Chapter 11

Income Tax Fundamentals 2010 Gerald E. Whittenburg &

Martha Altus-Buller

2010 Cengage Learning

Corporate rates are progressive ° Marginal rates are from 15% to 39%, depending

on taxable income° There are eight brackets° There are a number of ‘tax bubbles’ - occurs when

tax rate schedules recaptures savings from prior brackets

For corporations with large income (more than $18.33 million) the rate is a flat 35%

Qualified personal service corps taxed at flat 35%◦ Architects, CPAs, consultants, etc.


ExampleJohnson & Kelby Inc. (a dental products

wholesaler) has taxable income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services?


ExampleJohnson & Kelby Inc. (a dental products wholesaler) has taxable

income of $300,000 for the current year. What is the corporation’s tax liability? How would the answer change if it was an architectural firm, and Johnson & Kelby provided personal services?

SolutionCorporate tax = $100,250

$22,250 + (39%)(300,000 – 100,000)If Johnson & Kelby is a qualified personal service corporation,

corporate tax = $105,000 ($300,000 x 35%)


A corporation can choose from two alternative tax treatments on capital gains◦ Taxed at ordinary rates

or

◦ Elect to pay an alternative tax (35%) on net long-term capital gain (LTCG)

Essentially equivalent to maximum regular corporate tax (no tax benefit to LTCG)

Bottom line: there is no difference in tax on ordinary vs. capital income


Corporations are allowed a deduction for a % of the dividends received from other corporations ◦ Attempt to alleviate triple taxation

Dividends received deduction is allowed based upon ownership


Percentage Ownership Dividends Received % Deduction < 20% 70% 20% or more, less than 80% 80% > 80% 100%

Deductions limited by % and other items

Examples of organizational expenditures◦ Legal/accounting services incidental to organization◦ Incorporation fees

Organizational expenditures are capitalized and then amortized over 180 months

However, can make election to deduct up to $5,000 of organization costs in year corporation begins business◦ $5,000 amount is reduced $1 for each $1 that

organizational expenses exceed $50,000


Corporations are allowed a deduction for charitable contributions◦ Cash basis taxpayers can deduct when paid◦ Accrual basis taxpayers have until the 15th day of the

third month following year-end to contribute As long as pledge is made by year-end

Limited to 10% of taxable income*◦ Carry forward unused deduction for five years

*Calculated before any loss carrybacks, NOLS or the dividend received deduction


ExampleFerndale Corp. had net operating income of

$400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is its charitable contribution carryforward?


Example

Ferndale Corp. had net operating income of $400,000 for the current year and made a charitable contribution of $60,000. A dividends received deduction (DRD) of $80,000 is included in the net operating income calculation. What is Ferndale’s charitable contribution deduction; what is the carryforward?

Solution

The charitable contribution deduction is $48,000

($400,000 + 80,000) x 10% = $48,000 limit*

Therefore, carryforward is $32,000 ($80,000 – 48,000)

*Note: had to add back DRD first!!


Schedule M-1 of Form 1120 reconciles book to tax income ◦ Computed before NOLs and special deductions

Amounts added to book income◦ Federal tax expense◦ Capital losses◦ Income recorded on tax return but not on books◦ Expenses recorded on books but not on tax return

Amounts deducted from book income◦ Income recorded on books but not on tax return ◦ Expenses recorded on tax return but not on books

See chapter for other items included on Schedule M-1


Form 1120 - regular corporation Form 1120S - S Corporation

◦ Returns are due by the 15th day of the third month after year-end

◦ Can file Form 7004 and receive automatic 6-month extension

Corporations must make estimated tax payments in similar manner as self-employed taxpayers


Certain corporations may elect to be taxed in a manner similar to partnerships

Qualified small business corporation may elect S Corporation status if several criteria apply◦ Operates as a domestic corporation◦ Has 100 or fewer shareholders

Shareholders may not be corporations or partnerships

◦ Has only one class of stock◦ Has only shareholders that are U.S. citizens or

resident aliens


Corporation must make election of S status in a prior year ◦ Or within 2-1/2 months of the current tax year

S Corp status stays in effect until revocation◦ Status can be voluntarily revoked by consent of

shareholdersor

◦ Involuntarily revoked If corporation ceases to be a small business corporation

or If corporate passive income is 25% or more for 3

consecutive years and corporation has accumulated earnings and profits at the end of each of those years


ExampleSwannak Electronics Corporation is a

calendar year corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation?


ExampleSwannak Electronics Corporation is a calendar year

corporation that makes an S Corporation election on May 25, 2009. What year may the corporation first be treated as an S Corporation?

SolutionSince Swannak did not make its election within the first

2-1/2 months of the tax year, it will be treated as a regular corporation for the current year, and will become an S Corporation for tax year 2010.


Must report all elements of income and expense separately on Form 1120S

Then each shareholder reports his/her share of these items of corporate income/expense on personal return◦ K-1 takes total shareholder income/expenses and

allocates each item to each shareholder based upon his/her ownership percentage


Each shareholder of an S Corp may also report his/her respective share of loss◦ Cannot take a loss in excess of adjusted basis in

stock◦ If loss exceeds adjusted basis in stock plus

loans, shareholder can carry it forward If shareholder entered/departed S Corp

midyear, must allocate losses on a daily basis


Many items retain tax character when passing through to the S Corporation’s shareholders on individual K-1

Examples of such items include◦ Capital gains/losses◦ §1231 gains/losses◦ Dividend Income◦ Charitable contributions◦ Tax-exempt interest◦ Most credits


Shareholders often transfer assets to a corporation in exchange for stock

No tax is due on gain from transfer of appreciated assets if conditions met◦ Shareholder transferred cash or property

and◦ Shareholder made transfer solely in exchange for

stock* Shareholder is not providing a service and all taxpayers

together own at least 80% of stock after transaction

*If shareholder receives boot in addition to stock, transaction may qualify for partial nonrecognition of gain


A shareholder’s initial basis in his/her stock is calculated as follows Basis of property transferred

Less Boot receivedPlus Gain recognizedLess Liabilities transferred Basis in stock The corporation has a carry-over basis in the

property contributed equal to the basis in the hands of the shareholder, increased by any gain recognized by shareholder on the transfer


Note: generally assumption of shareholder liabilities that are attached to property are not considered boot received.

Penalty tax designed to prevent a corporation from avoiding tax by retaining earnings

15% AET imposed on “unreasonable” accumulation of earnings in addition to corporate tax◦ Corporation may accumulate up to $250,000 a

year that is exempt from AET tax or $150,000 for a service corporation May accumulate more if can prove a valid business

purpose


ExampleXinix Corporation (a medical device

manufacturing firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be?


ExampleXinix Corporation (a medical device manufacturing

firm) has accumulated earnings of $800,000. The corporation can establish reasonable needs for $500,000 of the accumulation. What would Xinix’ accumulated earnings tax be?

SolutionIts AET = $45,000 (in addition to regular tax)($800,000 – 500,000) x 15%


Penalty tax designed to encourage Personal Holding Companies to distribute earnings to shareholders◦ Tax is 15% on undistributed earnings

Corporation is not liable for both the personal holding company tax and the AET in the same year


Corporate AMT - calculated similar to the individual AMT AMT is 20% of Alternative Minimum Taxable Income

Taxable Income +/- Adjustments + Preferences - Exemption*

Alternative Minimum Taxable Income (AMTI)

Small corporations are not subject to the AMT◦ Defined as having average annual gross receipts < $7.5

million over a three-year period

*Exemption is $40,000, but is phased out when AMTI > $150,000



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Chapter 11