Chapter 2 "Corporations: Introduction and Operating Rules"
Read all pages of text except skip the parts of L.O. 2 that refer to personal services corporations; we will not cover L.O. 7 directly, but reading it is likely to help with advanced accounting coverage of accounting for income taxes
Tax Treatment of Various Business Forms
Sole proprietorships: Business income of the owner is taxed via individual income tax return.
Partnerships and S Corporations: Owners are taxed on income of the entity via "flow-through."
Entity is not subject to tax but files an information return (Partnerships - Form 1065 & S
Corporations - Form 1120S.)
Corporation (C Corp. or "regular" corporation): Entity is taxed (Form 1120). Owners are taxed on distributions from the corporation (dividends). C Corporations, therefore, are subject to double taxation.
Limited Liability Companies: Owners choose whether to be taxed as a partnership or corporation
- partnership is by far the more common choice. A one-owner LLC chooses between sole proprietorship and corporation.
In class 2, 5
HW 9
Important nontax issues:
Legal liability is probably the most important nontax issue.

Sole proprietors and general partners in a partnership have unlimited liability.

Corporate shareholders (including S Corps.), LLC members, and limited partners in a partnership have limited liability.
HW 10
Shareholder Tax on Qualifying Dividends
As of 2003, shareholders who are individuals pay tax at a maximum rate of 15%. The maximum net long-term capital rate is also 15%. This favorable rate affects traditional tax planning between a corporation and owners.
In class 36
HW 34, 35, 37
Income Taxation of Corporations
Background
Tax liability = tax base * rate(s)
Tax base = taxable income
Tax rates - see inside front cover of book
1

Corporate tax formula: see inside front cover of book
The language (gross income, exclusions, deductions, credits) is similar to that for individuals.

Many rules for measuring taxable income and tax liability apply without regard to an entity or person.

Many rules for measuring taxable income and tax liability apply with regard to an entity or person.
Financial accounting rules measure net income according to GAAP. Taxable income has many numbers that are the same as financial accounting numbers, but there can be numerous differences between financial accounting net income and taxable income. The corporate tax form requires a schedule that explains the difference between financial and taxable income.
Accounting periods
Corporations have a lot of flexibility for the choice of year-end. The financial accounting yearend will be used for tax. Fiscal year-end choices are likely to reflect the natural business cycle of the corporation.
Accounting methods
Accounting methods include cash, accrual, or hybrid (i.e., cash basis taxpayer is on accrual for inventory). The cash method is not available to large corporations because of the greater ability to manipulate taxable income under the cash method versus the accrual method.
Large: average annual gross receipts for the last three years exceed $5 million
In class: Handout #1
An accrual basis corporation cannot deduct a payment to a cash basis related party until the period in which the related party includes the payment in income. Related party is an owner with control of more than 50% of the stock.
In class 13
HW 42
Specific taxable income measurement issues
Capital gains and losses:

Netting process is the same as for individuals.

There is no preferential rate for net capital gains; i.e., a net long-term capital gain is taxed as ordinary income.

Net capital losses are not deductible but carry back for three years or carry forward for five years to offset capital gains in those other years. Carryback is not required.
In class 44, 46
HW 4, 14, 15, 43, 45
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Charitable contributions:

General rule for measurement of dollar amount of contributions is largely the same as for individuals.

Long-term capital gain property: ____________________
Ordinary income property: _________________
In class 49

One measurement rule is more generous for corporations: For some donations of ordinary income property, the dollar amount of the donation is increased. Qualifying donations: 1. donations of inventory when donation is used for certain individuals (ill, needy, or infants) and 2. donations of scientific property to certain organizations for research. The increase: 50% of the appreciation on the property but the total amount cannot be greater than 2xAB of the property
HW 48

Accrual basis taxpayers can take a deduction in the year of accrual if authorized by
Board of Directors and if the payment will be made by the tax return due date (15 th day of 3 rd
month following year-end). Otherwise, deduction is in year paid.
In class 18

