Tax Planning for Businesses

DBPT10

SELF�STUDY CONTINUING PROFESSIONAL EDUCATION

Tax Planning for

Businesses

Fort Worth, Texas(800) 431�9025trainingcpe.thomson.com

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Interactive Self�study CPE

Tax Planning for Businesses

TABLE OF CONTENTS

Page

Overview 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 1: Tax Payments 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Alternative Minimum Tax 23. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Business Income Taxes 53. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 4: Tax Credits 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Glossary 105. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index 109. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To enhance your learning experience, the examination questions are located throughoutthe course reading materials. Please look for the exam questions following each lesson.

Testing Instructions for Examination for CPE Credit 111. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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INTRODUCTION

Tax Planning for Businesses is an interactive self�study CPE course designed to enhance your understanding of thelatest issues in the field. To obtain credit, you must log on to our Online Grading System atOnlineGrading.Thomson.com to complete the Examination for CPE Credit by August 31, 2011. Completeinstructions are included below and in the Testing Instructions on page 111.

Taking the Course

You are asked to read the material and, during the course, to test your comprehension of each of the learningobjectives by answering self�study quiz questions. After completing each quiz, you can evaluate your progress bycomparing your answers to both the correct and incorrect answers and the reason for each. References are alsocited so you can go back to the text where the topic is discussed in detail. Once you are satisfied that youunderstand the material, answer examination questions which follow each lesson and record your answerchoices by logging on to our Online Grading System.

Qualifying Credit HoursQAS or Registry

Gear Up is registered with the National Association of State Boards of Accountancy as a sponsor of continuingprofessional education on the National Registry of CPE Sponsors (Registry) and as a Quality Assurance Service(QAS) sponsor. Part of the requirements for both Registry and QAS membership include conforming to theStatement on Standards of Continuing Professional Education (CPE) Programs (the standards). The standards weredeveloped jointly by NASBA and the AICPA. As of this date, not all boards of public accountancy have adopted thestandards. Each course is designed to comply with the standards. For states adopting the standards, recognizingQAS hours or Registry hours, credit hours are measured in 50�minute contact hours. Some states, however, require100�minute contact hours for self study. Your state licensing board has final authority on accepting Registry hours,QAS hours, or hours under the standards. Check with the state board of accountancy in the state in which you arelicensed to determine if they participate in the QAS program or have adopted the standards and allow QAS CPEcredit hours. This course is based on one CPE credit for each 50 minutes of study time in accordance withstandards issued by NASBA. Note that some states require 100�minute contact hours for self study. You may alsovisit the NASBA website at www.nasba.org for a listing of states that accept QAS hours. Credit hours for CPEcourses vary in length. Credit hours for this course are listed on the �Overview" page.

CPE requirements are established by each state. You should check with your state board of accountancy todetermine the acceptability of this course. We have been informed by the North Carolina State Board of CertifiedPublic Accountant Examiners and the Mississippi State Board of Public Accountancy that they will not allow creditfor courses included in books or periodicals.

Obtaining CPE Credit

Log onto our Online Grading Center at OnlineGrading.Thomson.com to receive instant CPE credit. Click thepurchase link and a list of exams will appear. You may search for the exam by selecting Gear Up/Quickfinder in thedrop�down box under Brand. Payment of $27 is accepted over a secure site using your credit card. For furtherinstructions regarding the Online Grading Center, please refer to the Testing Instructions located at the beginningof the examination. A certificate documenting the CPE credits will be issued for each examination score of 70% orhigher.

Obtaining CFP® Credit

To receive CFP® credit, please provide your name and CFP license number to Thomson Reuters within the OnlineGrading Center. Upon successful completion of the course, we will submit the credit hours you've earned directlyto the CFP Board. The CFP Board will then send you a confirmation email that includes the number of credits youhave been awarded and the category in which they were earned. If we do not receive your name and licensenumber within 30 days of completion, the CFP Board will not award you credit.

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Retaining CPE Records

For all scores of 70% or higher, you will receive a Certificate of Completion. You should retain it and a copy of thesematerials for at least five years.

PPC In�House Training

A number of in�house training classes are available that provide up to eight hours of CPE credit. Please call ourSales Department at (800) 431�9025 for more information.

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DBPT10 Tax Planning for Businesses

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�TAX PLANNING FOR BUSINESSES (DBPTG10)

OVERVIEW

COURSE DESCRIPTION: This interactive self�study course provides an introduction to tax issues faced bysmall businesses. Lesson One discusses tax payments, including estimated taxpayments. Lesson Two covers how a small business might be affected by thealternative minimum tax. Business income tax including the accumulated earningstax and the built�in gains tax are the subjects of Lesson Three. The last lessonoutlines various tax credits available to businesses.

PUBLICATION/REVISIONDATE:

August 2010

PREREQUISITE/ADVANCEPREPARATION:

Basic knowledge of tax preparation

CPE CREDIT: 8 QAS Hours, 8 Registry Hours8 CTEC Federal Hours, 0 CTEC California Hours

Check with the state board of accountancy in the state in which you are licensed todetermine if they participate in the QAS program and allow QAS CPE credit hours.Alternatively, you may visit the NASBA website at www.nasba.org for a listing ofstates that accept QAS hours. For those states requiring 100�minute contact hoursfor self study, the course qualifies for four credit hours.

Enrolled Agents: This CPE course is designed to enhance professional knowledgefor Enrolled Agents. PPC is a qualified CPE Sponsor for Enrolled Agents as requiredby Circular 230 Section 10.6(g)(2)(ii).

CFP® CREDIT: 4 CE HoursCFP® Credit hours are one half the number of CPE credit hours

FIELD OF STUDY: Taxes

EXPIRATION DATE: Postmarked by August 31, 2011

KNOWLEDGE LEVEL: Basic

LEARNING OBJECTIVES:

Lesson 1Tax Payments

Completion of this lesson will enable you to:� Calculate the appropriate amount of corporate estimated tax due in the manner prescribed by the Internal

Revenue Service.� Determine the correct amount of estimated tax payments (if any) required to be made by a C Corporation, an

S corporation or pass�through entity, and how to make deposits to suspend the running of interest on a potentialunderpayment of tax.

Lesson 2Alternative Minimum Tax

Completion of this lesson will enable you to:� Calculate the correct amount of alternative minimum tax (AMT) required to be paid by a corporation including

AMT adjustments, preferences and ACE adjustments.� Prepare a correct calculation of the AMT net operating loss (if any) and correctly apply this loss against the AMT

taxable income of the appropriate year.� Determine if the corporation meets any tests that would exempt it from AMT under the provisions for small

corporations.� Identify the actions to eliminate or reduce the amount of AMT that would otherwise be due for the tax year.

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Lesson 3Business Income Taxes

Completion of this lesson will enable you to:� Identify taxes imposed on the corporation for the current tax year.� Determine if the corporation is subject to the accumulated earnings tax and how to determine the correct

amount of such tax.� Determine if the corporation is considered a personal holding company (PHC) and, if so, calculate the amount

of PHC tax that might be due.� Recognize if any corporate�level taxes or taxes unique to an S Corporation might be due for the year and

calculate the LIFO recapture tax.

Lesson 4Tax Credits

Completion of this lesson will enable you to:� Describe the various tax credits that are available to the business such as the general business credit, passive

activity credit, foreign tax credit, and credit for federal excise tax on gasoline and special fuels.� Identify the various credits that make up the general business credit and how to correctly apply limitations, and

handle excess and unused credits.� Calculate the correct amount of the minimum tax credit and determine how to handle any excess credits for

a particular year.

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Lesson 1:�Tax Payments

C corporations (corporations not electing S corporation status) pay income tax on corporate�level earnings. Theygenerally must pay (deposit) any tax due on Form 1120 in full no later than the original due date of the return toavoid penalties and interest. However, the IRS may extend the time for payment in limited situations. Nevertheless,the corporation must pay interest to the IRS if it does not pay (or if it underpays) tax when it is due, without regardto extensions of time for payment. The failure to pay tax when it is due generally subjects the corporation to apenalty of 0.5% per month on the amount of unpaid tax for each month of the delinquency, up to a maximum of25%.

C corporations are normally required to make estimated tax payments. Underpaying or failing to make timelyestimated tax payments subjects the corporation to a penalty. Various options are available to minimize quarterlyestimated tax payments (preserving company cash) and still avoid underpayment penalties. Alternatively, if a Ccorporation discovers after its tax year that it has overpaid its estimated tax payments, it may be eligible to file fora quick refund of those payments.

Partnerships and S corporations generally do not have any company�level tax, because partnerships and Scorporations pass through any profits or losses to their owners. Owners must then include company items ofincome, deductions, and credits on their individual tax returns.

However, certain S corporations that were previously C corporations may face special S corporation�level taxesbecause of their conversion to S status. They must pay (deposit) any tax due on Form 1120S in full no later than theoriginal due date of the return to avoid penalties and interest. The S corporation may also be required to payestimated tax on these amounts. The S corporation must still pass through to its shareholders all other companyitems of income, deduction, and credit.

This lesson presents answers to common payment issues confronting C and S corporations when filing thecompany income tax return. It also covers procedures for making estimated tax payments for C and S corporations.

Learning Objectives:

Completion of this lesson will enable you to:� Calculate the appropriate amount of corporate estimated tax due in the manner prescribed by the Internal

Revenue Service.� Determine the correct amount of estimated tax payments (if any) required to be made by a C Corporation, an

S corporation or pass�through entity, and how to make deposits to suspend the running of interest on a potentialunderpayment of tax.

PAYMENT OF TAX DUE ON A COMPANY'S INCOME TAX RETURN

A corporation must pay the tax due on Form 1120 or 1120S in full no later than the original due date of the returnto avoid penalties and interest. If the due date falls on a Saturday, Sunday, or legal holiday, payment can be madeon the next business day. Partnerships do not pay tax at the company level.

Must a Corporation Use the Depository Method to Pay Income Taxes?

The rules for paying corporate income tax are fundamentally different from the rules for paying an individual'sincome tax. Taxpayers familiar with mailing in tax payments with Form 1040 should be careful not to use this sameapproach for the company's federal income tax payments.

If the corporation (C or S) owes tax when it files the income tax return (or the extension request), the company mustdeposit the tax payment. The tax payment is not included with the return. Nor is the payment sent directly to an IRSoffice. Similarly, if the corporation (C or S) is required to make estimated income tax payments during the year, thecompany must deposit the tax payments. The two methods of depositing corporate income taxes are explainedbelow.


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What Is the Depository Tax Method? A corporation (C or S) not required to deposit income taxes electronicallymust deposit its income tax payment along with Form 8109 (Federal Tax Deposit Coupon) in an authorizeddepository for federal taxes. An authorized depository is a financial institution (e.g., a commercial bank) that isauthorized to accept federal tax deposits. Checks or money orders should be made payable to that depository. (Forbusinesses that do not wish to use an authorized financial institution, the Treasury Department has authorized afinancial agent to process federal tax deposit payments through the mail. The address for this mail�in alternative isFinancial Agent, Federal Tax Deposit Processing, P.O. Box 970030, St. Louis, Missouri, 63197.)

To ensure proper crediting, the company should write the corporation's employer identification number, the taxperiod to which the deposit applies, and �Form 1120" on the check or money order being deposited. Also, the 1120box on Form 8109 should be darkened.

Employers submit their employment tax deposits with Form 8109, which is a book of coupons plus stub receipts forthe employer to keep track of the payments. The coupons are preprinted with the employer's name, address, andidentification number. According to IRS Pub. 15, Circular E, �Employer's Tax Guide" (2010), new employers whowould like to receive a coupon book should call (800) 829�4933. Delivery will take five or six weeks. Obtaining theproper coupons is the employer's responsibilitythe employer is not excused from making a deposit by not havingthe proper coupon book. The IRS tracks the employer's use of coupons and automatically resupplies the employerwith new Forms 8109. Employers who do not receive their resupply of deposit coupons should call (800) 829�4933.Employers who do not have the preprinted Form 8109 coupon booklet should deposit their taxes using a genericor non�preprinted Form 8109�B to make deposits.

Are Electronic Tax Deposits Required? Certain taxpayers are required to use electronic funds transfer (EFT) todeposit all federal taxes (income, payroll, excise, etc.) owed by the business, including income taxes due with thereturn and estimated tax payments made during the year. These companies may not simply write a check anddeposit it along with Form 8109 at their local banks. Instead, the company must make tax payments electronicallyusing the IRS's Electronic Federal Tax Payment System (EFTPS). Corporations not subject to EFT continue to makeincome tax payments by depositing funds with a qualified banking institution using Form 8109.

A business must make electronic deposits of all depository taxes (employment taxes, corporate income tax,corporate estimated income taxes, back�up withholding, etc.) using EFTPS in 2010 if (a) the total deposits of suchtaxes in 2008 were more than $200,000, or (b) the business was required to use EFTPS in 2009 (because totaldeposits of such taxes in 2007 were more than $200,000). Once a business is required to use EFT, it must continueto do so even if its tax deposits fall below $200,000 in a subsequent year. However, a company that voluntarily usesEFT is allowed to switch back to using Form 8109 without any penalty.

Absent reasonable cause, businesses that are required to make deposits by EFT and fail to do so are subject to apenalty up to 15%. Failure to deposit by EFT will subject the taxpayer to penalty even if the deposit is made timelyby other means.

Will the IRS Extend the Time to Pay?

An extension to file does not extend the time for payment of corporate income tax. Income tax must be paid by theoriginal due date of the corporation's income tax return (March 15 for a calendar year corporation). However, theIRS may allow the taxpayer to pay in installments. In addition, the IRS may grant the corporation an extended timefor paying the tax in the following circumstances:

a. Undue Hardship. Paying the tax would be an undue hardship on the corporation.

b. C Corporation Expecting a Net Operating Loss (NOL) Carryback. The C corporation has not yet paid someor all of last year's tax bill and expects current operations to generate an NOL it can carry back to offset lastyear's tax bill.

c. Federally Declared Disaster. The IRS can postpone certain tax deadlines for taxpayers affected by apresidentially declared disaster etc. area or a terroristic or military action.

What Is Undue Hardship? Payment may be extended by the IRS for a reasonable period (but not exceeding sixmonths) if the (C or S) corporation demonstrates that paying the tax when it is due will result in an undue hardship.


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The extension is not available for paying employment taxes. The extension does not stop interest from accruingafter payment is due.

Undue hardship is defined as a substantial financial loss to the company, such as the sale of property at a sacrificeprice to pay the tax. If a market exists, the sale of property at the current market price is not ordinarily consideredan undue hardship.

An application for the extension is made on Form 1127 (Application for Extension of Time for Payment of Tax Dueto Undue Hardship). The company is required to provide evidence showing the undue hardship that would resultto the company if refused. The application must also be accompanied by a statement of the assets and liabilities ofthe company, and an itemized statement showing all receipts and disbursements for each of the three monthsimmediately preceding the due date of the tax, if possible.

The application must be filed on or before the due date for the tax payment. (According to Notice 2003�19,applications under Reg. 1.6161�1 are filed with the Cincinnati or Ogden Submission Processing Centers.) The IRSwill examine the application and grant or deny (or grant subject to specified conditions) the application within 30days.

Can a C Corporation Expecting an NOL Carryback Obtain an Extension of Time to Pay Last Year's Tax Bill?A C corporation expecting current year operations to result in an NOL that can be carried back to the immediatelypreceding tax year can obtain an extension of time to pay its income tax bill for the preceding year. The extensionis only good for payments (including estimated tax payments) due after the request is filed. Thus, an extension isnot available for payments already made or due. Interest is payable on the unpaid tax even with the extension.

The extension request is made on Form 1138 (Extension of Time for Payment of Taxes by a Corporation Expectinga Net Operating Loss Carryback) and is filed with the IRS Service Center where the corporation files its income taxreturn. The request must be filed after the beginning of the year for which the NOL is expected but before theoriginal due date for paying the previous year's income taxes. If filed with Form 7004 (Application for Automatic6�Month Extension of Time To File Certain Business Income Tax, Information, and Other Returns), Form 1138reduces or eliminates the amount of tax to be deposited when Form 7004 is filed.

The corporation must include the following information on Form 1138 (or on an attachment):

a. The tax year of the NOL and the estimated amount of the NOL.

b. The reasons, facts, and circumstances causing the corporation to expect an NOL.

c. The amount by which the expected carryback reduces last year's tax.

d. The total tax for last year and the part for which payment is to be extended.

If the estimates upon which the Form 1138 is based change during the year (resulting in an increase or decreasein the expected NOL for the year), the corporation may file another Form 1138 reflecting the updated information.The new statement, which terminates the previously filed Form 1138, is considered an original statement and notan amendment of a prior Form 1138. This means the new statement may extend the time for payment of a greateror lesser amount of tax than was extended under the previously filed form.

Generally, the extension obtained by filing Form 1138 expires at the end of the month that the return for the tax yearof the expected NOL is required to be filed (including extensions). However, if the corporation has filed a Form 1139(Corporation Application for Tentative Refund) before such due date, the extension expires on the date the IRSmails, by either registered or certified mail, a notice to the corporation that it has allowed or disallowed theapplication for tentative refund. If the extension to pay covers only part of the tax, the time for payment of theremainder is the original due date of the tax return.

Example 5�1: Filing Form 1138 when corporation expects an NOL carryback.

Mega Loss, Inc. (MLI), a calendar year corporation, filed its 2010 return on March 15, 2011. That returnshowed a tax liability of $100,000 with a balance due of $97,000. (MLI paid $3,000 as estimated tax payments


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in 2010 based on 100% of its 2009 tax liability.) MLI anticipates a $400,000 NOL in 2011 that will carry back to2010 to offset the entire $100,000 tax liability. How can MLI extend the time for the payment of the remaining2010 tax?

MLI can file Form 1138 on or before March 15, 2011 requesting that the time for payment of the remaining taxbe extended due to MLI's anticipated 2011 NOL. Generally, that extension will expire on March 31, 2012unless the 2011 return is extended.

Variation:�Assume that on April 10, 2011, MLI estimates that the 2011 NOL will only result in an offset of$70,000 of the 2010 tax liability. MLI should file a new Form 1138 indicating that the reduction of 2010 tax dueto the 2011 NOL will only be $70,000. The new statement terminates the extension to pay $27,000 of the$97,000 unpaid tax liability. Consequently, $27,000, plus interest, is due immediately, since the due date forsuch tax payment was March 15, 2011.

What Is an Installment Payment Agreement?

The IRS has statutory authority to enter into a written installment agreement that enables the taxpayer to pay his taxliability over a period of time if the arrangement will facilitate the collection of tax. Installment agreements can beused by individuals, corporations, partnerships, trusts, etc.

What If My Business Is in a Federally Declared Disaster Area?

Under IRC Sec. 7508A, the IRS has authority to postpone certain tax deadlines, including the deadlines for filingreturns or paying tax, for up to one year for taxpayers affected by a Federally declared disaster [as defined in IRCSec. 165(h)(3)(c)] or a terroristic or military action [as defined in IRC Sec. 692(c)(2)]. Additionally, the IRS mayabate any interest on underpaid income tax for the period of the postponement.

In Rev. Proc. 2007�56, the IRS updated the list of time�sensitive acts that taxpayers can postpone under IRC Sec.7508A. Rev. Proc. 2007�56 is current through its August 2007 release date and so does not reflect subsequentannouncements. Taxpayers can access the �Tax Relief in Disaster Situations" section of the IRS website atwww.irs.gov/newsroom/article/0,,id=108362,00.html for the most recent announcements and instructions forobtaining relief.

ESTIMATED TAX PAYMENTS FOR C CORPORATIONS

Every C corporation that will have a federal income tax liability of at least $500 for the current year must makeestimated tax payments. Estimated tax payments normally are made in four installments on the 15th day of the 4th,6th, 9th, and 12th months of the tax year. For a calendar year corporation, those dates are April 15, June 15,September 15, and December 15. If the due date falls on a weekend or legal holiday, the estimated tax payment isdue on the next business day. Payments are credited against estimated tax in the order paid.

The amount of tax that must be included in tax estimates is the sum of the following taxes (reduced by allowablecredits for the year):

a. The regular corporate income tax (or the alternative tax on capital gains if that would apply).

b. The alternative minimum tax (AMT).

C corporations that fail to make timely estimated tax payments are subject to an underpayment penalty computedon Form 2220 (Underpayment of Estimated Tax by Corporations). C corporations that overpay their estimated taxesmay apply for a quick refund. The corporation may use Form 1120�W (Estimated Tax for Corporations) to aid incalculating its estimated tax payments.

A corporation can elect to apply all or any portion of a tax overpayment shown on its income tax return as apayment of estimated tax for its next tax year in lieu of receiving a refund. The election is made on page 1 of Form1120 (U.S. Corporation Income Tax Return). In Rev. Rul. 99�40, the IRS has stated that the overpayment will be


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applied to unpaid installments of estimated tax due on or after the date(s) the overpayment arose in the order theyare required to be paid to avoid an estimated tax penalty.

How Is the Required Installment Determined?

Corporations normally base their required installments of estimated tax on current year tax or prior year tax (this isthe general rule). However, the corporation is entitled to adopt an alternative to the general rule if it results in a lowerrequired installment. Following is a discussion of the general rule and available alternatives.

What Is the General Rule? Normally, each required installment of estimated tax must be 25% of the lesser of thefollowing two amounts (or options):

a. Option 1Current Year Tax. 100% of the tax shown on the current year's return.

b. Option 2Prior Year Tax. 100% of the tax shown on the preceding year's return. [For this purpose, theamount of tax shown on an amended return is ignored unless the amended return was filed on or beforethe due date (including extensions) of the preceding year's return.

Because accurately projecting the current year's tax liability is difficult, most companies rely on option 2 unless theyexpect net income to decrease significantly from the previous year. The second option is not available, however, ifa company's preceding tax year was not a full 12 months or the prior return does not show a tax liability. In thatsituation, a company's required installment under the general rule must be based on option 1. A large corporationcan use option 2 only for its first estimated payment each year.

Example 5�2: Compute the required installment using the general rule.

XYZ, Inc., a calendar year corporation, filed a full year return for 2009 showing a tax liability of $100,000. XYZis not a large corporation. As of March 31, 2010, XYZ has taxable income of $50,000. The controller cannotestimate with any great accuracy what the company's total income for the year will be but does anticipatehaving taxable income.

Based on the general rule, each required installment of estimated tax is 25% of the required annual payment.For 2010, XYZ's required annual payment is the lesser of 100% of its 2010 tax, or 100% of its tax shown on the2009 return. On March 31, 2010, XYZ does not know what its 2010 tax will be, so its required installment underthe general rule should be based on 100% of the 2009 tax ($100,000). XYZ should pay $25,000 of estimatedtax on or before April 15.

What Alternatives to the General Rule Exist? Corporations (including large corporations) may lower theirestimated tax payments by using an exception to the general rule for determining the required installment. The twoexceptions are the annualized income installment method and the adjusted seasonal installment method. Nor�mally, a company will benefit from using one or both of these methods if it earns most of its taxable income late inthe tax year (such as a retail company that earns 80% of its profit in the final two months of the year).

If the company's required installment under either method is less than its required installment under the generalrule, it can make estimates based on the lesser of the two amounts. However, any reduction achieved by using theannualized or seasonal method must be recaptured if any subsequent required installment during the year iscomputed using the general rule. This effectively prevents the corporation from selecting the best method on aquarter�by�quarter basis, and requires a total year approach to estimated tax payments.

Example 5�3: Increasing subsequent required installments.

For 2010, Manmade, Inc. (MI) has required quarterly estimated tax installments of $20,000 each, based onoption 2100% of the prior year's tax. On April 15, 2010, rather than paying $20,000, MI makes an annualizedincome installment of $17,000. For the second 2010 payment due on June 15, MI's annualized incomeinstallment exceeds the required installment (under option 2) of $20,000. How much must MI pay for thesecond 2010 installment of estimated tax?


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MI must add the $3,000 ($20,000 � $17,000) reduction it had from its first installment to its second install�ment. Accordingly, MI's second installment is $23,000 ($20,000 + $3,000).

How Are Annualized Income Installments Computed? Annualized income installments are computed using afour�step procedure.

Example 5�4: Computing the annualized income installment.

Assume the same facts as in Example 5�2. In this instance, XYZ should also compute its required installmenton April 15, 2010 using the annualized income installment method. If that amount is less than the requiredinstallment under the general rule, XYZ can elect to pay the lesser amount under the annualized method. XYZdoes not elect to use an alternative annualization period by filing Form 8842. Therefore, its annualized incomeinstallments will be based on the default periods under IRC Sec. 6655(e)(2)(A). XYZ computes its annualizedincome installment as follows:

Step 1 XYZ annualizes its income for the first installment period as follows:

$50,000 � 12

3 = $200,000

Step 2 XYZ computes tax on $200,000 in the amount of $61,250.

Step 3 XYZ computes the annualized income installment payment as follows:

$61,250 � 25% (applicable percentage for first installment) = $15,313

Step 4 This step is not applicable because the payment is being computed for the first installment.

Since XYZ's $15,313 annualized income installment payment is lower than the $25,000 required installmentunder the general rule, XYZ may make its April 15, 2010 estimated tax payment in the amount of $15,313.What is XYZ's estimated tax payment for June 15, 2010?

It will be the lesser of the required installment of $25,000 (under the general rule) or the annualized incomeinstallment computed by annualizing income for three months.

Step 1 XYZ annualizes its income for three months as follows: (The second installment payment isalso based on taxable income through March.)

$50,000 � 12

3 = $200,000

Step 2 XYZ computes tax on $200,000 in the amount of $61,250.

Step 3 XYZ computes the annualized income installment payment as follows:

$61,250 � 50% (applicable percentage for second installment) = $30,625.

Step 4 The annualized income installment for the payment period is the excess, if any, of the amountdetermined in Step 3 over the amount of any prior installment for the tax year. XYZ's estimated taxpayment for June 15 is $15,312 ($30,625 � $15,313).

When Does the Large Corporation Recapture Rule Apply under the Annualized Income Installment Method?A large corporation is one with $1 million or more of taxable income in any of the three years preceding the currentyear. For this purpose, taxable income does not include any NOL or capital loss carried to that year. If thecorporation had a short tax year for any of the three tax years immediately preceding the current tax year, thetaxable income for the short tax year is annualized. The short year's taxable income is computed by (a) multiplyingthe taxable income for the short tax year by 12 and (b) dividing the resulting amount by the number of months in the


9

short year. A large corporation can use option 2 under the general rule only for its first estimated payment each year.Furthermore, the large corporation must recapture any savings this option generates by adding the amount savedto the second installment of estimated tax.

Example 5�5: Estimated tax payments for a large corporation.

Assume the same facts as in Example 5�4 except that XYZ has a tax liability of $40,000 on its 2009 tax returnand taxable income of $1.5 million in 2008. What is XYZ's required installment of estimated tax for April 15,2010?

XYZ is a large corporation as it had taxable income of at least $1 million during one of the three years (2008)immediately preceding the current tax year (2010). XYZ can base only its first required estimate on thepreceding year's tax (option 2 under the general rule). Accordingly, XYZ can make an estimated tax paymentof $10,000 ($40,000 � 25%) for April 15, 2010. What is XYZ's required installment of estimated tax for June 15,2010?

Because XYZ is a large corporation, it cannot use option 2 (prior year's tax) for its second installment. Instead,it must use option 1 under the general rule (100% of current year's tax), the annualized income installmentmethod, or the adjusted seasonal installment method.

Assuming that XYZ cannot accurately estimate its current year liability (and that the adjusted seasonalinstallment method does not apply), XYZ must calculate the second installment using the annualized incomeinstallment method. XYZ will need to pay $20,625 [$30,625 (as computed in Example 5�4) � $10,000] for itssecond estimated tax payment due June 15.

When Is the Adjusted Seasonal Installment Method Available? A C corporation can use an adjusted seasonalinstallment as its required installment only if its base period percentage for any six consecutive months of the taxyear equals or exceeds 70%. The base period percentage for any period of months is the average percent thetaxable income for the three corresponding months in each of the three preceding tax years bears to the taxableincome for those years.

Example 5�6: Computing the base period percentage for adjusted seasonal installments.

Destiny, Inc. (DI) uses a calendar tax year. Its income for the three years preceding December 31, 2010, is asfollows:

Year Ending

TaxableIncomefor Year

TaxableIncome forApr.�Sept.

December 31, 2006 $ 65,000 $ 50,000December 31, 2007 67,000 43,000December 31, 2008 80,000 60,000

Total $ 212,000 $ 153,000

DI's base period percentage is greater than 70% ($153,000 � $212,000 = 72%); therefore, DI can use theadjusted seasonal installment method for the year ending December 31, 2010.

The adjusted seasonal installment amount is computed as follows:

Step 1 Divide the taxable income for all months during the tax year preceding the month in which theinstallment is due (referred to as the filing month) by the base period percentage for those months.

Step 2 Compute the tax due on the amount determined in Step 1.

Step 3 Multiply the tax computed in Step 2 by the base period percentage for the filing month and allmonths during the tax year preceding the filing month.


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Step 4 Subtract all previous required installments from the Step 3 amount. The resulting amount equalsthe adjusted seasonal installment.

Example 5�7: Computing the adjusted seasonal installment.

Assume the same facts as in Example 5�6. DI's first installment of estimated tax is due April 15, 2010. DI'staxable income for the period January 1, 2010�March 31, 2010 (the income for all months in the yearpreceding the filing month) is $10,000. For the three preceding years, its total taxable income for the periodJanuary�March is $44,520. The base period percentage for these months is 21% ($44,520 � $212,000).

