Homework Federal Tax and Management Decisions 4w

Chapter 13

Tax Accounting

OBJECTIVES

After completing  Chapter 13 , you should be able to:

1. List what are permissible tax years.

2. Explain the requirements for changing a tax year.

3. Identify the available accounting methods.

4. Understand the rules for accounting method changes.

5. Account for the capitalization of inventory costs.

6. Describe long-term contract reporting.

7. Define the installment method of accounting.

OVERVIEW

The first 12 chapters are presented primarily from the individual taxpayer’s point of view (including self-employed taxpayers). This chapter provides a general discussion of the previous material as it applies to other entities and provides a discussion of accounting periods and accounting methods as they apply to all entities. Discussions of specific provisions as they apply to other entities (e.g., corporations, partnerships, etc.) are contained in subsequent chapters.

The term “financial accounting” refers to the reporting of the financial data of an enterprise through financial statements prepared in accordance with generally accepted accounting principles.

Income tax accounting, hereafter referred to as “tax accounting,” is concerned with the reporting of financial data to satisfy the requirements of the Internal Revenue Code, the Regulations which interpret the Code, rulings by the IRS which further interpret the Code and Regulations, and the decisions of the courts on litigated issues.

Tax accounting is statutory. It is concerned with the determination of taxable income as the base to which tax rates are applied to establish the tax liability for a period, usually one year. Basically, taxable income or taxable loss is the net result of summarizing revenues, gains, expenses, and losses. This result is determined in considerable degree in accordance with accepted accounting principles and conventions. At every step in the process, however, there are differences, based on tax statutes and interpretations thereof, which distinguish taxable income from financial income. These differences are numerous and may prove substantial in amount.

The variations between taxable income and financial income are so great as to require specialization in taxation as distinguished from financial accounting. The two disciplines, however, are fundamentally related, and tax issues are usually resolved concurrently with the financial accounting issues.

The basic approach of the income tax is to impose a tax on the net result of financial transactions occurring during a fixed period of time called the tax year. The time for reporting income and deductions thus becomes of vital importance in determining taxable income. Therefore, the Internal Revenue Code provides that taxable income must be computed on the basis of the taxpayer’s tax year and permissible method of accounting.

There are some differences between financial and tax accounting, differences that are attributable to a number of factors. Financial accounting is designed to reflect the income position of a profit-seeking taxpayer; the rules of tax accounting not only must have regard for this but also must reflect the need to raise revenue equitably. Further, the general thrust and purpose of the tax law, to prescribe detailed rules in the interest of certainty, is bound to create conflicts with tailor-made systems designed for particular taxpayers in many instances. Experience has indicated that certain tax rules are necessary in order to control tax avoidance. Thus, the Internal Revenue Service has been provided with Code Sec. 482, under which it may reallocate items of income, deduction, credit, or allowance in order to prevent tax avoidance when two or more organizations are controlled by the same interest. Further, if the taxpayer’s method of accounting does not clearly reflect income, Code Sec. 446 authorizes the IRS to require the use of a method that will do so. Additionally, the Supreme Court has indicated that the use of generally accepted accounting principles (GAAP), which apply to financial accounting and are considered to be the “best” accounting practices, does not necessarily clearly reflect income and does not shift the burden of proof to the IRS to show otherwise. Thor Power Tool Co., 79-1 USTC ¶9139, 439 U.S. 522 (1979).

Once the questions of what items are includible in gross income and what items are deductible in computing taxable income are answered, a second set of questions must be faced. These relate to when such qualifying items are to be utilized in that computation. In other words, in what tax year is an item of income actually to be included in gross income? In what tax year is a deduction to be subtracted from gross income?

The general answers to most of these “when” questions are furnished in terms of the method of accounting regularly employed by the taxpayer in his or her business and recordkeeping. That record, however, must “clearly reflect income.” Various accounting methods are available in computing taxable income, but the significant effect of the selection of one method of reporting over another is that of timing. Total income and total deductions over the long run will generally be the same regardless of the method used. However, yearly determinations of taxable income may differ materially depending on the method selected.

Taxable Income and Tax Liability for Various Entities

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RECAPITULATION OF TAXABLE INCOME AND TAX LIABILITY

Table 1  contains a general outline of the computation of taxable income for various entities. A comparison of each provides an indication of some similarities and differences. All entities subtract exclusions to determine gross income. However, the types of exclusions are different; some apply to all entities (e.g., the exclusion for municipal bond interest income), and some apply to particular entities (e.g., the exclusion for qualified fringe benefits, which applies to individuals). Additionally, Code Sec. 61 applies to all entities in computing gross income.

