2-25
1.
A corporation (whether it has taxable income) must file a Federal income tax return on or before the 15 th
day of the 3rd month following the close of the corporation’s tax year
2.
Extension could be granted. File Form 7004 by the due date with corporation’s estimated tax liability.
3.
A corporation is also required to file a return:
a.
for a fraction of the year if the corporation was not in existence for the whole year
b.
if it has ceased to do business but has valuable claims for which it will bring suit
4.
A corporation uses Form 1120 unless it is a small corporation entitled to use the shorter Form 1120-A.
5.
Requirements for using Form 1120-A that all must be met are:
a.
Gross receipts or sales under $500,000
b.
Total income is under $500,000
c.
Total assets are under $500,000
d.
Corporation is not involved in a dissolution or liquidation
e.
Corporation is not a member of a controlled group under §§ 1561 and 1563
f.
Corporation does not file a consolidated return
g.
Corporation does not have ownership in a foreign corporation
h.
Corporation does not have foreign shareholders who directly or indirectly own 50%+ of its stock
ESTIMATED TAX PAYMENTS p. 2-26
1.
A corp. must make estimated tax payments if it reasonably expects its tax liability to be $500 or more.
2.
The required annual amount of estimated tax payments is the lesser of:
a.
100% of the corporation’s final tax or
b.
100% of the tax for the preceding year (if a 12-month tax year and return showed a tax liability)
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C.
D.
3.
Payments can be made in installments due on or before a corp’s 15th day of the 4th, 6th, 9th, and 12th month.
4.
Large corporations (taxable income over $1 M in any of three preceding years) cannot base estimated
payments on previous years tax liability except for its first payment.
RECONCILIATION OF TAXABLE INCOME AND FINANCIAL NET INCOME p 2-26
1.
Schedule M-1 (on the last page of Form 1120) is used to reconcile financial accounting net income with
taxable income as reported on the corporation’s income tax return.
2.
Net income per books/ financial net income is the starting point on Schedule M-1 with additions and
subtractions made to account for items that affect taxable inc. and net inc. differently.
3.
Additions on lines 2-5 of the Schedule M-1:
a.
Federal income tax liability
b.
The excess of capital losses over capital gains
c.
Income reported in current year for tax purposes but not reported in computing net income per
books (ex. Prepaid income)
d.
Various expenses that are deducted in computing net inc. per books but not allowed in
computing taxable income (ex. Charitable contributions in excess of the 10% ceiling appl. to
corps.)
4.
The following are items that are entered as subtractions on lines 7-8 of Schedule M-1:
a.
Income reported for financial accounting purposes but not included in taxable income (ex.
tax-exempt interest)
b.
Expenses deducted on the tax return but not deducted in computing net income per books (ex- a
charitable contributions carryover deducted in a prior year for financial accounting purposes but
deductible in the current year for tax purposes)
5.
Schedule M-2 reconciles beginning and ending retained earnings balances as well as listing any increases
or decreases in retained earnings in addition to accounting for dividend distributions
FORM 1120 COMMENTS p. 2-29
1.
2.
3.
4.
E.
V.
Schedule A must be completed to arrive at cost of goods sold amount
Schedule C must be completed to report dividends
Form 4562 is included to verify depreciation
Any other deductions should have supporting schedules
CONSOLIDATED RETURNS p. 2-30 – Parent / subsidiary may be able to file a consolidated return for the tax
year.
TAX PLANNING CONSIDERATIONS
A.
CORPORATE VS. NON-CORPORATE FORMS OF BUSINESS ORGANIZATION p.2-30
1.
2.
3.
4.
5.
6.
7.
Corp. income is taxed twice: once at the corporate level then at shareholder level.
Rates appear to favor corporations over individuals, but it depends on the corporation’s income.
Corp. income items (e.g., municipal bonds) that receive preferential tax treatment are not taxed as such.
Corp. distributions are treated as dividends. Shareholders have difficulty recovering all investments.
Corp. losses do not pass on to investor’s.
Corp. liquidations have tax consequences for both corp. and investor.
Corp. benefits if shareholder is deemed an employee (benefits are excluded from person’s gross income):
a.
Group term life insurance
b.
Excludable meals and lodgings
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c.
B.
C.
Accident and life insurance
OPERATING THE CORPORATION p. 2-35
1.
Charitable Contributions- must be authorized by the board by the end of the year and paid on or before the
15th day of the third month of the following year. Must be authorized to be valid even if paid on time.
2.
Timing of Capital Gains and Losses – Corporate capital losses can only be used to offset capital gains.
Can only be carried back 3 years and forward 5 years.
3.
Net Operating Losses – Can be carried forward or back. Take into consideration the time value of the
refund and remember that it is irrevocable.
4.
Dividend Received Deductions- limited to the lesser of 70 % of the qualifying dividends or 70% of
taxable income. It is raised to 80% if the stockholder owns 20% or more of that stock. Exception: when
the deduction causes an NOL.
5.
Organizational Expenditure – must occur in the first taxable year to qualify for 60 month amortization.
6.
Shareholder-Employee Payment of Corporate Expenses-which are not reimbursed by the corp. are not
allow as a deduction because the payment of such expenses are voluntary.
RELATED CORPORATIONS p. 2-36
Controlled Groups – Code prevents shareholders from operating a business as multiple corporations to have a
lower tax provision. To avoid this the corporations controlling shares should be divided up so that one has the
same amount of controlling interest.
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