Download - 2013 cch basic principles ch16 piii

Chapter 16

Partnerships, Corporations, and S CorporationsPart III: C Corporations

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CCH Federal Taxation Basic Principles 2 of 92

Chapter 16 Contents 1. Corporation Defined 2. C Corporations—Special Types 3. C Corporations—Tax Years 4. C Corporations—Accounting Methods 5. C Corporations—Tax Formula 6. C Corporations—Comparison with Individual Taxpayers 7. Income Items Requiring Special Treatment 8. Exclusions Requiring Special Treatment 9. Deductions Requiring Special Treatment—Organizational

Expenditures10. Dividends Received Deduction—Example 111. Dividends Received Deduction—Example 212. Deductions Requiring Special Treatment—Charitable Contributions13. Charitable Contributions—Example14. Deductions Requiring Special Treatment15. Deductions Requiring Special Treatment—Bond and Stock

Redemptions at a Premium16. Deductions Requiring Special Treatment—Compensation and

Educational Reimbursement

Chapter 16, Exhibit Contents A


17. Educational Expenses

18. Rules For Net Operating Losses (NOLs)

19. Net Operating Losses (NOLs)—Example

20. Capital Gains and Losses

21. Depreciation Expense

22. Code Sec. 291 Depreciation for Corporations—Example

23. Reconciling Book and Taxable Income

24. Corporate Tax Rates

25. Corporate Tax Credits

26. Template for Computing the Foreign Tax Credit/Deduction

27. Foreign Tax Credits—Example

28. Formation of Corporations—Overview of Code Sec. 351

29. Code Sec. 351 Contribution of Part Property/Part Services—Example

30. Code Sec. 351 Contributions—Tax Effect on Shareholders

Chapter 16, Exhibit Contents B

Chapter 16 Contents


30. Code Sec. 351 Contributions—Tax Effect on Shareholders

31. Code Sec. 351 Contributions—Tax Effect on Corporations

32. Code Sec. 351 Contributions—Example 1

33. Code Sec. 351 Contributions—Example 2

34. Nonstock Distributions—Effect on Shareholder of C Corporation

Chapter 16, Exhibit Contents C

Chapter 16 Contents


Definition of Corporation. Either an organization incorporated under state law, or an unincorporated association that has “checked the box” for corporate tax treatment on Form 8832 (Entity Classification Election). Code Sec. 7701; Reg. §301.7701-1 to 3.

Chapter 16, Exhibit 1a

Corporation Defined


Corporation Defined

Two Classifications of Corporate Entities.

C corporations. Taxpaying entities. (This results in what is known as a double tax effect. The corporation computes tax on the net income. When a corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns.)

S corporations. Not subject to regular corporate income tax. They are treated in a manner similar to partnerships, i.e., as pass-through entities, in that net profit or loss flows through to the owners to be reported on their separate returns.

Chapter 16, Exhibit 1b


C Corporations—Special Types

Professional association [PA]. An association of professionals (e.g., accountants, doctors, lawyers) treated as a C corporation for tax purposes if it has:

a. Organized under a state’s Professional Association Act; AND

b. “Checked the box” on Form 8832 for corporate tax treatment. [One individual may be a professional association.]




Personal Service Corporation [PSC]. C corporation whose shareholder-employee(s) owns over 10% of the stock and provides personal services (e.g., acting, entertainment, medical, legal, consulting, or other services performed through their personal efforts). Generally, a PSC must use a calendar tax year. Code Sec. 441(i). PSCs are subject to a flat 35% tax rate.




Chapter 16, Exhibit 2c

Personal Holding Company [PHC]. A nonexempt, closely held corporation, with a significant portion of its income that is passive in nature (e.g., from dividends or interest). PHCs are subject to a 15% penalty tax on excess personal holding company income in addition to the regular corporate income tax.



Chapter 16, Exhibit 2d

Q: When is a corporation deemed to be “closely held”?

A: When more than 50% of the value of the outstanding stock was owned by five or fewer individuals during the second half of the year.

Q: When is passive income deemed to be “significant”?

A: When passive income is 60% or more of “adjusted ordinary gross income” [AOGI]. AOGI is gross income less capital gains and Code Sec. 1231 gains, less adjustments such as certain expenses connected with rental and royalty income.


C Corporations—Tax Years

Every newly organized corporation other than a personal service corporation (PSC) has the unrestricted right to select its annual tax year, regardless of the tax years employed by its shareholders.

PSCs generally must use a calendar year-end. However, they may use a fiscal year-end under the same conditions as listed for S corporations.

Chapter 16, Exhibit 3


C Corporations—Accounting Methods

Most corporations must use the accrual method.

The cash method MAY be used by C corporations that have average annual gross receipts of $5 million or less in the three preceding years, or by PSCs.



C Corporations— Tax Formula

Net Tax Due or Refundable =

Personal Holding Co. Tax (If Any) +

Accumulated Earnings Tax (If Any) +

FICA Taxes +

Alt. Minimum Tax (If Any) +

Net Regular Tax Liability =

Credits (If Any) –

Gross Regular Tax Liability =

Tax Rate x

Taxable Income (Loss) =

Deductions –

Gross Income =

Cost of Goods Sold –

Exclusions –

Ord. and Cap. Income “From Whatever Source Derived”



C Corporations—Tax Formula

AGI, standard deductions, personal exemptions, at-risk rules, and passive activity loss rules do not pertain to regular C corporations.



