Chapter 9
Taxation of
Corporations
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Corporation
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A business entity created under the laws of
state of incorporation
Owns property and can be sued directly
Shareholders own part of corporation, but no
interest in individual assets
Shareholders have limited liability
Corporation has unlimited life
Ownership interests are freely transferable
Management is centralized
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Advantages
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Easier to raise capital than other business
forms
Corporations that reinvest their income rather
than paying dividends could have lower tax
bills than flow-through entities
Shareholders can be employees and
participate in tax-free employee fringe
benefits that are deductible by the corporation
Corporation can select calendar or fiscal year
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Disadvantages
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Double taxation
The 2003 Tax Act reduced the tax rate on
dividend income to 15% (5% for individuals in
10% or 15% tax bracket)

Shareholders cannot deduct losses of the C
corporation
Corporation can only offset NOLs against
operating income in carryover years
Capital losses can only offset capital gains
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Capital Structure
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Equity
 Common stock – shareholders have last claim
on income and assets in liquidation but are
entitled to all residual income when corporation
is profitable
 Preferred stock – claims take precedence over
claims of common stockholders for dividends
(preferred dividends must be paid before
common dividends permitted) and assets in
liquidation
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Debt
 Interest on debt is deductible (but dividends are
not deductible)
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Dividend Received Deduction
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To relieve burden of multiple taxation on
corporate income
DRD based on percentage of ownership in the
distributing corporation
100% DRD for 80% or more owned affiliate
80% DRD for ownership of 20% up to 80%
70% DRD for ownership less than 20%

