Chapter 11Chapter 11

The Corporate Taxpayer

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

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Identify legal characteristics of corporations Compute the dividends-received deduction Prepare a Schedule M-1 reconciliation Compute regular tax on corporate income Discuss corporate AMT Describe payment and filing requirements Explain why dividends are taxed twice Discuss the incidence of the corporate income tax

The Corporate TaxpayerThe Corporate Taxpayer

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Limited liability of shareholders Owners of closely-held corporations often are required to personally

guarantee repayment of debt Licensed professionals must still carry malpractice insurance

Unlimited life Legal existence not affected by changes in ownership

Free transferability of interests Through regulated markets with maximum

convenience and minimal transaction cost For closely-held corporations, a buy-sell

agreement may prevent transferability

Centralized management

Corporation Legal CharacteristicsCorporation Legal Characteristics

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Affiliated groups = a parent corporation that directly owns at least 80% of at least one domestic subsidiary + all other domestic subsidiaries that are 80% owned within the group

Affiliated groups may elect to file a consolidated tax return - applies to all members of affiliated group Advantage: losses and profits of

affiliated members offset each other

Affiliated Groups and ConsolidationsAffiliated Groups and Consolidations

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Nonprofit CorporationsNonprofit Corporations

Includes corporations formed exclusively for “religious, charitable, scientific, literary, educational purposes, etc.”

Section 501(c)(3) organizations require IRS recognition of tax-exempt status

Nevertheless, tax-exempt organizations may pay tax on “unrelated business taxable income”

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Page 1 of the Form 1120 resembles a financial income statement or a Schedule C in a personal tax return (Ch 10) See Chapters 6, 7, 8 and 9 for general rules

on business income Corporations entitled to dividends-received deduction Deduct charitable contributions up to 10% of taxable

income BEFORE charitable deductions and before dividends-received deduction Excess contributions can be carried forward for 5 years

Computing Corporate Taxable IncomeComputing Corporate Taxable Income

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Dividends-Received DeductionDividends-Received Deduction

Corporations receiving dividends from other taxable domestic corporations are entitled to this deduction

Ownership % Deduction % < 20% of stock 70% DRD 20%<= % < 80% 80% DRD 80%<= % 100% DRD What was Congress’ reasoning behind the DRD?

To mitigate “triple” taxation

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Dividends-Received Deduction ExampleDividends-Received Deduction Example

Aragorn Corp. owns 35% of Ent Corp. and 88% of Legolas Corp. If Aragorn receives dividends of $10,000 from Ent and $15,000 from Legolas, calculate Aragorn’s DRD.

$10,000 x 80% = $ 8,000

$15,000 x 100% = $15,000

Total DRD $23,000

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Schedules M-1 and M-3 reconcile book income to taxable income

The M-1 was used by all corporations until 2004 and can still be used by corporations with total assets less than $10 million

In 2004, the IRS developed the M-3 for use by large corporations (assets > $10 million); it requires more detailed information than the M-1 and enhances the transparency of book/tax differences

Book Versus Taxable Income - Schedule M-1 & M-3Book Versus Taxable Income - Schedule M-1 & M-3

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Net book income - line 1 Federal tax expense for books - line 2 Lines 3 - 6 explain increases in taxable income

relative to books Lines 7 - 9 explain decreases in taxable income

relative to books Line 10 = taxable income before

NOL and DRD = Line 28, page 1, form 1120

Schedule M-1Schedule M-1

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Example: Schedule M-1Example: Schedule M-1

Wilson Inc. reported $149,250 of net income after tax on its financial statements Wilson reported federal income tax expense of $61,250 Meals and entertainment expense = $15,000 MACRS depreciation = $60,000; book depreciation =

$42,000 Prepare Wilson Inc.’s M-1

Net book income $149,250 + Federal tax expense + 61,250 + 50% of meals & ent.+ 7,500 - MACRS over SL - 18,000 Taxable Income $200,000

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The surtax rates of 39% and 38% eliminate bracket benefits for ‘rich’ corporations

Corporations with taxable income Between $335,000 and $10 million

actually pay a flat rate of 34% Greater than $18.33 million pay a flat rate of 35%

Personal service corporations are taxed at a flat 35% rate Includes health, law, engineering, architecture,

accounting, actuarial science, performing arts, & consulting professionals

Computing Regular TaxComputing Regular Tax

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Available to US taxpayers deriving income from domestic production activities

For 2013, deduction is equal to 9% of the lesser of net production income or taxable income before the deduction

Deduction can’t exceed 50% of US compensation expense

Deduction is equivalent to a reduced tax rate on domestic production income

Domestic Production Activities DeductionDomestic Production Activities Deduction

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Credits directly reduce computed tax $1 of credit provides $1 of benefit $1 of deduction only provides ($1 x the tax rate) of benefit

Tax credits are generally limited to some % of tax before credits. Often a provision permits carry back or carry forward of excess credits

Biggest credits: R&D credit, foreign tax credit (see Chapter 13)

Tax CreditsTax Credits

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To be eligible, taxpayers must engage in specific activities that Congress believes are worthy of government support

The list of credits changes as Congress experiments with new credits and discards those that fail to produce the intended behavioral result

Tax CreditsTax Credits

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Alternative Minimum TaxAlternative Minimum Tax

A second federal tax system parallel to the regular income tax

Created to ensure that every corporation pays a “fair share” of taxes

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New corporation is exempt in Year 1 Exempt in Year 2 if Year 1 sales <=$5 million Exempt in Year 3 if average sales in years 1 and 2

<= $7.5 million Exempt in subsequent years if average gross

receipts for three prior years <= $7.5 million Once a corporation fails to be exempt, it is

ineligible for AMT exemption for all subsequent tax years

Alternative Minimum Tax - Who is Subject?