C Corporations—Comparison with Individual Taxpayers


Capital contributions.

Gain/loss on sale of treasury stock

Most exclusions receive the same tax treatment.

Different TreatmentSimilar Tax Treatment

Exclusions

Bond Redemptions – Discounts.

Sinking fund income.

Most items of gross income receive the same tax treatment.

Cost of goods sold (actually, part of gross income) are similar.

Different TreatmentSimilar Treatment

Income


C Corporations—Comparison with Individual Taxpayers


Organizational Expenditures Dividend Received Deduction Charitable Contribution Interest Expense Amortization of Original Issue Bond Redemptions-Premiums Stock Redemptions (not deductible) Compensation Educational Expenses Net Operating Losses Capital Gains and Losses

Travel, Meals and Entertainment Insurance Premiums Research and Experimental Fines (not deductible) Bad Debts Worthless Securities Casualty Losses (same as individuals’ business use

casualty losses) Taxes Depreciation (except Sec. 1250 recapture) Amortization Depletion Political Contributions & Lobbying Business Investigation Expense Business Start Up Expense

Different TreatmentSimilar Tax Treatment

Expenses


Income Items Requiring Special Treatment

Bond Repurchases.

A corporation’s income INCLUDES the original issue price of its own bonds being repurchased,

MINUS (i) The repurchase price,

MINUS (ii) Any premium already recognized on the original issuance.

PLUS (iii) Any discounts previously deducted.

Sinking Fund Income.

Interest or other income from property in a sinking fund established to satisfy an obligation IS INCLUDED, even if in the hands of a trustee (since both funded and nonforfeitable).



Exclusions Requiring Special Treatment

Treasury Stock.

No gain or loss is recognized by a corporation on the sale or exchange of its own stock.




Capital Contributions.Gifts from nonshareholders are excluded.

Noncash gifts. If a gift is property other than money, the corporation carries it with a zero basis. Cash gifts. When cash is contributed, reduce the basis of corporate property in the following order:

(i) Property acquired within 1 year after the contribution;

(ii) Then depreciable property in proportion to relative bases;

(iii) Then, if there is a remaining balance, NON-depreciable property acquired over 1 year after the contribution.




Pro rata contributions from shareholders are excluded.

Whether voluntary or by assessment, shareholder contributions are excluded from corporate income. The corporation carries the property at the same basis as had been reported by the contributing shareholder. That shareholder gets no deduction, but does get an increase in stock basis, equal to the basis in the property contributed.



Deductions Requiring Special Treatment—Organizational Expenditures

Amortizable expenditures.

Organizational expenses qualify for amortization if:

(a) = Incurred incidental to formation of the corporation (e.g., legal fees for drafting the charter, state incorporation fees, expenses for temporary directors and organizational meeting costs), and

(b) = Incurred before the end of the tax year in which the corporation commences business.

Amortization period must be over 180 months, starting with the month that the corporation commences business.



Nonamortizable expenditures. Organizational expenses DO NOT qualify for amortization if related to the transfer of assets to the corporation or the issuance and sale of stock (e.g., printing stock certificates, professional fees for issuing stock and broker’s commission on the sales of stock.) They are written off when the corporation completely liquidates.


Deductions Requiring Special Treatment—Organizational Expenditures


Dividends Received Deduction—Example 1

“Affiliated” means owning 80% of both voting power and value of stock.

ATI = Revenue - COGS - Operating expenses + Other income

(Another way to arrive at ATI is to start with taxable income and purge out three possible deductions: ATI = TI + (1) Actual DRD + (2) NOL carryover + (3) Capital loss carryover).

100% ATI 100% div. received ---80% & affiliated

80% ATI 80% div. received 80% 20%

70% ATI 70% div. received 20% ---

<

Tentative* DRD Limit:

* (Does not apply if DRD would create an NOL)

Tentative* DRD:

* (Subject to limit if DRD would NOT create an NOL)

% Ownership

(Value and Voting)

Dividends Received Deduction (DRD)

Dividends received from other corporations are included by both corporate and individual shareholders, but deductible only by corporate shareholders within limits explained below.



FACTS:

C Corp. has the following income and expenses:

Operating Revenue 800,000

COGS (300,000)

Operating expenses (520,000)

Other income (dividends received from a 25%-owned corp.) 100,000



CCH Federal Taxation Basic Principles 25 of 92Chapter 16, Exhibit 10c

Tax = $2,400 [From tax tables: 15% x $16,000 = $2,400]

(f) = (e) x appropriate tax rates

(f) Compute tax

TI =$16,000 [= ATI - DRD = 80,000 - 64,000] (e) = (a) - (d) (e) Compute TI

Actual DRD = $64,000 $80,000 ATI - $80,000 tentative DRD is 0;

therefore, DRD = the lesser of:

$64,000 tentative DRD limit, or $80,000 tentative DRD

(d)

If (a) - (c) 0, then (d) = the lesser of (b) or (c)

If (a) - (c) < 0, then (d) = (c)

(d) Determine actual DRD

Tentative DRD = $80,000

[= 80% x $100,000] (c) = 70% or 80% or 100% x Div. Rec’d

(c) Compute tentative DRD

Tentative DRD Limit = $64,000

[= 80% ATI = 80% x 80,000]

(b) = 70% or 80% or 100% x ATI

(b) Determine tentative DRD limit

ATI = $80,000

[= 800,000 - 300,000 - 520,000 + 100,000] (a) = Rev. - COGS - Oper. exp. + Other inc.