DRD limited to percentage times lesser of
taxable income or dividend income
Unless deducting DRD % x dividend income
creates or increases NOL
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Charitable Contributions
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Overall limit 10% of taxable income before
Charitable contribution deduction
Dividend received deduction
NOL or capital loss carrybacks
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Excess carried forward up to 5 years
Accrual basis corporation can deduct
contributions in year accrued if
Payment authorized by board before year end
Payment made by 15th day of 3rd month
following close of tax year in which accrued
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Charitable Contributions
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Deduction for ordinary income property
usually limited to basis
Deduction for LTCG property is FMV
Deduction for inventory (if donated for care of
infants, poor or ill) increased by 50% of
difference between basis and FMV (not to
exceed twice basis)
Similar exception for gifts of scientific property
given to universities and research
organizations
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Capital Gains and Losses
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All capital gains taxed as ordinary income
Capital losses can only offset capital gains
Net loss carried back 3 years as short-term
capital loss and forward up to 5 years in
sequence
Losses not used in the carryover periods are
lost
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Net Operating Losses
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NOL can be carried back 2 years
Remaining NOL carried forward 20 years
Can elect to forgo carryback and carry
forward only
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Computing Corporate Tax
Taxable revenues
Less: Deductible expenses
Equals: Taxable income
Times: Corporate tax rate
Equals: Corporate tax
Plus: Additions to tax
Less: Tax credits
Equals: Net corporate tax
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Corporate Tax Rates
Corporate rates:
15% on first $50,000
25% on $50,001 - $75,000
34% on $75,001 - $100,000
39% (34% + 5% surtax) on $100,001 - $335,000
34% on $335,001 - $10,000,000
35% on $10,000,001 - $15,000,000
38% (35% + 3%) on $15,000,001 - $18,333,333
35% on over $18,333,333
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PSC
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Personal service corporation is a corporation
that provides service in the fields of
accounting, actuarial science, architecture,
consulting, engineering, health, law, or
performing arts and
is substantially owned by its employees
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A flat 35% tax rate applies to its entire taxable
income
The PSC provisions encourage owneremployees to take earnings out of corporation
as salary
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Reconciling Book/Tax Income
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Form 1120 is the corporate tax return
Schedule L – beginning and ending financial
accounting balance sheet
Schedule M-1 – reconciliation of after-tax net
income on books with taxable income before
DRD and NOL carryover
Schedule M-2 – reports changes in
unappropriated retained earnings
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Schedule M-1
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Tax Credits
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Can reduce tax liability but not below zero
General business credit – a group of credits
aggregated into one credit
Cannot exceed $25,000 plus 75% of tax
liability in excess of $25,000
Unused credits carried back 1 year and
forward 20 years
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Alternative Minimum Tax
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AMT is a parallel tax that broadens the
regular income tax base to ensure some
taxes are paid
Small corporation are exempt
Average annual receipts less than $5 million in
each of prior taxable years
Remain exempt until average annual gross
receipts exceed $7.5 million
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Calculating AMT
Corporate taxable income
Plus/minus
Plus:
Equals:
Less:
Equals:
Times:
Equals:
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AMT adjustments
Preference items
AMT income
Exemption
AMTI base
AMT rate
Gross AMT
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Calculating AMT
Less:
Equals:
Less:
Equals:
Gross AMT
Regular corporate tax
Alternative minimum tax
Credits
Net AMT
Corporation only pays AMT if gross AMT is greater
that its regular corporate income tax
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AMT Adjustments
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Timing differences
Difference between regular tax depreciation
and AMT depreciation
Difference between gain reported for AMT by
percentage-of-completion method over gain
reported using completed contract method for
regular tax
75% of difference between adjusted current
earnings (ACE) and gross AMTI before this
adjustment
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AMT
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$40,000 Exemption
Phased out at rate of $1 for every $4 AMTI
exceeds $150,000 (completely phased out at
$310,000 AMTI)
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Credit – equal to AMT paid in prior years
Carried forward indefinitely but can only offset
regular tax in excess of AMT
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Filing and Payment
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Form 1120 is due on 15th day of 3rd month
following close of tax year
 File Form 7004 for 6 month automatic extension
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Quarterly estimated tax payments due on 15th
day of 4th, 6th, 9th, and 12th months of tax year
 Underpayment penalty assessed if liability $500
more than estimated payments
 If taxable income less than $1 million in each of 3
preceding years, no penalty if each estimated
payment equals 25% of prior year’s tax liability
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Consolidated Returns
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Affiliated group – parent corporation must
own directly 80% or more of subsidiary’s
stock (by voting and value)
Can include more than 2 corporations if 80%
of stock owned by one or more corporations
that are part of affiliated group
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Consolidated return reports combined results
of operations of all corporations in the group
All subsidiaries must consent and must have
or change to same tax year as parent
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Consolidated Net Income
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Affiliated corporations viewed as divisions of
parent requiring modification for deferred
intercompany transactions and intercompany
dividends
Items subject to limitations and netting are
determined on a consolidated basis
Capital gains and losses
Section 1231 gains and losses
Charitable contributions deductions
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Consolidated Tax Returns
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Advantages
Intercompany dividends are eliminated from
taxation
Gains on intercompany transactions are eliminated
Deductions subject to limitation may be allowed
when consolidated
Losses of one corporation can offset gains of
another
Income from one corporation can offset losses of
another
Limitations based on consolidated income permit
greater use of deductions or credits
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Dividend Distributions
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Dividend – a distribution of corporate
earnings and profits (E&P) that is taxable
income to shareholders but not deductible
by the corporation
2003 Tax Act lowered rates on dividend
income to 15% (5% for individuals in 10% or
15% tax brackets) – same rates as LTCG
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Earnings and Profits
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E&P measures how much a corporation can
distribute as a dividend and leave contributed
capital intact
Dividends in excess of E&P
Tax free return of capital to extent of
shareholder’s stock basis (reducing basis)
If shareholder’s basis is reduced to zero,
excess distribution is capital gain
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Earnings and Profits
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Current earnings and profits (CE&P) - the current
year’s taxable income (as adjusted)
Accumulated earnings and profits (AE&P) –
accumulations of CE&P for all prior years that has
not been distributed as dividends
Dividends are first paid from CE&P then AE&P
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Computing Current E&P
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Starts with taxable income, but is subject to
for positive and negative adjustments
 DRD, loss carryovers, and tax-exempt income are
added back
 Federal income taxes paid are deducted
 Charitable contributions are deducted without
regard to the 10% limit
 Only 20% of Section 179 expensing allowed
 Also deductible for E&P are life insurance
premiums on key employees, capital losses in
excess of capital gains, nondeductible expenses
related to tax-exempt income, disallowed losses
on related party sales, and nondeductible fines
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Property Distributions
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Property distributions – corporation
recognizes gain on distribution of appreciated
property (but not loss)
Value of distribution is net FMV (net of any
liabilities assumed) and basis to shareholder is
FMV
Like cash dividends, property dividends
taxable only to extent of E&P
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Stock Dividends and Rights
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Stock dividend – distribution of stock that
gives shareholder a greater number of shares
Nontaxable if proportionate distribution (unless
given choice of cash or stock)
Shareholder allocates basis among all shares
of stock
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Stock rights – the right to purchase additional
stock at a set price
 If value of rights is less than 15% of value of stock,
then no basis must be allocated to rights
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Redemptions
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Redemption – a repurchase of stock from a
shareholder by the issuing corporation that
may result in either sale or dividend treatment
to the redeeming shareholder
Sale treatment allowed if
 The redemption is substantially disproportionate
(ownership after redemption is less 50% and also
less than 80% of ownership before redemption or
 Shareholder completely terminates interest in the
corporation
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Redemptions
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If treated as a sale, shareholder recognizes
capital gain (or loss) on the difference
between the proceeds received and the basis
of the stock surrendered
If not a sale, the amount the shareholder
receives is taxed as a dividend to the extent
of the corporation’s E&P
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Redemptions
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Attribution rules apply in determining ownership
Family attribution – includes stock owned by
spouse, parent, child, grandchild
Entity to owner – attributed proportionately from
partnership to partners, from estate or trust to
beneficiaries, from corporation to 50% or greater
shareholders
Owner to entity – attributed from partner to
partnership, from beneficiary to estate or trust,
from 50% or greater shareholder to corporation
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Partial Liquidation
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Partial liquidation – the significant reduction in
a corporation’s operations or a termination of
one of its qualifying businesses with a
distribution of property or cash to its
shareholders
Corporation recognizes gain (but not loss) on
distribution of appreciated property
Noncorporate shareholders receive sale
treatment
Corporate shareholders receive dividend
treatment with dividend amount eligible for
DRD
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Corporate Liquidation
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Corporation adopts a plan of liquidation and
ceases operations
Sells assets recognizing both gains and losses
on asset sales
Distributes cash from sales and any remaining
assets to shareholders in exchange for their
stock
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Liquidating Distributions to
Shareholders
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Corporation recognizes loss as well as gain
on distribution of property in liquidation
Shareholders recognize gain or loss on
difference between FMV received and basis
of stock surrendered
Basis of property to shareholders is FMV
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Parent corporation can liquidate a subsidiary
tax free (but basis of assets carries over)
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Constructive Dividends
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Shareholder of closely held corporation
receives informal economic benefit
 Examples include rents in excess of property’s
FMV, use of corporate property for personal use,
loans to shareholder at no interest, payment of
personal expenses by corporation, and excessive
compensation

