BACC 452
Chapter 1
Income Taxation of Corporations
I. Tax Treatment of Business Forms
A. Sole Proprietorship
1. Not a taxable entity
2. Net income or loss computed on Schedule C and attached to owner’s individual tax return (1040)
3. Items of income and expense retain their character
B. Partnerships
1. Conduit - not subject to tax itself but provides an informational return
2. Net profit or loss and separately reported items allocated to partners based on the partnership agreement
3. Reported to each partner on Schedule K-1
4. Partner reports items on own return
C. Subchapter S corporation
1. Conduit
2. Items of profit and loss flow through the corporation to the shareholder retaining their character
3. Treated similarly to partnerships
D. Subchapter C corporations
1. Tax paying entity
2. Double taxation effect - earnings taxed at the corporate level and again at the shareholder level when distributions are made
3. Form 1120 or 1120-A
4. Corporate rate schedules (see front of book) different from individual rate schedules
E. Limited Liability Company
1. Limited liability of a corporation
2. Flow through characteristics of a conduit
3. May be treated as either a corporation or a partnership depending on state of organization
4. For federal income tax purposes
a. Law now allows a check the box determination of status
b. if no election is made
1) entity with 2 or more members will be treated as a partnership
2) entity with only one member will be treated as a sole proprietorship
F. Why do business as a corporation?
1. Tax factors
a. Top corporate marginal rate is 35% (the 39% and 38% are phaseouts of the advantages of the lower marginal rates so that the average rate on all income over $10,000,000 is 35% - top individual marginal rate is 38.6%
2. Nontax factors
a. Limited liability
b. Ability to raise large amounts of capital
c. Free transferability of ownership
d. Continuity of life
II. What is a corporation?
A. Generally incorporation under the laws of a particular state - filing the forms and meeting the requirements of that state to be a corporation
B. Sham corporation - IRS or courts feel the facts and circumstances do support the corporate form - the corporation is collapsed and the income is taxable directly to the shareholders
C. Assignment of income - especially with high income professional such as an athlete
1. situation - corporation is formed and the money earned by the athlete is paid to the corporation - corporation pays athlete a modest salary -
2. IRS will likely disregard the corporate form if the payor for the services has a contract with the athlete since the athlete is the one with whom the contract is and the athlete earned the income (appears to be trying to assign the income to the corporation)
D. Associations - considered a corporation by federal law
1. Association tests - must exhibit more corporate characteristics that non- corporate characteristics
a. Associates
b. An objective to carry on a business and divide the gains
c. Continuity of life
d. Centralized management
e. Limited liability
f. Free transferability of ownership
2. Advantages
a. Availability of tax-sheltered (group term life insurance, accident and health plans) and tax deferred fringe benefits (qualified pension plans)
b. Disadvantages - because of the enactment of limited partnership rules, associations are now generally a form to stay away from
3. Limited liability companies
a. Remember - under state law may be treated as either corporations or partnerships depending on the state of organization
b. Owners typically prefer partnership status because of double taxation problem with corporations
c. Depending on the state of organization LLC may be automatically partnerships - if not then must observe association tests and make certain that the company lacks at least two of the following three corporate characteristics
1) centralized management
2) continuity of life
3) free transferability of ownership
d The check the box system
1) allows organizations not defined by state law to choose how they will be taxed for Federal purposes.
2) exception : publically traded partnerships are taxed as corporation.
III. Introduction to the income taxation of corporations
A. Similarities and Differences between Corporate and Individual taxation (look at Exhibits 1-1 & 1-2, page 1-8 & 1-9)
1. Similarities - examples
a. Gross income arrived at generally in the same manner but there are some differences in the exclusions from gross income
b. Section 1221 (definition of a capital asset) applies to both
c. Nonrecognition of gains and losses on like-kind exchanges are handled in the same way
d. Inventory must be accounted for using the accrual method - that is sales and cost of goods sold must be determined using accrual
2. Differences
a. Corporation has only business deductions - no standard or itemized deductions or personal or dependency exemptions
b. There are different rate schedules
c. Corporations generally have greater flexibility in the choice of their tax year
d. Generally corporations may not use the cash method of accounting for tax purposes
1) exceptions - S-corporations, corporations engaged in farming and timber, qualified PSCs, corporations with gross receipts of $5 million or less
e. Individuals may deduct up to $3000 in net capital losses against other income each year - any remaining capital losses are carried forward indefinitely while corporations may not offset capital losses against any income other than capital gains and remaining net capital losses must be carried back 3 years and then forward 5 years after which they are lost
f. Generally individual capital gains are generally taxed at no more than 20% (10% for taxpayers in the 10 and 15% tax brackets) while corporate capital gains are given no preferential treatment
g. Recapture of depreciation - an additional provision for recapture of depreciation on real estate (Sec 291(a)(1) - 20% of the excess of any amount that would be treated as ordinary income under Sec 1245 over the amount treated as ordinary income under Sec 1250)
h. Passive loss rules apply to noncorporate taxpayers, PSCs (personal service corporation), and closely held C corporations
1) closely held corporation - if at any time during the taxable year more than 50% of the value of the outstanding stock is owned, directly or indirectly by fewer than 5 individual
2) PSC –
a) principal activity is performance of personal services,
b) such services are substantially performed by owner- employees,
c) more than 10% (in value) of the stock is held by the owner-employees
i. Charitable contributions -
1) for an accrual basis corporation - a deduction for a charitable contribution may be taken in the year preceding the payment if
a) authorization for the contribution has been made by the board of directors by the end of the preceding year and
b) payment is made on or before the 15th day of the 3rd month of the year
2) amount of contribution deduction - limited to 10% of taxable income computed without regard to the charitable contribution, NOL carryback, capital loss carryback and dividend received deduction
B. Deductions available only to corporations
1. Dividend received deduction - see Exhibit 1-3 (page 1-10)
a. Purpose to mitigate triple taxation
b. Limitations
1) Limited to a percentage of the ownership of the corporate shareholder in the dividend paying corporation (see p.1-10)
2) Limited to a percentage of the taxable income of the corporation without regard to NOL, dividend received deduction or capital loss carryback
3) Generally, the percentage for the taxable income limitation is the same as the percentage of the deduction limitation
4) The taxable income limitation does not apply if the corporate shareholder has an NOL for the year
c. Restrictions
1) stock must be held for more than 45 days in a 90 day period before its sale or disposition
2) extraordinary dividends received within the first two years of ownership reduce the basis of the stock by the amount of the nontaxable portion of the dividend (but not below zero)
3) can’t use borrowed funds to buy stock and take the dividends received deduction, too