For the three preceding years, its total taxable income for the period January�April (for the filing month plus allpreceding months in the tax year) is $74,200. The base period percentage for these months is 35% ($74,200� $212,000). What is DI's adjusted seasonal installment for April 15, 2010?

Step 1 $10,000 � 21% = $47,619

Step 2 $47,619 � 15% = $7,143

Step 3 $7,143 � 35% = $2,500

Step 4 There are no previous required installments to subtract as this is the first estimated tax payment ofthe year. Therefore, the adjusted seasonal installment is $2,500.

This example illustrates the computation of an adjusted seasonal installment. However, the use of anothermethod could result in a lower required payment. For example, use of the annualized income installmentmethod will result in a required payment of only $1,500 ($10,000 � 3 � 12 = $40,000 � 15% = $6,000 �25% = $1,500).

Are Estimated Taxes Required in Short Tax Years?

The due date and amount of estimated tax payments for short tax years are addressed in Reg. 1.6655�5.

The following guidelines apply to estimated payments in short tax years:

a. No estimated payments are required if the short tax year is a period of less than four full calendar months;or, the tax shown on the return for such year (or if no return is filed), the tax is less than $500.

b. The corporation makes its installment payments on the same dates as for a 12�month tax year. However,if the first installment would be due before the 15th day of the fourth month of the short year, then the firstinstallment is due on the next due date following the 15th day of the fourth month of the corporation's taxyear.

c. The amount due for any required installment determined for a short tax year based on 100% of tax for thecurrent tax year [under IRC Sec. 6655(d)(1)(B)(i)] is 100% of the required annual payment for the short taxyear divided by the number of required installments due for the short tax year (see Example 5�6). Theamount due for any required installment based on 100% of tax shown on the return for the preceding taxyear [under IRC Sec. 6655(d)(1)(B)(ii)] is determined by multiplying 100% of the tax shown on the returnfor the preceding tax year by the number of full calendar months in the current short tax year, dividing theresult by 12, and dividing the second result by the number of required installments due for the current shortyear.

d. In the event a tax year ends early (e.g., due to an acquisition or a change in tax year), the due date for thefinal installment is the date that the next installment would have been due had the event that gave rise tothe short year not occurred. However, if this date is within thirty days of the last day of the short tax year,the final installment is due the fifteenth day of the second month following the month that includes the lastday of the short tax year.


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Special rules apply for taxpayers using the annualized income or seasonal installment methods for a short tax year.

What Estimated Tax Requirements Apply Following a Deemed Asset Sale?

Taxpayers may elect to treat qualified stock sales as asset sales. The taxpayer may have to take the gain or loss intoconsideration when making estimated tax payments in certain instances.

What Are the Requirements Following a Section 338 Election? A buyer can make a unilateral election under IRCSec. 338(a) to treat a qualified stock purchase as an asset acquisition. In this case, the seller recognizes gain orloss on the stock sale and takes the gain or loss into consideration when making its estimated tax payments. Thebuyer recognizes gain or loss on the deemed asset sale; however, the gain or loss is not required to be taken intoconsideration when calculating its estimated tax payments.

What Are the Requirements Following a Section 338(h)(10) Election? Eligible buyers and sellers can make ajoint election under IRC Sec. 338(h)(10) to treat the stock sale as an asset sale. In this case, the seller recognizesgain or loss on the deemed asset sale. Tax attributable to the gain or loss on the deemed asset sale has to beaccounted for when determining the amount of the corporation's estimated tax payments for the year. If a transac�tion eligible for the election occurs, estimated tax is based on the stock sale unless there is an agreement to makea Section 338(h)(10) election. If the agreement is concluded after the stock sale and the original computation wasbased on a stock sale, estimated tax is recomputed based on an asset sale.

May a C Corporation Apply for a Quick Refund of Overpaid Estimated Tax?

A C corporation that overpays its estimated tax may apply on Form 4466 (Corporation Application for Quick Refundof Overpayment of Estimated Tax) for a quick refund. To qualify for the quick refund, the amount of the adjustmentmust be 10% or more of the tax liability, and the overpayment must be at least equal to $500.

The form is filed after the close of the tax year and on or before the original due date for the return for that tax year(or, if earlier, when the corporation actually files its return). The original of the form must be filed with the ServiceCenter specified in the Form 4466 instructions. A copy of the form should be attached to the Form 1120 when it isfiled.

The IRS must act on Form 4466 within 45 days from the date it is filed. During this time, the IRS may make a limitedexamination of the form to determine the amount of the adjustment [IRC Sec. 6425(b)(1)].

A nondeductible penalty is imposed if the quick refund of estimated tax is subsequently determined to be exces�sive. The penalty is computed from the date the credit was allowed or refund was paid to the original due date of thereturn.


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13

SELF�STUDY QUIZ

Determine the best answer for each question below. Then check your answers against the correct answers in thefollowing section.

1. To receive an extension of time for paying income tax due with the return, what action must a corporation take?

a. File Form 7004 (Request for Automatic Extension) by the due date of the return.

b. Attach a statement to the tax return requesting an extension for paying the tax because of an unduehardship and providing an explanation for the hardship.

c. File Form 1128 (Extension of Time for Payment of Taxes by a Corporation expecting a Net Operating LossCarryback) before the end of the year the NOL is expected to occur.

d. File Form 1127 (Application for Extension of Time for Payment of Tax) on or before the due date of the taxreturn.

2. Under which of the following scenarios will a corporation not be required to pay estimated tax for the year?

a. The total tax liability of the corporation is less than $500 for the year.

b. The total tax liability for the previous year was zero.

3. A corporation may lower the amount of its estimated tax payments by using one of the exceptions to the generalrule for determining the required installment. Which of the following is an exception?

a. Paying in 100% of its tax liability by the due date of the return.

b. Using an adjusted seasonal installment if its base period percentage for any six consecutive months of thetax year exceeds 75% of the annual income.

c. Computing installments based on an annualized income method.

d. Computing installments based on an annualized income method and paying the lower of the amount duefor each quarter based on this exception or the amount due under the general rule.


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SELF�STUDY ANSWERS

This section provides the correct answers to the self�study quiz. If you answered a question incorrectly, reread theappropriate material. (References are in parentheses.)

1. To receive an extension of time for paying income tax due with the return, what action must a corporation take?(Page 4)

a. File Form 7004 (Request for Automatic Extension) by the due date of the return. [This answer is incorrect.A request to extend the filing date of the return does not extend the date for payment of any tax due withthe return.]

b. Attach a statement to the tax return requesting an extension for paying the tax because of an unduehardship and providing an explanation for the hardship. [This answer is incorrect. Even though an unduehardship may be a reason for allowing an extension of time for payment of the tax, the request must bemade using the proper IRS Form.]

c. File Form 1128 (Extension of Time for Payment of Taxes by a Corporation expecting a Net Operating LossCarryback) before the end of the year the NOL is expected to occur. [This answer is incorrect. Form 1128must be filed after the beginning of the year for which the NOL is expected to occur, but before the originaldue for payment of the tax for which the extension request is made.]

d. File Form 1127 (Application for Extension of Time for Payment of Tax) on or before the due date ofthe tax return. [This answer is correct. The IRS may grant an extension if the corporation files Form1127. The Form 1127 must provide evidence of the undue hardship as well as other financialinformation showing the inability to make a timely payment.]

2. Under which of the following scenarios will a corporation not be required to pay estimated tax for the year?(Page 6)

a. The total tax liability of the corporation is less than $500 for the year. [This answer is correct. Thetotal tax liability for the year must be $500 or more for the corporation to be required to makeestimated tax payments per IRC Sec. 6655(f).]

b. The total tax liability for the previous year was zero. [This answer is incorrect. Even though estimated taxcan be based on 100% of the tax shown on the prior year's return, that return must show a tax liability forthis option to apply.]

3. A corporation may lower the amount of its estimated tax payments by using one of the exceptions to the generalrule for determining the required installment. Which of the following is an exception? (Page 7)

a. Paying in 100% of its tax liability by the due date of the return. [This answer is incorrect. A corporationgenerally must pay estimated tax in installments in order to avoid an underpayment penalty.]

b. Using an adjusted seasonal installment if its base period percentage for any six consecutive months of thetax year exceeds 75% of the annual income. [This answer is incorrect. The base period percentage is onlyrequired to exceed 70%.]

c. By computing installments based on an annualized income method. [This answer is correct. The twoexceptions to the general rule are, the annualized income installment method and the adjustedseasonal installment method. Any reduction achieved by using the annualized income method mustbe recaptured if any subsequent required installment during the year is computed using the generalrule.]

d. By computing installments based on an annualized income method and paying the lower of the amountdue for each quarter based on this exception or the amount due under the general rule. [This answer isincorrect. If a quarterly installment is paid under the general rule, any previous reductions achieved byusing the annualized or seasonal method must be recaptured and added to the amount due under thegeneral rule.]


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ESTIMATED TAX PAYMENTS FOR S CORPORATIONS

An S corporation that was formerly a C corporation must make estimated tax payments only if it will have a $500 orgreater tax liability related to built�in gains, excess net passive income, or recapture of certain business credits. (Inaddition, S corporation shareholders must include their share of company items of income, deduction, and creditwhen computing individual estimated tax payments.)

Other taxes paid by an S corporation (e.g., the tax due on a final C corporation return, or the tax caused by LIFOinventory recapture upon conversion to S status) are not subject to estimated taxes, nor are Section 444 payments(i.e., payments required to elect or retain a fiscal year).

Estimated tax payments normally are made in four installments on the 15th day of the 4th, 6th, 9th, and 12th monthsof the tax year. For a calendar year S corporation, those dates are April 15, June 15, September 15, and December15. If the due date falls on a weekend or legal holiday, the estimated tax payment is due on the following businessday. Payments are credited against estimated tax in the order paid.

S corporations that fail to make timely estimated tax payments are subject to a nondeductible underpaymentpenalty on the amount of underpayment. The penalty is computed on Form 2220 (Underpayment of Estimated Taxby Corporations). S corporations that overpay their estimated taxes are not allowed to apply for a quick refundusing Form 4466 (Corporation Application for Quick Refund of Overpayment of Estimated Tax). Although paymentof taxes imposed on S corporations is not eligible for a quick refund, the instructions to Form 4466 state that theform can be filed in certain cases by S corporations who have made protective estimated tax payments in their firsttax year (i.e., protective payments of C corporation income taxes in case the S election is improperly made).S�corporations may use Form 1120�W (Estimated Tax for Corporations) to calculate their estimated tax payments.

What Is the General Rule for Calculating the Required Installment?

Normally, each required installment of estimated tax must be 25% of the lesser of the following two amounts (oroptions):

a. Option 1Current Year Tax. 100% of the tax ultimately shown on the current year's return.

b. Option 2Alternative Method. 100% of the sum of the following:

(1) The tax that would be owed for the current tax year if the only taxes considered are the taxes on built�ingains and recapture of business credits.

(2) The tax on excess net passive income shown on the preceding year's return.

For purposes of option 2, the estimated payments for the tax on excess net passive income can be based on theamount of that tax shown on the prior year's return. (This is true even if there is no net passive income tax for theprior year.) However, under option 2 an S corporation cannot use the preceding year's tax as a basis for makingestimated payments for any tax other than the tax on excess net passive income.

Example 5�8: Compute the required installment using the general rule.

Kemp, Inc. (KI), a calendar year C corporation, elected S status on January 1, 2009. In March 2009, it sells abusiness asset that results in built�in gains tax of $5,000. In May 2010, it sells a business asset that results inbuilt�in gains tax of $3,060. The corporation also receives passive investment income in 2010 and incurs a$4,000 tax on its excess net passive income.

For 2009, estimated tax payments for the built�in gains tax cannot be avoided by reference to the precedingyear's tax. However, since the corporation did not incur the tax on excess net passive income in 2009, the


16

alternative method under option 2 still results in a lesser required installment. Therefore, each of KI's requiredquarterly installments for 2010 should be based on 25% of the following tax (option 2):

100% of current year's built�in gains tax $ 3,060100% of last year's passive income tax �

Total estimated tax $ 3,060

May an S Corporation Use the Annualized or Seasonal Installment Method to Calculate the RequiredInstallment?

S corporations may lower their estimated tax payments by using an exception to the general rule for determiningthe required installment. The two exceptions are the annualized income installment method and the adjustedseasonal installment method. If the company's required installment under either method is less than its requiredinstallment under the general rule, it can make estimates based on the lesser of the two amounts. Normally, acompany will benefit from using one or both of these methods if it earns most of its income subject to estimated taxlate in the tax year.

What Estimated Tax Requirements Apply Following Termination of S Status?

Terminating an S corporation election at any time other than the first day of the corporation's tax year results in twoshort tax years, referred to as the S short year and the C short year. After terminating its S election, a corporationimmediately faces estimated tax requirements for the C short year, unless the tax for the short year is less than $500.Since S corporations ordinarily do not pay corporate�level tax, the first C�corporation return following S statustermination will not have a prior�year tax exception on which to base the quarterly estimates. Accordingly, thequarterly estimates for the first C corporation return year must be based on 100% of the tax computed on the actualincome earned in the first C tax year.

The annualized income or adjusted seasonal installment method may provide relief for corporations whose profitsare generated late in the year or with seasonal businesses. However, if the corporation's taxable income accruesratably throughout the year, it has no choice but to monitor taxable income throughout its first C year and computequarterly estimates on the actual year�to�date income.

MAKING ESTIMATED TAX PAYMENTS FOR PASS�THROUGH INCOME

Taxpayers with interests in partnerships and S corporations and beneficiaries of estates and trusts must considertheir allocable share of income or loss from such entities when computing quarterly estimated payments. Theseamounts must be considered as follows:

� S Corporations. Under IRC Sec. 1366(a)(1), S corporation income or loss is passed through toshareholders on a daily basis. For estimated tax payment purposes, S�shareholders must take into accounttheir pro rata share of the S corporation's actual taxable income for any S corporation year ending with orwithin their tax years to the extent that taxable income or loss was attributable to the months in the Scorporation's tax year that ended on or before the due date of the payment period. The shareholdercomputes the amount of the S corporation's income or loss for a given period as if the S corporation's taxyear ended on the last day of the payment period.

� Partnerships. A partner must include his or her distributive share of partnership income, any guaranteedpayments, and any gains or losses on partnership distributions that are treated as gains or losses on salesof property, all computed as of each installment due date.

In determining net earnings from self�employment, a partner takes into account his or her distributive shareof the partnership's nonseparately stated income or loss and any guaranteed payments if the partnershipis engaged in a trade or business. These items are included to the extent that they are attributable to monthsin the partnership tax year that precede the month in which the installment is due.

� Trusts and Estates. If the individual is a beneficiary of a trust or estate, income included will depend onwhether the trust or estate is required to distribute income currently. If the trust or estate is required to


17

distribute income currently, the individual beneficiary must include his or her share of income in thecalculation of the amount of estimated tax owed on each installment date. If the trust or estate is not requiredto distribute income currently, only the amounts actually distributed must be included in the beneficiary'sincome as of the dates the distributions occur when computing the required estimated tax installment.

When the income of a trust need not be distributed currently, amounts distributed during the first 65 daysof one year that are treated as having been distributed on the last day of the previous year under IRC Sec.663(b) are not considered to have been distributed for computing any underpayment penalty under the90% current year tax or the annualization exceptions.

MAKING DEPOSITS TO SUSPEND RUNNING OF INTEREST ON POTENTIALTAX UNDERPAYMENT

Taxpayers are permitted to make a deposit with the IRS to suspend the running of interest on a potential underpay�ment of tax. The underpayment of tax must not have been assessed prior to the time the deposit is made. Forcomputing interest under IRC Sec. 6601, to the extent that the deposit is ultimately used to pay tax, the payment isdeemed to have been made on the date the taxpayer made the deposit.

The taxpayer can request in writing that all, or part, of the deposit be returned. The IRS will return the requestedamount unless it has previously been used to pay tax or the IRS determines returning the deposit would jeopardizethe collection of tax. The IRS will pay interest on the returned deposit, to the extent it is attributable to a disputed tax,at the federal short�term rate. The payment must have been specified at the time of deposit as being a reasonableestimate of the maximum amount of tax that is likely to be due as the result of a disputable item. Both the taxpayerand the IRS must have a reasonable basis for disputing the item in question.

The IRS has provided a procedure for making deposits under IRC Sec. 6603 and the treatment of other remittancesthat are not designated by the taxpayer as being attributable to a disputed tax. It also provides guidelines formaking a request for return of a deposit. The procedure also specifies that a deposit that ultimately exceeds theamount of the disputed tax can be applied against another assessed or unassessed liability. The taxpayer mustrequest such a transfer in writing.


18


19

SELF�STUDY QUIZ


4. When is an S corporation is required to make estimated tax payments?

a. It has a tax liability of $400.

b. An S corporation does not have a tax liability and is not required to pay estimated tax.

c. The S corporation has $1000 tax due because of LIFO inventory recapture when it converted to Scorporation status.

d. The S corporation expects to have a tax liability of $900.

5. How must S Corporation shareholders take into account income passed through from the corporation indetermining their individual estimated tax payments?

a. As if the income was passed through on a daily basis.

b. As if the S corporation income is received on the final day of the S corporation tax year.

c. The S corporation income or loss must be estimated for the year and combined with the shareholder'sincome in determining required estimated tax payments.

6. A taxpayer can make a deposit in order to stop the running of interest on a potential underpayment of tax. Whichof the following correctly states the rules for such a deposit?

a. Once made, no part of the deposit can be returned until the potential underpayment has been determined.

b. The IRS will pay interest on the returned deposit.

c. Any deposit that exceeds the amount of disputed tax cannot be applied against another tax liability.

d. Taxpayers are permitted to make a deposit after the disputed liability has been assessed but before it hasbeen billed by the IRS.


20



4. When is an S corporation required to make estimated tax payments? (Page 15)

a. It has a tax liability of $400. [This answer is incorrect. An S corporation is not required to make estimatedtax payments unless it has tax liability above a certain threshold. However, $400 is not the correctthreshold.]

b. An S corporation does not have a tax liability and is not required to pay estimated tax. [This answer isincorrect. An S corporation can have a tax liability due to built�in gains tax, tax on excess net passiveincome, or recapture of certain business credits.]

c. The S corporation has $1000 tax due because of LIFO inventory recapture when it converted to Scorporation status. [This answer is incorrect. Taxes due on the final C corporation return, as a result of LIFOrecapture, or Section 444 payments to retain a fiscal year, do not require the S corporation to makeestimated tax payments.]

d. The S corporation expects to have a tax liability of $900. [This answer is correct. The S corporationmust make estimated tax payments if it has a tax liability of $500 or more due to built�in gains tax,excess passive investment income, or recapture of certain business credits.]

5. How must S Corporation shareholders take into account income passed through from the corporation indetermining their individual estimated tax payments? (Page 16)

a. As if the income was passed through on a daily basis. [This answer is correct. Under IRC Sec.1366(a)(l), S corporation income or loss is passed through to shareholders on a daily basis.Shareholders must compute the amount of S corporation income or loss for a given period as if theS corporation's tax year ended on the last day of the payment period.]

b. As if the S corporation income is received on the final day of the S corporation tax year. [This answer isincorrect. The S corporation income or loss must be calculated for each payment period and consideredas being passed through at the end of the payment period].

c. The S corporation income or loss must be estimated for the year and combined with the shareholder'sincome in determining required estimated tax payments. [This answer is incorrect. This approach is likelyto result in estimated tax payments that are higher or lower than required.]

6. A taxpayer can make a deposit in order to stop the running of interest on a potential underpayment of tax. Whichof the following correctly states the rules for such a deposit? (Page 17)

a. Once made, no part of the deposit can be returned until the potential underpayment has been determined.[This answer is incorrect. A taxpayer can request in writing that all or part of the deposit be returned.]

b. The IRS will pay interest on the returned deposit. [This answer is correct. Per IRC Sec 6603(d), theIRS will pay interest on the returned deposit at the federal short�term rate.]

c. Any deposit that exceeds the amount of disputed tax cannot be applied against another tax liability. [Thisanswer is incorrect. The taxpayer can request in writing to apply the excess against another assessed orunassessed liability.]

d. Taxpayers are permitted to make a deposit after the disputed liability has been assessed but before it hasbeen billed by the IRS. [This answer is incorrect. The deposit must be made before the liability has beenassessed by the IRS.]


21

EXAMINATION FOR CPE CREDIT

Lesson 1 (DBPTG10)

Determine the best answer for each question below. Then record your answer choices by logging onto the onlinegrading system.

1. How does a corporation pay any tax owed when it files the income tax return?

a. In quarterly installments.

b. By check made payable to the U.S. Treasury attached to the return.

c. By sending the check to the applicable service center.

d. By depositing the tax with an authorized federal depository.

2. What amount of penalty can be assessed against businesses that are required to make deposits by EFT andfail to do so?

a. 5%

b. 15%

c. 25%

d. None, if deposit is made timely by other means.

3. Payment of tax may be extended by the IRS for what period of time as a result of undue hardship?

a. 90 days.

b. A reasonable period of time not exceeding 6 months.

c. A reasonable period of time not exceeding 9 months.

d. Due date of timely extended return.

4. C corporations are required to make estimated tax payments in four installments on the 15th day of the:

a. 3rd, 6th, 9th, and 12th months of the tax year.

b. 4th, 6th, 9th, and month following corporation's year end.

c. 4th, 6th, 9th, and 12th months of the tax year.

d. 4th, 7th, 10th, and month following corporation's year end.

5. For estimated tax purposes, a large corporation is defined as having what characteristic?

a. Taxable income of $1 million or more in any of the three preceding years.

b. Average Gross receipts of $5 million or more for the preceding three years.

c. Taxable income of $1 million or more for the preceding year.

d. Gross receipts of $10 million or more for the preceding year.


22

6. What is the requirement for using the adjusted seasonal installment method to calculate estimated taxpayments?

a. The base period percentage for any six consecutive months of the tax year cannot exceed 70%.

b. The base period percentage for any six consecutive months in the preceding two tax years must equal orexceed 70%.

c. The corporations must expect more than 70% of its income in any six consecutive months of the tax years.

d. The base period percentage for any six consecutive months of the tax year equals or exceeds 70%.

7. What is the requirement for estimated tax payments in the event of a stock sale qualifying for the Section 338Election?

a. Estimated tax is based on the stock sale unless an agreement has been made to make the Section 338election.

b. Estimated tax is computed as if an asset sale occurred.

c. No estimated tax is due on the transaction.

d. If the estimated tax was originally based on a stock sale, no change can be made.

8. A corporation is allowed to apply for a quick refund of estimated tax if the overpayment is at least what amount?

a. 10% or more of the tax liability and at least $500.

b. More than $500.

c. More than 10% of the tax liability and more than $500.

d. 10% or more of the tax liability.

9. An S corporation can base its estimated tax payments on which of the following options?

a. 100% of the previous year's tax if the previous year's return showed a tax liability.

b. 100% of the sum of the previous year's built�in gains and net passive income tax.

c. Estimated tax payments are not required.

d. 100% of the tax on the current year's return.


23

Lesson 2: �Alternative Minimum Tax

The alternative minimum tax (AMT) is, in effect, a separate system of taxation with its own rules and methods. Itparallels the regular income tax system. The primary purpose of the AMT system is to ensure that C corporationsand individuals with economic income, but little or no taxable income, pay at least some current income tax.Compliance with the AMT system requires a multitude of computations and schedules (in addition to thoseprepared for regular tax purposes) to keep track of AMT adjustments and AMT preference items. Many businessesincur a high cost to comply with the AMT system.

a. C Corporations. A C corporation (other than a small corporation) is subject to both the regular corporateincome tax (under the regular tax system) and the AMT. The corporation must compute its AMT and thencompare this against the amount of its regular corporate income tax. The C corporation's tax liability isdetermined based on the larger of the two taxes. For a C corporation, AMT is computed and reported onForm 4626 (Alternative Minimum TaxCorporations).

b. Partnerships or S Corporations. A partnership or an S corporation is not subject to the AMT, but its ownersmay be subject to AMT on their individual income tax returns. (Each owner must perform the AMTcalculation to determine whether the tax applies and to maintain records for future years.) AMT for individualtaxpayers is computed and reported on Form 6251 (Alternative Minimum TaxIndividuals).

Partnerships and S corporations must provide each owner with sufficient information to perform the AMTcalculations with respect to items passed through from the company. This is done on the Schedule K�1 oran attachment. Since AMT must be considered when owners calculate estimated tax payments, thebusiness may also be required to provide AMT information on a quarterly basis.

This lesson provides businesses with the information and resources needed to compute the AMT for a C corpora�tion, or to transmit necessary AMT information to owners of a partnership or an S corporation. Although itemphasizes the calculation of AMT for a C corporation, the principles explained apply to items passed through froma partnership or an S corporation to its owners. (Except for some minor differences in rates, adjustment items, andexemption amountsand that only C corporations are subject to the ACE adjustmentAMT is calculated similarlyfor C corporations and individuals.)


Completion of this lesson will enable you to:� Calculate the correct amount of alternative minimum tax (AMT) required to be paid by a corporation including

AMT adjustments, preferences and ACE adjustments.� Prepare a correct calculation of the AMT net operating loss (if any) and correctly apply this loss against the AMT

taxable income of the appropriate year.� Determine if the corporation meets any tests that would exempt it from AMT under the provisions for small

corporations.� Identify the actions to eliminate or reduce the amount of AMT that would otherwise be due for the tax year.

AMT CALCULATIONC CORPORATIONS

How Is AMT for a C Corporation Calculated?

The following ten�step procedure can be used to calculate alternative minimum taxable income (AMTI) andalternative minimum tax (AMT) for a C corporation:

Step 1 Start with Regular Taxable Income before the NOL Deduction, but After Special Deductions.

Although AMT is a separate tax system, it starts with regular taxable income. If an NOL hasreduced taxable income, it must be added back because the AMT system allows only an alterna�tive tax NOL (ATNOL), as explained later in this lesson.

Step 2 Add or Subtract AMT Adjustments. The AMT adjustments eliminate the tax impact (for AMT pur�poses) of items treated differently under the regular tax and AMT systems. Adjustment items can


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increase or decrease AMTI. Some examples of AMT Adjustment items include the alcohol fuelscredit, the difference between MACRS and ADS and the Section 199 deduction.

Step 3 Add AMT Tax Preference Items. AMT tax preference items are other income items and deductionsthat receive preferential treatment for regular taxes. Only positive preference items increase AMTI.Negative preference amounts are ignored. Some examples of AMT Preference items includeSection 611 depletion and excess IDC.

Step 4 Recompute Deductions Based on a Percentage of AMTI. The IRS instructions to Form 4626 statethat for AMT purposes, deductions based on an income limit (e.g., charitable contributions andpercentage depletion) must be recomputed based only on income and deductions allowed underthe AMT system.

Step 5 Calculate Preadjustment AMTI. Preadjustment AMTI is a critical subtotal in the AMT calculation. Itis used in Step 6 to calculate the ACE adjustment.

Step 6 Add or Subtract the Adjusted Current Earnings (ACE) Adjustment. The ACE adjustment keepscorporations from reporting a profit for financial purposes while paying little or no corporateincome tax. ACE is a tax concept that is intended to represent the corporation's economicearnings for the year. The ACE adjustment equals 75% of the difference between ACE andpreadjustment AMTI (in absolute numbers). This amount may be either added to or subtractedfrom AMTI.

Step 7 Calculate the Allowable ATNOL. For AMT, an NOL (known as the alternative tax net operating lossor ATNOL) is defined as the regular tax NOL, increased or decreased by AMT adjustments anddecreased by AMT preferences. An adjustment for an AMT preference is only required to theextent it caused the regular tax NOL to increase. The ATNOL must be carried back or forward justlike the regular NOL. Additionally, it generally cannot exceed 90% of the corporation's AMTI for thatyear figured before the ATNOL deduction.

Step 8 Subtract the AMT Exemption. The AMT does not apply to a corporation in the lower income taxbrackets with small amounts of AMT adjustments or preference items. Accordingly, an exemptionamount is subtracted from a corporation's AMTI before figuring the tentative minimum tax (TMT).The base exemption is $40,000. The exemption phases out as income gets higher (reduced by$0.25 for every dollar that the corporation AMTI exceeds $150,000). This means a corporation withAMTI of at least $310,000 is not entitled to any portion of the exemption.

Step 9 Calculate TMT. The tentative AMT before foreign tax credit is figured by multiplying the corpora�tion's AMTI, minus the exemption amount, by 20%. The foreign tax credit, if any, is then subtractedto arrive at the TMT. The business may elect to use a simplified foreign tax credit limitation for AMTpurposes. The simplified calculation is based on the ratio that foreign source regular taxableincome (rather than foreign source AMT income) bears to the business's entire alternative mini�mum taxable income. The election can be made only in the first year for which a taxpayer claimsan AMT foreign tax credit. Once made, the election applies to all subsequent years and may berevoked only with the consent of the IRS.

Step 10 Compute AMT. If TMT is greater than regular tax, the difference is AMT. Regular tax is reduced bythe foreign tax credit and the possessions credit for this purpose.

Example 6�1: AMT calculation.

Dirt Busters, Inc. (DBI), a calendar year C corporation, operates a commercial and residential janitorial/maidservice. Selected information related to its current tax year is as follows:


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Description Amount

Taxable income (net of a $65,000 NOL carryover from previousyear) $ 385,000

Regular tax liability 130,900Depreciationpost�1986 properties:

Regular tax 530,000AMT 360,000ACE 220,000

Adjusted basis of MACRS property sold during the year:Regular tax adjusted basis 80,000AMT adjusted basis 87,500ACE adjusted basis 91,700

Excess of depreciation deducted on pre�1987 real propertyover straight�line depreciation 21,000

Tax�exempt interest income 11,500Expenses related to the tax�exempt interest income 100ATNOL carryover from previous year 32,000

The ACE depreciation adjustment is eliminated for property placed in service after December 31, 1993.However, an ACE adjustment is still necessary in 1994 and subsequent years for property placed in servicebefore 1994. Does DBI have an AMT liability in the current year?

