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Corporation
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
1) Easier to raise capital than other business forms
2) Corporations that reinvest their income rather than paying dividends could have lower tax bills than flow-through entities
3) Shareholders can be employees and participate in tax-free employee fringe benefits that are deductible by the corporation
4) Corporation can select calendar or fiscal year
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Disadvantages
1) Double taxation The 2003 Tax Act reduced the tax rate on
dividend income to 15% (5% for individuals in 10% or 15% tax bracket)
2) 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
Equity – dividends paid are not deductibleCommon 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
Debt – interest paid on debt is deductible
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Dividend Received Deduction
To relieve burden of multiple taxation on corporate income
DRD based on percentage of ownership in the distributing corporation100% DRD for 80% or more owned affiliate80% 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 incomeUnless deducting DRD % x dividend income
creates or increases NOL
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Charitable Contributions
Overall limit 10% of taxable income beforeCharitable contribution deductionDividend received deductionNOL or capital loss carrybacks
Excess carried forward up to 5 years Accrual basis corporation can deduct
contributions in year accrued ifPayment authorized by board before year endPayment made by 15th day of 3rd month
following close of tax year in which accrued
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Charitable Contributions
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
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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Qualified U.S. Production Activities Deduction
New deduction for domestic production activities for most manufacturing, leasing, and construction (including architectural & engineering) that take place in the U.S.
Receipts from sale of food or beverages prepared at a retail establishment are not eligible
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Qualified U.S. Production Activities Deduction
For 2005 & 2006 deduction equals 3% of lesser of:Qualified production activities income orTaxable income before deduction
Deduction cannot exceed 50% of wages paid during the year
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Qualified U.S. ProductionActivities Income
Qualified production activities income is domestic production gross receipts less the sum of:Cost of goods sold & other deductions related
to these gross receipts andA ratable share of other deductions not related
to this income
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Net Operating Losses
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 revenuesLess: Deductible expenses
Equals: Taxable incomeTimes: Corporate tax rate
Equals: Corporate taxPlus: Additions to taxLess: 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
Personal service corporation isa 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 A flat 35% tax rate applies to its entire taxable
income The PSC provisions encourage owner-
employees to take earnings out of corporation as salary
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Reconciling Book/Tax Income
Form 1120 is the corporate tax returnSchedule L – beginning and ending financial
accounting balance sheetSchedule 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
Schedule M-3 – reconciliation of net income (loss) for corporations with total assets of $10 million or more
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Tax Credits
Can reduce tax liability but not below zero General business credit – a group of credits
aggregated into one creditCannot exceed $25,000 plus 75% of tax
liability in excess of $25,000Unused credits carried back 1 year and
forward 20 years
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Alternative Minimum Tax
AMT is a parallel tax that broadens the regular income tax base to ensure some taxes are paid
Small corporations are exemptAverage annual receipts less than $5 million in
each of prior taxable yearsRemain exempt until average annual gross
receipts exceed $7.5 million
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Calculating AMT
Corporate taxable income
Plus/minus AMT adjustments
Plus: Preference items
Equals: AMT incomeLess: Exemption
Equals: AMTI baseTimes: AMT rate
Equals: Gross AMT
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Calculating AMT
Gross AMTLess: Regular corporate tax
Equals: Alternative minimum taxLess: Credits
Equals: Net AMT
Corporation only pays AMT if gross AMT is greater than its regular corporate income tax
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AMT Adjustments
Timing differences1) Difference between regular tax depreciation
and AMT depreciation2) Difference between gain reported for AMT
by percentage-of-completion method over gain reported using completed contract method for regular tax
3) 75% of difference between adjusted current earnings (ACE) and gross AMTI before this adjustment
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AMT
$40,000 ExemptionPhased out at rate of $1 for every $4 AMTI
exceeds $150,000 (completely phased out at $310,000 AMTI)
Credit – equal to AMT paid in prior yearsCarried forward indefinitely but can only offset
regular tax in excess of AMT
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Filing and Payment
Form 1120 is due on 15th day of 3rd month following close of tax yearFile Form 7004 for 6 month automatic extension
Quarterly estimated tax payments due on 15th day of 4th, 6th, 9th, and 12th months of tax yearUnderpayment 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
Affiliated group – parent corporation must directly own 80% or more of subsidiary’s stock (by voting rights and value)Can include more than 2 corporations if 80%
of stock owned by one or more corporations that are part of affiliated group
Consolidated return - reports combined results of operations of all corporations in the groupAll subsidiaries must consent and must have
or change to same tax year as parent
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Consolidated Net Income
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
1) Capital gains and losses2) Section 1231 gains and losses3) Charitable contribution deductions
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Consolidated Tax Returns
Advantages1) Intercompany dividends are eliminated from
taxation2) Gains on intercompany transactions are eliminated3) Deductions subject to limitation may be allowed