Any benefit reclassified by IRS as dividend is
taxable to shareholder but not deductible by
corporation
 Benefit to a related party can also be reclassified
as dividend to shareholder
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Penalty Taxes
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There is a 15% penalty tax, in addition to the
regular corporate tax, to encourage payment of
dividends to shareholders
Personal holding company – closely held
corporation with more than 60% AOGI from
passive sources
Accumulated earnings tax – assessed when
corporation accumulates more than $250,000
($150,000 if service business) without valid
business purpose
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Controlled Groups
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Controlled groups must apportion lower tax rates
to members of group
Parent-subsidiary group – 2 or more corporations
with a common parent
 Parent directly owns 80% of stock of subsidiary
 80% or more of stock must be jointly or separately
owned of all other corporations by parent and
subsidiaries
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Brother-sister group
 2 or more corporations have 80% of more of each
corporation’s stock owned by 5 or few individuals
and sum of lowest common ownership of each
shareholder is 50% or more
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Exempt Organizations
Appendix 9A
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Exempt Organizations
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Organizations whose purpose is to serve the
public are classified as tax-exempt
organizations
Persons who donate to exempt organizations
may be permitted a charitable contribution
deduction
Exempt organizations do not pay tax on their
income if they qualify under Section 501(c)
If it fails to meet the requirements on a
continuing basis, it may either lose its status
or be assessed an income or excise tax
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Exempt Organizations
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Exempt organizations normally operate as
corporations or as trusts
An exempt organization can be assessed
taxes when it engages in prohibited
transactions
Unrelated businesses
Transactions that benefit disqualified persons
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UBIT
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An exempt organization is assessed the
unrelated business income tax if it regularly
carries on a trade or business that is
substantially unrelated to the organization’s
exempt purpose
A business is substantially unrelated to the
exempt purpose if the sales of goods or
services do not make a significant contribution
to its exempt purpose
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UBIT
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UBIT is assessed when the exempt
organization regularly carries on a business
that competes with for-profit businesses
UBIT is assessed on the net unrelated
business income at the regular corporate tax
rates
$1,000 exemption is allowed
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UBIT
Gross unrelated business income
Less:
Deductions
Plus/minus: Modifications
Less:
$1,000 exemption
Equals:
Unrelated business income
Times:
Corporate tax rates
Equals:
Unrelated business income tax
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Filing
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Form 990: Return of Organizations Exempt
from Income Tax is due on the 15th day of the
5th month after the close of the organization’s
tax year
If UBIT must be paid, then it must also file
Form 990-T: Exempt Organization’s Business
Income Tax Return
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Excise Taxes
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An excise tax is levied on any excess benefit
transaction in which a disqualified person
participates (bargain purchase or personal use
of assets)
Disqualified person – anyone who can
substantially influence the activities of an exempt
organization
Excise tax is 25% of the excess benefit (up to
$10,000 maximum) for the disqualified person
(200% if they fail to correct the transaction) and
10% for the exempt organization’s manager
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Private Foundations
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Exempt organizations are classified as private
foundations if they are not supported by or
operated for the general public as a whole but
have a more narrow focus for their activities
Private foundations exclude 501(c)(3)
organizations that receive a major part of
their support from the public or government
To be excluded from private foundation
designation, an organization must meet both
an external and internal support test
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Private Foundations
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External support test – must receive more
than one-third of its annual support from the
general public, governments, or other exempt
organizations
Support includes membership fees,
contributions, and grants