DBI's AMT liability is $11,480, calculated using the following schedule (which is a summary of Form 4626):

Taxable income before NOL $ 450,000AMT adjustments:

Depreciation of post�1986 property 170,000Adjusted gain or loss (7,500)Accelerated depreciation of pre�1987 real

property 21,000 183,500Preadjustment AMTI 633,500ACE adjustment (see Example 6�4) 110,400AMTI before alternative tax net operating

loss (ATNOL) 743,900Less ATNOL (32,000)

Alternative minimum taxable income (AMTI) 711,900Exemption �Net AMTI 711,900AMT tax rate � 20%Tentative minimum tax before foreign tax credit 142,380Less AMT foreign tax credit �Tentative minimum tax (TMT) 142,380Less regular tax (after foreign tax credit) (130,900)

Alternative minimum tax (AMT) $ 11,480

Must Deductions Based on a Percentage of AMTI Be Recomputed? The IRS has taken the position that, for AMTpurposes, deductions subject to an income limit (e.g., charitable contributions and percentage depletion) must berecomputed based on income as determined under the AMT system. This approach is incorporated into theinstructions to Form 4626. For most taxpayers, the change is beneficial because income for AMT purposes isnormally larger than for regular tax purposes and larger deductions may result. However, the increased record�keeping required to keep track of all the AMT carryover differences may negate any economic savings.

A deduction for regular tax is allowed for U.S. production activities beginning in tax years after 2004 (IRC Sec. 199).The deduction is also allowed in computing AMTI except that the deduction is computed as a percentage of thelesser of (a) qualified production activities income of the taxpayer as determined for regular tax; or (b) AMTI beforethe U.S. production activities deduction.


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Must AMTI Be Adjusted for Wage Credits?

When a corporation takes certain employment�related credits allowed by the Code, for regular tax purposes it isrequired to reduce its deductible wages by the amount of the employment�related credits allowable. Both the IRSand the Tax Court have taken the position that this reduction of deductible wages also applies when computingAMTI. The Allen case deals with the pre�1995 targeted jobs tax credit. However, the court's reasoning wouldpresumably apply to the current employment credits (such as the work opportunity credit) that are covered by IRCSec. 280C(a). A corporation must reduce its deductible wages when computing AMTI by the amount of the creditstaken.

In Ventas, Inc., the court held that wages for regular tax and AMT must be reduced by the targeted jobs credit eventhough the credit is not allowed against AMT.

Which Credits can offset AMT?

In addition to the AMT foreign tax credit, certain other credits can be used to offset the AMT. While, most of thecombined credits that make up the general business credit cannot be used to offset the AMT; certain specifiedcredits are allowed to offset 100% of AMT. Specified credits include (a) the credit for electricity produced fromcertain renewable sources (IRC Sec. 45), (b) the alcohol fuels credit (IRC Sec. 40), (c) the work opportunity credit(IRC Sec. 51), (d) the FICA tip credit (IRC Sec. 45B) , (e) the low�income housing credit (IRC Sec. 42), (f) the energycredit (IRC Secs. 46 and 48), and (g) the rehabilitation credit (IRC Secs. 46 and 47).

How Is AMT Figured for Short Tax Years?

A special AMT calculation must be made for short tax years. The calculation annualizes AMTI and normally resultsin a reduction of the benefit of the $40,000 AMT exemption. Unlike the short period rules for regular taxable income(under which income is not annualized in the taxpayer's first or last year), the AMT annualization rules applyregardless of the reason for the short period. This means a taxpayer is more likely to be subject to AMT in a shortyear.

AMT ADJUSTMENTS

AMT adjustments account for differences between methods of computing items of income, expense, gain, or lossfor the regular tax system and the AMT system. The adjustment equals the difference between the amountdetermined for regular taxes and the amount determined for AMT.

Adjustments can either increase or decrease AMTI. For example, if depreciation allowable for AMT is $600 and thedepreciation expense for regular tax is $400, the $200 difference is a negative adjustment that reduces AMTI.

How Are Depreciation Adjustments Calculated?

Property placed in service after 1986 normally is depreciated under the Modified Accelerated Cost RecoverySystem (MACRS) for regular tax purposes. The AMT system, however, provides separate and distinct rules for thedepreciation of most property placed in service after 1986. Under these rules, different depreciation methods andrecovery periods must be used in the determination of AMT depreciation.

Because different depreciation methods and recovery periods are used for regular tax and AMT, two differentdepreciation amounts arise. The difference between these two amounts is the AMT adjustment. This difference isadded to or subtracted from regular taxable income to arrive at AMTI.

a. A C corporation reports this adjustment on Form 4626 in the Adjustments and preferences section on theline captioned Depreciation of post�1986 property.

b. A partnership (other than an electing large partnership) or an S corporation reports this adjustment onSchedule K and Schedule K�1 of Form 1065 or Form 1120S, respectively, in the Alternative Minimum Tax(AMT) Items section with the code �A" for the post�1986 depreciation adjustment. An electing large


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partnership reports this adjustment if related to passive income on line 5 of Schedule�K of Form 1065�B andin box 5 of Schedule K�1 for interests held as a limited partner (box 9 of Schedule K�1 for interests held asa general partner). If not related to passive income, this adjustment is reported by an electing largepartnership on line 6 of Schedule K and in box 6 of Schedule K�1 for all partners.

Example 6�2: Depreciation adjustment for property placed in service after 1986 by an S corporation.

Jimmy Jackson is the sole shareholder in Jackson Product, Inc. (JPI), an S corporation formed in 1987.Depreciation expense on page 1 of JPI's Form 1120S (i.e., for regular tax purposes) is $23,875, and depreci�ation for AMT purposes is $15,000. The AMT adjustment of $8,875 increases AMTI.

JPI reports the depreciation adjustment on Schedule K�1 in the Alternative Minimum Tax (AMT) Items sectionwith the code captioned �A" for the post�1986 depreciation adjustment.

How Is the Adjustment Calculated for Property Placed in Service before 1999? For property placed in serviceafter 1986 and before 1999, the depreciation adjustment equals the difference between the regular MACRSdepreciation and the AMT depreciation.

a. For personal property, the regular MACRS depreciation method generally is the 200% declining balancemethod using the MACRS recovery periods provided for regular tax depreciation. (Under MACRS, a switchis made to the straight�line method beginning in the year this will maximize the depreciation deduction.)The AMT depreciation method is the 150% declining balance (DB) or straight�line (SL) method using theMACRS recovery periods provided for regular tax depreciation.

b. For nonresidential real property, the regular MACRS depreciation is computed using the SL method anda recovery period of 39 years (31.5 years for property placed in service before 5/13/93). Real propertyplaced in service after 1998 is depreciated for AMT purposes over 39 years using an SL method.

c. Property depreciated under a method other than MACRS (e.g., units�of�production method) is notconsidered when making the AMT adjustment.

Instead of using regular MACRS, taxpayers could elect one of two depreciation methods for regular tax purposesto eliminate the AMT depreciation adjustment and the need for two sets of depreciation records for property placedin service before 1999.

How Is the Adjustment Calculated for Property Placed in Service after 1998? For property placed in serviceafter 1998, the recovery periods for both regular tax and AMT are the regular MACRS recovery periods [IRC Sec.56(a)(1)(A)(i)]. The longer class life recovery periods of the ADS system are no longer required for AMT purposes,but the 150% DB method generally applies.

For personal property, an AMT adjustment will be necessary because the 150% DB method is used for AMTpurposes while the 200% DB method is used for regular tax. However, the adjustment will be claimed over the samerecovery period for regular tax and AMT purposes. For real property, no AMT adjustment will be necessary becausethe same method (SL) and recovery periods are used for both regular and AMT purposes.

When Are Basis Adjustments Required?

When computing AMTI, an adjustment must be made to account for the difference in the adjusted basis (regular taxversus AMT) used to compute gain or loss on the disposition of assets. If an AMT depreciation adjustment isnecessary for an asset, a different gain or loss amount on the sale or disposition of that asset arises (assuming theproperty has not been fully depreciated for both regular tax and AMT before the sale or disposition). The basisadjustment for depreciable assets only applies to assets placed in service after 1986 (MACRS assets). No adjust�ment is required for property placed in service before 1987.

a. A C corporation reports this adjustment on Form 4626 in the Adjustments and preferences section on theline captioned Adjusted gain or loss.


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b. A partnership (other than an electing large partnership) or an S corporation reports this adjustment onSchedule K and Schedule K�1 of Form 1065 or Form 1120S, respectively, in the Alternative minimum tax(AMT) items section with a code �B" for adjusted gain or loss. An electing large partnership reports thisadjustment, if related to passive gain/loss, on line 5 of Schedule K of Form�1065�B and in box 5 of ScheduleK�1 for interests held as a limited partner (box 9 of Schedule�K�1 for interests held as a general partner).If not related to passive gain/loss, this adjustment is reported by an electing large partnership on line 6 ofSchedule K and in box 6 of Schedule K�1 for all partners.

Example 6�3: Calculating the basis adjustment when property is sold.

Bigcorp, a C corporation, buys a computer during 2006 for $5,700. The computer is sold in 2010. At the timeof sale, the accumulated depreciation for regular taxes is $4,060. For AMT, the figure is $3,325. Bigcorp'sbasis adjustment equals the difference between the adjusted basis of the computer for regular taxes versusAMT, or $735, calculated as follows:

Regular Tax AMT

Original cost $ 5,700 $ 5,700Accumulated depreciation (4,060 ) (3,325 )

Adjusted basis $ 1,640 $ 2,375

Additional AMT basis ($2,375 � $1,640) $ 735

The $735 is a negative adjustment in calculating AMT (i.e., it will decrease AMTI) since the AMT basis of thecomputer exceeds its regular tax basis.

AMT PREFERENCE ITEMS

AMT tax preference items are other income items and deductions that receive preferential treatment under theregular tax system. The preference item is usually the difference between the recomputed amount (for AMT) andthe amount shown for regular tax. Unlike adjustment items that can either increase or decrease AMTI, preferencescan only increase AMTI. For example, if regular tax depreciation for a pre�1987 asset is less than the AMTdepreciation, the preference amount is zero (i.e., the preference cannot be a negative amount).

THE ACE ADJUSTMENT

C corporations must compute an adjustment equal to 75% of the difference between

a. AMTI prior to the ACE adjustment (preadjustment AMTI), and

b. ACE (which is a tax concept that is intended to roughly represent the corporation's economic earnings forthe year).

The adjustment is added to, or subtracted from, preadjustment AMTI to arrive at AMTI.

The ACE adjustment can be negative (i.e., subtracted) if preadjustment AMTI exceeds ACE. However, this negativeadjustment is limited to the total positive ACE adjustments reduced by the total negative adjustments made in prioryears to which the ACE adjustment was applicable. (The negative adjustment is allowed to prevent inequitiesresulting from timing differences between financial and taxable income.)

A partnership must gather the information needed to compute the ACE adjustment and pass through this informa�tion (on Schedule K�1 or an attachment) to any C corporation partners in the partnership. An S corporation is neverrequired to provide information about the ACE adjustment since it cannot have a C corporation as a shareholder.


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How Is the ACE Adjustment Calculated?

When computing ACE, the corporation must, in effect, perform the AMT calculation twice.

a. Calculate Preadjustment AMTI. Preadjustment AMTI is regular taxable income before NOL carryovers,modified by tax adjustments and preferences.

b. Calculate ACE. ACE (the second AMT base computation) is calculated by changing some of the items usedin calculating preadjustment AMTI and making some additional adjustments. The purpose of theseadjustments is to ensure that the corporation pays tax on economic income not included in preadjustmentAMTI.

For purposes of determining the amount by which ACE exceeds the preadjustment AMTI, a positive amountexceeds a negative amount by the sum of the absolute numbers, and a smaller negative amount exceeds a largernegative amount by the difference between the absolute numbers. For example, if a corporation has positive ACEof $40 and negative preadjustment AMTI of $20, the ACE adjustment is 75% of $60.

ACE is based on several of the same concepts used in calculating corporate earnings and profits (E&P). CurrentE&P generally represents all corporate income and expenses for the year, regardless of whether the income orexpense is included in determining taxable income.

a. Generally, all items included when computing a corporation's E&P must be included in ACE. However,differences exist between the ACE calculation and the E&P calculation. For example, while the starting pointfor the ACE adjustment is preadjustment AMTI, the starting point for E&P is taxable income. Anotherdifference lies in the fact that not all the items used to calculate E&P are considered when computing ACE.

b. Generally, any item not deductible in computing preadjustment AMTI cannot be deducted for ACE. (Thisis true even if the item is deductible in computing E&P for the year.) One example is capital losses in excessof capital gains for the year. Other examples might include nondeductible fines and penalties,nondeductible federal taxes, and the 50% nondeductible portion of meals and entertainment expenses.(However, expenses incurred in earning tax�exempt income that must be included in ACE can be used toreduce that income.)

Example 6�4: Computing the ACE adjustment.

Assume the same facts as in Example 6�1. DBI's ACE adjustment for the current year is computed as follows:

Preadjustment AMTI $ 633,500ACE depreciation adjustments:

AMT depreciation 360,000ACE depreciation (220,000) 140,000

Income items included in ACE but not in preadjustment AMTI 11,400a

Deductions in arriving at preadjustment AMTI that are neverallowable for ACE �

Other ACE adjustments (4,200)b

ACE 780,700Less preadjustment AMTI (633,500)Excess of ACE over preadjustment AMTI 147,200Multiplied by 75% � 75%

ACE adjustment $ 110,400

Notes:

a $11,500 (tax�exempt income) � $100 (expenses) = $11,400

b $87,500 (AMT adjusted basis) � $91,700 (ACE adjusted basis) = $4,200


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How Is the ACE Depreciation Adjustment Calculated?

The ACE depreciation adjustment has been repealed for property placed in service after December 31, 1993.However, an ACE adjustment is still necessary for property placed in service before 1994 that is still beingdepreciated for AMT purposes. To determine ACE, the depreciation deduction for a corporation must be recalcu�lated using allowable ACE depreciation methods and property basis. Once this is accomplished, the ACE depreci�ation adjustment is the difference between AMT depreciation and allowable ACE depreciation. The computation ofACE depreciation depends on the year the property was placed in service.

What Income Items Are Included in the ACE Adjustment But Not in Preadjustment AMTI?

Any income permanently excluded from AMTI but required to be taken into account when computing E&P must beincluded when computing ACE. Conversely, as long as an item is included in preadjustment AMTI, an ACEadjustment for that item can be avoided. It does not matter what year the income will be included in preadjustmentAMTIit only matters that at some point it is included. Exhibit 6�1 is a partial list of income items that must beincluded in ACE.

Exhibit 6�1

Income Items Required as ACE Adjustments

1. Inside build�up in life insurance contracts. ACE must be increased by the nontaxable excess, if any, ofthe annual increase in the policy's net surrender value over its annual premium. This amount can onlybe a positive number. No deduction is allowed if the calculation for a period yields a negative number[Reg. 1.56(g)�1(c)(5)(ii), (iii), and (vii), Example 3]. (For term insurance that provides no net surrendervalue, ACE is reduced by the annual premium.) Solely for ACE purposes, any income included as a resultof the inside build�up increases the corporation's basis in the contract.

2. Life insurance proceeds if the corporation is the beneficiary. (These proceeds are reduced by thecorporation's adjusted basis in the contract.)

3. Interest on tax�exempt bonds other than private activity bonds. (Private activity bonds are alreadyincluded in AMTI.) Tax�exempt interest is reduced by related expenses.

4. Income attributable to the recovery of an item deducted in computing ACE in a prior year that is excludedunder IRC Sec. 111.

* * *

The amount of any income item that must be included in ACE (because it is not already in preadjustment AMTI) isreduced by any expenses incurred in earning that income (if they are not already part of preadjustment AMTI).These expenses are deducted in accordance with the company's normal method of accounting for similarexpenses, even if the related income has not yet been included in ACE.

What Items Are Deductible in Arriving at Preadjustment AMTI But Not for ACE?

An item not deductible in computing E&P for any tax year cannot be deducted for ACE [IRC Sec. 56(g)(4)(C)]. Thisis true even if the item is considered in determining preadjustment AMTI. So, ACE must be increased for these itemsto the extent they are already deducted in computing preadjustment AMTI.

A deduction is allowed for qualified U.S. production activities (IRC Sec. 199). Even though this deduction is notallowed in computing a corporation's earnings and profits for regular tax purposes, it is allowed in computing thecorporation's ACE.

The most common addback item is the dividends received deduction (DRD). However, the 100% DRD and the DRDfor certain dividends received from 20% owned corporations are not added back to the extent the payer corporationis subject to federal income tax on its earnings.


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What Other Adjustments Are Made When Computing ACE?

Other ACE adjustments and their treatment for purposes of the computation of ACE are as follows:

a. Intangible Drilling Costs. This adjustment only applies to integrated oil companies.

b. Organization and Circulation Expenses. These costs generally are capitalized for purposes of ACE ratherthan deducted as current expenses or amortized over a period of several years. However, if a specialelection is made to amortize circulation expenses over a three�year period for regular taxes, no AMT or ACEadjustment is required. The AMT adjustment for circulation expenditures applies only to personal holdingcompanies [IRC Sec. 56 (b)(2)(c)], but the ACE adjustment for circulation expenditures applies to allcorporations [IRC Sec. 56(g)(4)(D)(ii)].

c. LIFO Recapture (Corporations Using the LIFO Inventory Method). ACE must be increased or decreased bythe amount of the increase or decrease in a corporation's LIFO recapture amount (i.e., the increase ordecrease in the LIFO reserve). However, an election can be made to use regular tax inventory to computethe AMT inventory and ACE inventory adjustment. This election eliminates the need to maintain separateinventory records for regular tax, AMT, and ACE.

d. Installment Sales. The installment method generally cannot be used to compute ACE; income frominstallment sales must be included in ACE in the year in which the property is sold. However, it can be usedin the following instances:

(1) To report gain on which a company is paying interest charges under IRC Sec. 453A.

(2) If it applies in determining preadjustment AMTI and the disposition creating the installment obligationoccurred in a tax year beginning before 1990.

e. Depletion. ACE depletion must be computed using the cost depletion method of IRC Sec. 611. However,this ACE adjustment does not apply to percentage depletion taken by independent oil and gas producersand royalty owners under IRC Sec. 613A(c).


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33

SELF�STUDY QUIZ


7. Which of the following items is not a step required for determining alternative minimum taxable income (AMTI)of a corporation?

a. Add or subtract AMT adjustments.

b. Add or subtract the Adjusted Current Earnings (ACE) adjustments.

c. Add or subtract AMT preferences.

d. Subtract the AMT exemption.

8. Certain AMT adjustments are required in computing AMTI. Which of the following is an AMT adjustment item?

a. The alcohol fuels credit.

b. Section 611 depletion.

c. Depreciation computed under the units�of�production method.

d. Depreciation on property placed in service after 1998 and depreciated over MACRS recovery periodsusing the 150% DB method.

9. In what manner are partnerships and S corporations impacted by AMT?

a. The AMTI is calculated in the same manner as that for a corporation and then allocated to partners orshareholders for their use in calculating AMT on their own tax returns.

b. Partnerships and S corporations do not pay AMT and do not need to be concerned with the AMT rules.

c. Partnerships and S corporations do not make basis adjustments since there is no computation of AMTIat the entity level.

d. Partnerships and S corporations must identify AMT adjustment and preference items so they can bepassed through to partners or shareholders.

10. Which of the following correctly describes the adjusted current earnings (ACE) calculation? It must:

a. Preadjustment AMTI must be calculated before calculating ACE.

b. The ACE calculation must be computed by partnerships and S corporations.

c. The ACE calculation produces an increase to AMTI. A negative ACE adjustment is not allowed.

d. The ACE calculation is calculated in the same manner as that for calculated earnings and profits (E&P).


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7. Which of the following items is not a step required for determining alternative minimum taxable income (AMTI)of a corporation? (Page 22)

a. Add or subtract AMT adjustments. [This answer is incorrect. AMT adjustments can both decrease andincrease AMTI.]

b. Add or subtract the Adjusted Current Earnings (ACE) adjustments. [This answer is incorrect. The ACEadjustment is a required and can either increase or decrease AMTI.]

c. Add or subtract AMT preferences. [This answer is correct. AMT preferences can only decreaseAMTI. There is no provision for subtracting AMT preference items.]

d. Subtract the AMT exemption. [This answer is incorrect. The AMT does not affect corporations in the lowertax brackets because the AMT exemption is subtracted from AMTI.]

8. Certain AMT adjustments are required in computing AMTI. Which of the following is an AMT adjustment item?(Page 24)

a. The alcohol fuels credit. [This answer is correct. The amount equal to the alcohol fuels credit addedto income for regular tax purposes is taken as a negative adjustment in calculating AMTI].

b. Section 611 depletion. [This answer is incorrect. The percentage depletion amount is an AMT preferenceitem.]

c. Depreciation computed under the units�of�production method. [This answer is incorrect. Propertydepreciated under a method other than MACRS (such as the units�of�production method) is notconsidered when making AMT adjustments.]

d. Depreciation on property placed in service after 1998 and depreciated over MACRS recovery periodsusing the 150% DB method. [This answer is incorrect. If the election is made to use the 150% DB methodrather than the 200% DB method allowed under MACRS, no AMT adjustment is required.]

9. In what manner are partnerships and S corporations impacted by AMT? (Page 23)

a. The AMTI is calculated in the same manner as that for a corporation and then allocated to partners orshareholders for their use in calculating AMT on their own tax returns. [This answer is incorrect. There isno calculation of AMTI for partnerships and S corporations.]

b. Partnerships and S corporations do not pay AMT and do not need to be concerned with the AMT rules.[This answer is incorrect. AMT adjustments and preferences must be identified at the entity level so theycan be passed through to partners or shareholders.]

c. Partnerships and S corporations do not make basis adjustments since there is no computation of AMTIat the entity level. [This answer is incorrect. Basis adjustments must be reported on Schedules K and K�1of either the partnership or S corporation tax return.]

d. Partnerships and S corporations must identify AMT adjustment and preference items so they canbe passed through to partners or shareholders. [This answer is correct. Partnerships and Scorporations are not subject to AMT, but their owners may be subject to AMT on their individualincome tax returns. Therefore, partnerships and S corporations must provide each owner withsufficient information to perform the AMT calculations on their own tax returns.]


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10. Which of the following correctly describes the adjusted current earnings (ACE) calculation? (Page 29)

a. Preadjustment AMTI must be calculated before calculating ACE. [This answer is correct. Whencomputing ACE, the corporation essentially performs the AMT calculation twice, by first calculatingpreadjustment AMTI and then calculating ACE.]

b. Tha ACE calculation must be computed by partnerships and S corporations. [This answer is incorrect.Partnerships must gather the information needed to compute the ACE adjustment and pass through thisinformation to any C corporation partners. S corporations are never required to provide ACE informationsince they cannot have C corporations as shareholders.]

c. The ACE calculation produces an increase to AMTI. A negative ACE adjustment is not allowed. [Thisanswer is incorrect. The ACE adjustment can be negative if preadjustment AMTI exceeds ACE. Howeverthe negative adjustment is limited to the excess of the positive ACE adjustments over negative ACEadjustments made in prior years.]

d. Tha ACE calculation is calculated in the same manner as that for calculated earnings and profits (E&P).[This answer is incorrect. While the calculation of ACE is based on several of the same concepts used incalculating E&P, the calculations of these amounts is not the same.]


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ALTERNATIVE TAX NET OPERATING LOSS (ATNOL)

In principle, an NOL offsets AMTI in much the same way it offsets regular taxable income. However, an ATNOL maydiffer in amount from a regular tax NOL. Also, there can be an ATNOL and no regular tax NOL and vice versa. Sincethe regular tax NOL and the ATNOL will rarely be the same, it is necessary to maintain two carryover schedules, onefor each type of NOL.

An ATNOL is defined as the regular tax NOL increased or decreased by AMT adjustments and decreased by AMTpreferences. However, an adjustment for an AMT preference is only required to the extent it caused the regular taxNOL to increase. An ATNOL can be carried back two years and forward 20 years.

If the business elects to forgo the carryback period for its regular NOL, the carryback period is also waived for anyATNOL for the same year. If the business elects to forgo the five�year carryback period for NOLs arising in tax yearsending in 2001 or 2002, the losses are subject to the rules that otherwise would have applied without the five�yearrule. Thus, electing to forgo the five�year carryback means that the ATNOL is carried back two years (unless anelection to forgo the two�year carryback is made).

What Is the Limit on ATNOL Deductions?

To ensure that a corporation cannot eliminate its entire AMT liability with an NOL, the deduction for the ATNOLgenerally is limited to 90% of AMTI. An ATNOL deduction attributable to ATNOL carrybacks arising in tax yearsending in 2001 and 2002, as well as ATNOL carryforwards to these taxable years, are allowed to offset 100% of thetaxpayer's AMTI. In determining AMTI for purposes of this rule, the ATNOL carryovers and carrybacks from theearliest years are used first.

Example 6�5: ATNOL limited to 90% of AMTI.

In 2009, Y Corp. incurred a $95,000 regular tax NOL and a $70,000 ATNOL. Y elected to forgo the two�yearcarryback period for the NOLs. In 2010, Y had an AMTI (prior to the ATNOL deduction) of $60,000. Y's use ofthe ATNOL carryover in 2010 is $54,000 (90% � $60,000).

If an ATNOL is carried to a year when AMT is positive, it is offset against AMTI even if the corporation does not oweany AMT for the year. Any unused ATNOL then carries forward to subsequent years.

Does the Domestic Production Deduction Affect the ATNOL? The ATNOL deduction is limited to the lesser ofthe ATNOL or 90% of AMTI determined without regard to the ATNOL and the domestic production activitiesdeduction allowed by IRC Sec. 199. This limitation is effective for tax years beginning after December 31, 2004.

Example 6�6: Applying the ATNOL limitation with a domestic production activities deduction.

For the current year, Zee Corp. has the following activity:

Income before domestic production activities deduction $ 100,000(3) Domestic production activities deduction (3,000)

Taxable Income 97,000(4) ATNOL carried forward from previous year 500,000

ATNOL allowed for current year 90,000

The ATNOL allowed for the current year is 90% of taxable income before taking (1) or (2) into consideration.


37

SELF�STUDY QUIZ


11. Which of the following statements regarding the alternative tax net operating loss (ATNOL) is correct?

a. An ATNOL can only be incurred if there is a regular NOL for the year.

b. A separate election is required to forego the carryback period for the ATNOL.

c. The ATNOL can be carried back two years and forward 20 years.

12. X Corporation incurs a regular tax NOL of $100,000 and an ATNOL of $75,000 and elects to forego the carrybackperiod for the NOLs. AMTI for the year is $80,000. How much of the ATNOL can be deducted for the tax year?

a. $75,000.

b. $72,000.

c. $90,000.

d. $67,500.


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11. Which of the following statements regarding the alternative tax net operating loss (ATNOL) is correct?(Page 36)

a. An ATNOL can only be incurred if there is a regular NOL for the year. [This answer is incorrect. AMTadjustments and preferences can create an ATNOL for a year in which there is not an NOL. However, anadjustment for an AMT preference is only required to the extent it caused a regular tax NOL to increase.]

b. A separate election is required to forego the carryback period for the ATNOL. [This answer is incorrect. Thetaxpayer is allowed to make one election to forego both the regular NOL and ATNOL.]

c. The ATNOL can be carried back two years and forward 20 years. [This answer is correct. Thecarryback period is three years and forward 15 years for tax years beginning before August 6, 1997.]

12. X Corporation incurs a regular tax NOL of $100,000 and an ATNOL of $75,000 and elects to forego the carrybackperiod for the NOLs. AMTI for the year is $80,000. How much of the ATNOL can be deducted for the tax year?(Page 36)

a. $75,000. [This answer is incorrect. The ATNOL is subject to the 90% limitation rule.]

b. $72,000. [This answer is correct. AMTI � $80,000 � 90% = $72,000.]

c. $90,000. [This answer is incorrect. The 90% limit is based on AMTI and not on the regular tax NOL.]

d. $67,500. [This answer is incorrect. The 90% limitation is not based on the ATNOL amount, but instead onAMTI.]


39

AMT DETERMINATION FOR SMALL CORPORATIONS

AMT was repealed for small C corporations for tax years beginning after 1997. A small corporation is defined as onehaving three�year average annual gross receipts not exceeding $5 million for its first tax year beginning after 1996,and not having three�year average annual gross receipts exceeding $7.5 million for any later year. The rules underIRC Sec. 1563(a) (with certain modifications) are used to determine whether gross receipts of related entities mustbe aggregated when determining if the gross receipts rules are met.

A corporation that has been exempt from the AMT as a small corporation and then becomes subject to the AMTwhen it exceeds the gross receipts threshold will remain liable for the AMT in all future years. The corporation willbe subject to the AMT only on certain adjustment items (e.g. the depreciation adjustment applies only to propertyplaced in service after the disqualification date) and on transactions entered into after the corporation is disqualifiedas a small corporation.

What Are the Qualifications for a New Corporation?