when consolidated4) Losses of one corporation can offset gains of
another5) Income from one corporation can offset losses of
another6) Limitations based on consolidated income permit
greater use of deductions or credits
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Dividend Distributions
Dividend – a distribution of corporate earnings and profits (E&P) that is taxable income to shareholders but not deductible by the corporation2003 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
E&P measures how much a corporation can distribute as a dividend and leave contributed capital intact
Dividends in excess of E&PTax 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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Property Distributions
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
Stock dividend – distribution of stock that gives shareholder a greater number of sharesNontaxable if proportionate distribution (unless
given choice of cash or stock)Shareholder allocates basis among all shares
of stock 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
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
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
Attribution rules apply in determining ownershipFamily attribution – includes stock owned by
spouse, parent, child, grandchildEntity 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
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 shareholdersCorporation 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
Corporation adopts a plan of liquidation and ceases operationsSells assets recognizing both gains and
losses on asset salesDistributes cash from sales and any remaining
assets to shareholders in exchange for their stock
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Liquidating Distributions to Shareholders
Corporation recognizes loss as well as gain on distribution of property in liquidation
Shareholders recognize gain or loss on difference between FMV of property received and basis of stock surrenderedBasis of property to shareholders is FMV
Parent corporation can liquidate a subsidiary tax free (but basis of assets carries over)
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Constructive Dividends
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 corporationBenefit to a related party can also be reclassified
as dividend to shareholder
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Penalty Taxes
There is a 15% penalty tax, in addition to the regular corporate tax, to encourage payment of dividends to shareholders Personal holding company tax – 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
Controlled groups must apportion lower tax rates to members of group
Parent-subsidiary group 1) 2 or more corporations with a common
parent
2) Parent directly owns 80% of stock of subsidiary
3) 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 group1) 2 or more corporations have 80% or more of
each corporation’s stock owned by 5 or fewer individuals and
2) Sum of lowest common ownership of each shareholder is 50% or more
Controlled Groups
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Computing Current E&P
Starts with taxable income, but is subject to positive and negative adjustments
1) DRD, loss carryovers, and tax-exempt income are added back
2) Federal income taxes paid are deducted3) Charitable contributions are deducted without
regard to the 10% limit4) Only 20% of Section 179 expensing allowed5) 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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Earnings and Profits
Current earnings and profits (CE&P) Current year’s taxable income (as adjusted)
Accumulated earnings and profits (AE&P)Accumulations of CE&P for all prior years that have
not been distributed as dividends Dividends are first paid from CE&P then AE&P 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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Exempt Organizations
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 they fail to meet the requirements on a
continuing basis, they may either lose their status or be assessed an income or excise tax
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Exempt Organizations
Exempt organizations normally operate as corporations or as trusts
An exempt organization can be assessed taxes when it engages in prohibited transactionsUnrelated businessesTransactions that benefit disqualified persons
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UBIT
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 purposeA 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
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: ModificationsLess: $1,000 exemption
Equals: Unrelated business incomeTimes: Corporate tax rates
Equals: Unrelated business income tax
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Filing
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
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
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 governmentTo be excluded from private foundation
designation, an organization must meet both an external and internal support test
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Private Foundations
External support test – must receive more than one-third of its annual support from the general public, governments, or other exempt organizationsSupport 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
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 personsExcise 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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State Income Taxes
45 states assess some type of income tax on corporationsFranchise tax – an excise tax based on the
right to do business or own property in the state
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
Typical modifications of federal taxable income includeState and local income taxesInterest income earned on state and local
bondsInterest income on federal notes or bondsDividends received deductionNet operating losses
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State Income Taxes
Nexus – the connection between a state and the business that the state is seeking to taxNexus 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 stateMost 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 state in which the corporation is
domiciled or where property is located or used 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 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 personaltyRetailer 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 locationExempt 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 purchaseA use tax is self-assessed and usually has the
same rate as the sales tax