(a) Compute ATI (i.e., taxable income before special deductions)

Note: The relevant DRD % is 80% since C Corp. owned 20% and < 80% of stock.




FACTS:

Same as Example 1 except operating expenses are $520,001, not $520,000.

SOLUTION:

ATI = $79,999 [= 800,000 - 300,000 - 520,001 + 100,000] Tentative DRD Limit = $63,999 [= 80% ATI = 80% x 79,999 = 63,999] Tentative DRD = $80,000 [= 80% x $100,000] Actual DRD = $80,000 [Same as tentative DRD, since $79,999 ATI -

$80,000 Tentative DRD is < 0.] TI = $(1), an NOL [= ATI - DRD = 79,999 - 80,000] Tax = $0



Note that in Example 1, the tentative DRD limit applies since the DRD does not create an NOL. In Example 2, where operating expenses are $520,001 instead of $520,000, the tax results are much more favorable. An additional $1 of operating expenses saves $2,400 of taxes!




Charitable contributions. As with individuals, corporate charitable contributions are deductible if made to qualified organizations. [i.e., Code Sec. 501(c) organizations]. Also, as with individuals, corporate contributions in excess of deductions are carried forward 5 years. No carrybacks are allowed for corporations or individuals. The following DIFFERENCES distinguish corporate tax treatment from individual tax treatment.


Deductions Requiring Special Treatment—Charitable Contributions


= TI (i.e., after all deductions)

Addback:

+ DRD

+ NOL carryback

+ Capital loss carryback

+ Charitable deductions

Another way to compute ATI:

= Rev. - COGS - Operating expenses + Other income

ATI for Charitable Deduction Computations.


10% ATI limitation. Deductions are limited to 10% ATI. What is ATI?



2 1/2 Month Rule. If a charitable contribution is board-approved in the current year and paid within 2 1/2 months of the subsequent year, then a deduction is allowed in the current year. Not so for individuals.

Inventory. Generally, as with individuals, corporations may deduct only the basis of inventory contributed. However, corporations may deduct 50 percent of market value if the inventory is donated solely for care of infants, the ill, or the needy.




Charitable Contributions—Example

FACTS: C Corp.’s taxable income BEFORE the charitable deduction

was $410,000. C Corp. contributed $40,000 to a qualified charitable

organization. Included in the $410,000 is a $20,000 DRD. C Corp. also has a $5,000 carryover contribution from a prior

year (not part of the $410,000).

QUESTION:

How much is the charitable deduction?



SOLUTION: $43,000

1. ATI = $430,000 [410,000 + 20,000]

2. 10% ATI Limitation = $43,000

[10% x 430,000 = 43,000]

3. Contribution = $45,000

[40,000 current year + 5,000 carryover]

4. Deduction = $43,000 [ Lesser of 2. or 3. above]


Charitable Contributions—Example


Deductions Requiring Special Treatment

Interest Expense. Interest expense on a corporation’s own debt is fully deductible, even if in connection with the repurchase of its own stock. Recall that individuals’ investment interest deductions are limited to net investment income. Not so with corporations.



Original Issue Discounts. OID is deductible as interest expense.

(1) Pre-7/1/82 issue bonds. Discount may be amortized using the straight-line method over the life of the bonds.

(2) Post-6/30/82 issue bonds. For bonds issued on or after 7/1/82, discounts from face value must be amortized using the effective yield method.





Example on OID, Post-6/30/82 Bonds (Effective Yield Method)

Facts: 3/1/x1: A corporation hired an investment banking firm to underwrite and sell 5-

year, $10,000 bonds. 6/15/x1: The bonds were printed when the market yielded 10% on five-year bonds of

comparable risk. Accordingly, the investment banking firm set the coupon rate at 10%.

6/15/x1 - 6/30/x1: The market yield on comparable five-year bonds rose to 12%. 6/30/x1: Five-year, $10,000, 10% bonds were issued to the public. Since the market

then yielded 12%, the bonds had to be discounted to $9,250 to be saleable.

Question: How much OID is deductible on one $10,000 bond in 20x1 and 20x2?

Solution: 20x1: $55.00; 20x2: $120.10 (i.e., $120.10 = $58.30 + $61.80)



* AIP = Adjusted Issue Price, the original issue price increased by the OID deduction.

9,425

9,363 + 61.80 = 9,425

61.80 500 561.80

[9,363 x (12% x 1/2)] 9,363 20x2

(2nd half)

9,363

9,305 + 58.30 = 9,363

58.30 500 558.30

[9,305 x (12% x 1/2)] 9,305 20x2

(1st half)

9,305

9,250 + 55 = 9,305

55.00 500

[1,000 x 1/2]

555.00

[9,250 x (12% x 1/2)]

9,250 20x1

(2nd half)

AIP,

End. Bal. *

OID Deduction

Less: Interest Payment Deduction

x 12% yield AIP, Beg Bal. *

Year

(e) = (a) + (d) (d) =

(b) – (c)

(c) =

10m x 10%

(b) = (a) x 12% (a)

Solution




Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium

Repurchasing Bonds at a Premium. A corporation that repurchases its bonds may deduct as interest expense the excess of the repurchase price over the adjusted issue price.