The amount that can be deducted on the current tax return is limited to 10% of taxable income computed before these items: the charitable contribution, a capital loss carryback, a net operating loss carryback, the dividends received deduction, and the
DPAD. (NOL carryforward is taken into account.) Any excess (nondeductible) contribution can be carried forward five years (current year amounts are deducted before any carryforward amounts).
In class Handout #2, 50
HW 19
Domestic Production Activities Deduction (DPAD)
This deduction is effective for tax years beginning after 12-31-2004. The deduction is available to all businesses (C Corps, sole proprietors, flow through entities) engaged in domestic production activities. In many cases, domestic production activities are a subset or part of all business activities. Rules and definitions will “carve out” the qualified activities, and thus, the numbers that go into the calculations.
Calculations
Percentage: 2005 and 2006
2007 through 2009
3%
6%
2010 and after 9%
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Current allowable deduction = lesser of
1. qualified production activities income x 6%
2. taxable income before the DPAD x 6%
3. 50% of DPA wages paid by business (reported on W-2s)
In class 52
HW 21
Net operating losses (NOL):
A net operating loss = negative taxable income in the current year. The NOL can be used to offset positive taxable income in other periods: carryback = 2 years and carryforward =
20 years. Carryback is not required.
Dividends received deduction (DRD):
Dividend income received by corporation minus DRD = taxable portion of dividend
Reason for DRD: reduce multiple taxes that would otherwise occur on same income
The amount of the DRD is calculated based on the following:
Corporation's ownership percentage in other corporation DRD
Less than 20%
20% to less than 80%
80% or more
70%
80%
100%
In addition, there are limits on the DRD based on taxable income computed without the
DRD, NOL carryforwards or carrybacks, capital loss carrybacks, or the production activities deduction.
Three steps to follow:
1.
DRD percentage * dividends received = tentative DRD
2.
DRD percentage * “taxable income computed without …” = possible DRD
3.
Taxable income in step 2 minus step 1 tentative DRD = step 3 amount

If step 3 amount is positive, DRD = lesser of step 1 (tentative DRD) or step 2
(possible DRD)

If step 3 amount is negative, DRD = step 1 (tentative DRD)
In class 54 Green, 53
In class 22 (review)
HW 54 Yellow and Orange
4

Organizational expenditures and start up costs:
Organizational expenditures (e.g., legal and accounting fees related to incorporation) are capitalized (i.e., create an asset) for tax purposes. The expenditures can be amortized if an election is made under IRC § 248. The election is filed with the first tax return. The same concept applies to start up costs (e.g., business investigation, pre-opening expenditures) under
IRC § 195.
Basic new rule for time period of amortization: 180 months
Complication for immediate deduction up to $5,000
Amount capitalized = $0 to $50,000
Can deduct $5,000 and then amortize the rest
Amount capitalized = $50,000 to $55,000 (phase out range)
Can deduct $5,000 minus ($ amount capitalized minus $50,000) and then amortize the rest
Amount capitalized = or > $55,000
Can only amortize
In class Handout #3
HW 24, 56
Determining Corporate Tax Liability
Rate schedule: inside front cover of book
Example: What is the tax liability on taxable income of $500,000?
What's interesting about the pattern of rates?
Like individuals, corporations pay which amount is higher: the regular tax liability or the alternative minimum tax liability (Chapter 3).
Each year, related corporations (technically: controlled groups) can only take advantage of the lower rates once. Parent-subsidiary is an example of a controlled group.
In class Handout #4
HW 28, 57
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Procedural Requirements
Corporation files Form 1120. Small corporations may file Form 1120-A. Due date: 15 th
day of
3 rd month following year-end with extension of six months if necessary.
Estimated payments are due by the 15 th
day of the following months: 4 th
, 6 th
, 9 th
, 12 th
.
Underpayment penalties could apply.
Schedule M-1:
The corporate tax return requires a reconciliation of financial statement net income to taxable income on the tax return (taxable income before NOL and DRD – tax return Line 28). In practice, the financial statements are the starting point of the tax return.
In class 59, 29
HW 58
Schedule M-3 (see form in Appendix B):
Large corporations (total assets > or = $10 million) use Schedule M-3 instead of the M-1. The
M-3 basically requires consist reporting of common transactions that cause book-tax differences.
The IRS can assemble and then compare and contrast reporting much more easily.
Part I “Financial Information and Net Income (Loss) Reconciliation”
Overall financial statement net income is reconciled to a number that is relevant for tax reporting. There are differences in consolidation rules for book and tax.
Part II “Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations with Taxable Income per Return”
Part III information transfers to the bottom of Part II.
Part III “Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations with Taxable Income per Return – Expense/Deduction Items”
In class 60, 62
HW 30
6