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Year 1 sales = $4 million Exempt from AMT because it’s year 1

Year 2 sales = $8 million Exempt because Year 1 sales <=$5 million

Year 3 sales = $12 million Exempt because average of years 1 and 2 = $6 million,

which is <= $7.5 million Year 4 sales = $2 million

Subject to AMT because average of years 1, 2 & 3 = $8 million, which is > $7.5 million

Thus, the firm is subject to AMT in all subsequent years

Example: AMT ExemptionExample: AMT Exemption

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Alternative minimum taxable income (AMTI) less Exemption = AMTI in excess of Exemption x 20% = Tentative minimum tax (TMT) less Regular Tax = Alternative minimum tax (AMT)

Alternative Minimum Tax - OverviewAlternative Minimum Tax - Overview

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Starts with regular taxable income Add AMT preferences Add or subtract AMT adjustments Subtract AMT NOL

Alternative Minimum Taxable Income (AMTI)Alternative Minimum Taxable Income (AMTI)

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Preferences are always positive additions to AMTI Examples

Tax-exempt interest income from private activity bonds - municipal bonds issued to fund non-government activities

Percentage depletion in excess of cost basis

AMT PreferencesAMT Preferences

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AMT AdjustmentsAMT Adjustments

Represent timing differences between regular taxable income and alternative minimum taxable income - will eventually reverse, perhaps over several periods

Examples Differences between MACRS and ADS depreciation

amounts Completed-contract method Amortization of pollution control facilities ACE adjustment

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Adjustment equals 75% of difference between ‘adjusted current earnings’ and AMTI before ACE adjustment and AMT NOL Adjusted current earnings an economic measure of

earnings that approximates financial statement net income

Any negative ACE adjustment (ACE > AMTI before ACE and AMT NOL) limited to cumulative positive ACE adjustments from prior years

ACE AdjustmentACE Adjustment

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AMT NOL amount computed using alternative taxable income approach

Deduction limited to 90% of AMTI before the AMT NOL Example: If AMTI before consideration of any NOL is

$100,000, the maximum allowable AMT NOL deduction is $90,000

AMT NOL DeductionAMT NOL Deduction

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Exemption = $40,000 but is reduced by 25% of the amount that AMTI exceeds $150,000

AMTI in excess of the Exemption is multiplied by 20% = Tentative Minimum Tax (TMT)

If TMT > Regular tax, then TMT less Regular Tax = Alternative Minimum Tax (AMT)

If TMT < Regular tax, AMT = 0 Corporations with modest AMT adjustments and

preferences avoid AMT

AMT - More DetailsAMT - More Details

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Minimum tax credit Results when AMT is paid Reduces regular tax in subsequent year Can’t reduce regular tax to less than TMT Carries forward indefinitely

Corporate AMT is not designed as a permanent tax increase, but only accelerates the payment of tax

Eliminating the AMT is a frequent taxdebate in the news

AMT TimingAMT Timing

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Tax return due 15th day of 3rd month, may extend to 15th day of 9th month However, the extension does not extend the payment

deadline Estimated payments are due on the 15th day of

4th, 6th, 9th, and 12th months Must pay 100% of tax due; Small corporations

(TI < $1 million) may use safe-harbor rule of paying 100% of prior year tax

Underpayment penalty is computed like interest expense but is nondeductible

Payment and Filing Requirements

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Interest payments are deductible, while payments on stock (i.e., dividends) are non-deductible

This creates a bias in favor of debt financing Non-tax costs associated with debt financing

include large cash flow commitments and a greater risk of insolvency

The non-tax costs often outweigh the tax savings associated with debt

Distributions to Investors Distributions to Investors (Creditors & Shareholders)(Creditors & Shareholders)

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Alternatives to Double Taxation of DividendsAlternatives to Double Taxation of Dividends

Treat corporations as pass-through entities Administratively cumbersome, if not impossible

Make dividends nontaxable Current policy of taxing dividends to individuals at 15% is

a step in this direction

Tax credit for individuals for the corporate tax attributable to dividends included in individual taxpayers’ income

All of these alternatives would result in significant revenue loss to the Treasury

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Corporations do not pay taxes - people do What are examples of ways that the incidence of

the corporate tax could be born by individual taxpayers in the U.S.? Higher consumer prices Lower employee wages Lower dividends

Incidence of the Corporate TaxIncidence of the Corporate Tax

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