Repurchasing Stock at a Premium. Amounts paid to repurchase stock are not deductible. Both acquiring and target corporations may capitalize legal fees, invest banker fees and other cost associated with a takeover.



Deductions Requiring Special Treatment—Bond and Stock Redemptions at a Premium

SOLUTION:

$375 (i.e., $9,800 payment, less $9,425 AIP balance)

QUESTION:

How much of the payment premium is deductible in the year 20x1 as interest expense?

FACTS: ABC Corporation buys back one $10,000 bond on 1/1/x1 at a repurchase price of $9,800. The adjusted issue price (AIP) on the bond is $9,425 as of 1/1/x1.

Example on Repurchasing Original Issue Bonds at a Premium



Deductions Requiring Special Treatment—Compensation and Educational Reimbursement

Compensation. Four independent rules:

(1) Unreasonable compensation to a shareholder is generally treated as a dividend, to the extent of earnings and profits.

(2) Informal short-term arrangements. Payments made by March 15 of the succeeding year may be accrued and expensed in the current year if related to services incurred in the current year.




(3) Executive Compensation Limitations. Deductible compensation for the top five executives of publicly traded companies is limited to $1,000,000 for each executive unless performance based.

(4) Restricted Stock. Compensation to an employee in the form of stock is deductible when the employee reports the amount as ordinary income. Employees must include the market value of stock received for services in GI when (i) it is not subject to a substantial risk of forfeiture, and (ii) its value is ascertainable.



SOLUTION:

20x1: No TI to employee; no deduction to employer.

20x7: $1,500 ordinary income to employee; $1,500 corporate deduction 1,500 [2,000 - 500]

QUESTION:

What is the timing and amount of the employee’s taxable income & the corporate employer’s deduction?

FACTS: 20x1: Employee purchases restricted stock (FMV = $1,000) from employer-corporation for $500. The stock is forfeitable until the employee serves the employer 6 years. 20x7: After 6 yrs., the restriction is lifted when the FMV = $2,000.

Example on Restricted Stock Compensation:




Educational Expenses

An employer’s expenditures for employee education are deductible as business expenses. An individual, in contrast, may deduct only educational expenses required to maintain or improve skills in a present position



Rules for Net Operating Losses (NOLs)

Same as corporate. May elect to forego carrybacks.

Election:

Deduction for AGI in a subsequent year.

Deduction from gross income in a subsequent year.

If carried forward.:

Same as corporate. Prior taxable income (TI) is recomputed, & taxpayer files for a refund with an amended return.

If carried backward:

Same as corporate. 2 years back, 20 years forward. [For pre-8/5/97 NOLs: 3 yrs. back; 15 yrs. forward.]

Carryovers

[NOLs from tax years beginning after 8/5/97.]:

Same general definition as corporate.

Excess business exp. over bus income

Definition of NOL

Proprietorships Corporations

Comparison of NOL Rules Between Corporations and Proprietorships


CCH Federal Taxation Basic Principles 44 of 92Chapter 16, Exhibit 18b

Comparison of NOL Rules Between Corporations and Proprietorships

ProprietorshipsCorporations

(Unlike individuals, corporations need not make adjustments to NOL for capital gains or losses. Also, corporations are permitted the full DRD in computing NOLs.)

TI (a negative amount)+ NOL Carryovers+ Alimony+ IRA contributions+ Nonbus. CLs in XS of nonbus. CGs+ Std. or itemized deductions, except personal casualty. deductions are not added back.+ Personal exemptions- Interest income- Dividend income- Nonbus. CGs in XS of nonbus. CLs- Other nonbusiness inc. (except wages are not subtracted.)= NOL

TI (a negative amount)

+ NOL Carryovers

Deducted

+ Charitable deductions

= NOL

[Note that DRD is not added back; also net capital losses are not added back since they aren’t deductible in the first place.]

Calculation

Rules for Net Operating Losses (NOLs)


Net Operating Losses (NOLs)—Example

FACTS: Fred Corporation had $100,000 sales and $135,000 expenses, plus a

$(30,000) NOL carryover from 20 years ago. Fred Corporation also had the following income and expenses:

$1,000 interest income on a savings account; $70,000 dividends from a 30% - owned corporation; $1,500 LTCG on the sale of business property; $(10,000) STCL on the sale of stock; $ 9,000 LTCG on the sale of a painting held for investment; $ (6,000) charitable contributions.

QUESTION: Compute Fred Corporation’s NOL.


CCH Federal Taxation Basic Principles 46 of 92Chapter 16, Exhibit 19b

(53,150) Taxable income =

10% ATI where ATI = (35,000) + 1,000+ 70,000 +500

(3,650) Charitable deduction

The lesser of:

(1) $6,000; or (2) 10% ATI

–

1,500 - 10,000 + 9,000 500 Net LTCG +

80% x 70,000 (56,000) DRD –

70,000 Dividends received +

1,000 Interest income +

(30,000) NOL carryover –

100,000 - 135,000 = (35,000) (35,000) Operating loss

Taxable Income = $(53,150):



(19,500) NOL =

3,650 Charitable deduction +

30,000 NOL carryover +

(53,150) TI

NOL = $(19,500):



Capital Gains and Losses

Carry forward (not back) indefinitely

3 yrs. back, 5 yrs. fwd. (Unlike with NOLs, no election allowed to forgo carrybacks.)