In a corporation's first year of existence, it receives an automatic AMT exemption, regardless of its receipts. In itssecond year, the corporation continues to be exempt if its gross receipts for the first year were no more than $5million (on an annualized basis, if the first year was less than 12 months). In its third year, the corporation willcontinue to be exempt if average gross receipts for the first two years are not more than $7.5 million (afterannualizing the first year's receipts if necessary). In its fourth and later years, the corporation continues to beexempt from AMT as long as its average gross receipts for the three prior years are no more than $7.5 million. Oncethe corporation ceases to qualify for the exemption, there is no opportunity for it to regain the exemption in futureyears.

Example 6�7: Small corporations exempt from AMT.

KJ Corporation (KJ), a calendar�year taxpayer, began business in Year 1. KJ had the following gross receipts:

Tax YearGross

Receipts

PriorThree�year

Average

Year 1 $ 5,000,000Year 2 7,500,000 $ 5,000,000Year 3 10,500,000 6,250,000Year 4 6,500,000 7,666,667Year 5 5,000,000 8,166,667Year 6 7,000,000 7,333,333

KJ qualified as a small corporation for Year 1, its first year of existence, regardless of its gross receipts. KJqualified as a small corporation for Year 2 because its average annual gross receipts for its first priorthree�year period (or portion thereof) were $5,000,000 or less. KJ qualified as a small corporation for Year 3because its average annual gross receipts for the prior three�year period (or portion thereof) were $7,500,000or less. In Years 4 and 5, KJ no longer met the small corporation exemption because its average annual grossreceipts for the prior three�year period exceeded $7,500,000. In Year 6, even though KJ's average annualgross receipts dropped below $7,500,000, it no longer qualifies for the small corporation exemption becauseit became subject to the AMT in Year 4 (and thus, all subsequent years).

What Is the MTC Carryover for a Small Corporation Exempt from AMT?

Some small corporations that became exempt from the AMT when the small corporation exemption was enactedwill have a minimum tax credit (MTC) carryover that is available to offset regular tax. The MTC is subject to a limit forsmall corporations.


40

In computing the otherwise allowable credit for prior minimum tax liability for a tax year that a corporation is exemptfrom AMT as a small corporation, the corporation must reduce its regular tax liability for that year (after reduction byspecified credits) by 25% of the excess of the liability over $25,000. Note that this situation can only arise when acorporation was subject to minimum tax prior to 1998, before the small corporation exemption was enacted, andhas been unable to fully use the credit since that time. After 1997, if a corporation is once subject to minimum tax,it can never again qualify for the small corporation exemption.


41

SELF�STUDY QUIZ


13. A C corporation is exempt from AMT as a small corporation for 2010 if it meets which of the followingrequirements?

a. The calendar year corporation began business on March 1, 2010.

b. The calendar year corporation began business in 2009 and had gross receipts of $6.5 million dollars forits initial short year.

c. The corporation was subject to AMT in 2009 but had average annual gross receipts for 2007, 2008, and2009 of less than $7.5 million.

d. The corporation has average annual gross receipts for the previous three years of $4 million and is amember of a controlled group of corporations under IRC Sec. 1563(a).

14. Some small corporations that become exempt from the AMT will have a minimum tax credit (MTC) carryoverthat is available to offset regular tax. How is this MTC used?

a. The MTC can be used against regular tax without limit.

b. The corporation must reduce its regular tax liability for the year by 25% of the excess of the regular taxliability over $25,000.

c. The MTC will remain unused since the corporation can never be exempt in future years.

d. The MTC can be used only in the first year after becoming subject to AMT.


42



13. A C corporation is exempt from AMT as a small corporation for 2010 if it meets which of the followingrequirements? (Page 39)

a. The calendar year corporation began business on March 1, 2010. [This answer is correct. Acorporation is exempt from the AMT in its first year of existence regardless of the amount of grossreceipts per IRC Sec. 55(e)(i)(c).]

b. The calendar year corporation began business in 2009 and had gross receipts of $6.5 million dollars forits initial short year. [This answer is incorrect. A corporation having gross receipts of more than $5 million(on an annualized basis) in its first tax year beginning after 1996 will be subject to AMT for its second yearand all future years.]

c. The corporation was subject to AMT in 2009 but had average annual gross receipts for 2007, 2008, and2009 of less than $7.5 million. [This answer is incorrect. Once a corporation fails to meet the smallcorporation gross receipts test, it will remain subject to AMT in all future years.]

d. The corporation has average annual gross receipts for the previous three years of $4 million and is amember of a controlled group of corporations under IRC Sec. 1563(a). [This answer is incorrect. Membersof a controlled group must aggregate their earnings with other members when determining if the grossreceipts test is met.]

14. Some small corporations that become exempt from the AMT will have a minimum tax credit (MTC) carryoverthat is available to offset regular tax. How is this MTC used? (Page 39)

a. The MTC can be used against regular tax without limit. [This answer is incorrect. A limit must be appliedto reduce the regular tax that can be offset in any year.]

b. The corporation must reduce its regular tax liability for the year by 25% of the excess of the regulartax liability over $25,000. [This answer is correct per IRC Sec. 55(e)(5). This situation can only arisewhen a corporation was subject to minimum tax prior to 1998, before the small corporationexemption was enacted, and has been unable to fully use the credit since that time.]

c. The MTC will remain unused since the corporation can never be exempt in future years. [This answer isincorrect. The MTC can be taken against regular tax in future years, subject to limitation, until it is fully used.]

d. The MTC can be used only in the first year after becoming subject to AMT. [This answer is incorrect. TheMTC can be carried forward until it has been fully used.]


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ELECTIONS THAT MINIMIZE AMT

Businesses are allowed to make special elections that minimize the amount of certain AMT adjustments andpreferences that must be added to taxable income in computing AMTI. Some examples of elections to minimizeAMT include: using MACRS recovery periods and 150% DB method to compute regular taxable income; amortiz�ing intangible drilling costs over a 60 month period; and amortizing circulation expenditures over a 36 monthperiod. The elections usually impact the computation of taxable income for regular tax. Thus, its effect on bothtaxable income and AMTI should be considered before an election is made.

What Elections Are Available to Eliminate AMT Depreciation and Basis Adjustments?

For property placed in service after 1986, the depreciation methods and recovery periods used for AMT purposesmay differ from those used for regular tax calculations. An AMT adjustment is required for the difference betweenregular tax depreciation and AMT depreciation. Furthermore, when computing AMTI, an adjustment must be madeto account for the difference in the adjusted basis (regular tax versus AMT) used to compute gain or loss on thedisposition of assets.

However, taxpayers can elect among the following depreciation methods for regular tax purposes to avoid AMTdepreciation and basis adjustments:

a. Property Placed in Service before 1999. The business could elect the Alternative Depreciation System(ADS) for both regular tax and AMT. [ADS uses a straight�line (SL) method over longer class life recoveryperiods.] Alternatively, the company could elect to use the AMT depreciation rules (150% DB method usingthe longer class life recovery periods) for the regular tax system.

b. Property Placed in Service after 1998. The recovery periods for both regular tax and AMT are the regularMACRS recovery periods. The longer class life recovery periods of the ADS are no longer required for AMTpurposes. Therefore, the company can elect the 150% DB method, which eliminates the AMT depreciationadjustment for personal property and still allows an accelerated method of depreciation for regular taxpurposes. Alternatively, the business can elect either the ADS (SL over longer class life recovery periods)or MACRS SL (with no effect on the recovery periods) for both regular tax and AMT.

If the business makes an election to use one of these methods, depreciation expense is the same for both regulartax and AMT. There are no depreciation or basis adjustments made for that asset and no need for two sets ofdepreciation and fixed asset records.

The election to use a depreciation method is made on Form 4562 (Depreciation and Amortization) for the tax yearin which the expenditure is incurred. Although a statement is not required by the Code, companies may want toattach a statement to the return to explicitly state their intentions as a matter of record.

Can a C Corporation Make an Election to Eliminate Inventory Adjustments?

If a C corporation uses the last�in, first�out (LIFO) inventory method for regular tax purposes, it must keep track ofa LIFO reserve when calculating its earnings and profits (E&P) for the year. Under the ACE rules, it is necessary forthe corporation to maintain this LIFO reserve computed using the principles of the AMT. The corporation must alsocompute its inventory for ACE purposes by taking into account ACE adjustments. This requires that another set ofrecords be maintained to track the amount of the inventory and LIFO reserve for ACE purposes.

A C corporation may elect to use its regular tax inventory amount to compute preadjustment AMTI and ACE,including the ACE LIFO adjustment. This eliminates the need to maintain separate inventory records for preadjust�ment AMTI and ACE. C corporations may also elect to use preadjustment AMTI inventories to compute ACE.


44

Can the Business Adopt Section 59(e) Optional Amortization to Minimize Certain Preferences?

IRC Sec. 59(e) provides the following optional amortization elections to allow businesses to minimize certain AMTadjustments and preferences:

a. Partnerships and S corporations with owners who do not materially participate in the entity's businessactivities may want to consider making this special election for research and experimental expenses.Otherwise, there is an AMT adjustment for these amounts with respect to those owners.

b. Circulation expenditures (for personal holding companies only), intangible drilling and developmentexpenditures, and mining exploration and development costs are other items for which this special electionis available.

By virtue of the Section 59(e) election, the qualified expenditures will not be treated as tax adjustment or preferenceitems if capitalized and amortized over a 10�year period (three years in the case of circulation expenditures and 60months in the case of intangible drilling and development expenditures). While the amortization period normallybegins in the year the expenditure is made, intangible drilling and development expenditures are amortizedbeginning in the month they are paid or incurred.

The Section 59(e) election is made by attaching a statement to the tax return for the tax year in which theamortization of the qualified expenditure begins. An election under IRC Sec. 59(e) must be for a specific dollaramount; no formulas are allowed. The election can be revoked only with the consent of the IRS. In the case of apartnership or S corporation, the election applies at the partner or S shareholder level to the owner's share of theparticular expenditure.

AMT FOREIGN TAX CREDIT

The AMT foreign tax credit (FTC) is computed in a manner similar to the regular tax FTC. However, in making thecomputation, AMTI is used, rather than taxable income, and tentative minimum tax (before credits) is used as thetax against which the FTC is applied. Other differences are (a) increases or reductions of AMTI due to ACEadjustments that must be sourced on an item�by�item basis, and (b) the AMT rate is used in place of the highestcorporate tax rate in determining whether income is high�taxed income.

A corporation's tax liability may be reduced to zero by the AMT FTC. Any amount of unused AMT FTC (arising in taxyears beginning after October 22, 2004) can be carried back one year and carried forward ten years.

Businesses can elect to use foreign source regular taxable income instead of foreign source AMTI to compute theFTC limitation for AMT purposes. If elected, the FTC limitation is based on the ratio of regular taxable income fromforeign sources (but not in excess of AMTI) to AMTI. Also, deductions are not reallocated and reapportioned. Whenforeign source regular taxable income exceeds AMTI, and there is income in more than one FTC limitation category,all of the categories are reduced pro rata.

The election to use foreign source regular taxable income can be made only in the first tax year for which a taxpayerclaims an AMT foreign tax credit. Thus, the election is not available to taxpayers that claimed an AMT FTC (limitedby AMTI) in prior years. Once made, the election applies to all future years unless the IRS consents to revoke theelection.

AMT TREATMENT OF INCENTIVE STOCK OPTIONS

Although individuals are directly affected by the AMT treatment of incentive stock options (ISO), the use of ISO mayhave an indirect negative impact on the issuing corporation. While stock options have proven a popular form ofnon�cash compensation, a recent case illustrates one of the problems that may arise.

When an individual exercises stock options, the difference between the strike price and the fair market value at thetime of exercise is reported as income for AMTI purposes. If the stock is subsequently sold at a loss for AMTI aftera one�year holding period, the AMTI loss is limited to the $3,000 net capital loss limitation allowed per year for


45

regular tax. (It is not treated as an ATNOL.) If the $3,000 limitation is included in the calculation of regular taxableincome, no additional loss can be recognized for AMTI so there is no adjustment.

Example 6�8: AMT Adjustments for ISOs.

On March 13, 2009, Victor Ash paid $20,000 to exercise an ISO to buy 200 shares of stock worth $200,000.The $180,000 difference between his cost and the stock's value when the option was exercised is not taxablefor regular tax. His regular tax basis in the stock at the end of 2009 is $20,000. For AMT, however, Ash mustinclude the $180,000 as an adjustment on Form 6251. His AMT basis in the stock at the end of 2009 is$200,000.

On January 20, 2010, Ash sells the shares to an unrelated party for $150,000 (a disqualifying disposition). Forregular tax, he has compensation income of $130,000 ($150,000�$20,000 basis). He has no capital gain orloss for regular tax (sales proceeds of $150,000 less basis of $150,000). For AMT, Ash has no ordinaryincome, but has a short�term capital loss of $50,000 ($150,000 proceeds minus $200,000 AMT basis in theshares). Ash has no other capital gains or losses in 2010.

On his 2010 Form 6251, Ash reports a negative adjustment of $133,000, consisting of a $130,000 negativeadjustment (compensation income recognized for regular tax but not AMT) and $3,000 of AMT capital loss inexcess of regular tax capital loss. Ash also has a $47,000 ($50,000�$3,000) AMT capital loss carryforward.

Variation:�Assume the same facts except that Ash sold the stock on December 31, 2009. Here, the positiveadjustment related to exercising the option is limited to $130,000 ($150,000 proceeds less $20,000 cost). HisAMT basis in the stock is $150,000 ($130,000 AMT adjustment plus $20,000 cost). When the stock is sold, Ashagain realizes compensation income of $130,000 ($150,000 � $20,000) for regular tax. For AMT, he recog�nizes no gain or loss on the transaction, since his AMT basis equals the sales proceeds. Therefore, he has anegative adjustment of $130,000 for the compensation income recognized for regular tax but not AMT. This$130,000 negative adjustment offsets the previous $130,000 positive adjustment from the exercise. Accordingto the Form 6251 instructions, since the option was exercised and the stock sold in the same year, neither ofthese adjustments is reported on the Form 6251.

The unfavorable result in Palahnuk may affect an employee or potential employee's willingness to accept stockoptions as compensation thereby increasing the cash compensation companies must pay. However, effectiveplanning can minimize the negative tax consequences to the employee, as illustrated in the variation to thepreceding example.


46


47

SELF�STUDY QUIZ


15. Which of the following depreciation elections will not minimize the administrative burden of computing bothregular tax and AMT depreciation?

a. The business can elect to use the MACRS S/L method for both regular tax and AMT purposes.

b. The business can elect to use MACRS recovery periods and the 150% DB method for both regular tax andAMT purposes.

c. The business can elect the ADS method of depreciation over MACRS recovery periods for both regulartax and AMT for all assets placed in service during 2009.

d. The business can elect to use the ADS S/L and class life recovery periods for both regular tax and AMTpurposes.

16. Electing to use the LIFO method for both regular tax and AMT tax purposes will eliminate what record�keepingproblem for a C corporation?

a. It will eliminate the need to keep track of the LIFO reserve.

b. The corporation can use the LIFO reserve calculated for ACE purposes for regular tax and AMT purposes.

c. Maintaining separate inventory records for preadjustment AMTI and ACE.

17. Which of the following statements concerning the AMT foreign tax credit (FTC) is correct?

a. The AMT FTC can offset only 90% of a corporation's AMT tax liability.

b. An election can be made, on an annual basis, to use foreign source regular taxable income to computethe FTC limitation for AMT purposes.

c. AMTI and tentative minimum tax (before credits) are used to compute the AMT foreign tax credit.

d. Any unused AMT FTC (arising in years after October 22, 2004) can be carried back two years and forwardten years.


48



15. Which of the following depreciation elections will not minimize the administrative burden of computing bothregular tax and AMT depreciation? (Page 43)

a. The business can elect to use the MACRS S/L method for both regular tax and AMT purposes. [This answeris incorrect. The business can elect to use the S/L method over MACRS recovery periods for both regularand AMT purposes. Thus there would be no depreciation adjustment if this election is made.]

b. The business can elect to use MACRS recovery periods and the 150% DB method for both regular tax andAMT purposes. [This answer is incorrect. The recovery periods for both regular tax and AMT are theMACRS recovery periods. AMT allows the use of the 150% DB method. If this method is elected for regulartax purposes, there is no AMT depreciation adjustment.]

c. The business can elect the ADS method of depreciation over MACRS recovery periods for bothregular tax and AMT for all assets placed in service during 2009. [This answer is correct. While theADS straight�line method can be elected for both regular tax and AMT purposes, the longer ADSclass life recovery periods must also be used.]

d. The business can elect to use the ADS S/L and class life recovery periods for both regular tax and AMTpurposes. [This answer is incorrect. S/L depreciation and longer class life recovery periods can be electedfor both regular tax and AMT purposes.]

16. Electing to use the LIFO method for both regular tax and AMT tax purposes will eliminate what record�keepingproblem for a C corporation? (Page 43)

a. It will eliminate the need to keep track of the LIFO reserve. [This answer is incorrect. A C corporation usingLIFO must quantify its LIFO reserve in order to calculate E&P.]

b. The corporation can use the LIFO reserve calculated for ACE purposes for regular tax and AMT purposes.[This answer is incorrect. The election will allow the corporation to use the regular tax inventory to computethe ACE LIFO adjustment.]

c. Maintaining separate inventory records for preadjustment AMTI and ACE. [This answer is correct.A C corporation may elect to use its regular tax inventory amount to compute preadjustment AMTIand ACE, as well as the ACE LIFO adjustment.]

17. Which of the following statements concerning the AMT foreign tax credit (FTC) is correct? (Page 44)

a. The AMT FTC can offset only 90% of a corporation's AMT tax liability. [This answer is incorrect. After 2004,a corporation's AMT tax liability may be reduced to zero by the AMT FTC.]

b. An election can be made, on an annual basis, to use foreign source regular taxable income to computethe FTC limitation for AMT purposes. [This answer is incorrect. This election can be made only in the firsttax year for which a taxpayer claims an AMT foreign tax credit. If made the FTC limitation is based on theratio of regular taxable income from foreign sources (not in excess of AMTI) to AMTI.]

c. AMTI and tentative minimum tax (before credits) are used to compute the AMT foreign tax credit.[This answer is correct. Also ACE adjustments must be sourced on an item�by�item basis and theAMT rate is used in place of the highest corporate tax rate in determining whether income isconsidered �high�tax" income.]

d. Any unused AMT FTC (arising in years after October 22, 2004) can be carried back two years and forwardten years. [This answer is incorrect. Any unused AMT FTC can be carried back only one year and forwardten years.]


49


Lesson 2 (DBPTG10)


10. Which of the following entities are subject to the alternative minimum tax (AMT)?

a. C corporations not considered small corporations.

b. S corporations.

c. Partnerships with a C corporation partner.

d. All C corporations.

11. What is the starting point for the calculation of AMT for a corporation?

a. Regular taxable income after the NOL deduction but before special deductions.

b. Regular taxable income before the NOL deduction but after special deductions.

c. Alternative minimum taxable income (AMTI).

d. Regular taxable income.

12. Which of the following properly defines AMT?

a. The total tax on the return if greater than regular tax.

b. The amount by which the AMT exceeds regular tax before the foreign tax credit and possessions credit.

c. The amount by which the AMT exceeds regular tax after the foreign tax credit and possessions credit.

d. 90% of the excess of AMT over the regular tax.

13. Which of the following general business credits can be used to offset 100% of AMT?

a. New Markets Credit.

b. Renewal Community Employment Credit.

c. Credit for Alcohol Used as Fuel.

d. Foreign Tax Credit

14. AMT allows what type of depreciation for property placed in service after 1998?

a. ADS system useful lives with 200% declining balance method.

b. MACRS with 150% declining balance method.

c. MACRS with 200% declining balance method.

d. MACRS with straight�line method only.


50

15. An AMT preference item receives what treatment?

a. It can only decrease AMTI.

b. It can both increase and decrease AMTI.

c. It can only increase AMTI.

d. It cannot decrease AMTI below zero.

16. Which of the following is the correct calculation?

a. A corporation has a positive ACE of $10 and a negative preadjustment AMTI of $20. The ACE adjustmentis zero.

b. A corporation has a negative ACE adjustment of $10 and a positive preadjustment AMTI of $20. The ACEadjustment is 75% of $10.

c. The corporation has a positive ACE adjustment of $10 and a negative preadjustment AMTI of $50. The ACEadjustment is 75% of $60.

d. The corporation has a positive ACE adjustment of $20 and a negative preadjustment AMTI of $10. The ACEadjustment is $30.

17. What income items are included in the ACE adjustment but not in the calculation of AMTI?

a. Cash surrender value of life insurance contracts.

b. Any income permanently excluded from AMTI but required to be taken into account when computingearnings and profits.

c. Interest income on private activity bonds.

d. Life insurance proceeds where the corporation is not the beneficiary.

18. What is the proper treatment of an alternative tax net operating loss (ATNOL) when carried forward to a yearhaving positive AMT?

a. It is offset against the greater of AMTI or regular taxable income.

b. It will be offset against 90% of AMTI even if the corporation does not owe AMTI for the year.

c. It is only offset against any AMT owed for the year.

d. It may offset 100% of AMTI even if the corporation does not owe AMTI for the year.

19. What is the starting point for calculating the ATNOL?

a. Regular tax NOL.

b. AMTI.

c. AMTI after ACE adjustment.

d. AMTI before foreign tax credit.


51

20. Which of the following corporations would be considered a small corporation for AMT purposes?

a. The corporation has gross receipts for the previous year of less than $7.5 million and three year averagegross receipts of $10 million.

b. The corporation is in its third year of existence and had gross receipts for the first year of $7.49 million andthree year average gross receipts of $10 million.

c. The corporation is in its first year and has gross receipts of $5 million.

d. The corporation has average annual gross receipts of $7.6 million for its previous three years.

21. What is the result if a corporation that has been subject to AMT has average gross receipts for the previous threeyears of $4.5 million?

a. The corporation will not be subject to AMT for the year.

b. The corporation must have average annual gross receipts of $7.5 million or less for three years before itwill no longer be subject to AMT.

c. The corporation can average the current year's earnings with the previous two year's income to determineif it is subject to AMT for the current year.

d. The corporation remains subject to AMT for the current year and all future years.

22. Certain elections can be made to minimize the amount of AMT adjustments and preferences that must beconsidered in computing AMTI. Which of the following is not one of those elections?

a. Electing to use MACRS recovery periods and 150% DB method to compute regular taxable income.

b. Electing to amortize intangible drilling costs over a 60 month period.

c. Electing to amortize circulation expenditures over a 36 month period.

d. Electing to use the FIFO inventory method for AMT and regular tax purposes.

23. What is the most important consideration before making an election to reduce AMTI adjustments andpreferences?

a. Its effect on regular tax.

b. The year a timing adjustment will turn around.

c. The effect the election has on the ACE adjustment.

d. The effect the election will have on administrative burden.


52


53

Lesson 3:�Business Income Taxes

A corporate income tax is imposed on C corporations under the regular tax system. (This is the regular corporateincome tax.) C corporations may be subject to a variety of other corporate�level income taxes, including thealternative tax on capital gains, the alternative minimum tax, recapture of business credits, and certain penalty taxeson undistributed corporate earnings.

Partnerships and S corporations generally do not pay any company�level tax. This is because partnerships and Scorporations pass through profits or losses to their owners. (Owners must then include company items of income,deductions, and credits on their individual tax returns.) However, certain S corporations that were previously Ccorporations may be subject to the following corporate�level taxes due to their conversion to S status: the tax onbuilt�in gains, the tax on excess net passive income, and recapture of business credits. The S corporation must paythese special taxes at the corporate level. The S corporation must still pass through to its S shareholders all othercompany items of income, deduction, and credit.

This lesson explains the corporate�level taxes that may be imposed on a C corporation. It also discusses the typesof corporate�level income taxes that may be assessed to an S corporation, and certain other tax payments an Scorporation must make. See Lesson 1 for information on estimated tax payments for C and S corporations, andLesson 2 for an explanation of the alternative minimum tax. See Lesson 4 for information on business credits usedto offset tax liability.


Completion of this lesson will enable you to:� Identify taxes imposed on the corporation for the current tax year.� Determine if the corporation is subject to the accumulated earnings tax and how to determine the correct

amount of such tax.� Determine if the corporation is considered a personal holding company (PHC) and, if so, calculate the amount

of PHC tax that might be due.� Recognize if any corporate�level taxes or taxes unique to an S Corporation might be due for the year and

calculate the LIFO recapture tax.

THE CORPORATE INCOME TAX AND OTHER TAXES IMPOSED ON CCORPORATIONS

A corporate income tax is imposed on C corporations under the regular tax system. This regular corporate incometax is computed and reported on Schedule J of Form 1120.

Under the tax rate schedule, only small corporations may receive a tax benefit for the lower graduated rates. A 5%surtax is imposed on taxable income in excess of $100,000, up to a maximum surtax of $11,750. This is the net taxsavings associated with having the first $75,000 of corporate taxable income taxed at rates lower than the 34% rate.The 5% surtax applies between $100,000 and $335,000 of taxable incomethis is the 39% rate.

Corporations with taxable income in excess of $15 million are subject to a 35% rate on all taxable income. Thesecorporations must phase out any benefit received from using the lower 34% rate. A 3% surtax is imposed on taxableincome in excess of $15 million, up to a maximum surtax of $100,000. This is the net tax savings associated withhaving the first $10 million of corporate taxable income taxed at a 34% rate versus a 35% rate. The 3% surtax appliesbetween $15 million and $181/3 million of taxable incomethis is the 38% rate.

Are Members of a Controlled Group Required to Share the Benefit of Lower Graduated Tax Rates?

Component members of a controlled group are treated as one corporation for purposes of the graduated tax ratesand certain surtaxes.


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The tax law defines a controlled group of corporations as:

a. Parent/Subsidiary Group. This controlled group exists if a corporation (the parent) owns 80% or more ofthe total combined voting power of all classes of stock entitled to vote or 80% or more of the total value ofall classes of stock of at least one other corporation (the subsidiary). Additional corporations are includedin the group if at least 80% of their voting stock or at least 80% of the value of their stock is owned by a parentor a subsidiary of the group.

b. Brother/Sister Group. Effective for tax years beginning after October 22, 2004, this controlled group existsif five or fewer individuals, estates, or trusts own more than 50% of the total combined voting power of allclasses of stock entitled to vote or more than 50% of the total value of shares of all classes of stock of eachcorporation, considering only the stock ownership percentage of each shareholder that is identical withrespect to each corporation (the more�than�50% test).

c. Combined Group. This controlled group consists of three or more corporations, each of which is a memberof either a parent/subsidiary controlled group or a brother/sister controlled group, and at least one is boththe common parent corporation of a parent/subsidiary controlled group and a member of a brother/sistercontrolled group.

When Is a Corporation a Component Member of a Controlled Group? A corporation is a component memberof a controlled group for any tax year for which it meets one of the following two tests:

a. The corporation is a member of a controlled group on the December 31 falling within such tax year and isnot an excluded member. The following corporations are excluded under IRC Sec. 1563(b)(2) and Reg.1.1563�1(b)(2) from being members of a controlled group:

(1) Corporations that have been members of the group for less than half the days in their tax year thatprecede the December 31 membership determination date.

(2) Corporations exempt from tax under IRC Sec. 501(a) or IRC Sec. 521, with the exception ofcorporations subject to tax on unrelated business taxable income under IRC Sec. 511.

(3) Foreign corporations subject to tax under IRC Sec. 881, but per the regulationnot subject to taxunder IRC Sec. 882(a).

(4) Life insurance companies subject to taxation under IRC Sec. 801. However, insurance companies mayform their own controlled group.

(5) Franchised corporations as defined in IRC Sec. 1563(f)(4).

(6) An S corporation as defined in IRC Sec. 1361 for any tax benefit item described in IRC Sec. 1561(a)to which it is not subject.

b. The corporation is not a member of a controlled group on the December 31 falling within such tax year, butis treated as an additional member. An additional member is a corporation that was a member of thecontrolled group (other than an excluded member) for half or more of the days in its tax year precedingDecember 31, even though it was not a member on that date.

Example 7�1: Distinguishing component members from other members.

Benny Jets owns 100% of the stock of Corporations P and S throughout 2010. P and S each have a calendartax year. On January 1, 2010, Benny also owns 100% of the stock of Corporation T, which has a fiscal yearending June 30. On October 15, 2010, he sells all of the stock of T. On December 1, 2010, Benny buys all ofthe stock of Corporation Z, which has a fiscal year ending August 31. Which corporations are componentmembers of a controlled group on December 31, 2010 and thus subject to the rules regarding allocation ofcertain tax benefits?


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The status of each corporation is summarized as follows:

1. Corporations P and S are component members of the group on December 31, 2010 since theywere members of the group on that date and are not excluded members.

2. Corporation Z is excluded from being a component member since it was a member of the groupfor less than half the days during the period beginning on September 1, 2010 (the first day of itstax year) and ending on December 30, 2010. Thus, it does not have to share tax benefits with thegroup. It is entitled to 100% of these benefits.

Number�of�days�Z�was�a�member�of�the�group�(29)

Number�of�days�from�September�1,� 2010�to�December�30,� 2010�(121)�� 24%

3. Although not a member of the group on December 31, Corporation T is still considered acomponent member because it qualifies as an additional member. The corporation was a memberof the group for at least half the days during the period beginning on July 1, 2010 (the first dayof its tax year) and ending on December 30, 2010.

