Chapter 16

Corporations

Learning Objectives

• Determine the types of entities that can be classified as a corporation for federal income tax purposes

• Calculate the corporate income tax liability and explain specific tax rules

• Apply the non-recognition of gain or loss rules for corporate formations

Learning Objectives

• Understand the significance of earnings and profits

• Determine the consequences of non money distributions and stock redemptions

• Understand the consequences of a corporate liquidation to shareholders and the liquidating corporation

How A Business May Be Organized

• Sole Proprietorship• C (regular) Corporation• S Corporation• Partnership• Limited Liability

Partnership - LLP• Limited Liability Company

- LLC

Major Types

• TAXABLE ENTITIES– Sole proprietorship– C corporation

• FLOW-THROUGH OR CONDUIT ORPASS-THROUGH ENTITIES• S corporation• Limited Liability

Companies• Limited Partnerships• Partnership

Taxation Of Businesses

• Income from sole proprietorships and flow-through entities – is taxed once at the individual owner

level while corporate income is taxed twice,

– once at the corporate level – and again at the shareholder level upon

dividend distributions or stock sales

Define A Corporation

• A business entity with two or more owners is classified as either a corporation or a partnership

• A business entity with one owner is classified as a corporation or a sole proprietorship

Define A Corporation

• A business entity is a corporation if it is organized under a federal or state statue that refers to the entity as incorporated or as a corporation

• If a business entity incorporates, it is a corporation

Define A Corporation

• If a business forms itself as a Partnership, Limited Liability Company(LLC) Or Limited Liability Partnership(LLP), the entity can elect to be taxed as either a partnership or corporation

Similarities Of Individuals And Corporations

• Similar computation of taxable income

• Allowed to deduct ordinary and necessary business expenses

• Can deduct interest and depreciation

Differences Between Corporations And Individuals

• Personal, consumption-type expenditures and exemptions apply solely to individuals

• Computation of AGI applies only to individuals• Corporation is not permitted to use standard

deduction or deduct personal and dependency exemptions

• Corporations receive a dividends-received deduction

• Corporate charitable deductions limited to 10% taxable income

• Compensation deduction limitation for Publicly Held Corporations

• Corporations are not permitted any preferential treatment of net long term capital gains

Specific Rules Applicable To Corporations

• Capital gains & losses

• Dividends received deduction

• Net operating losses

• Charitable contributions

• Compensation deduction limitation for publicly held corporations

Computation Of Taxable Income• Reflects a stair-step

progression (see table on page 16- 9)

• Corporation income tax is essentially a flat tax for large corporations

• Special rules for certain Personal Service Corporations

Computation Of Corporate Alternative Minimum Tax

• Designed to ensure that no corporation with substantial economic income can use exclusions, deductions, and credits to avoid significant tax liability

• 20% of alternative minimum taxable income (AMTI) less an exemption amount

Exception To AMT For Small Corporations

• For tax years after 1997 AMT does not apply to small corporations

• $5 million gross receipts test in its first tax year after 1996

Penalty Taxes

• Two penalty taxes– Accumulated earnings tax– Personal holding company tax

Computation of Tax for Controlled Groups

• Definition of controlled group

• To prevent manipulation

• Brother – Sister

• Parent – Subsidiary

• Combine Controlled

Consolidated Returns

• Corporations that are members of a parent – subsidiary affiliated group are eligible to file a consolidated tax return.

Transfers Of Property To Controlled Corporations

• Section 351 non-recognition requirements

• Basis considerations

• Treatment of liabilities

Capitalization Of The Corporation

• Debt has two main tax advantages:– Interest payments are deductible– Principal repayments are a tax-free return

of capital

• Safe harbor rule

Earnings And Profits

• Calculation of earnings and profits

• Current versus Accumulated E&P

Non Money Distributions

• Tax consequences to the shareholders– Amount distributed = FMV of property

(reduced by liabilities)– Treated as taxable dividend if corporation has

sufficient E&P– Basis of distributed property = FMV (without

reduction for liabilities)

Non Money Distributions

• Tax consequences to the distributing corporation– General rule, the corporation recognizes

no gain or loss upon a distribution to its shareholders

– If corporation distributes appreciated property to its shareholders, the corporation is treated as if it sold the property to the shareholder for its FMV immediately before the distribution, and the corporation recognizes any realized gain

Stock Redemption

• Redemption treated as a taxable dividend (E&P)

• Redemption treated as an exchange, resulting in capital gain or loss by shareholder

Determining Whether A Redemption Is A Dividend Or Capital Gain

• Subject to capital gain or loss if any of following met: Redemption...– Is not essentially equivalent to a dividend– Is substantially disproportionate with

respect to shareholders’ interest– Results in a complete termination of

shareholders’ interest– Is made in partial liquidation of corporation

Corporate Distributions In Complete Liquidation

• Tax consequences to the liquidating corporation

• Tax consequences to the shareholders

• Section 332: Liquidation of a subsidiary corporation

Typical Misconception

• It is sometimes assumed that the liquidation of a corporation always is associated with the discontinuance of business activities. Sometimes the business is operated as a partnership or sole proprietorship after the liquidation

Tax Planning Considerations

• Capital structure and Section 1244

• Dividend policy• Use of losses• Charitable contributions• Dividends-received

deductions• Reduced taxes on

taxpayer stock sales

Compliance & Procedural Considerations

• Filing requirements– Corporation must file Form 1120– Not based on gross income– Due date is one month earlier than

individual returns– Due date for estimated tax installment

also one month earlier

Compliance & Procedural Considerations

• Schedule M-1 and M-2 reconciliation– M-1 used to reconcile financial accounting

net income with taxable income (before NOL & dividends-received deductions)

– M-2 reconciles the beginning year balance in retained earnings with year-end balance

– M-3 starting 2004 Corporations with total assets of $10million or more are required to disclose information about book-tax differences

• Maintenance of records/E&P