Carryovers:

Deductible up to $3m ($1.5m if married filing separately.)

Not deductible Net long-short-term capital losses:

Ord. ind’l tax rates, no limit Ordinary corporate tax rates Tax on net short-term capital gains:

Ord. ind’l rates, up to 10%/15%/20%/28%

Ordinary corporate tax rates Tax on net long-term capital gains:

Requires netting among several “rate baskets”

Requires netting from a single “rate basket”

Determining long/short-term capital gains/losses:

IndividualsCorporations

Comparison Between Corporations and Individuals



Capital Gains and Losses

Net nonbusiness capital losses are added back to taxable income (TI).

(Note that they are always $3,000);

Net nonbusiness capital gains are subtracted from TI.

Net capital losses are never part of NOL since they are not deductible. Therefore, no addback to taxable income (TI).

Net capital gains are not subtracted from TI (i.e., capital gains reduce NOLs).

Computing NOL:

Long/short-term loss carryovers retain their character.

Long and short-term capital losses carried over as short-term

Character of capital loss carryovers:

IndividualsCorporations

Comparison Between Corporations and Individuals



Depreciation Expense

Depreciation Including Code Sec. 179. Generally, the rules for corporations are identical to the rules for proprietorships. However, for Code Sec. 1250 assets, an additional recapture amount is required under Code Sec. 291.



Depreciation Expense

Code Sec. 291 Exception for Corporations. For corporations, realized gain must be characterized as Code Sec. 291 ordinary income (OI) to the extent of 20% of any excess of “pretend” Code Sec. 1245 OI over Code Sec. 1250 OI.



Code Sec. 291 Depreciation for Corporations—Example

FACTS:

1/1/x1: ABC Corp. acquired an office building for $450,000.

1/1/x1 - 12/31/13: The building was depreciated using 15-year straight-line.

1/1/14: The building was sold 13 years later for $240,000.

QUESTION: Compute Code Sec. 291 OI and Code Sec. 1231 gain.



< of 390,000 or 180,000 180 “Pretend” Sec. 1245 OI

(f)= < of (c) or (e)

180 Realized gain (e)=(a)-(d)

60 Adjusted Basis (d)=(b)-(c)

(450,000 15 years) x 13 yrs, (ignoring mid-month convention)

390 Accumulated

Depreciation

(c)

450 Cost (b)

Adjusted Basis:

240 Sales Price (a)

Computations: 000’s DescriptionFormula:

SOLUTION:




180,000 - 36,000 144 Sec. 1231 cap. gain (j) = (e) - (i)

180,000 x 20% 36 Sec. 291 OI (i) = (h) x 20%

180 Excess “pretend” Sec. 1245 OI

(h) = (f) - (g)

“$0” since ACRS (i.e., accelerated depreciation) was not used.

0 OI under Sec. 1250 (g)= Excess accel depr. over S/L depreciation.

Computations: 000’s DescriptionFormula:

SOLUTION:




Form 1120. A corporation files its federal return on Form 1120.

Schedule M-1. Reconciling accounting and tax income is done on Schedule M-1 of Form 1120. M-1 addresses differences, both permanent and temporary, between accounting and tax income. The differences are caused by using different accounting and tax methods to report income and expenses. In addition to tax reporting, the M-1 is also useful for tax planning.


Reconciling Book and Taxable Income


7,000 Charitable contribution carryover

5,000 XS MACRS over S/L depreciation (S/L is used for accounting purposes.)

10,000 Life ins. proceeds received due to death of key employee

1,000 Premium paid on life insurance for key employees (ABC = Beneficiary)

1,250 Net capital loss (in XS of CGs)

3,000 Tax-exempt interest on Municipal bonds

13,750 Federal income taxes

11,000 Rent received in advance (booked as a liability)

88,000 Net income per books, after taxes

FACTS:

ABC Corp. reports the following results of operations:

Example on M-1 Reconciling Items




90,000 Taxable income =

11,000 Future rent received in advance. +

Taxable income not booked for accounting purposes

(10,000) Life insurance proceeds received on death of key employee

(3,000) Tax-exempt interest on municipal bonds

Income per books not taxable: –

(7,000) Charitable contribution carryover

(5,000) XS MACRS depr. per tax return over S/L depreciation per books

Deductible expenses not booked for accounting purposes: –

1,000 Insurance premiums (not deductible since ABC is a beneficiary)

1,250 XS capital losses over capital gains (not tax deductible)

13,750 Federal income tax expense (not tax deductible)

Expenses per books that are not deductible: +

88,000 Net income per books

Prepare an M-1 reconciliation and compute taxable income.

Example on M-1 Reconciling Items:



Corporate Tax Rates

39% (3rd + 5% surcharge)

35% (4th bracket) 18,333,333 Over

38% (4th + 3% surcharge) 18,333,333 15,000,000

35% (4th bracket) 15,000,000 10,000,000

34% (3rd bracket) 10,000,000 335,000

335,000 100,000

34% (3rd bracket) 100,000 75,000

25% (2nd bracket) 75,000 50,000

15% (1st bracket) $ 50,000 $ 0

Marginal Tax Rate: But Not Over: At Least:

Tax Rates on Corporate Taxable Income

Computing Regular Income Tax. Corporations are subject to the 4-bracket graduated tax rate structure below.