Number�of�days�T�was�a�member�of�the�group�(107)

Number�of�days�in�tax�year�preceding�December�31�(183)�� 58%

What Tax Benefits Must Be Shared? Component members of a particular controlled group of corporations basedon the more�than�50% test at calendar year end must divide the following tax benefits among themselves as thoughthey were a single corporate taxpayer for their tax years that include such December 31:

a. The amounts in each IRC Sec. 11(b)(1) taxable income bracket.

b. One $250,000 amount for computing the accumulated earnings credit ($150,000 if any componentmember is a personal service corporation).

c. One $40,000 alternative minimum tax (AMT) exemption.

As of October 22, 2004, the definition of a controlled brother�sister group changed so that the 80% test no longerapplies for purposes of IRC Sec. 1561, which includes those items listed previously.

However, for the general business credit and the Section 179 deduction, the 80% test still applies in determiningwhether a brother�sister controlled group exists.

a. The $25,000 limit on the dollar�for�dollar reduction of the tax liability by the general business credit mustbe apportioned among component members of a controlled group.

b. The limit on the election to expense certain depreciable assets granted by IRC Sec. 179 is $250,000 for taxyears beginning in 2010].

Corporations that are members (rather than component members) of a controlled group must apportion amongthemselves various items relating to pension and profit�sharing plans, such as qualification, participation, andvesting rules.

How Is the Election to Apportion Tax Benefits Made? A formal election statement must be attached to eachmember's tax return. Generally, component members of a controlled group can apportion tax benefits and allow�ances among themselves in any manner as long as all members consent in writing to the apportionment plan. Theapportionment plan is made as of each December 31 for the tax year of each member of the group that includesthat December 31. To consent to an apportionment plan, a corporation must be a member of the group on theparticular December 31 for which it adopts the apportionment plan. If the group fails to adopt an apportionmentplan, the members must divide the benefits equally among themselves.


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What Other Taxes Are Imposed on a C Corporation?

In addition to the regular corporate income tax, a C corporation may be subject to the income taxes discussed inthe following paragraphs.

What Is the Alternative Tax on Capital Gains? For tax years when the corporate tax rate is higher than 35%,corporations with net capital gain can pay an alternative tax on capital gains if the alternative tax is less than theregular corporate income tax. (Under this formula, any net capital gain is effectively taxed at 35%, while regularcorporate taxable income would be taxed at the higher tax rate.) Since the maximum corporate tax rate is currently35% (disregarding the 38% and 39% rates), the alternative tax generally does not currently apply.

What Is the Alternative Minimum Tax? The alternative minimum tax (AMT) is a separate, independent tax systemthat runs parallel to the regular tax system. C corporations (other than small corporations) must compute the AMTand then compare it against the regular corporate income tax. The Corporation's tax liability is the larger of the twotaxes and is reported on Form 4626 (Alternative Minimum TaxCorporations). A small corporation is exempt fromAMT and is defined as one having three�year average annual gross receipts not exceeding $5 million for its first taxyear and not having three�year average annual gross receipts exceeding $7.5 million for any later year.

When Is a Corporation Subject to Recapture of Business Credits? A corporation that disposes of investmentcredit property, or changes its use before the end of its useful life or recovery period, may owe recapture tax. Therecapture tax is computed on Form 4255 (Recapture of Investment Credit). See that form for further details. Acorporation that disposes of property (or for which there is a reduction in the qualified basis of the property) onwhich the company took the low�income housing credit may owe a recapture tax. The tax is computed on Form8611 (Recapture of Low�Income Housing Credit). See that form for further details.

What Penalty Taxes May Be Imposed on Undistributed Corporate Income? A C corporation may take actionsthat will subject it to penalty taxes on undistributed corporate income. For example, penalty taxes may be assessedif a closely held corporation retains earnings at the company level to defer the shareholder�level tax that arises ifthese earnings are paid out to shareholders in the form of compensation or dividends. Penalty taxes may also beassessed if an individual shareholder places investment assets into the corporation to take advantage of thefavorable dividends received deduction available to C corporations, or to realize other benefits by having theinvestment income generated through a C corporation.

Congress has enacted two penalty taxes to discourage these practices:

a. Accumulated Earnings Tax (AET). This tax penalizes the unnecessary accumulation of income within acorporation. The application of the AET is subjective, as it is based on the accumulation of income at thecorporate level with an intent to avoid tax at the shareholder level.

b. Personal Holding Company Tax (PHC). The PHC tax penalizes the use of a corporation to hold anindividual's investments. The calculation of the PHC tax is objective, requiring the use of specificquantitative tests. The corporation can easily determine whether or not this tax applies. If a corporation paysthe PHC tax, it is not subject to the AET.

What Is the Penalty Tax Rate? The penalty tax rate on accumulated earnings and personal holding companyearnings is currently 15%, the rate at which the earnings would be taxed if distributed. For tax years beginning afterDecember 31, 2010, the tax rates will correspond to the maximum individual tax rate.

Why Is It Important to Avoid These Penalty Taxes? Avoiding the AET and the PHC tax is important becausefailing to do so could result in triple taxation of the corporation's income.

a. The income is taxed at the regular corporate rate when it is earned by the corporation.

b. If the income is not distributed and the corporation is subject to the AET or the PHC tax, the penalty tax isimposed on undistributed income.

c. When the income is finally distributed to the shareholder (e.g., as a dividend), it is taxed at the shareholderlevel. Even if it is distributed to the shareholder in the form of a deductible expense (e.g., compensation)


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after AET or PHC tax has been paid, it is subject to double taxationthe corporation has paid AET or PHCtax on the income, and the shareholder pays tax on it when received.

The corporation frequently does not anticipate application of the AET or the PHC tax. Although the PHC tax can becomputed on Schedule PH [U.S. Personal Holding Company (PHC) Tax] of Form 1120, both taxes are morecommonly assessed by the IRS on audit, which can occur as long as the statute of limitations is open. If thathappens, the taxes and interest due can be devastating to a small, closely held corporation. Therefore, it is criticalthe company know enough about these taxes to recognize when they may apply and what their tax impact will be.The following discussion points out general principles surrounding when these taxes may arise and the mechanicsof how they are calculated.


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59

SELF�STUDY QUIZ


18. Which of the following benefits does not have to be apportioned by component members of a controlled groupof corporations under the more�than�50% test?

a. The general business credit.

b. The accumulated earnings credit.

c. The lower tax brackets allowed by IRC Sec. 11(b)(1).

d. The alternative minimum tax exemption.

19. Under what conditions would a corporation be allowed to pay an alternative tax on capital gains for 2010?

a. If the capital gains exceed $500,000.

b. There is no alternative tax on capital gains for 2009.

c. If the effective tax rate on regular corporate income is less than 35%.

d. If total corporate income (including capital gains) is less than $100,000.

20. Why is it so important to avoid being subject to the accumulated earnings tax (AET) or personal holdingcompany tax (PHC)?

a. These penalty tax rates are extremely high.

b. Additional civil penalties will also be added to the total assessment.

c. Being subject to these taxes could result in double taxation.

d. The assessment of both taxes would likely occur two or three years after the return is filed and could resultin very high interest costs.


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18. Which of the following benefits does not have to be apportioned by component members of a controlled groupof corporations under the more�than�50% test? (Page 55)

a. The general business credit. [This answer is correct. The 80% test still applies in determiningwhether a brother�sister controlled group exists for the general business credit.]

b. The accumulated earnings credit. [This answer is incorrect. The $250,000 accumulated earnings credit($150,000 if any component member is a personal service company) must be apportioned among allcomponent members.]

c. The lower tax brackets allowed by IRC Sec. 11(b)(1). [This answer is incorrect. The benefits of the lowertax brackets must be apportioned between component members.]

d. The alternative minimum tax exemption. [This answer is incorrect. The $40,000 AMT exemption must beapportioned between each component member.]

19. Under what conditions would a corporation be allowed to pay an alternative tax on capital gains for 2010?(Page 56)

a. If the capital gains exceed $500,000. [This answer is incorrect. There is no such provision in the currenttax law.]

b. There is no alternative tax on capital gains for 2010. [This answer is correct. Because both themaximum corporate tax rate and the alternative capital gain tax rate are 35%, the alternative tax doesnot currently apply.]

c. If the effective tax rate on regular corporate income is less than 35%. [This answer is incorrect. Thealternative tax would only apply if the corporate tax rate is higher than the 35% alternative tax rate.]

d. If total corporate income (including capital gains) is less than $100,000. [This answer is incorrect. Thereis no such provision in the current tax law.]

20. Why is it so important to avoid being subject to the accumulated earnings tax (AET) or personal holdingcompany tax (PHC)? (Page 56)

a. These penalty tax rates are extremely high. [This answer is incorrect. The penalty tax rate for both AET andPHC is 15%.]

b. Additional civil penalties will also be added to the total assessment. [This answer is incorrect. While thismay or may not be true, the threat would be no greater than for any other underpayment of tax.]

c. Being subject to these taxes could result in double taxation. [This answer is incorrect. Being subject to theAET or PHC could actually result in triple taxation on the same income (regular corporate tax, penalty tax,tax at the shareholder level).]

d. The assessment of both taxes would likely occur two or three years after the return is filed and couldresult in very high interest costs. [This answer is correct. The AET and, very often, the PHC tax arenormally assessed as the result of an IRS audit that can occur anytime before the statute oflimitations has lapsed.]


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ACCUMULATED EARNINGS TAX (AET)

C corporations with substantial accumulated earnings face exposure to the AET. The tax rate on accumulatedearnings is currently 15%, the rate at which the earnings would be taxed if distributed. For tax years beginning afterDecember 31, 2010, the accumulated earnings tax rate will again correspond to the maximum individual tax rate.The tax is assessed by the IRS, rather than being self�assessed by the company. Therefore, there is no annual taxform to fill out or schedule to attach to the return.

Unlike the PHC tax, the AET can be assessed regardless of the number of shareholders a corporation has. The taxcan be imposed on any corporation except an S corporation, personal holding company, tax�exempt organization,or passive foreign investment company.

Application of the AET is often confusing. Although accumulated earnings from all prior years must be consideredwhen determining whether the AET should apply, the AET is assessed only against the portion of the current year'searnings that are accumulated without justification. Corporations should focus on the following three generalprinciples that govern the AET:

a. Determining Whether the AET Applies. The AET may be assessed if the corporation has earningsaccumulated from past�year operations, or from current operations, and cannot justify why these earningswere not distributed to its shareholders. If earnings are accumulated for no valid business reason, this fact,in and of itself, is sufficient for the IRS to assess the AET.

b. Identifying Reasonable Business Needs. The company can counter the application of the AET by provingthat accumulated earnings have been retained for reasonable business needs. To the extent the companycan prove that earnings are being accumulated for a valid business reason, there is no exposure to the AET.

Each year, as a layer of accumulated earnings is added, the company must be prepared to prove areasonable business need (perhaps the same continuing need) to accumulate those earnings.

c. Computing the AET. The AET is assessed only against the portion of the current year's income that isaccumulated without justification. For any one tax year, the company's maximum exposure to the AET isbased solely on that year's earnings. For example, if a company has no taxable income in the current year,there is no exposure to the AET for this year. However, the IRS can go back at least three years and assessthe AET separately for each year.

To compute AET, certain adjustments are made to taxable income to more clearly reflect the company'sability to pay dividends. The company is then entitled to a credit against modified taxable income for anyportion of the current year's earnings for which an accumulation is justified by reasonable business needs.The net amount (accumulated taxable income), considered an unjustified accumulation of current year'searnings, is subject to the penalty tax.

When Does the AET Apply?

The AET applies when there is an accumulation of earnings at the corporate level with an intent to avoid share�holder�level tax. Tax avoidance must be one reason for the actions of the corporation, but does not have to be thesole or dominant reason.

Tax avoidance is automatically present when the corporation is merely a holding or investment company. A holding

company is a corporation in which there is practically no activity other than the holding of investment property. Aninvestment company is one that buys and sells stock, securities, real estate, and other investment property, inaddition to holding investment property. In one case, the Tax Court ruled that the IRS's assertion that a corporationwas a mere holding company that engaged in no business activities was wrong. The court noted that the corpora�tion and its affiliates had a close�knit structure, management, and operation. The court permitted the corporation toconsider the activities and business needs of its affiliated businesses (including one affiliate operating as apartnership) in determining the reasonableness of accumulated earnings and identifying its reasonably anticipatedbusiness needs.


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Also, tax avoidance is automatically presumed when the corporation has accumulated earnings for the year inexcess of the reasonable needs of the business unless it can prove otherwise by a preponderance of evidence.However, the courts have occasionally ruled that even if earnings are accumulated beyond the reasonable needsof the business, if an intent to avoid taxes did not exist, the penalty should not be imposed.

The determination of whether a corporation has a tax avoidance motive is subjective; it is always a question of factsand circumstances. The company should seek to identify uses of corporate accumulated earnings that may causethe IRS to assess the AET. The following circumstances may indicate that accumulations beyond the reasonableneeds of the business exist:

a. Loans to shareholders or related parties. (These indicate the ability to pay dividends and may beconsidered substitute dividends.)

b. Payments by the corporation that personally benefit the shareholders.

c. Investments in assets having no reasonable relationship to the corporation's business.

d. A weak dividend history.

e. Retention of earnings as protection against unrealistic business hazards.

What Are Reasonable Business Needs?

Earnings accumulated at the corporate level for reasonable business needs are insulated from the AET. Accumula�tions of earnings in excess of amounts deemed to be for reasonable business needs face exposure to the AET.

Reasonable business needs that justify the accumulation of earnings at the corporate level include the following(not an all�inclusive list):

a. To provide for bona fide expansion of business or replacement of plant.

b. To acquire a business enterprise through purchasing stock or assets.

c. To provide for the retirement of company debt created in connection with its trade or business.

d. To provide necessary working capital for the business.

e. To provide for investments or loans to suppliers or customers if necessary to maintain the business of thecorporation.

f. To provide for contingencies such as the payment of reasonably anticipated product liability losses, actualor potential lawsuit, loss of a major customer, or self insurance.

How Does a Corporation Document Reasonable Business Needs? The corporation should identify and quantifythe anticipated needs of the business, and should contemporaneously document these reasonable businessneeds in its minutes. These should be documented because the issue may be raised during an IRS audit severalyears later. The reasonableness of a business need is based on the facts that existed at year�end.

The following are suggested ways to document that the company's accumulations are necessary to meet itsbusiness needs:

a. Include in the corporate minutes a discussion of why the funds are being accumulated (e.g., plans for plantexpansion, debt retirement, inventory increases, etc.). The purpose as outlined in the minutes should bespecific and definite. It should also be feasible. The minutes should be prepared in the normal course ofthe directors' meeting instead of after the fact.

b. Shortly after the end of each tax year, compile written evidence of the business needs for the accumulationof funds, i.e., an accumulated earnings plan. Include in that plan:

(1) Definitive and verifiable reasons for the accumulation of funds.


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(2) Specific projected dates for the use of the funds. Vague plans that are never carried out or that thecompany does not plan to carry out in the near future provide little support for an accumulation.

(3) Specific amounts needed for each purpose for which earnings are being accumulated.

(4) Copies of appraisals, bills for surveying costs and architectural fees, building estimates, site studies,working capital requirement computations, and other similar materials when applicable and feasible.

c. Update the plan annually.

(1) Identify in the updated plan all new reasons for accumulations.

(2) Revise details on previously identified purposes for the accumulations. The IRS will usually consideronly factors existing at the time of the accumulation. It does not matter if circumstances later changeand make the accumulation unnecessary provided it was reasonable and necessary for the year inquestion. Accordingly, the plan can be revised annually without affecting the prior year's basis forreasonableness.

How Is the AET Computed?

To arrive at accumulated taxable income, certain adjustments are made to taxable income to more clearly reflectthe company's ability to pay dividends to its shareholders for the year. In addition, accumulated taxable income isalso net of dividends paidincluding consent dividends deemed paidduring the year. A consent dividend is ahypothetical dividend agreed to by the company and the shareholders. A summary of the dividend options for theAET is shown in Exhibit 7�1.

A corporation is allowed an accumulated earnings credit that reduces the amount of accumulated taxable income.The credit is equal to the amount of earnings and profits for the year retained to meet the reasonable businessneeds of the company, reduced by after�tax net capital gains. This means the corporation can reduce its accumu�lated taxable income against which the AET is assessed by documenting reasonable business needs for accumu�lating the current year's earnings at the corporate level. At a minimum, all corporations other than holding orinvestment companies are entitled to a credit equal to $250,000 ($150,000 for a personal service corporation).Component members of a controlled group are treated as one corporation and are allowed one $250,000 (or$150,000) amount, which is allocated among the component members.

What Strategies Are Available to Avoid the AET?

Corporations having accumulated earnings in excess of the reasonable needs of the business should consider thefollowing strategies to avoid the AET:

a. Election of S corporation status.

b. Liquidation of the corporation with the business continued in a different type of entity.

c. Expansion of the existing business with the earnings used to finance the expansion.

d. Acquisitions of other business entities.

e. Payments of dividends to shareholders.

f. Increasing the salaries of shareholder/employees or declaring bonuses, if total compensation remainsreasonable.

Each of these options has its own related costs and should be considered thoroughly before any action is taken.


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65

SELF�STUDY QUIZ


21. The accumulated earnings tax is based on what amount?

a. Accumulated earnings in excess of $250,000.

b. Any earnings accumulated during the current year.

c. The portion of the current year's earnings accumulated beyond the reasonable needs of the business.

22. A tax avoidance motive, for AET purposes, is not indicated by which of the following?

a. A large amount of corporate indebtedness.

b. A lack of dividend payments.

c. Loans to shareholders.

d. Investments that are not business related.

23. If a corporation finds itself in a position where the assessment of AET would be a strong possibility, what canit do to lessen this threat?

a. Prepare documentation showing plans to possibly purchase business assets in the future.

b. Go back and revise the corporate minutes for previous years to show a plan to purchase business assetsactually existed.

c. Purchase shares of common stock that are likely to provide high investment returns.

d. Pay dividends.


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21. The accumulated earnings tax is based on what amount? (Page 61)

a. Accumulated earnings in excess of $250,000. [This answer is incorrect. While corporations have a creditof $250,000 for AET purposes, the tax is based on any accumulation of earnings beyond the reasonableneeds of the business.]

b. Any earnings accumulated during the current year. [This answer is incorrect. The tax would be based oncurrent year earnings accumulated without justification.]

c. The portion of the current year's earnings accumulated beyond the reasonable needs of thebusiness. [This answer is correct. The tax can be assessed if the corporation has earningsaccumulated from prior years, or the current year, and cannot justify the accumulation. However, thetax itself is assessed only against the current year accumulation. The IRS can go back and assessthe AET against any open year.]

22. A tax avoidance motive, for AET purposes, is not indicated by which of the following? (Page 62)

a. A large amount of corporate indebtedness. [This answer is correct. The retention of earnings toretire company debt can actually justify an accumulation of earnings.]

b. A lack of dividend payments. [This answer is incorrect. Normally, excess capital would be disbursed toshareholders in the form of dividends. The lack of dividends may indicate a desire to avoid double taxationon the income.]

c. Loans to shareholders. [This answer is incorrect. Such loans may indicate a tax avoidance motive if validbusiness reasons cannot be established.]

d. Investments that are not business related. [This answer is incorrect. If the funds are available to makeinvestments that are not business related, the funds would also be available for dividend payments.]

23. If a corporation finds itself in a position where the assessment of AET would be a strong possibility, what canit do to lessen this threat? (Page 63)

a. Prepare documentation showing plans to possibly purchase business assets in the future. [This answeris incorrect. A sudden plan to purchase assets that is made after earnings have been accumulated, andis not documented in previous corporate minutes, is likely to have little impact on an IRS auditor'sdecision.]

b. Go back and revise the corporate minutes for previous years to show a plan to purchase business assetsactually existed. [This answer is incorrect. Such action might be considered fraudulent if the IRS discoversthat revisions were made in order to evade the AET.]

c. Purchase shares of common stock that are likely to provide high investment returns. [This answer isincorrect. The purchase of investments unrelated to business operations shows the ability to pay dividendsand would probably not preclude the assessment of the AET.]

d. Pay dividends. [This answer is correct. Dividends would be taxed at a maximum rate of 15% toshareholders which is the same rate as the AET. However, the possibility of high interestassessments, due to an imposition of the AET upon audit, would be eliminated.]


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PERSONAL HOLDING COMPANY (PHC) TAX

A personal holding company pays a penalty tax on undistributed personal holding company income. Currently thePHC tax rate is 15%, the rate at which the income would be taxed if distributed. For tax years beginning afterDecember 31, 2010, the PHC tax rate will again correspond to the maximum individual tax rate. The tax is inaddition to other corporate income taxes. The tax is self�assessed by the company and reported on Form 1120,Schedule PH [U.S. Personal Holding Company (PHC) Tax]. The PHC tax does not apply if certain exemptions aremet.

C corporations concerned about the possible application of the PHC tax should perform the following two�stepprocedure each year:

a. Determine PHC Status. A corporation is a PHC if it meets two objective tests: (1) a stock ownership test and(2) an income test.

b. Calculate the PHC Tax. Once it is determined that the corporation is a PHC, the next step is to determinewhether it owes a PHC tax. This requires the company to perform a PHC tax calculation. Remember thateven though a corporation is a PHC, it does not necessarily owe PHC tax.

What Is a PHC?

A corporation is a PHC if it meets two objective tests. The penalty tax may apply when the objective tests are meteven if there is no accompanying tax�related motive.

a. Stock Ownership Test. More than 50% of the value of the corporation's outstanding stock is owned (directlyor indirectly) by five or fewer persons on any day during the last half of the corporation's tax year. Stockowned by related individuals, partners, and through other businesses will be deemed to be owned by ashareholder. From a practical standpoint, very few closely held corporations have sufficiently diverseownership to avoid PHC status based on this test.

b. Income Test. At least 60% of the corporation's adjusted ordinary gross income (principally, ordinary grossincome) is PHC income. PHC income includes dividends, interest income, royalty income, annuities,adjusted rental income, Section 1245 gains, and similar income.

Since many closely held corporations meet the ownership test, the real key is the income test. The presence ofsignificant amounts of investment income increases the likelihood the corporation is a PHC.

How Is the PHC Tax Calculated?

Once it is determined that the corporation is a PHC, the next step is to determine whether it owes a PHC tax. Thisrequires the company to perform a PHC tax calculation. This calculation is different from the computationsundertaken when testing for PHC status.

A PHC pays a regular corporate income tax, plus the PHC tax at the rate of 15% for tax years beginning in 2003 andprior to 2011 of undistributed personal holding company income (UPHCI). The computation of UPHCI begins withtaxable income to which specific adjustments must be made. Generally, taxable income is increased by thedividends received deduction, the net operating loss deduction, charitable contributions allowed under the corpo�rate regular tax rule, and excess rental expenses. Taxable income is decreased by current year federal income taxliability, foreign income and profits taxes not deducted in computing taxable income, charitable contributions underthe individual (rather than corporate) limitations, prior year net operating losses, net capital gains, and deficiencydividends. The PHC tax is computed on Form 1120, Schedule PH [U.S. Personal Holding Company (PHC) Tax].The schedule includes a computation of UPHCI and of the PHC tax itself.

A PHC may eliminate or mitigate the PHC tax by making actual dividends or consent dividends. Consent dividendsare hypothetical dividends agreed to by the corporation and its shareholders. (The shareholders must includethese consent dividends in their personal income, even though no cash is actually received.) A summary of thedividend options for the PHC tax is shown in Exhibit 7�1.


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Exhibit 7�1

Comparison of Dividends Paid and Deemed Paid for PHC Tax and AET

Description PHC Tax AET

Dividends paid during thetax year

Deductible in year of payment. Deductible in year of payment.

Dividends paid within 21/2months after year�end

May elect to deduct post�year�enddividends in the current year,subject to certain limitations.

Deductible as if they had beenpaid in the current tax year.

Consent dividends Deductible in year for whichconsent is made, subject to certainlimitations.

Deductible in year for whichconsent is made, subject to certainlimitations.

Dividend carryover Carryover from the two prior taxyears deductible in the current taxyear, subject to certain limitations.

Not deductible.

Deficiency dividends Deductible in year for which adetermination establishing liabilityfor PHC tax is made.

Not deductible.

* * *

Consent dividends are made by filing a timely consent with the corporation's income tax return. To elect to useconsent dividends, the shareholder must complete Form 972 (Consent of Shareholder To Include Specific Amountin Gross Income) and provide it to the corporation by the due date of the corporate income tax return. A separateform must be used for each shareholder. When a shareholder agrees to a consent dividend, that amount isincluded in the shareholder's taxable income as a dividend received on the last day of the corporation's tax year forwhich it claims the consent deduction. The corporation should attach Forms 972 received from the shareholders toits return.

Form 973 (Corporation Claim for Deduction for Consent Dividends) must be executed by the corporation and filedwith its return. Form 973 supports the consent dividend deduction shown on Form 1120, Schedule PH [U.S.Personal Holding Company (PHC) Tax], which is also part of the return.

Must a PHC File Schedule PH (Form 1120)?

Even if no PHC tax is due, a corporation that is a PHC for the tax year must provide information concerning its statusas a PHC with its return on either Form 1120, Schedule PH, or on a separate supplemental schedule. It is most likelythat, with very few exceptions, Schedule PH should be used. The corporation must also indicate it is a PHC bychecking a box on page 1 of Form 1120. The statute of limitations period for assessment and collection of PHC taxis extended from three to six years if the corporation fails to file Schedule PH or a schedule setting forth the sameinformation.


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SELF�STUDY QUIZ


24. Which of the following corporations would be considered a personal holding company (PHC)?

a. Six individuals own more than 50% of the value of outstanding stock and 100% of the corporation'sadjusted ordinary gross income (AOGI) is PHC income.

b. One individual owns 100% of the corporation's stock and PHC income comprises 51% of the corporation'sAOGI.

c. Three individuals own 100% of the corporation's stock and PHC income comprises 75% of AOGI.

d. Which of the following corporations would be considered a personal holding company (PHC)?

25. Which of these steps is not a part of the PHC tax calculation?

a. Per IRC Sec. 545 the computation of UPHCI begins with taxable income to which specific adjustments mustbe made.

b. Taxable income is decreased by net operating loss deduction.

c. Taxable income is increased by the dividends received deduction.

26. A consent dividend may be made to eliminate or alleviate the PHC tax. Which of the following statements is notvalid concerning a consent dividend?

a. The consent is made only by the corporation.

b. Form 973 is used by the corporation to make the consent dividend.

c. Form 1120, Schedule PH, should be filed even if the corporation owes no PHC tax.


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24. Which of the following corporations would be considered a personal holding company (PHC)? (Page 67)

a. Six individuals own more than 50% of the value of outstanding stock and 100% of the corporation'sadjusted ordinary gross income (AOGI) is PHC income. [This answer is incorrect. Two tests must be metin order for the corporation to be considered a PHC. In this case the number of shareholders owning morethan 50% of the stock is greater than five. The ownership test is not met.]

b. One individual owns 100% of the corporation's stock and PHC income comprises 51% of the corporation'sAOGI. [This answer is incorrect. The income test is not met since PHC income is less than 60% of AOGI.]

c. Three individuals own 100% of the corporation's stock and PHC income comprises 75% of AOGI.[This answer is correct. Both the stock ownership test and income tests are met, which are the twoobjective tests that a corporation must meet to be a PHC.]

d. Four individuals own 60% of the value of the corporation's stock and the corporation's AOGI is made upof 65% PHC income. However, the corporation has no tax avoidance motive. [This answer is incorrect. Thetwo required tests are objective and will apply even if there is no accompanying tax�related motives.]

25. Which of these steps is not a part of the PHC tax calculation? (Page 67)

a. Per IRC Sec. 545, the computation of UPHCI begins with taxable income to which specific adjustmentsmust be made. [This answer is incorrect. Taxable income is the starting point for calculating undistributedpersonal holding company income (UPHCI).]

b. Taxable income is decreased by net operating loss deduction. [This answer is correct. Taxableincome is increased by the net operating loss deduction.]

c. Taxable income is increased by the dividends received deduction. [This answer is incorrect. This is a validadjustment in computing UPHCI under IRC Sec. 545.]

26. A consent dividend may be made to eliminate or alleviate the PHC tax. Which of the following statements is notvalid concerning a consent dividend? (Page 68)

a. The consent is made only by the corporation. [This answer is correct. Both the corporation andshareholders must elect to use consent dividends.]

b. Form 973 is used by the corporation to make the consent dividend. [This answer is incorrect. Form 973must be executed by the corporation and filed with the corporate return to support the consent dividenddeduction shown of Form 1120, Schedule PH, which is also part of the return. Form 972 must be completedby the shareholder and provided to the corporation by the due date of the corporate income tax return.]

c. Form 1120, Schedule PH, should be filed even if the corporation owes no PHC tax. [This answer isincorrect. Even if no PHC tax is due, a PHC must file Schedule PH (or a separate statement) concerningits status as a PHC. The corporation must also check the box on page 1 of Form 1120 indicating it is a PHC.The statue of limitations is extended to six years if the corporation fails to file the Schedule PH, or a properstatement, with the return.]


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FEDERAL INCOME TAXES ASSESSED AND PAID AT THE S CORPORATION LEVEL

Generally, income earned by an S corporation is taxed only at the shareholder level. That is, the income passesthrough to the shareholder's individual tax return. However, as explained in this lesson, some federal income taxesare assessed to and paid by the S corporation.

What Taxes Are Assessed to an S Corporation?