Internal support test – limits interest,
dividends, rent, royalty, and unrelated
business income (net of tax) to one-third of its
total support
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Private Foundations
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Subject to taxes on investment income, for
failure to distribute its income, for excess
business holdings, for investing in speculative
assets, and for participating in transactions with
disqualified persons
Excise tax on investment income is 2%
Taxes on other activities range from 5% to 15%
Second round of excise taxes of up to 200% if
corrective actions are not taken
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Multistate Issues
Appendix 9B
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State Income Taxes
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45 states assess some type of income tax on
corporations
Franchise tax – an excise tax based on the
right to do business or own property in the
state
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Rates typically range from 4% to 10%
Most states piggyback on the federal system
by beginning their computations with the
corporation's federal taxable income
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State Income Taxes
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Typical modifications of federal taxable
income include
State and local income taxes
Interest income earned on state and local
bonds
Interest income on federal notes or bonds
Dividends received deduction
Net operating losses
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State Income Taxes

Nexus – the connection between a state and
the business that the state is seeking to tax
Nexus can be established through physical
presence of corporate property or employees
in the state

When there is nexus in several states, each
state can tax only the percentage of income
based on the business allocated to that state
Most states use the three-factor allocation
formula of sales, payroll costs, and tangible
property
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State Income Taxes

Nonbusiness income (interest, dividends,
rent) is taxed in one state only
Usually the in which the corporation is
domiciled or where property is located or used
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Income tax planning usually involves shifting
income from high-tax states to low-tax states
by eliminating nexus in a state through the
outsourcing of functions or shifting assets
A few states subject S corporations to the
corporate income tax
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Sales Taxes

45 states charge sales taxes that typically
range from 3% to 7%
Many local governments impose local sales
taxes resulting in more than 7,400 different
taxing jurisdictions

Sales taxes are imposed on gross receipts
from retail sales or leases of tangible
personalty
Retailer is responsible for collecting
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Sales Taxes

Multistate retailers must determine not only
the appropriate tax rate but also which items
are subject to tax in each location
Exempt items typically include food,
prescription drugs, realty, intangible property,
and most services

A state can require an out-of-state business
to collect sales tax only if it has nexus with
the state
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Use Tax

Use tax – imposed on the use of property
brought into a state that levies a sales tax
when sales tax was not paid in the state of
purchase
A use tax is self-assessed and usually has the
same rate as the sales tax
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The End
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