Surtaxes imputed in the table from the previous slide. A 5% surtax is charged on TI between $100,000 and $335,000,

which eliminates the “tax savings” on the first $100,000 of TI. A 3% surtax is charged on TI between $15,000,000 and

$18,333,333, which recaptures the “tax savings” from $335,000 to $10,000,000.

Capital gain rates. Same as ordinary rates. No rate breaks as with individual tax rates.

Capital losses. Not deductible as with individuals, offset only against capital gains.

Personal Service Corporations. Taxed at a flat rate of 35% on all taxable income (TI).


Corporate Tax Rates


Controlled group of corporations. Rates are applied to the aggregate TI of the group as if it were a single corporation. A controlled group a parent corporation and one or more subsidiaries in which the parent owns EITHER:

(a) 80% total voting power of Subsidiary, or

(b) 80% total value of Subsidiary’s stock.

Any additional corporation with an 80% connection to any member of the controlled group becomes part of the controlled group.


Corporate Tax Rates


Corporate Tax CreditsGeneral Availability of Credits. Most tax credits available to individuals are available to corporations. Exceptions include:

• Earned income credit;• Child and dependent care credit;• Elderly and disabled credit;• Hope credit;• Lifetime Learning credit;• Adoption credit.

Foreign Tax Credit (FTC) or Deduction (FTD). A U.S. citizen or resident alien may elect either a credit or a deduction “FOR” AGI, on taxes paid to other countries or U.S. possessions. The maximum amount credited or deducted is determined from the following table.



Template for Computing the Foreign Tax Credit/Deduction

FTCs are credited against gross tax liability before all other credits.• FTDs are deductible from gross income.• FTC’s usually result in greater tax benefits than FTDs.• Unused foreign tax credits or deductions are carried back 2 years and then carried

forward 5 years.• For nonresident aliens, FTC is allowed to reduce U.S. tax on U.S. income but only to

the extent that foreign taxes have been paid on U.S. income.

Foreign tax credit or deduction. (f) = < (d) or (e)

Foreign taxes actually paid on worldwide TI. (e)

Allocation amount. (d) = (a) x [(b) (c)]

Worldwide taxable income. (c)

Foreign source taxable income (TI). (b)

U.S. income tax before the foreign tax credit or deduction. (a)



Foreign Tax Credits—Example

34,000 Foreign tax credit or deduction. (f) = < (d) or (e)

45,000 Foreign taxes actually paid on worldwide TI. (e)

34,000 Allocation amount. (d) = (a) x [(b) (c)]

500,000 Worldwide taxable income (c)

100,000 Foreign source TI (b)

$170,000 U.S. income tax before the FTC or FTD. (a)

SOLUTION:

QUESTION:

What is U.S. Corp.’s FTC or FTD?

FACTS:

U.S. Corp. has worldwide TI of $500,000, and a tentative U.S. tax liability of $170,000. From its Chinese operations, U.S. Corp. had $100,000 of TI on which a $45,000 Chinese tax was paid.



Formation of Corporations—Overview of Code Sec. 351

What is the general rule on transferring property to a corporation in exchange for stock?

Code Sec. 351 requires that no gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation and immediately after the exchange, such person or persons control the corporation. This nonrecognition treatment is mandatory, not elective. Note that Code Sec. 351 protects only the transfer of property. It does not protect the transfer of services. Also, Code Sec. 351 applies even after a corporation has been formed.




What was Congress thinking when it enacted Code Sec. 351?

There are two reasons for Code Sec. 351. First, as the stockholders receive only stock, they may not have the wherewithal to pay taxes. Second, the incorporation of a going concern is not an economic transaction but rather a change in legal form only.



What is “control”?

Control is ownership by all transferors of property of 80% or more of BOTH the voting power AND the value of all classes of stock. Do not include the % ownership of transferors of services in this determination.




What is “property”?

Consistent with Code Sec. 351(d) “property” includes just about everything except services. (i.e., cash, inventory, receivables, land, other tangible assets, nonexclusive licenses, and industry know-how.)




Why are “services” NOT “property’?

Under Code Sec. 351(d)(1), services are NOT property to ensure that a person who provides ONLY services to a corporation (1) will be taxed immediately (on the FMV of stock received); and (2) will NOT be included in the 80% control computation.

Chapter 16, Exhibit 28e



How does Code Sec. 351 apply if a person contributes both property and services?

The receipt of stock attributable to services will generally be treated as a separate transaction outside the scope of Code Sec. 351. [However, the stock received in exchange for part property, part services will ALL be included in the 80% control computation!]

Chapter 16, Exhibit 28f



Code Sec. 351 Contribution of Part Property/Part Services—Example

SOLUTION 1: Yes, B’s stock attributable to services counts in the “control” computation—and control by A and B after the exchange is 100%. Since control immediately after the exchange 80%, the exchange qualifies as a Code Sec. 351 exchange.

QUESTION 1: Has the 80% control requirement been met under Code Sec. 351?