The following taxes are assessed to and paid by an S corporation:

a. Tax on Built�in Gains. The built�in gains tax applies to C corporations that make S corporation elections. Thetax is assessed when the S corporation disposes of an asset that was on hand at the date the S electionbecame effective. The built�in gain equals the difference between the asset's FMV and adjusted basis onthat date. However, a taxable income limitation rule or an overall built�in gain limitation rule may limit theamount of taxable built�in gain. The tax is imposed at the highest corporate rate, presently 35%.

b. Tax on Excess Net Passive Income. An S corporation with accumulated earnings and profits (AE&P) fromprior C corporation years may be subject to a tax on passive investment income. Passive income includesdividends, interest, and other investment�type earnings. The tax does not apply unless the passiveinvestment income is more than 25% of the company's gross receipts for the year. The tax is imposed atthe maximum corporate rate, presently 35%.

c. Recapture of Business Credits. When an S corporation disposes of property upon which an investmentcredit was claimed while it was a C corporation, the S corporation is liable for recapture tax.

An S corporation must make estimated tax payments if it is subject to one or more of the three taxes assessed at theS corporation level and the total of the taxes for the year is $500 or more.

The built�in gains tax is treated as a loss sustained by the S corporation during the tax year. Each recognized built�ingain item should be reduced by its proportionate share of the built�in gains tax. Similarly, the pass�through ofexcess net passive income is reduced by the tax imposed on the passive investment income items. The taxresulting from business credit recapture and other tax payments by the S corporation are nondeductible expensesand pass�through to shareholders as separately stated items.

What Other Tax Payments Are Made by an S Corporation?

There are three other situations where an S corporation pays tax, but the tax is not subject to estimated taxpayments. These situations are as follows:

a. Predecessor's Tax. An S corporation pays any tax assessed to the C corporation before the S electionbecame effective. For example, if a calendar year C corporation elects to become an S corporation effectiveJanuary 1, any tax due on the C corporation return for the year just ended is paid by the S corporation. TheS corporation would also have to pay any tax resulting from an IRS audit of a prior C corporation tax year.

b. Fiscal�year Tax Payments. An S corporation generally makes required payments to elect or retain a fiscalyear�end (termed a Section 444 election).

c. LIFO Inventory Recapture Tax. An S corporation makes the installment payments of tax caused by LIFOinventory recapture when it converted from C corporation to S status.


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BUILT�IN GAINS TAX

Generally, a liquidation involves a sale of corporate assets at fair market value (FMV), and gain or loss is recognizedat the corporate level. C corporation liquidation gain is effectively taxed twiceonce at the corporate level andagain at the shareholder level as payment for stock, when that stock is surrendered. This makes S status moreattractive because gain recognized upon liquidation of an S corporation generally will be taxed only once (corpo�rate level gain from the sale of assets, but passed through and taxed at the shareholder level) because of theincrease in stock basis that results from the pass�through treatment of the liquidation gain. To discourage a Ccorporation from electing S status to avoid double taxation upon liquidation, certain S corporations are subject toa tax on built�in gains.

S corporations that potentially face the built�in gains tax should:

a. Determine whether the corporation is subject to the built�in gains tax. This requires a review of the date thecompany's S election was made.

b. Determine whether an overall built�in gain existed as of the date the S election became effective.

c. Calculate the built�in gains tax if a built�in gain asset is disposed of at any time during the 10 years followingthe first day of the first year the S election became effective.

When Does the Built�in Gains Tax Apply?

The built�in gains tax applies to C corporations that make S elections. The built�in gains tax generally does notapply to a corporation that is an S corporation at all times during its existence. However, the built�in gains tax willapply to a corporation that has always been an S corporation to the extent it has acquired transferred basis propertyfrom a C corporation, or from another S corporation that is subject to the built�in gains tax.

The built�in gain provisions apply during the 120�month (i.e., 10�year) period beginning with the first day of the firsttax year the S election was effective. The recognition period will end on the same date even if there are more than10 taxable periods during the 120�month recognition period. For example, if a fiscal year S corporation subject tothe built�in gains tax changes its tax year to a calendar year, there will be more than 10 taxable periods within therecognition period because of the short tax year ending December 31. However, the recognition period is notaltered by the short tax year and will still end on the last day of the 120�month period following the first day of thefirst tax year the S election was effective.

A corporation is not subject to the built�in gains tax after the expiration of the 10�year recognition period unless (a)the corporation acquires certain transferred basis property or exchanged basis property, or (b) the corporation isreporting on the installment method for dispositions either before or during the 10�year recognition period. Corpo�rations that have always been S corporations will become subject to the built�in gains tax if they acquire transferredbasis property from a C corporation, such as in a merger, or from another S corporation that is subject to the built�ingains tax rules. Also, a new 10�year recognition period begins when a C corporation (that was previously an Scorporation) reelects S status.

Does the Built�in Gain Apply to Property Distributed in Liquidation? Built�in gains are triggered by the disposi�tion of assets that were on hand at the time the S election became effective. Therefore, an S corporation that issubject to the built�in gains tax will incur tax at the corporate level if it recognizes gain on the sale or distribution ofappreciated assets in liquidation. The gain passes through and is also subject to tax at the shareholder level.

Does the Built�in Gain Apply after S Corporation Terminates S Status? The built�in gains tax applies to Scorporations, and is no longer applicable after S status is revoked or terminated. The resulting C corporation'sincome, however, is first subject to tax at the corporate level and is taxed again at the shareholder level whendistributed.

Property has a transferred basis if its basis in the hands of the acquiring entity is determined, in whole or in part, byreference to the asset's (or any other asset's) basis in the hands of the transferor entity. Exchanged basis property


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is property received in a like�kind exchange or involuntary conversion. Any unrecognized built�in gain carries overfrom an S corporation's asset to the new asset received in the exchange if the basis of the new asset is determined,at least in part, by the basis in the exchanged asset.

The 10�year recognition period for transferred basis property is measured from the date of acquisition by the Scorporation, rather than from the date of election of S corporation status. For exchanged basis property, the 10�yearrecognition period is measured from the date the S election became effective (not the date of the exchange).

Example 7�2: Acquiring exchanged basis property.

Zeecorp, a C�corporation, elected S status on January 1, 2010. On that date, it held land that had a tax basisof $100,000 and a fair market value of $150,000. Zeecorp's unrealized net built�in gain for all of its assets,including the land, at the date the S election became effective was $60,000, and no built�in gains have yetbeen recognized by the corporation. Zeecorp's annual income from business operations is approximately$95,000. On January 1, 2015, Zeecorp exchanges the land for like�kind property under IRC Sec. 1031. Forbuilt�in gains purposes, the new property takes the place of the property transferred and carries a $50,000built�in gain potential through the end of the original recognition period, December 31, 2019. No built�in gainis recognized and the corporation's net unrealized built�in gain remains at $60,000.

When Does a Net Unrealized Built�in Gain Exist?

The maximum built�in gain upon which an S corporation is potentially subject to tax is the net unrealized built�ingain (that is, the excess of the total FMV over the total adjusted basis of all assets on hand as of the first day the Selection is effective, reduced by any previously recognized built�in gains). However, if the net unrealized built�ingain is zero as of that date, the S corporation is not subject to the built�in gains tax even for assets that had a built�ingain.

The disposition of any asset whose FMV exceeds its adjusted basis at the effective date of the S election may createa built�in gain tax liability (assuming the net unrealized built�in gains is greater than zero). Examples include thecollection of accounts receivable by a cash basis corporation (since the corporation will have a zero basis in thereceivables), inventory sales, and collections on notes receivable. In addition, a distribution of property can resultin built�in gains tax if the FMV of the distributed property exceeded its tax basis at the time of conversion to S status.

The calculation of net unrealized built�in gains allows built�in losses to offset built�in gains. Losses are built�in if anasset's basis exceeded its FMV at the S election's effective date. In addition, accounts payable as of the effectivedate of the S election represent built�in losses if payment results in a deductible expense for the S corporation.Built�in losses do not offset recognized built�in gains unless they are recognized in the same year. There are noprovisions for carrying recognized built�in losses to prior or subsequent years if they exceed recognized built�ingains for a given year. In addition, no built�in loss will be recognized if the built�in loss asset is sold to someone whois (directly or indirectly) a shareholder in the S corporation.

Various techniques for generating built�in losses can be used when a C corporation plans to make an S election foran upcoming tax year. For example, a C corporation can declare reasonable bonuses to shareholder�employeesand not pay them until the S election is effective. In addition, to the extent good business practice allows, acash�basis corporation can delay operating expenses until the company is an S�corporation. Under this technique,the bonuses or unpaid operating expenses would be built�in losses. As such, they would reduce net unrecognizedbuilt�in gains and would offset built�in gains in the year the bonuses or expenses are paid. (However, the bonus orexpense must be paid within two and a half months after the S election becomes effective.)

Example 7�3: Offsetting built�in gains with built�in losses.

Exxcorp, a cash basis C corporation elects S status and has the following assets on hand on the first day it istreated as an S corporation:


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FMVAdjusted

BasisBuilt�in Gain

(Loss)

Cash $ 15,000 $ 15,000 $ �Accounts receivable 60,000 � 60,000Machinery and equipment 30,000 95,000 (65,000 )

Totals $ 105,000 $ 110,000 $ (5,000 )

Exxcorp is not subject to the built�in gains tax because the total basis of all assets exceeds the total FMV. Thenet unrealized built�in gain is zero.

Example 7�4: Determining net unrealized built�in gain.

Assume the same facts as Example 7�3, except Exxcorp also has $50,000 of goodwill in which it has a zerobasis on the day its S election becomes effective. It also has $10,000 of accounts payable that will be paid anddeducted after the S election is effective. The net unrealized built�in gain is $35,000, determined as follows:

FMVAdjusted

Basis Built�in Gain

Cash $ 15,000 $ 15,000 $ �Accounts receivable 60,000 � 60,000Machinery and equipment 30,000 95,000 (65,000 )Goodwill 50,000 � 50,000

Totals $ 155,000 $ 110,000 45,000

Accounts payable (10,000 )

Net unrealized built�in gain $ 35,000

Since Exxcorp has a net unrealized built�in gain, it is subject to the built�in gains tax.

Gains are not built�in gains if it can be proven that the asset that generated the gain was not on hand on the datethe S election was first effective or that the asset appreciated in value after the election date. (However, certainproperty may be subject to tax if it was acquired from another corporation under the transferred basis property rulesor exchanged basis property rules.) Gains on dispositions of assets reported by an S corporation are presumed tobe built�in gains unless the corporation establishes otherwise.

Consequently, it is essential that assets on hand be identified and appraised to establish their existence and thevalues at the date the S election becomes effective. Appraisals of intangible assets, such as goodwill, should not beoverlooked. Of course, factors such as relatively low asset values or the types of corporate assets involved mayreduce the need to rely on a formal appraisal. If no formal appraisal is made, the business should retain otherdocumentation to support asset values.

How Is the Built�in Gains Tax Calculated?

If the S corporation is subject to the built�in gains tax, the tax is triggered when the company disposes of an assetthat was on hand on the date the S election became effective. The built�in gains provisions apply to all suchdispositions during the 10�year period beginning with the first day of the first tax year for which the S election iseffective. An asset not on hand when the S election became effective (such as assets subsequently purchased by,or contributed to, the corporation) is not subject to the tax.

To determine whether a disposition of an inventory item has occurred, the S corporation must generally use thesame inventory method (FIFO, LIFO, etc.) that it uses for tax purposes. For example, an S corporation using theLIFO inventory method is not subject to the built�in gains tax on sales of inventory unless the corporation invadesa LIFO layer that existed prior to the beginning of its first S corporation tax year.


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Before computing the tax, the corporation reduces reported built�in gain by unused net operating loss (NOL) orcapital loss carryforwards from C corporation tax years and any built�in losses reported in the same tax year.However, capital losses are allowed only to the extent the net built�in gain is net capital gain (i.e., capital losscarryovers cannot offset net built�in gain that is ordinary income).

Is There Any Limit on the Amount of Built�in Gains Tax? The amount of built�in gains subject to tax in any yeargenerally is limited to the lesser of

a. the net unrealized built�in gain (built�in gain at the date the S corporation election is effective) less amountspreviously recognized during the 10�year recognition period,

b. the built�in gain and loss recognized during the year (including any built�in gain carryover), or

c. the taxable income for the year, computed as if the corporation was a C corporation.

The built�in gains tax is imposed on the smallest of these three amounts at the highest tax rate applicable to acorporation in the year the gain is recognized (presently 35%), regardless of whether the gain is ordinary or capital.An S�corporation that pays the built�in gains tax generally is required to make estimated tax payments on thisamount.

The S corporation can use the minimum tax credit and business tax credit carryovers from the C corporation taxyears as credits against the built�in gains tax [subject to the general business credit limitations of IRC Sec. 38(c)].Reg. 1.1374�6(b) provides that, even though an S corporation is not subject to the alternative minimum tax (AMT),a �tentative minimum tax" limits the amount of C corporation credits that the S corporation can use to offset thebuilt�in gains tax. (In other words, when applying the general business credit limitation, an S corporation has to�pretend" it is a C corporation for AMT purposes.) However, this tentative minimum tax limitation does not affectmany S corporations because the AMT does not apply to �small" corporations.

The built�in gains tax is deductible from the S corporation's income because the S corporation can treat it as a losssustained during the tax year. The character of such loss is determined by allocating the loss proportionatelyamong the built�in gains that give rise to the built�in gains tax. The built�in gains tax is calculated on Form 1120S,Schedule D. According to the instructions to that form, the built�in gains tax attributable to ordinary gain is deductedon Form 1120S, page 1, line 12 (Taxes and licenses). The built�in gains tax attributable to short�term capital gain isreported as a short�term capital loss on Form 1120S, Schedule D, line 5. The built�in gains tax attributable tolong�term capital gain is reported as a long�term capital loss on Form 1120S, Schedule D, line 12.

TAX ON EXCESS NET PASSIVE INCOME

Passive investment income can be subject to tax at the rate of 35% at the S corporation level, but the tax does notapply unless

a. the S corporation has accumulated earnings and profits (AE&P) at the end of the tax year. This means thetax on excess net passive income only applies to S corporations that previously were C corporations or thatmerged with a corporation that has AE&P, and

b. passive investment income is more than 25% of the corporation's gross receipts for the year.

The purpose of the tax on excess net passive income is to prevent C corporations from converting to S status toavoid the personal holding company (PHC) tax that applies to C corporations earning large amounts of passiveinvestment income. In essence, the tax on excess net passive income is the S corporation corollary to the Ccorporation PHC tax.

In the year the passive income is recognized, each item of passive investment income passed through to theshareholders is reduced by a prorata portion of the tax on excess passive income regardless of when the tax isactually paid. An S corporation that pays the tax on excess net passive income generally is required to makeestimated tax payments on this amount.


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How Is the Tax on Excess Net Passive Income Calculated?

The following formula summarizes how the tax on excess net passive income is calculated. Exhibit 7�2 explains thedefinitions used in the formula.

a. Passive Income � 25% of Gross Receipts

Passive Income�

Net PassiveIncome �

Excess NetPassive Income

b. Excess Net Passive Income (or Taxable Income if Less) � 35% = Tax on Net Passive Income

Exhibit 7�2

Definitions Used in Calculating the Tax on Excess Net Passive Income

1. Passive investment income generally includes gross receipts from royalties, rents, dividends, interest,and annuities. However, it does not include interest received on accounts receivable generated byinventory or service sales. Gross receipts (including royalties, interest, and income from certain lendingor financing activities) derived in the ordinary course of a trade or business are not passive investmentincome. Also, gross receipts from the active trade or business of renting property (e.g., income from hoteloperations and vehicle leasing) are not passive investment income. A corporation conducts an activerental trade or business when it performs significant services or incurs substantial costs (other thandepreciation) in the rental business.

A net lease generally will not be considered a rental trade or business. Other than the net lease provision,the regulations do not provide any guidance on what significant services or substantial costs are.However, in a series of letter rulings, the IRS has consistently ruled that income from rental real estateis not passive investment income where the taxpayer performs various services relating to the rentals andtenants. For example, rents received for commercial property by the corporate owner that incurredbasically all expenses associated with the property and used the services of an individual contractor fordaily maintenance, were deemed not to be passive investment income. Also, an S corporation'spass�through income from a partnership was not passive investment income when the S corporationheld 50% of a partnership that owned a rental building. The partnership (either directly or through anagent) performed all operational and managerial functions associated with the building. The Scorporation's employees reviewed the partnership's billings, collections, and expenses; reviewed tenantleases and renewals; inspected the building; and provided other services relating to the rental.

2. Net passive income is calculated by subtracting from passive investment income deductions directlyconnected with the production of the passive investment income. To be directly connected, an item ofdeduction must have �proximate and primary relationship to the income."

* * *

When calculating the tax, excess net passive income can never exceed the corporation's taxable income. Thismeans that the tax on excess net passive income does not apply if the corporation has other losses that reduce itstaxable income to zero. For these purposes, taxable income is computed as if the S corporation was a C corpora�tion. However, the NOL deduction and special deductions [except the deduction of organization expenses are notallowable.

Example 7�5: Computing the tax on excess net passive income.

An S corporation has $500 of operating income, $300 of rental income, and $200 of rental expenses. Passiveinvestment income equals $300. Net passive income equals $100 ($300 � $200). Gross receipts equal $800


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($500 + $300). Assume taxable income equals $30. Excess net passive income equals $33, computed asfollows:

Passive Income � 25% of Gross Receipts

Passive Income�� Net Passive Income =

$300 � (25% � $800)

$300�� $100 = $33

The tax is imposed at the maximum corporate tax rate on the lesser of taxable income or excess net passiveincome. In this case, taxable income is lower than excess net passive income, so the tax is 35% of $30, or$10.50.

The tax can be avoided by distributing all of the AE&P before year�end, which may be appropriate in some cases.To accomplish this, the corporation can elect to distribute AE&P before the company's accumulated adjustmentsaccount (AAA) is distributed.

Can the Tax on Excess Net Passive Income Be Waived?

The IRS has the authority to waive the tax on excess net passive income if the following two conditions are met:

a. The corporation believed, in good faith, that it had no Subchapter C AE&P for the year in question; and

b. The AE&P was distributed within a reasonable time after the corporation realized that it had AE&P.

To obtain a waiver, the company should file a ruling request with the appropriate user fee.

Can Passive Investment Income Cause Termination of S Status?

If passive investment income exceeds 25% of gross receipts for three consecutive tax years and the S corporationhas AE&P at the end of each of those years, the S corporation election will automatically terminate. This applieseven if there is no tax liability (because net passive income is less than zero or because of the taxable incomelimitation).

However, the IRS has the authority to treat the corporation as a continuing S corporation if the terminating eventwas inadvertent, the corporation takes steps to regain its S eligibility within a reasonable period after discovery ofthe terminating event, and the corporation and shareholders agree to make adjustments as might be required bythe IRS.

Is S Corporation Gain Subject to Both the Built�in Gains Tax and the Tax on Excess Net Passive Income?

If a gain would otherwise be subject to both the tax on excess net passive income and the built�in gains tax, it is notsubject to taxation under both provisions. The amount treated as passive investment income does not include anyrecognized built�in gain or loss that is taxable under the built�in gains tax rules.

LIFO RECAPTURE TAX

A C corporation using the LIFO inventory method must add a LIFO recapture amount to income when it elects Sstatus. The LIFO recapture rule was designed to prevent corporations from avoiding built�in gain on sales ofinventory. The LIFO recapture amount is included in income on the tax return for the last C corporation year but theincrease in tax is paid over a four�year period. Special rules apply to prevent the corporation from merging witheither a new or existing S corporation to avoid the LIFO recapture provisions.

Applying Look�through Provisions When the C Corporation Owns Partnership Interests

Under the regulations, a C corporation that holds an interest in a partnership owning LIFO inventory must includethe look�through LIFO recapture amount in its gross income when it elects S status or transfers its interest in the


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partnership to an S corporation in a nonrecognition transaction. The look�through LIFO recapture amount must bedetermined, in general, on the day before the effective date of the S corporation election or the date of the transfer.The corporation then increases its basis in the partnership interest by the recapture amount. The regulations alsoallow the partnership to adjust the basis of its inventory (or look�through partnership interests held by that partner�ship) to account for the LIFO recapture. The regulations apply to S elections and transfers made on or after August13, 2004.

The regulations discussed in the preceding paragraph effectively overturn Coggin Automotive Corp. In that case,the 11th Circuit reversed the Tax Court and held that a corporation owning six partnership interests was not requiredto compute LIFO recapture based on its share of the partnerships' inventories on the date the corporation electedS status. The 11th Circuit ruled that, under the plain meaning of IRC Sec. 1363(d), LIFO recapture applies only if theC corporation itself holds the LIFO inventory.

How Is the LIFO Recapture Tax Figured?

The LIFO recapture tax is calculated on the tax return for the final C corporation year. A LIFO recapture amount (anincome item) must be included in the C corporation's gross income. The LIFO recapture amount is the excess ofthe inventory's FIFO value over its LIFO value at the end of the last C corporation year. The FIFO value is determinedusing the retail inventory method, if that method has been used for LIFO purposes. If the retail method is not used,the FIFO value is determined by using the lower of cost or market method.

The corporation is not required to change to the FIFO inventory method upon its conversion to S status. (The LIFOrecapture provision simply taxes any built�up LIFO reserve at that date.) In fact, unless the corporation obtainspermission from the IRS to switch from the LIFO method, it is required to continue using the LIFO method in its Scorporation tax returns.

The LIFO recapture tax is computed using a with/without tax calculation:

a. Compute the corporate income tax with the LIFO recapture amount included in income.

b. Recompute the corporate income tax without the LIFO recapture amount included in income. (For thispurpose, certain items may have to be recalculated, including the alternative minimum tax, generalbusiness credits, and the foreign tax credit.)

The difference in tax under the with/without calculation is the amount of LIFO recapture tax. The basis of theinventory is increased by the recapture amount included in income, so the income from the sale of inventory istaxed only at the corporate level.

How Is the LIFO Recapture Tax Paid?

The LIFO recapture tax is payable in four equal annual installments. The first installment is due on or before theoriginal due date (excluding extensions) of the corporation's last C return. The remaining three installments are dueon or before the original due dates of the corporation's S returns for the three succeeding tax years. No interest ischarged on the installments unless they are paid after the due dates. The failure to pay or late payment of a LIFOrecapture installment payment will not cause any remaining unpaid installments to become due and payableimmediately.


79

SELF�STUDY QUIZ


27. The following situations may cause an S corporation to be subject to taxation at the corporate level except for:

a. A corporation that elects to be an S corporation in its first year of existence sells a building it received fromits sole shareholder for a gain. The building had appreciated by 200% since it was originally purchasedby the shareholder and the corporation had a carryover basis from the shareholder.

b. A profitable S corporation has accumulated earnings & profits and 30% of its gross receipts for the yearis from interest and dividend income.

c. The S corporation was a C corporation until 2005 and has no accumulated C corporation earnings. It sellsa building that had been owned since 2000 for a gain of $100,000.

d. The S corporation was a C corporation until 2008. In 2006 the corporation had taken a business credit fora piece of equipment it purchased. This asset was sold in 2010 and a portion of the credit would need tobe recaptured.

28. A C corporation elected S status on January 1, 2010. On that date it had an asset with a basis of $100,000 anda FMV of $150,000. On May 1, 2013 the corporation exchanged the asset for like�kind property with a value of$200,000. As a result of this exchange what gain (if any) does the corporation have?

a. A recognized gain of $50,000 and a basis in the new asset of $150,000. No built�in gain remains.

b. No gain is realized. The corporation has a basis of $!00,000 in the new asset and the built�in gain on theasset remains at $50,000.

c. No gain is realized. The corporation has a basis of $100,000 in the new asset and a built�in gain of $100,000on the asset.

d. A recognized gain of $100,000 and a basis of $200,000 in the new asset. No built�in gain remains.

29. Which of the following S corporations will be liable for the tax on excess passive investment income (allcorporations have accumulated E&P)?

a. The corporation has passive investment income of $100, $25 of related expenses, and gross receipts of$200.

b. The corporation has passive investment income of $75, $50 of related expenses, and gross receipts of$300.

c. The corporation has passive investment income of $75, $110 of related expenses, and gross receipts of$100.

30. When and how is a C corporation required to pay a LIFO recapture tax?

a. In four equal annual installments.

b. In four annual installments beginning on the date the S election is effective.

c. With the final C corporation return.

d. By the due date (without extensions) of the first S corporation return.


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31. Which of the following statements concerning the calculation of the LIFO recapture tax is true?

a. The LIFO recapture amount is the excess of the inventory's LIFO value over its FIFO value at the end ofthe last C corporation year.

b. The LIFO recapture tax is calculated using a with/without tax calculation.

c. If the retail method is used for LIFO purposes, the FIFO value is determined by using the lower of cost ormarket method.

d. The corporation is required to change to the FIFO inventory method upon its conversion to S status.


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27. The following situations may cause an S corporation to be subject to taxation at the corporate level except for:(Page 71)

a. A corporation that elects to be an S corporation in its first year of existence sells a building it receivedfrom its sole shareholder for a gain. The building had appreciated by 200% since it was originallypurchased by the shareholder and the corporation had a carryover basis from the shareholder. [Thisanswer is correct. Because the corporation has been an S corporation since inception, it is notsubject to the built�in gains tax on the building.]

b. A profitable S corporation has accumulated earnings & profits and 30% of its gross receipts for the yearis from interest and dividend income. [This answer is incorrect. The S corporation would be subject to thetax on excessive net passive income because its passive income exceeds 25% of its gross receipts. Thekey point is the corporation must have accumulated C corporation E&P to be subject to the tax.]

c. The S corporation was a C corporation until 2005 and has no accumulated C corporation earnings. It sellsa building that had been owned since 2000 for a gain of $100,000. [This answer is incorrect. The built�ingains tax would apply to any appreciation from the original purchase to the date S corporation's status waselected. Accumulated C corporation earnings are not a requirement for this tax.]

d. The S corporation was a C corporation until 2008. In 2006 the corporation had taken a business credit fora piece of equipment it purchased. This asset was sold in 2010 and a portion of the credit would need tobe recaptured. [This answer is incorrect. An S corporation is responsible for any recapture tax that appliesto its predecessor C corporation.]

28. A C corporation elected S status on January 1, 2010. On that date it had an asset with a basis of $100,000 anda FMV of $150,000. On May 1, 2013 the corporation exchanged the asset for like�kind property with a value of$200,000. As a result of this exchange what gain (if any) does the corporation have? (Page 73)

a. A recognized gain of $50,000 and a basis in the new asset of $150,000. No built�in gain remains. [Thisanswer is incorrect. No gain would be recognized on the like�kind exchange and the new asset's basiswould remain $100,000.The built�in gain on the new asset would remain $50,000.]

b. No gain is realized. The corporation has a basis of $100,000 in the new asset and the built�in gainon the asset remains at $50,000. [This answer is correct. Any unrecognized built�in gain carries overfrom an S corporation's asset to the new asset received in a Section 1031 exchange.]

c. No gain is realized. The corporation has a basis of $100,000 in the new asset and a built�in gain of $100,000on the asset. [This answer is incorrect. The built�in gain amount is not increased by the unrecognized gainfrom the like�kind exchange.]

d. A recognized gain of $100,000 and a basis of $200,000 in the new asset. No built�in gain remains. [Thisanswer is incorrect. No gain is recognized on the like�kind exchange and the new asset's basis and built�ingain amount would remain the same as for the original asset.]

29. Which of the following S corporations will be liable for the tax on excess passive investment income (allcorporations have accumulated E&P)? (Page 75)

a. The corporation has passive investment income of $100, $25 of related expenses, and grossreceipts of $200. [This is the correct answer. Passive investment income ($100) is more than 25%of gross receipts ($200 � 25% = $50).]

b. The corporation has passive investment income of $75, $50 of related expenses, and gross receipts of$300. [This answer is incorrect. Passive investment income ($75) is not more than the percentagethreshold of gross receipts.]


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c. The corporation has passive investment income of $75, $110 of related expenses, and gross receipts of$100. [This answer is incorrect. Excess passive income can never exceed the corporation's taxableincome.]

30. When and how is a C corporation required to pay a LIFO recapture tax? (Page 77)

a. In four equal annual installments. [This answer is correct. Per IRC Sec. 136(d)(2); Reg. 1.1363�2(b),the LIFO recapture tax is required to be paid in four equal annual installments. The first installmentis due on or before the original due date (excluding extensions) of the C corporation's last return.]

b. In four annual installments beginning on the date the S election is effective. [This answer is incorrect. Thefirst payment is due on or before the due date of the last C corporation return.]

c. With the final C corporation return. [This answer is incorrect. The corporation is permitted to makeinstallment payments.]

d. By the due date (without extensions) of the first S corporation return. [This answer is incorrect. The firstinstallment is due by the due date of the last C corporation return.]

31. Which of the following statements concerning the calculation of the LIFO recapture tax is true? (Page 78)

a. The LIFO recapture amount is the excess of the inventory's LIFO value over its FIFO value at the end ofthe last C corporation year. [This answer is incorrect. The LIFO recapture amount is the excess of the FIFOinventory over the LIFO inventory.]

b. The LIFO recapture tax is calculated using a with/without tax calculation. [This answer is correct.The tax is computed with and without the LIFO recapture amount. The difference is the LIFOrecapture tax.]

c. If the retail method is used for LIFO purposes, the FIFO value is determined by using the lower of cost ormarket method. [This answer is incorrect. If the retail method is used for LIFO purposes, it must also beused to compute the FIFO inventory.]

d. The corporation is required to change to the FIFO inventory method upon its conversion to S status. [Thisanswer is incorrect. The corporation is not required to change to the FIFO method and would normallyneed to obtain IRS permission to do so.]