FACTS:

A transfers land worth $50,000, and B transfers land worth $15,000 and contributes services worth $35,000 to X Corp. in exchange for all of the stock of X.




SOLUTION 2: Then B’s stock would not count in the control computation, and control immediately after the exchange would be limited to A’s 50%. Since 50% < 80%, this would not have been a Code Sec. 351 exchange.

QUESTION 2: What would be the result if B contributed ONLY services?

FACTS:





SOLUTION 3: No, services are not property under Code Sec. 351(d)(1). Therefore, B will recognize $35,000 OI as compensation for his services.

QUESTION 3: Can B get Code Sec. 351 tax free treatment for the $35,000 services contributed?

FACTS:




Code Sec. 351 Contributions—Tax Effect on Shareholders

What is the recognized gain of shareholders in a Code Sec. 351 transfer of property for stock?

Code Sec. 351(b) provides that a shareholder’s recognized gain will be the smaller of (1) boot received or (2) realized gain. (Students should not confuse Code Sec. 351 boot with Code Sec. 1031 “net boot received”—that term applied to like-kind exchanges under Code Sec. 1031.) Here, boot is money and the FMV of property other than the common stock of the corporation received in the exchange. Also, under Code Sec. 358(c), a shareholder liability assumed by the corporation is boot if it exceeds the AB of all property contributed by the shareholder. If not, then it’s not boot.




How is the basis of the stockholder in the stock determined?

Code Sec. 358 provides the following formula (referred to as the “front-in” approach):

AB in contributed property

– FMV of boot received, including liabilities assumed by corporation that ARE boot

– Liabilities of shareholder assumed by corporation that are NOT boot. Code Sec. 358(d)

+ Gain recognized by the shareholder

– Loss recognized by the shareholder

= SHAREHOLDER BASIS OF STOCK.




How is a shareholder’s holding period in the stock determined?

The holding period of the property contributed tacks on to the stock received. If several properties have been contributed, the stock will have a split holding period!

What is a shareholder’s basis and holding period in the boot received?

The shareholder’s basis in boot received is generally the corporation’s basis (not FMV). The holding period of boot received does not tack on as does stock received. Instead, it begins on the day AFTER receipt.



Code Sec. 351 Contributions—Tax Effect on Corporations

What is the corporation’s basis in the assets transferred by shareholders?

Code Sec. 362 provides that the basis of assets received by a corporation in a Code Sec. 351 transfer will be (a) + (b), where:

(a) = Shareholder’s basis in contributed property(b) = Gain recognized by the shareholder, allocated using

relative FMVs.(a) = (a) + (b) = Corporation’s basis in assets contributed by

S/H.



Code Sec. 351 Contributions—Tax Effect on Corporations

What is the corporation’s holding period in the assets contributed by a shareholder?

Same as the holding period of the shareholder.

Does the corporation recognize gain or loss on the exchange of its stock for property under Code Sec. 351?

No, never.

What about property other than stock transferred by the corporation?

If a corporation transfers other property to shareholder, then YES, it generally recognizes gain (but not loss) based on [FMV - AB].



6,000,000 Bldg. mtg.assumed by corporation

3,000,000 2,000,000 Basis, 12/31/x1

14,000,000 1,000,000 FMV, 12/31/x1

Began 8/19/x1 Began 3/21/97 Holding period

Building Land

Facts: On 12/31/x1, Dennis forms a new corporation and receives 100% of the corporation’s stock after contributing the following property:


Code Sec. 351 Contributions—Example 1


Question:Compute the following items: Dennis’ realized gain. Dennis’ boot received. Dennis’ recognized gain. Dennis’ postponed gain. Dennis’ basis in the stock received. Dennis’ holding period in the stock received. The corporation’s basis in the land and building contributed by Dennis. The corporation’s holding period in the land and building.





4 Note: Dennis’ stock is not publicly traded. However, its value may be assumed to be equal to the net value of assets received by the corporation:FMV of land........................... 1+ FMV of bldg......................+ 14- Mtg. assumed by corp....... (6)= Net value of assets .(i.e., Dennis’ amt. realized)........... 9- Basis of contributed property (2mm land + 3mm bldg)..... 5 = Dennis’ realized gain.......... 4

(a) = Amt. Realized

- Basis of contributed property

= Realized gain

(Similar to rules for any disposition)

(a) Dennis’ realized gain

000’sComputation FormulaSolution:




1 Dennis’ debt relief.................... 6

- Basis of contributed property

(2mm land + 3mm bldg)...... (5)

= Excess debt relief..........…... 1

+ FMV of other boot received.. 0

= Dennis’ total boot received.. 1

(b) = Excess debt relief (i.e., debt relief —AB of assets contributed)

+ FMV of other boot received

(b) Dennis’ boot received:

000’s Computation FormulaSolution:



3 (d) = 4,000,000 – 1,000,000 = 3,000,000

(d) = (a) - (c)(d) Dennis’ postponed gain:

1 (a) = 4,000,000

(b) = 1,000,000

(c) = 1,000,000 (the lesser amount)

(c) = Lesser of (a) or (b)

(Similar to “like-kind” exchange rules)

(c) Dennis’ recognized gain

000’s Computation FormulaSolution:

Chapter 16, Exhibit 32e




0

000’s

Back-in approach:

(Here, the stock’s FMV must first be “plugged” from amount realized):

FMV of stock:

Amt realized........ 9

- Debt relief.......... (6)

= Stock FMV........ 3

Stock basis:

Stock FMV......... 3

-Postponed gain....(3)

= Stock basis......... 0

Front-in approach:

Stock basis:

+ AB in cont’d

property....... 5

- Boot rec’d... (1)

- Debt relief,

nonboot ....... (5)

+ Gain recog’d.. 1

- Loss recog’d.. 0

= Stock basis ... 0

Dennis’ stock basis can be determined two ways: Using the Sec. 358 formula, i.e., the “front-in” approach (shown above) Using the “back-in” approach, as was done for like-kind property received

(e) Dennis’ basis in the stock received:

Computation FormulaSolution:

Chapter 16, Exhibit 32f


000’s

HP of 1/15 share begins on 3/21/97; HP of 14/15 share begins on 8/19/x1.

(Thus, as of 12/31/x1, 1/15 of each share is deemed to be long-term, and 14/15 short-term!)

(f) = Same as holding period of the contributed property

Note 1. Since more than one property was contributed for the stock, each share will have a split holding period (HP).

Note 2. The HP rules for Sec. 351 stock is similar to HP rules for like-kind assets received under Sec. 1031.

(f) Dennis’ holding period in the stock received:


Chapter 16, Exhibit 32g



(Same as Dennis’ HP)

Bldg.

8/19/x1

Land

3/15/97HP beginning date

(h) = Same as shareholder’s HP

(h) The corporation’s holding period in assets received:

Bldg.3,000,000

933,333

3,933,333

000’s

Land2,000,000

66,667

2,066,667

Dennis’ asset basis

+ Alloc. of recog. gain:

1 mm x [ 1 (1 + 14)]

1 mm x [14 (1 + 14)]

Corporation’s basis

The corporation’s basis in the land and building can be determinedusing the Sec. 362 above.

(g) The corporation’s basis in the assets

received:


Chapter 16, Exhibit 32h





The FMV of the stock is $1,000 per share. Ellsworth’s land is subject to a $10,000 mortgage which the corporation assumed.

100$110,000 TOTALS

1011,000 10,000EquipmentTebessum

6020,000 70,000LandEllsworth

30$ 0$ 30,000ServicesAnu

# shares issuedAB to S/HFMVAssetStockholder

FACTS:

Anu, Ellsworth, and Tebessum decided to pool their efforts and form a corporation. They made the following contributions to the corporation:


QUESTION 1: Does this transfer of assets qualify for Code Sec. 351 treatment?

SOLUTION 1: No, Anu is not a transferor of property. Only Ellsworth and Tebessum can be included in the control computation. Since their combined control is only 70% [(60 + 10) 100], the 80% control requirement has not been met. What would be the result if Anu had also contributed $1.00?




Basis of stock

(AB - debt relief + recog’d gain - recog’d loss)

Basis of the land to the corporation: $20,000. (Ellworth’s AB of $20m + $0 gain recognized by Ellsworth)

11,000 (11m -0 + 0)0 ($0 boot received)(1,000) (10m - 11m)Tebessum

10,000 (20m - 10m + 0)0 ($0 boot received)50,000 (70m - 20m)Ellsworth

30,000 (0 - 0 + 30m)30,000 (services income)

30,000 (30m - 0)Anu

Recog. Gain/Loss

(< Real gain or boot rec’d)

Realized G/L

(FMV - AB)

Stockholder

SOLUTION 2:

QUESTION 2: Assuming the previous transaction did qualify under Code Sec. 351, fill in the blanks below. (Answers provided.)




10,000 (11,000 – 0 – 1,000) (1,000) (1,000) Tebessum

60,000 (20,000 – 10,000 + 50,000) 50,000 50,000 Ellsworth

30,000 (0 - 0 + 30,000) 30,000 30,000 Anu

Basis of stock

(AB – debt relief + recog’d gain – recog’d loss)

Recog. G/L

(FMV – AB)

Realized G/L

(FMV – AB)

Stockholder

SOLUTION 3:

QUESTION 3: Assuming the previous transaction did NOT qualify under Code Sec. 351, fill in the blanks below. (Answers provided.)




What is the amount of “distributions other than stock”?

The amount of distribution other than stock of the corporation is:

(a) - (b), where

(a) = The fair market value of all property received (other than the common stock of the distributing corporation).

(b) = Liabilities of the distributing corporation, both recourse and nonrecourse, assumed by the shareholder.


Nonstock Distributions—Effect on Shareholder of C Corporation


Do shareholders of C corporations recognize income on nonstock distributions?

Yes, then yes, then no, then yes. That is, when a corporation distributes property other than its own stock to shareholders, the tax treatment to shareholders moves in different directions, according to the following pecking order:





Basis = FMV of the asset. The assumption of a liability does not affect basis.

What is a shareholder’s basis in the non-stock property distributed by the C corporation?

Capital gainAny balance remaining 4th

Nontaxable return of capital S/H’s basis in the stock 3rd

Ordinary income based on FMV Accumulated E&P 2nd

Ordinary income based on FMV Current earnings and profits (E&P) 1st

Tax Treatment to S/H: Distributions Other Than Stock, to the Extent of:

Tier