83


Lesson 3 (DBPTG10)


24. A 5% surtax is imposed on C corporation taxable income in excess of $100,000 up to a maximum tax surtaxof what amount?

a. $10,000.

b. $11,750.

c. $10,750.

d. $7,500.

25. Which of the following choices accurately defines a component member of a controlled group of corporations?

a. The corporation is a member of a controlled group of corporations on December 31 of the year in questionand has been a member for more than half the days in their tax year that precedes December 31.

b. The corporation is a member of a controlled group of corporations on December 31 of the year in question,is not an excluded member, or is treated as an additional member.

c. The corporation is owned more than 50% in stock value by the group's parent.

d. The corporation is a member of the controlled group at the end of the tax year in question.

26. For purposes of apportioning the Section 179 deduction, a brother�sister controlled group exists if it has fiveor fewer individuals, estates, or trusts that own more than what percentage of the total combined voting powerof all classes of stock?

a. 80%

b. 50%

c. 49%

d. 10%

27. What is the current penalty tax rate on undistributed corporate income?

a. 15%

b. 28%

c. 34%

d. 39%

28. Which of the following choices correctly matches the type of entity subject to the AET and the number ofshareholders the entity must have?

a. S Corporation; 100 shareholders.


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b. Tax�exempt organization; any number of shareholders.

c. C Corporation; any number of shareholders.

d. Passive foreign investment company; at least 5 shareholders.

29. A corporation receives a maximum credit against imposition of the AET tax of what amount?

a. $200,000 in the case of a personal service corporation (PSC).

b. $250,000 for PSCs and $150,000 for all other types of corporations.

c. Earnings accumulated in prior years.

d. Earnings and profits for the year retained to meet the reasonable business needs of the business, reducedby after�tax capital gains.

30. Which of these choices is a strategy for avoiding the AET?

a. Sell off assets not related to business operations.

b. Elect S corporation status.

c. Increase the number of shareholders to six.

d. Make bona fide loans to shareholders.

31. All of the following actions will reduce or eliminate the imposition of the PHC tax except for:

a. Paying dividends during the year.

b. Carryover dividends from the three prior tax years.

c. Paying consent dividends.

d. Paying deficiency dividends.

32. The built�in gains tax will apply to which of these corporations in 2010?

a. C corporations that made S elections.

b. A former C corporation with appreciated assets that elected S status in 1984.

c. An S corporation with appreciated assets and zero accumulated E&P.

d. Do not select this answer choice.

33. Which of the following asset types is not subject to the built�in gains tax?

a. Cash basis accounts receivable.

b. Inventory.

c. Notes receivable.

d. A fixed asset whose basis equals its FMV at effective date of the S election.


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34. A corporation must meet two conditions before the IRS will exercise its authority to waive the tax on net passiveinvestment income. Which of the following correctly identifies the two conditions?

a. The corporation believed, in good faith, that it had no Subchapter C AE&P for the year in question and theAE&P was distributed within a reasonable time after the corporation realized that it had AE&P.

b. The tax amount is insubstantial and the S corporation was able to prove no tax avoidance was intended.

c. The tax amount is insubstantial and the S corporation distributed the AE&P within a reasonable time afterthe corporation realized that it had AE&P.

d. The corporation applies for the waiver and distributes the AE&P using a consent dividend.


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87

Lesson 4:�TAX CREDITS

Business tax credits may offset the regular income tax dollar for dollar, but not below the level of the alternativeminimum tax (AMT). Taxpayers are also allowed a credit for the amount of AMT incurred in a prior year. (This is theminimum tax credit.) Taxpayers may use the minimum tax credit (MTC) to offset their regular income tax insubsequent yearsbut not below the AMT for that year.

Tax credits generated by a partnership or an electing large partnership are passed through to its partners (allocatedin accordance with the partner's interest in the partnership) on Schedule K�1, Form 1065 or Form 1065�B, respec�tively. Tax credits generated by an S corporation are passed through to the shareholders (allocated in accordancewith the shareholder's interest in the S corporation) on Schedule K�1, Form 1120S. However, the credit for federaltax on fuels is taken at the company level for S corporations and electing large partnerships (it is passed throughto partners of a partnership other than an electing large partnership). The partners use the pass�through informa�tion to calculate the amount of credit allowable on their individual income tax returns, with credit limitation rulesapplying at the individual tax return level.


Completion of this lesson will enable you to:� Describe the various tax credits that are available to the business such as the general business credit, passive

activity credit, foreign tax credit, and credit for federal excise tax on gasoline and special fuels.� Identify the various credits that make up the general business credit and how to correctly apply limitations, and

handle excess and unused credits.� Calculate the correct amount of the minimum tax credit and determine how to handle any excess credits for

a particular year.

COMMON TAX CREDITS THAT ARE AVAILABLE TO BUSINESSES

What Is the General Business Credit?

The general business credit is composed of a number of separate credits that are computed on various federal taxreturn forms and then summarized on Form 3800 (General Business Credit). These separate credits are combinedand a tax liability limitation is applied to the overall general business credit.

What Is the Passive Activity Credit?

The passive activity rules may apply to personal service corporations and closely held corporations. For a partner�ship or an S corporation, the passive activity rules apply at the individual partner or shareholder levelnot at thecompany (entity) level.

When the passive activity rules apply, credits arising from passive activities are treated similarly to losses from thoseactivities. For example, limitations are placed on the amount of passive losses and credits that can offset taxableincome or tax liability. Passive activity credits are not additional credits, but are regular general business creditsarising from a passive activity and thus, are tainted with a passive character. Form 8810 (Corporate Passive ActivityLoss and Credit Limitations) is used to compute the passive activity credit limitation.

Except for certain closely held C corporations, credits arising from a passive activity can only be used to offset thetax attributable to passive income. Disallowed credits are carried forward in a manner similar to disallowed losses.Once allowed under the passive loss rules, the credits become subject to other rules and limitations for credits (forexample, the limitation based on the amount of tax). Credits affected by this provision include (but are not limitedto) the low�income housing credit, the research and development credit, and the rehabilitation credit.

How Does the Passive Activity Credit Offset Tax for Certain Closely Held C Corporations? Generally, a closelyheld C corporation can use credits arising from a passive activity to offset tax attributable to net active income. Netactive income is the taxable income of the C corporation determined without regard to passive activity income or


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loss and portfolio income, expense, gain or loss (for example, interest, dividends, annuities, royalties, relatedexpenses, and gain or loss on the disposition of assets producing portfolio income).

When applying the PAL rules, a closely held corporation is a C corporation (other than a personal service corpora�tion) that at any time during the last half of the tax year is owned more than 50% in value (directly or indirectly) byfive or fewer individuals. Stock is owned indirectly under the following rules:

a. Stock owned, directly or indirectly, by a corporation, partnership, estate, or trust is deemed ownedproportionally by the shareholders, partners, or beneficiaries.

b. Stock owned, directly or indirectly, by an individual's family members is considered owned by theindividual. Family members include only brothers and sisters (full or half), spouses, ancestors, and linealdescendants.

c. Having an option to purchase stock is the same as owning it.

What Is the Minimum Tax Credit?

The amount of AMT paid in one year is allowed as a minimum tax credit (MTC) against the taxpayer's regular taxliability in a subsequent year. Although the MTC cannot be carried back, it can be carried forward indefinitely. Thus,no ordering rules exist for using it. C corporations take the MTC on their corporate returns. Partners and Sshareholders use the credit on their individual income tax returns with respect to AMT items passed through fromthe company (along with AMT items from any other source).

The amount of MTC that can be used in any one year is limited to the excess of regular tax (after reduction by mostcredits) over the tentative minimum tax.

Example 8�1: Claiming the AMT credit against regular tax.

Muddy Boots, Inc. paid $15,000 of AMT in 2009. In 2010, Muddy Boots had a regular tax liability of $50,000,an AMT liability of $20,000, and no other tax credits. Muddy Boots can use the 2009 AMT as a credit againstits 2010 regular tax liability, reducing it to $35,000.

Variation:�Assume the same facts except Muddy Boots' AMT liability in 2010 was $41,000. Since the AMTcredit cannot reduce Muddy Boots' regular tax liability below AMT, only $9,000 of the credit ($50,000 �$41,000) can be used. The remaining $6,000 can be carried over to 2011.

Small C corporations are not subject to AMT. However, some small corporations may have an MTC carryover thatis available to offset regular tax. The MTC is subject to a limit for small corporations.

What Is the Foreign Tax Credit?

A U.S. corporation is subject to U.S. taxation on its worldwide income. If foreign�source income is also taxed by aforeign country, the corporation could be subject to double taxation. A U.S. taxpayer can either deduct [under IRCSec. 164(a)] or claim a credit (under IRC Sec. 901) for certain taxes paid to foreign countries. If the deduction istaken, it is reported as a part of taxes on line 17 of Form 1120. If the credit is taken, Form 1118 (Foreign TaxCreditCorporations) is used to calculate and report the credit. The foreign tax credit is also available for useagainst a taxpayer's AMT liability.

A partnership or S corporation is not allowed to claim the deduction or credit; rather, foreign taxes, paid by thesecompanies are passed through to owners, who then elect to either deduct or claim a credit for the taxes.

How Is the Foreign Tax Credit Computed? The amount of the foreign tax a corporation can use as a credit iscomputed (as well as limited) based on the following formula:

U.S.�tax�(before�credit ) �Foreign�source�taxable�income

Worldwide�taxable�income


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The U.S. tax liability considered is the regular tax liability minus the possessions corporation tax credit determinedunder IRC Sec. 936. The tax amount does not include AMT, PHC tax, or recapture of ITC. As a result of this formula,the foreign tax credit may not exceed the portion of the U.S. tax liability attributable to income from foreign sources.The limitation is calculated on Form 1118.

Example 8�2: Calculation of limitation on credit.

Hot Tamales, Inc. (HTI) has foreign�source taxable income of $200,000 for 2010. The foreign tax paid on thatincome is $40,000. HTI has worldwide income of $3,000,000 for 2010 (including the $200,000 of foreignincome) and a U.S. regular tax liability of $1,020,000. The 2010 limitation on the use of the credit by HTI iscalculated as follows:

$1,020,000�$200,000

$3,000,000�� $68,000�available�credit

In this instance, the amount determined by the formula ($68,000) is more than the actual foreign tax paid($40,000). Therefore, the foreign tax credit for 2010 is limited to $40,000.

What Are Foreign Source Income Baskets? A separate limitation of the foreign source income must be calcu�lated for the two categories (also referred to as �baskets") and foreign�source income. The two baskets are asfollows:

a. The passive income basket includes passive income and specified passive income, which is defined as(1) dividends from a DISC or former DISC to the extent the dividends are treated as foreign source income;(2) taxable income attributable to foreign trade income; and (3) distributions from a FSC or a former FSCout of earnings and profits attributable to foreign trade income or interest or carrying charges from atransaction that results in foreign trade income.

b. The general income basket includes income other than passive income. For example, shipping incomeusually will be considered general income, while, depending upon the circumstances, high withholding taxinterest could be considered either passive or general income. Dividends from a DISC or former DISC, FSCor former FSC will all be considered passive income. The basket classification does affect the separatecomputation of foreign tax credit limitations under special Code provisions relating to treaty�basedsourcing rules.

In determining the limitation, the source of all income must be established using the general source rules of IRCSecs. 861 through 865, the specific source rules of IRC Sec. 904(g), and any applicable source rules contained invarious tax treaties. In addition, the deductions applicable to the various categories of income must be determined.Some deductions that cannot be definitely allocated to a specific category of income must be apportioned inaccordance with IRC Sec. 864. Schedule H of Form 1118 is used for making these apportionments.

Can Excess Foreign Taxes Be Carried Over? If the foreign taxes paid or accrued in the current year exceed thelimitation, the excess eligible taxes are first carried back to the preceding year and then forward to the tensucceeding years. The excess taxes are considered paid in the year to which they are carried and can be used onlywhen the overall limitation for that year exceeds the foreign taxes actually paid or accrued.

What Is the Credit for Federal Excise Tax on Gasoline and Special Fuels?

Certain types of fuels are subject to federal excise tax. If the fuel is used in a nontaxable manner by the ultimatepurchaser, the purchaser may claim a refund of excise taxes paid, or the purchaser may take a refundable creditagainst income tax.

What Types of Fuel Are Subject to the Fuels Credit? The types of fuel subject to the credit include gasoline,undyed diesel fuel and undyed kerosene, alcohol fuel mixtures, biodiesel or renewable diesel mixtures, alternativefuel or alternative fuel mixtures, diesel water fuel, aviation gasoline and kerosene used in commercial aviation.


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Note: The biodiesel mixture credit, renewable diesel mixture credit, alternative fuel credit and alternative fuelmixture credit (except for liquefied hydrogen) expired on December 31, 2009. The alcohol fuel mixtures credit isscheduled to expire on December 31, 2010.

What Is a Nontaxable Use? Each type of fuel has separate requirements for its use to qualify as nontaxable. Ingeneral, uses of fuel that qualify as nontaxable include, but are not limited to, (a) use on a farm, (b) off�highwaybusiness use, (c) commercial fishing, (d) certain buses, (e) foreign trade, (f) commercial aviation, (g) trains, and (h)for production of alternative fuels.

How Is the Fuel Credit Claimed? The refundable credit for the federal excise tax on fuels is claimed at the entitylevel for C corporations, S corporations, and electing large partnerships. Partnerships (other than electing largepartnerships) pass through the credit to their partners. Rather than claiming the credit on its tax return, a C or Scorporation or electing large partnership generally may be able to claim a quarterly refund of the federal fuel tax onForm 720 (Quarterly Federal Excise Tax Return) or Form 8849 (Claim for Refund of Excise Taxes). A refund can beclaimed on Form 720 if the business is reporting a federal excise tax liability on other portions of the Form 720. If thebusiness is not otherwise required to file Form 720 (i.e., it has no federal excise tax liabilities to report), Form 8849is used to claim the refund (subject to minimum dollar thresholds).

Form 4136 (Credit for Federal Tax Paid on Fuels) is used by C and S corporations and electing large partnershipsto claim credit for federal excise tax paid on fuels on the company's annually filed income tax return. Partnerships(other than electing large partnerships) cannot file this form. Instead they must include a statement on Schedule K�1(Form 1065) (U.S. Partnership Return of Income) showing the number of gallons of fuel allocated to each partnerand the applicable tax rates. The fuel credit information flows through to the partners on Schedule K�1.

The choice between a credit or refund is available with respect to all four quarters of the year. To claim a refundinstead of a credit, certain minimum dollar amounts must be met. See IRS Pub. 510, �Excise Taxes," for claimrequirements including minimum dollar thresholds and deadlines for filing refund claims.

Credits for alternative fuel mixtures, alcohol fuel mixtures and biodiesel (including agri�biodiesel) mixtures areallowed. These credits must first be taken against the fuel liability on Form 720. Any credits in excess of the liabilityon Form 720 may be claimed (only once) on Forms 8849 or 4136. Alternatively, the credits may be taken as ageneral business credit using Form 6478 (Credit for Alcohol Fuel used as Fuel) or Form 8864 (Biodiesel andRenewable Diesel Fuels Credit). Sales or uses of alcohol or biodiesel, which are not in a mixture, are claimed aspart of the general business credit instead of the fuels credit.

Is the Fuels Credit or Refund Reported as Income? If the cost of the gasoline or special fuel for which the creditor refund is claimed is deducted on the company's tax return and that deduction reduces the company's taxliability, the company must report the amount of credit or refund as income. The proper treatment depends onwhether the company uses the cash or accrual method.

a. A cash method taxpayer that files a claim for refund includes the refund in income when the refund isreceived. A cash method taxpayer that claims a credit includes the credit in income for the tax year in whichthe company files Form 4136. (For example, a fuels credit used in the company's 2010 income tax returnfiled March 16, 2011 is taken into income in 2011, the year in which the company files Form 4136.)

b. An accrual method taxpayer includes the credit or refund in income for the tax year in which the taxpayerused the fuel (or sold the fuel if the taxpayer is a registered ultimate vendor).


91

SELF�STUDY QUIZ


32. The passive activity credit can be taken by which of these entities?

a. A C corporation, owned equally by 12 individuals, that has credits arising from passive activities.

b. A closely held C corporation has passive activity credits, no passive income, no active income, but $20,000of interest and dividend income.

c. A personal service corporation (PSC) that has passive activity income and passive activity credits.

d. An S corporation that has passive activity income and passive activity credits.

33. What are the foreign�source income �baskets" for purposes of the foreign tax credit?

a. Nine various categories of foreign�source income.

b. Two categories of foreign�source income: passive and general.

c. This term refers to the foreign taxes paid to various countries during the tax year.

34. The following fuels are subject to the credit for federal excise tax on gasoline and special fuels except for:

a. Dyed diesel fuel.

b. Biodiesel.

c. Aviation gasoline.

d. Gasoline.

35. How is the refundable credit for the federal excise fuels tax claimed?

a. C and S corporations claim the credit on their tax returns.

b. Partnerships file Form 4136 (Credit for Federal Tax Paid on Fuels).

c. As a credit or a refund.


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32. The passive activity credit can be taken by which of these entities? (Page 87)

a. A C corporation, owned equally by 12 individuals, that has credits arising from passive activities. [Thisanswer is incorrect. The passive activity rules do not apply to C corporations unless they are PHCs orclosely�held corporations.]

b. A closely held C corporation has passive activity credits, no passive income, no active income, but $20,000of interest and dividend income. [This answer is incorrect. Passive activity credits can be used against theactive income of a closely�held C corporation, but not against portfolio income.]

c. A personal service corporation (PSC) that has passive activity income and passive activity credits.[This answer is correct. A PSC can offset passive activity credits only against passive activityincome.]

d. An S corporation that has passive activity income and passive activity credits. [This answer is incorrect.The passive activity rules do not apply at the S corporation or partnership level. The results of passiveactivities are passed through to the partners and shareholders.]

33. What are the foreign�source income �baskets" for purposes of the foreign tax credit? (Page 89)

a. Nine various categories of foreign�source income. [This answer is incorrect. Effective for years beginningafter December 31, 2006, the number of �baskets" has been reduced to two.]

b. Two categories of foreign�source income: passive and general. [This answer is correct. The numberof �baskets" was changed from nine to two for years ending after December 31, 2006.]

c. This term refers to the foreign taxes paid to various countries during the tax year. [This answer is incorrect.The term refers to various categories of foreign�source income.]

34. The following fuels are subject to the credit for federal excise tax on gasoline and special fuels except for:(Page 89)

a. Dyed diesel fuel. [This answer is correct. Undyed diesel fuel is eligible for the credit.]

b. Biodiesel. [This answer is incorrect. This fuel is eligible for the credit.]

c. Aviation gasoline. [This answer is incorrect. This fuel is eligible for the credit.]

d. Gasoline. [This answer is incorrect. This fuel is eligible for the credit.]

35. How is the refundable credit for the federal excise fuels tax claimed? (Page 90)

a. C and S corporations claim the credit on their tax returns. [This answer is incorrect. Rather than claimingthe credit on their tax return, C or S corporations generally may be able to claim a quarterly refund of thefederal fuel tax on Form 720 (Quarterly Federal Excise Tax Return) or Form 8849 (Claim for Refund of ExciseTaxes).]

b. Partnerships file Form 4136 (Credit for Federal Tax Paid on Fuels). [This answer is incorrect. Partnerships(other than electing large partnerships) cannot file this form. Instead, they must include a statement onSchedule K�1 (Form 1065) (U.S. Partnership Return of Income) showing the number of gallons of fuelallocated to each partner and the applicable tax rates. The fuel credit information flows through to thepartners on Schedule K�1.]

c. As a credit or a refund. [This answer is correct. The choice between a credit or refund is availablewith respect to all four quarters of the year. However, to claim a refund instead of a credit, certainminimum dollar amounts must be met.]


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COMMON CREDITS THAT ARE A PART OF THE GENERAL BUSINESSCREDIT

A number of business income tax credits are combined into the general business credit.

Which Credits Are Included in the General Business Credit?

The following briefly describes each credit and summarizes its provisions or references to where additionalinformation is located:

a. Section 30B Alternative Motor Vehicle Credits. The credits are available for new vehicles placed in serviceafter December 31, 2005. Credit amounts are determined under a complicated set of rules.

b. Section 30C Alternative Fuel Vehicle Refueling Property Credit. This credit is available to taxpayers whoplace property in service that is used to store or dispense clean�burning fuel into a fuel tank, or for propertyused to recharge motor vehicles propelled by electricity. The volume of the clean�burning fuel must be atleast 85% ethanol, natural gas, compressed natural gas, liquefied natural gas, liquefied petroleum gas,hydrogen, or at least 20% biodiesel. Electricity is an alternative fuel for property placed in service afterOctober 3, 2008. Except for hydrogen property, the property must be placed in service by December 31,2010. This credit is computed on Form 8911 (Alternative Fuel Vehicle Refueling Property Credit).

c. Section 30D Qualified Plug�in Electric Drive Motor Vehicles Credit. This credit is available for 4�wheeledvehicles propelled to a significant extent by an electric motor that draws electricity from a battery that hasa capacity of at least 4 kilowatt hours and is rechargeable from an external source. The credit applies tovehicle purchases beginning in 2009 and is scheduled to expire in 2014.

d. Section 40 Alcohol Fuels Credit. This credit is available to certain producers, sellers, and users ofalcohol�based fuels and special fuels suitable for use in an internal combustion engine. This credit mustbe coordinated with the excise tax credit. The credit is scheduled to expire December 31, 2010.

e. Section 41 Research Credit. The research credit expired on December 31, 2009; however, Congress hasretroactively reinstated this credit several times in previous years. Taxpayers should monitor any legislativedevelopments in this area.

f. Section 42 Low�income Housing Credit. This credit can be claimed by owners of new or substantiallyrehabilitated residential property rented to low�income persons. The percentage credit is based on theproperty's qualified basis multiplied by a percentage (published monthly by the IRS) in effect for the monththe property is placed in service.

g. Section 43 Enhanced Oil Recovery Credit. This credit is available to an owner of an operating mineralinterest with respect to qualified enhanced oil recovery costs (depreciable or amortizable tangible propertycosts, IDC, and tertiary injectant expenses). Costs to construct a gas treatment plant in Alaska are alsoeligible. The credit equals 15% of qualified costs, but is phased out as the average well head (unregulated)price of a barrel of domestic crude oil exceeds $28 (adjusted for inflation).

h. Section 44 Disabled Access Credit. The maximum credit is $5,000 in any one year.

i. Section 45 Renewable Electricity Production Credit. This credit is available (during the ten�year periodbeginning on the placed�in�service date) for electricity produced by a company from wind�energy or aclosed�loop biomass in a facility placed in service before January 1, 2014, (for closed�loop biomass facility)or before January 1, 2013 (for a facility using wind energy). This credit is also available for electricityproduced at open�loop biomass facilities, geothermal or solar energy facilities, small irrigation powerfacilities, landfill gas facilities, trash combustion facilities, and electricity produced at refined coalproduction facilities placed in service after October 22, 2004 and before January 1, 2014. Electricityproduced at hydroelectric and Indian coal facilities placed in service after August 8, 2005 and beforeJanuary 1, 2014 , (for hydropower facility), and before January 1, 2009 (for Indian coal facility) also qualifiesfor the credit.


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j. Section 45B Employer Credit for FICA Tax Paid on Tip Income. This credit is available to owners of food andbeverage establishments who are required to report employees' tips in excess of those treated as wagesfor purposes of the Fair Labor Standards Act.

k. Section 45C Orphan Drug Credit. This credit applies to qualified expenses incurred in the testing of drugsto cure rare diseases or conditions (drugs termed generally as orphan drugs).

l. Section 45E Small Employer Pension Plan Startup Cost Credit. Certain eligible employers can claim a creditequal to 50% of the qualified startup costs paid or incurred in the establishment or administration of aneligible employer plan, or the retirement�related education of employees with respect to the plan. The creditis limited to $500 for the first credit year and each of the two tax years immediately following the first credityear. No credit is available after the first three credit years.

Employers that had no more than 100 employees who received at least $5,000 of compensation from theemployer for the previous year are eligible for the credit. After an eligible plan is maintained for a year, anemployer failing eligibility will be considered eligible for two years after the last year the employer waseligible, unless the failure is due to an acquisition, disposition, or similar transaction involving an eligibleemployer. Employers that established or maintained a qualified employer plan for substantially the sameemployees as are in the eligible employer plan during the three tax years preceding the first tax year forwhich the credit would be allowable are not eligible for the credit.

m. Section 45F Employer�provided Child Care Credit. This credit has two components: a credit equal to 25%of qualified child care expenditures (paid to acquire, construct, rehabilitate, expand, and operate a childcare facility) and a credit equal to 10% of qualified expenses for providing child care resources and referralservices to an employee. The maximum credit allowed for a single tax year is $150,000. The employercannot claim a deduction and a credit for the same expenses. The taxpayer must also reduce its basis inany facility by the amount of the credit claimed. The employer may have to recapture the portion of the 25%credit taken for qualified child care expenditures if it ceases operation of the qualified child care facility (orchange ownership). This credit is scheduled to expire for years beginning after December 31, 2010.

n. Section 45I Credit for Producing Oil and Gas From Marginal Wells. This credit is available to taxpayers whohave qualified oil production and qualified natural gas production from marginal wells.

o. Section 45J Advanced Nuclear Power Facility Production Credit. This credit is for electricity produced bythe taxpayer at an advanced nuclear power facility and sold to an unrelated person during the 8�year periodbeginning on the date the facility was originally placed in service.

p. Section 45K Nonconventional Source Fuel Credit. This credit is for oil produced from shale and tar sands,and gas produced from geopressured brine, Devonian shale, coal seams, a tight formation, or biomass.

q. Section 45M Energy Efficient Appliance Credit. This credit is for qualified energy efficient appliancesproduced by the taxpayer during calendar years 2008, 2009, and 2010. Eligible appliances includedishwashers, refrigerators, and clothes washers meeting the energy star standards.

r. Law Change Alert: Section 45R Small Employer Health Insurance Tax Credit. The 2010 Health Care Actprovides a new tax credit for qualified small employers that purchase health insurance for their employees.The credit, which is part of the general business credit, is effective for tax years beginning in 2010 through2013.

s. Section 47 Rehabilitation Credit. This credit can be claimed for expenses incurred to rehabilitate olderbuildings used for nonresidential purposes or certified historical structures used for residential ornonresidential purposes. The credit is 20% for a certified historical structure or 10% for other than a certifiedhistorical structure.

t. Section 48(a) Energy Credit. This credit is available to an owner of depreciable or amortizable energyproperty (solar, wind, and geothermal energy) placed in service during the year. The credit equals 10% ofthe basis of each energy property placed in service. This credit must be coordinated with the Section 45


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renewable electricity production credit. For property placed in service before 2017, the credit is 30% for thebasis of qualified fuel cell property, qualified small wind energy property, and solar energy equipment usedto heat and cool or illuminate structures.

Note: The Section 47 rehabilitation credit and the Section 48(a) energy credit make up what is known asSection 46 investment credit.

u. Section 51 Work Opportunity Tax Credit. The maximum amount is 40% of the first $6,000 that was paidduring the first year of employment. (Maximum credits is $2,400 per employee.)

v. Section 4612(e) Credit for Unused Payments Into Trans�Alaska Pipeline Liability Fund. This credit is availableto taxpayers who pay into the Trans�Alaska Pipeline Liability Fund.

w. Section 5011(a) Distilled Spirits Credit. This credit for wholesalers is computed by multiplying the numberof cases of bottled distilled spirits purchased or stored during the tax year by the average tax�financing costper case.

x. Law Change Alert: Temporary Tax Credit for Retaining Qualified New Employees. This new one�year creditof up to $1,000 for employers who hired and retained out of work employees is realized through an increasein the general business credit and first available for calendar year taxpayers in 2011.

How Is the Alternative Motor Vehicle Credit Claimed?

The portion of this credit attributable to depreciable property is treated as a general business credit.

How Much Is the Alternative Motor Vehicle Credit? The credit arises from the purchase of a qualified vehicle. Theoriginal use of the vehicle must begin with the taxpayer. The credit calculation is different for each category ofvehicle as follows:

a. Qualified Alternative Fuel Cell Motor Vehicle. Qualified new alternative fuel vehicles include those capableof running only on compressed or liquefied natural gas, liquefied petroleum gas, hydrogen, or any liquidthat is at least 85% methanol. Reduced credits are allowed for mixed�fuel vehicles that run on a mixture thatconsists of at least 75% of an alternative fuel and not more than 25% of a petroleum�based fuel. The creditcan range from $4,000 to $40,000 based on the weight of the vehicle. The credit amount can also beincreased if the vehicle meets specified benchmarks of fuel economy.

b. Advanced Lean�burn Technology Motor Vehicle. Qualified new lean burn vehicles are passenger autos andlight trucks with an internal combustion engine that uses lean burn technology, which involves directinjection of a fuel mix using more air than normal (such as certain diesel engines). The credit ranges from$400 to $2,400 based on the level of fuel economy that is reached. An additional conservation creditranging from $250 to $1,000 can be earned based on lifetime fuel savings. The credit for advancedlean�burn technology motor vehicles expires on December 31, 2010.

c. Qualified Hybrid Motor Vehicle. Qualified new hybrid vehicles combine an internal combustion engine withanother propulsion system that uses an onboard rechargeable energy source such as electric batteries.In the case of passenger vehicles and light trucks, the credit is calculated in the same manner as that forthe advanced lean�burn technology vehicle. It is also comprised of a fuel economy amount andconservation credit amount. The credit for passenger vehicles and light trucks is scheduled to expire onDecember 31, 2010. For vehicles other than passenger vehicles and light trucks, the credit expired onDecember 31, 2009.

d. Qualified Alternative Fuel Cell Motor Vehicle. Qualified new fuel cell vehicles include those capable orrunning only on compressed or liquefied natural gas, liquefied petroleum gas, hydrogen, or any liquid thatis at least 85% methanol. Reduced credits are allowed for mixed�fuel vehicles that run on a mixture thatconsists of at least 75% of an alternative fuel and not more than 25% of a petroleum�based fuel. The creditis scheduled to expire on December 31, 2010.


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Which Vehicles Qualify for the Alternative Motor Vehicle Credit? Check the IRS website at www.irs.gov/busi�nesses/corporations/article/0,,id=202341.htm for the latest information regarding qualifying vehicles. This web�site contains a list of qualified vehicles and credit amounts for which the IRS has acknowledged manufacturers'certifications.

How Is the Alternative Motor Vehicle Credit Claimed? Form 8910 (Alternative Motor Vehicle Credit) is used tocompute and claim this credit. The credit is carried to Form 3800 (General Business Credit), then to Form 8810(Corporate Passive Activity Loss and Credit Limitations) if from a passive activity.

The taxpayer can elect not to have IRC Sec. 30B apply to the purchase of a vehicle. The IRS is to provideregulations providing for recapture of any credit for any property that ceases to be property eligible for the credit.(At the time this course went to press, the IRS had not released the applicable regulations.)

What Is the Temporary Tax Credit for Retaining Qualified New Employees?

The Hiring Incentives to Restore Employment (HIRE) Act added a temporary new credit of up to $1,000 for wagespaid to each qualified new employee. The credit equals the lesser of: (1) 6.2% of wages paid to the worker duringthe 52�consecutive�week period beginning on the date of hire or (2) $1,000. The credit is implemented by anincrease to the employer's general business credit. The provisions for this credit are found in Section 102 of theHIRE Act.

What Is a Qualified New Employee? Qualified new employees are full�time or part�time workers who start workafter February 3, 2010 and by no later than December 31, 2010, and certify on Form W�11 that they were notemployed more than 40 hours during the 60�day period ending on the start date. The new employee cannotreplace another worker unless that person quit voluntarily or was discharged for cause.

When Can the Credit for Retaining Qualified New Employees Be Claimed? The credit can be claimed for a taxyear ending after March 18, 2010 during which the 52�week requirement is first met for the worker. The 52�weekrequirement cannot be met until February 11, 2011 at the earliest (for a worker who started on the earliest possibledate of February 4, 2010). Calendar year taxpayers can benefit from the credit on the 2011 returns.

How Is the General Business Credit Claimed?

The components of the general business credit are passed through to partners (on line 15) and S shareholders (online 13) on Schedule K�1 and do not affect the partnership or S corporation's tax.

Each one of the credits making up the general business credit has its own form on which to claim the credit. Ataxpayer (including partners and S shareholders with flow�through credits) (a) claiming more than one of thesebusiness credits, (b) having a carryback or carryforward of any of these credits, (c) having credits from an electinglarge partnership shown in box 7 of Schedule K�1 (Form 1065�B), or (d) having credits from a passive activity, mustsummarize them on Form 3800 (General Business Credit).

Partners in an electing large partnership report general business credits (other than the low�income housing creditand the rehabilitation credit from a rental real estate activity) on Form 3800 as part of the general business credit.The low income housing credit, the rehabilitation credit (IRC Sec. 47), the nonconventional fuel source credit (IRCSec. 45K), and the foreign tax credit passed through from an electing large partnership on Schedule K�1 (Form1065�B) are subject to special reporting requirements at the partners' level. See the instructions to Schedule K�1(Form 1065�B) for information on the special reporting requirements.

HOW TO USE THE GENERAL BUSINESS CREDIT

IRC Sec. 38(c) contains limitations on the amount of the credit that can be claimed in any one year. Unused creditscan be carried to other years under the rules discussed below. The limitation rules are different for the empower�ment zone and renewal community employment credit, the work opportunity credit, the credit for alcohol used asa fuel, and the renewable electricity production credit than for other credits.


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Is There a Limit on the Allowable General Business Credit?

The general business credit is generally applied dollar for dollar against the first $25,000 of a C corporation'sregular corporate income tax and then against 75% of the remaining regular corporate income tax. Partners and Sshareholders apply these limits against the net tax liability (generally, regular income tax less personal credits)shown on their individual returns.

Additional limitations may apply if significant amounts of AMT adjustments and preferences exist, even if the AMTitself does not apply. Furthermore, general business credits arising from passive activities may be limited under thepassive loss rules.

What Are the Credit Carryback and Carryforward Rules?

Unused general business credits arising in 1998 and subsequent tax years generally can be carried back one yearand forward 20 years. For credits arising in tax years before 1998, the carryback period is three years and thecarryforward period is 15 years. However, no component of the general business credit can be carried back to ayear before that component was allowable.

Are General Business Credits Deductible If They Expire Unused?

Some portions of the general business credit (e.g., the work opportunity tax credit, rehabilitation investment credit,and incremental research credit) remaining at the end of the 20�year carryover period (15�year carryover period forcredits arising prior to 1998) are deductible in the following year (i.e., year 21 for post�1997 credits and year 16 forpre�1998 credits). If a corporation ceases to exist prior to this time, the unused credits are deductible in the last yearof the corporation's existence. The deduction for certain unused credits (e.g., research credits arising before 1990)is limited to 50%.

MINIMUM TAX CREDIT (MTC)

The amount of AMT paid by a C corporation in one year is allowed as a credit (the MTC) against the corporation'sregular tax liability in subsequent years. For partners and S corporation shareholders, the MTC is calculated andoffsets regular tax liability on the individual income tax returns.

The rationale for allowing the AMT paid in one year to reduce the regular tax liability in a subsequent year is that,because of the independent nature of the AMT and regular tax systems, double taxation of income or the disallow�ance of deductions might otherwise result.

For example, a corporation that uses accelerated depreciation for regular tax purposes may pay AMT in the first fewyears that a depreciable asset is placed in service. In later years, if AMT depreciation exceeds regular depreciationand the corporation is not subject to AMT, it receives no benefit from the higher AMT deductions. The MTCgenerated in the year the AMT liability is incurred reduces the regular tax liability in a subsequent year so that thebenefit of the depreciation deduction is not lost.

For tax years beginning after 1997, small corporations are exempt from the AMT, but may have an MTC carryoverfrom earlier tax years that is available to offset regular tax.

Can a C Corporation Carryforward the MTC?

The amount of MTC that may be carried forward as a credit by a C corporation equals the entire AMT tax liability forthe year. In addition, the portion of the electric vehicle credit not allowable (from tax years before 2006) solelybecause it could not reduce regular tax liability to less than the amount of tentative minimum tax liability, can becarried forward as part of the MTC. Form 8827 (Credit for Prior Year Minimum TaxCorporations) is used tocompute the MTC carryforward from prior years, the amount that may be used in the current year, and the amountavailable for carryforward.

MTC generated in one year can offset only the regular tax of a subsequent year. MTC cannot under any circum�stances be carried back. Because MTC can, however, be carried forward indefinitely, no ordering rules exist for useof the credit.


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For individuals (including partners and S corporation shareholders), only the AMT attributable to deferral (or timing)preferences is allowed as MTC. AMT attributable to exclusion preferences (permanent difference between regulartax and AMT) does not generate or increase the MTC. Form 8801 (Credit for Prior Year Minimum TaxIndividuals,Estates, and Trusts) is used to compute the MTC carryforward from prior years, the amount that may be used in thecurrent year, and the amount available for carryforward.

How Is the Allowable MTC Computed?

The amount of MTC that can be used in any year is limited to the excess of the regular tax (after reduction by mostcredits) over the tentative minimum tax (TMT) for the year. Small corporations (exempt from AMT) must reduce theirregular tax liability (after reduction by credits) by 25% of the amount in excess of $25,000.

CREDIT CARRYOVERS THAT OFFSET THE S CORPORATION BUILT�INGAINS TAX

An S corporation that has converted from C status may be subject to a corporate�level built�in gains tax. This tax canbe offset by unused business and minimum tax credit carryforwards from prior C corporation tax years. However,the general business credit and minimum tax credit carryovers are allowed only to the extent they could be usedunder the C corporation rules.

An S corporation is not subject to the alternative minimum tax. However, under Reg. 1.1374�6(b), a tentativeminimum tax acts as a limitation on the amount of C corporation credit carryovers that can be used to offset thebuilt�in gains tax. The tentative minimum tax is calculated using the corporate AMT rate, without regard to any AMTforeign tax credit.


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SELF�STUDY QUIZ


36. Genco, Inc., A C corporation has a general business credit of $40,000 and a tax liability, before credits, of$42,000. What is the amount of allowable business credit for the year?

a. $25,000

b. $37,750

c. $40,000

d. $30,000

37. Listed below are some attributes of common business credits. Which of the following statements is mostaccurate?

a. The work opportunity credit equals 40% of eligible wages paid up to a maximum of $10,000 per employeeduring the first year of employment.

b. The maximum disabled access credit is $5,125 in any one year.

c. The qualified plug�in electric drive motor vehicles credit applies to vehicles purchased in 2010.

38. How are credits comprising the general business credits claimed?

a. By filing the respective form for each credit and attaching them to the return.

b. By filing the respective form for each credit and summarizing the credits on Form 3468 (Investment Credit).

c. The general business credits are passed through to partners and shareholders of S corporations.

39. What tax can the minimum tax credit (MTC) be used to offset?

a. Only the AMT tax liability.

b. The MTC can be carried back and forward to offset the regular tax liability.

c. The MTC can offset the regular tax for the current year and subsequent years.

d. The MTC can only be carried forward to offset regular tax in a subsequent year.

40. The MTC can be carried forward for how many years?

a. 20 years.

b. Indefinitely.

c. 10 years.

d. 15 years.


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36. Genco, Inc., A C corporation has a general business credit of $40,000 and a tax liability, before credits, of$42,000. What is the amount of allowable business credit for the year? (Page 97)

a. $25,000 [This answer is incorrect. The general business credit is limited to $25,000 plus 75% of theremaining tax liability.]

b. $37,750 [This answer is correct. The amount of credit that can be used is $25,000 + {[75%($42,000� $25,000 = $17,000) = $12,750] = $37,750}.]

c. $40,000 [This answer is incorrect. The credit is limited. This answer choice does not properly reflect thepercentage credit limit.]

d. $30,000 [This answer is incorrect. The credit itself is not limited to 75%.]

37. Listed below are some attributes of common business credits. Which of the following statements is mostaccurate? (Page 93)

a. The work opportunity credit equals 40% of eligible wages paid up to a maximum of $10,000 per employeeduring the first year of employment. [This answer is incorrect. The maximum amount is 40% of the first$6,000 of wages paid during the first year of employment.]

b. The maximum disabled access credit is $5,125 in any one year. [This answer is incorrect. The maximumcredit is $5,000 per year.]

c. The qualified plug�in electric drive motor vehicles credit applies to vehicles purchased in 2010. [Thisanswer is correct. The qualified plug�in electric drive motor vehicles credit applies to vehiclepurchases beginning in 2009 and is scheduled to expire in 2014.]

38. How are credits comprising the general business credits claimed? (Page 88)

a. By filing the respective form for each credit and attaching them to the return. [This answer is incorrect. Whileeach of these forms must be filed, the taxpayer must also summarize the credits on Form 3800 unless onlyone credit is claimed.]

b. By filing the respective form for each credit and summarizing the credits on Form 3468 (Investment Credit).[This answer is incorrect. The credits are not summarized on Form 3468. Form 3468 is used to calculatethe amount of the Rehabilitation Credit and Energy Credit.]

c. The general business credits are passed through to partners and shareholders of S corporations.[This answer is correct. The credits are still summarized on Form 3800 but shown on Schedule K�1rather than the pass through entity's tax return.]

39. What tax can the minimum tax credit (MTC) be used to offset? (Page 97)

a. Only the AMT tax liability. [This answer is incorrect. The MTC can offset the corporation's regular tax liabilityin a subsequent year.]

b. The MTC can be carried back and forward to offset the regular tax liability. [This answer is incorrect. TheMTC can never be carried back.]

c. The MTC can offset the regular tax for the current year and subsequent years. [This answer is incorrect.The MTC cannot offset regular tax in the current year.]


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d. The MTC can only be carried forward to offset regular tax in a subsequent year. [This answer iscorrect. The entire AMT tax liability for a year can be carried forward.]

40. The MTC can be carried forward for how many years? (Page 97)

a. 20 years. [This answer is incorrect. The MTC can be carried forward for more than 20 years.]

b. Indefinitely. [This answer is correct. No ordering rules exist for use of the credit.]

c. 10 years. [This answer is incorrect. The MTC can be carried forward for more than 10 years.]

d. 15 years. [This answer is incorrect. The MTC can be carried forward for more than 15 years.]


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Lesson 4 (DBPTG10)


35. If the foreign taxes paid or accrued in the current year exceed the limitation on the foreign tax credit, how arethe excess taxes treated?

a. They produce no further benefit to the taxpayer.

b. They can be carried back one year and then forward 10 years.

c. They can only be carried forward and used in a year when the limitation exceeds the amount of foreigntaxes paid.

d. They can be carried back three years and forward twenty years.

36. The credit for federal excise taxes on gasoline and special fuels can be used by which of the followingpurchasers?

a. Purchasers that use the gasoline or fuel for business purposes.

b. Purchasers that are required to pay the excise tax.

c. Purchasers that use the fuel in a nontaxable manner.

d. Purchasers required to pay excess excise taxes on the fuel.

37. A purchaser that receives a credit or refund for excise tax on gasoline or special fuels is required to take whataction?

a. Report the amount of credit or refund as income.

b. If a cash basis taxpayer, the amount of a credit or refund received must be reported in the year for whichthe credit or refund is taken.

c. The credit is not required to be treated as income.

d. Report the amount of credit or refund as income only if the credit or refund reduced the purchaser's taxliability.

38. Unused general business credits arising in 1998 and subsequent tax years can be used in which of the followingways?

a. They can be carried back one year and forward twenty years.

b. If incurred before 1998, they can be carried forward ten years.

c. They can be carried back three years and forward twenty years.

d. They can only be carried forward for fifteen years.

39. Which of the following unused business credits cannot be deducted in the final year of a corporation'sexistence?


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a. The rehabilitation investment credit arising after 2004.

b. The work opportunity credit.

c. The disabled access credit.

d. The incremental research credit.

40. Which of the following statements concerning the minimum tax credit (MTC) is false?

a. The amount of AMT in one year is allowed as a credit against the corporation's minimum tax liability in asubsequent year.

b. The amount of MTC that may be carried forward as a credit by a C corporation equals the entire AMT taxliability for the year.

c. The amount of MTC that can be used in any year is limited to the excess of the regular tax (after reductionfor most credits) over the tentative minimum tax for the year.

d. Small corporations (exempt from AMT) must reduce their regular tax liability by 25% of the amount inexcess of $25,000.


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105

GLOSSARY

Accumulated Earnings Tax: A penalty tax that can be assessed due to the unnecessary accumulation of earningswithin a corporation. The tax of 15% is normally assessed as the result of an IRS audit and requires a subjectivedetermination that there is an attempt to avoid tax at the shareholder level. Taxpayers must show a reasonablebusiness need in order to avoid the penalty tax.

ACE Adjustment: Adjusted Current Earnings (ACE) is a tax concept that is intended to represent the corporation'seconomic earnings for the year. It is somewhat similar to the accounting concept of earnings and profits (E&P) butis calculated in a different manner. The purpose of the ACE adjustment is to ensure that C corporations with economicincome pay some amount of corporate income tax. The ACE adjustment equals 75% of the difference between ACEand preadjustment AMTI (in absolute numbers). The adjustment can be positive or negative.

Allocation of Tax Benefits: Component members of a controlled group of corporations at the end of a calendar yearmust apportion certain tax benefits among all component members. These benefits are: 1) The benefit of the lowertax rates on taxable income under $100,000, 2) the $250,000 amount for computing the accumulated earnings credit,and 3) the $40,000 AMT exemption.

Alternative Minimum Tax: In effect, a separate system of taxation with its own rules and computation methods. Itparallels the regular income tax system and was designed to ensure that C corporations and higher incomeindividuals with economic income, but little or no taxable income, pay some amount of income tax.

Alternative Tax Net Operating Loss: The regular tax NOL increased or decreased by AMT adjustments anddecreased by AMT preferences. The adjustment for an AMT preference is only required to the extent it caused theregular tax NOL to increase. An ATNOL can be carried back two years and forward twenty years.

Alternative Tax on Capital Gains: Corporate capital gains are taxed at a maximum rate of 35%. Therefore,corporations with net capital gains can pay an alternative tax on capital gains if the regular corporate income tax rateis greater than 35%. At the current time the alternative tax on capital gains provides no benefits since the regularcorporate income tax rate is 35%.

AMT Adjustments: Adjustments that account for differences between methods of computing items of income,expense, gain, or loss for the regular tax system and the AMT system. The adjustment equals the difference betweenthe amounts determined under each system. The adjustments can either increase or decrease alternative minimumtaxable income (AMTI).

AMT Preferences: Certain items of income and deduction that receive preferential treatment under the regular taxsystem that are not allowed under the alternative tax system. AMT preferences can only increase AMTI. Negativeadjustments are ignored.

Basis adjustments: Adjustments made to account for the difference in the basis of an asset due to differences inthe regular tax and AMT system. The disposition of an asset on which such an adjustment is required will result ina different gain or loss for regular tax versus AMT.

Built�in Gains Tax: A tax that applies to C corporations that make S corporation elections after 1986. The tax isassessed when the S corporation disposes of an asset that was on hand at the date the S corporation electionbecame effective. The built�in gain equals the difference between the asset's FMV and adjusted basis on that date.The tax is imposed at the highest corporate tax rate (currently 35%). The built�in gain rules apply during the 120 monthperiod beginning with the first month of the year the S election became effective.

Consent Dividends: Hypothetical dividends agreed to by the corporation and its shareholders in order to mitigatethe accumulated earnings tax or PHC tax. The shareholders must include these consent dividends in their personalincome, even though no cash is actually received.

Deposit to Suspend Running of Interest: A deposit made with the IRS to suspend the running of interest on apotential underpayment of tax. The underpayment must not have been assessed prior to the time the deposit ismade. The IRS will pay interest on any part of the deposit that is returned to the taxpayer.


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Deficiency Dividends: Dividends paid after a determination is made that a corporation is subject to the PHC tax.The deficiency dividend reduces PHC income in the year for which the PHC tax liability is incurred.

Depository Method: The method used by corporate taxes to make tax payments to the federal government. Taxpayments are deposited at an authorized federal depository (usually a bank) along with Form 8109 (Federal TaxDeposit Coupon) that identifies the type of return and tax period for which the payment applies. This method appliesto corporate income tax, estimated tax, employment tax, back�up withholding, and excise tax.

Excess Net Passive Income Tax: A tax that may apply at the S corporation level when C corporation accumulatedearnings are present and passive investment income is more than 25% of the company's gross receipts for the year.The tax is imposed at the maximum corporate rate, presently 35%.

Foreign Source Income Baskets: Separate categories of foreign source income categories. Beginning in 2007these baskets are limited to two: the passive income basket and general income basket. A separate foreign tax creditlimitation must be calculated for each of these baskets of income.

Foreign Tax Credit: A U. S. corporation can take a deduction or claim a credit for certain taxes paid to foreigncountries. The credit is claimed on Form 1118 (Foreign Tax CreditCorporations) which is attached to the corporatetax return for the year. The foreign tax credit is also available against a taxpayer's AMT liability. The tax is computedas the U.S. tax multiplied by the percentage of foreign taxable income to worldwide taxable income, or the amountof the actual foreign tax if lower.

General Business Credit: A tax credit composed of a number of separate credits computed on various federal taxreturn forms and then summarized on Form 3800 (General Business Credit). These separate credits are combinedand a tax liability limitation is applied to the overall general business credit.

General Rule for Estimated Tax Payments: Each required installment must be 25% of the lesser of the following:1) 100% of the tax shown on the current year's return, or 2) 100% of the tax shown on the preceding year's return.However the previous year's return must be for a full tax year and must show a tax liability.

Large Corporation: For estimated tax purposes, a large corporation is one with $1 million or more of taxable incomein any of the three years preceding the current year.

LIFO Recapture Tax: A C corporation using the LIFO inventory method must add a LIFO recapture amount to incomewhen it elects S status. The LIFO recapture amount is included in income on the tax return for the last C corporationtax year. The resulting increase in tax is paid over a four�year period.

Minimum Tax Credit: The amount of AMT paid in one year is allowed as a minimum tax credit (MTC) against thetaxpayer's regular tax liability in a subsequent year. The MTC cannot be carried back but can be carried forwardindefinitely. It can be used against the amount of regular tax that exceeds the AMT in a subsequent year.

Passive Activity Credit: Tax credits arising from passive activities. Passive activity credits are not additional credits,but are regular general business credits arising from a passive activity. In the case of regular C corporations thesecredits can be used to offset the tax attributable to any income. In the case of certain closely held corporations thesecredits can offset tax attributable to active and passive income but not portfolio income. In the case of personalservice corporations these credits can only offset tax attributable to passive income.

Personal Holding Company: A corporation is a PHC if it meets two objective tests: 1) Stock Ownership Test. Morethan 50% of the value of outstanding stock is owned by five or fewer individuals on any day during the last half ofthe corporation's tax year, and 2) Income Test. At least 60% of the corporation's adjusted ordinary gross income isfrom dividends, interest, royalties, annuities, adjusted rental income, Section 1245 gains, and similar income.

Personal Holding Company Tax: A tax that penalizes the use of a corporation to hold an individual's investmentsand pay tax on the resulting income at lower corporate rates. The 15% tax is objective, requiring the use of an incometest and a stock ownership test. A corporation that pays the PHC tax is not subject to the accumulated earnings tax.


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Quick Refund: A C corporation that overpays its estimated tax may apply on Form 4466 (Corporation Applicationfor Quick Refund of Overpayment of Estimated Tax) for a quick refund. The IRS must act on Form 4466 within 45 daysfrom the date it is filed. The overpayment requested must be 10% or more of the tax liability and equal at least $500.

Small C Corporation: For AMT purposes, a small C corporation is one having three�year average annual grossreceipts not exceeding $5 million for its first tax year beginning after 1996, and not having three�year average annualgross receipts exceeding $7.5 million for any prior later years. Such corporations are exempt from the AMT.

Undue Hardship: In the context of business taxes, the term is defined as a substantial financial loss to the company,such as the necessity to sell property at a sacrifice in order to make a tax payment. Undue hardship may provide areason for the allowance of an extension of time to make a tax payment.


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109

INDEX

A

ACCUMULATED EARNINGS TAX� Generally 61. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Holding company 61. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Reasonable business needs 62. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Strategies to avoid AET 63. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ACE ADJUSTMENT� Computing 28. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ALTERNATIVE MINIMUM TAX (AMT)� ACE adjustment 28. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Adjustments 26. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Alternative tax net operating loss (ATNOL) 36. . . . . . . . . . . . . . . . . � Basis adjustment 27. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Computing 23. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Depreciation adjustment 26. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Elections to minimize AMT 43. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Depreciation and basis adjustments 43. . . . . . . . . . . . . . . . . . . �� Inventory elections for a C corporation 43. . . . . . . . . . . . . . . . . �� Section 59(e) optional amortization 44. . . . . . . . . . . . . . . . . . . .

� Employment�related credits 26. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Foreign tax credit 44, 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � General business credits 26. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Incentive stock options 44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Minimum tax credit 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � MTC carryover 39. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Preferences 28. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Repeal of AMT for small corporations 39. . . . . . . . . . . . . . . . . . . . . � Short period returns 26. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � U.S. production deduction 30, 36. . . . . . . . . . . . . . . . . . . . . . . . . .

ALTERNATIVE TAX ON CAPITAL GAINS� Generally 56. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

B

BUILT�IN GAINS TAX� Computation 74. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exchanged basis property 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Generally 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Net unrealized built�in gain 73. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � S corporations subject to 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Transferred basis property 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

C

C CORPORATION INCOME TAX� Controlled groups, share graduated rates and tax benefits 53. . � Other taxes imposed 56. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTROLLED GROUP� Definition 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Election to apportion tax benefits 55. . . . . . . . . . . . . . . . . . . . . . . . . � Graduated tax rates 55. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Member of 54. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � S corporation 72. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CREDITS� Alcohol fuels 90, 93, 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Alternative fuel refueling property 93. . . . . . . . . . . . . . . . . . . . . . . . � Alternative fuels 90. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Alternative motor vehicle credit 95. . . . . . . . . . . . . . . . . . . . . . . . . . � Biodiesel fuels 90, 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Carryover by an S corporation 98. . . . . . . . . . . . . . . . . . . . . . . . . . . � Disabled access 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Distilled spirits credit 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Employer�provided child care 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . � Empowerment zone employment 93. . . . . . . . . . . . . . . . . . . . . . . . � Energy 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Energy efficiency credits 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Enhanced oil recovery 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � FICA tax on tips 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Foreign tax credit 88. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Fuels credit 90, 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � General business credit 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Common credits making up 93. . . . . . . . . . . . . . . . . . . . . . . . . . �� Generally 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Limit on 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� When deductible 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Generally 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Hybrid vehicles 95. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Indian employment 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Low�income housing 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Mine rescue team 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Minimum tax credit

�� Allowable MTC 98. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Carryforward by a C corporation 97. . . . . . . . . . . . . . . . . . . . . . �� Generally 88, 97. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� New market tax 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � New York liberty zone 96. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nonconventional fuel 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Nuclear power facility 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Orphan drug 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Passive activity credit 87. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Pension start�up costs 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Producing oil and gas from marginal wells 93. . . . . . . . . . . . . . . . � Production of low sulfur diesel fuel 93. . . . . . . . . . . . . . . . . . . . . . . � Railroad track maintenance 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Reforestation 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Rehabilitation 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Renewable electricity 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Renewal community employment 93. . . . . . . . . . . . . . . . . . . . . . . . � Research credit 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Trans�Alaska pipeline 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Welfare�to�work 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Work opportunity 93. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

D

DEPOSIT OF POTENTIAL TAX TO SUSPEND INTEREST 17. . . .

DOMESTIC PRODUCTION ACTIVITIES� AMT adjustments 36. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

E

ESTIMATED TAX PAYMENTS� C corporation

�� Annualized or seasonal installment method 7. . . . . . . . . . . . . �� Applying for a quick refund of overpaid estimated tax 11. . . . �� Computing annualized income installments 8. . . . . . . . . . . . . �� Deemed asset sales 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Generally 6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Large corporation recapture rule 8. . . . . . . . . . . . . . . . . . . . . . . �� Pass�through income 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Required installment, general rule 7. . . . . . . . . . . . . . . . . . . . . . �� Short tax year 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� S corporation�� Annualized or seasonal installment method 16. . . . . . . . . . . . �� Following termination 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Generally 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Required installment, general rule 15. . . . . . . . . . . . . . . . . . . . .

EXCESS NET PASSIVE INCOME TAX� Computation 76. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Coordination with built�in gains tax 77. . . . . . . . . . . . . . . . . . . . . . . � Generally 75. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Termination of S status 77. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Waiver of tax 77. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

EXTENSION OF TIME TO PAY� Federal income tax 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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F

FORM 1120S (U.S. INCOME TAX RETURN FOR AN S CORPORATION) 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Extending time to pay tax 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Paying tax due

�� Depository method 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Electronic tax deposits 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Generally 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

FORM 1120 (U.S. CORPORATION INCOME TAX RETURN)� Extending time to pay tax 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Installment payment agreement 6. . . . . . . . . . . . . . . . . . . . . . . . . . . � Paying tax due

�� Depository method 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Electronic tax deposits 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Generally 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

I

INSTALLMENT PAYMENT AGREEMENT� Generally 6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

L

LIFO RECAPTURE TAX� Computation 78. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Generally 77. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Look�through for flow�through entities 77. . . . . . . . . . . . . . . . . . . . � Paying the tax 78. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

N

NET OPERATING LOSS (NOL)� Extension of time to pay tax 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P

PASS�THROUGH INCOME� Making estimated tax payments 16. . . . . . . . . . . . . . . . . . . . . . . . . .

PAYING TAX DUE� Depository method 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Electronic tax deposits 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Extending the time to pay 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

�� Net operating loss 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . �� Undue hardship 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

� Generally 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Installment payments 6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

PERSONAL HOLDING COMPANY TAX� Computation 67. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Definition of PHC 67. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Exemption from PHC status 67. . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Generally 67. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � PHC income test 67. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � Schedule PH 67, 68. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

R

RECAPTURE OF BUSINESS CREDITS� Generally 56. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

S

S CORPORATIONS� Taxes imposed on 71. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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Tax Planning for Businesses (DBPTG10)

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To enhance your learning experience, examination questions are located immediately following each lesson. Eachset of examination questions can be located on the page numbers listed below. The course is designed so theparticipant reads the course materials, answers a series of self�study questions, and evaluates progress bycomparing answers to both the correct and incorrect answers and the reasons for each. At the end of each lesson,the participant then answers the examination questions and records answers to the examination questions bylogging onto the Online Grading System. For more information on completing the Examination for CPE Credit,see the Testing Instructions above.

CPE Examination Questions Page

Lesson 1: Tax Payments 21. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 2: Alternative Minimum Tax 49. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 3: Business Income Taxes 83. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lesson 4: Tax Credits 102. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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Tax Planning for Businesses

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