Each entity also is permitted to reduce gross income by qualified deductions. However, the type, classification, and computation of deductions can vary. Only individuals dichotomize their deductions into “for adjusted gross income” and “from adjusted gross income,” the latter being deductions for personal expenses such as itemized deductions that do not apply to other entities. Corporations have routine deductions and several “special” deductions such as the dividends-received deduction. This deduction applies only to corporations. Some items are not deductible by conduit entities (e.g., S corporations) but instead pass through to the owners, while some have different constraints. For example, the charitable contribution deduction is constrained by adjusted gross income for individuals, but is constrained by “modified” taxable income for corporations; yet both entities must go through the same general process of classifying the contributions as cash, ordinary income assets, and long-term capital assets.

To the extent that each entity (including self-employed taxpayers) has business activities, Code Sec. 162 applies to trade or business expenses, and the general criteria for a deduction apply (e.g., ordinary, necessary, reasonable, etc.). Code Sec. 212 applies to an entity’s nonbusiness expenses and is most applicable to individuals. Similarly, the “hobby loss” rules of Code Sec. 183 apply to individuals and S corporations. Thus, while each entity is entitled to deductions in the computation of its taxable (or ordinary) income, the nature of these deductions can vary. In subsequent chapters, significant differences are explained further.

Table 1. COMPUTATION OF TAXABLE INCOME
Individuals
Income Broadly Conceived	xxxxx
Less: Exclusions	− xxx
Gross Income	xxxxx
Less: Deductions for Adjusted Gross Income	− xx
Adjusted Gross Income	xxxxx
Less: Deductions from Adjusted Gross Income	− xx
Taxable Income	xxxxx
C Corporations
Income Broadly Conceived	xxxxx
Less: Exclusions	− xxx
Gross Income	xxxxx
Less: Deductions
Routine	− xx
Special	− xx
Taxable Income	xxxxx
S Corporations
Income Broadly Conceived	xxxxx
Less: Exclusions	− xxx
Gross Income	xxxxx
Less: Deductions	− xx
Ordinary Income	xxxxx
Partnerships
Income Broadly Conceived	xxxxx
Less: Exclusions	− xxx
Gross Income	xxxxx
Less: Deductions	− xx
Ordinary Income	xxxxx
Estates and Trusts
Income Broadly Conceived	xxxxx
Less: Exclusions	− xxx
Gross Income	xxxxx
Less: Deductions	− xx
Taxable Income	xxxxx

Table 2  contains a general outline of each entity’s computation of net tax due or refund due. Pure conduits do not pay an income tax; rather, various components such as income, certain deductions, and credits pass through to the owners or beneficiaries. Those entities that do pay a tax utilize taxable income to determine gross tax liability, which is then reduced by the credits and prepayments to which they are entitled. However, the type and/or computation varies (e.g., only individuals are entitled to the earned income credit).

Table 2. NET TAX LIABILITY
Individuals
Gross Tax Liability	yyyyy
Less: Credits	− yy
Net Tax Liability	yyyyy
Less: Prepayments	− yy
Net Tax or Refund Due	yyyyy
C Corporations
Gross Tax Liability	yyyyy
Less: Credits	− yy
Net Tax Liability	yyyyy
Less: Prepayments	− yy
Net Tax or Refund Due	yyyyy
Estates and Trusts (assuming not completely a conduit)
Gross Tax Liability	yyyyy
Less: Credits	− yy
Net Tax Liability	yyyyy
Less: Prepayments	− yy
Net Tax or Refund Due	yyyyy

In summary, many of the concepts that you learned in the first 12 chapters apply to all entities. However, there are numerous and substantial differences that require additional explanation. The remainder of this chapter deals with accounting periods and accounting methods as they pertain to all entities, but the focus begins to shift to business entities. Subsequent chapters deal with the specific entities.

Accounting Periods

The basic approach of income taxation is to impose a tax on the net result of financial transactions occurring during a fixed period of time, otherwise called the “tax year.” The time for reporting income and deductions is of vital importance in determining taxable income. Therefore, Code Sec. 441 requires that taxable income must be computed on the basis of the taxpayer’s tax year. This annual accounting period may be either a calendar year or a fiscal year.

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THE TAX YEAR

“Tax year” means the calendar year or the fiscal year on the basis of which the taxable income is computed. The tax year may not exceed 12 calendar months, except where a 52-53-week tax year is adopted. (No further mention of this option is made in this text because of the relative infrequency with which this taxable period is encountered in practice.) The term “calendar year” means a period of 12 months ending on December 31. A taxpayer who has not established a fiscal year must file a tax return on the basis of a calendar year.

A “fiscal year” is defined as a period of 12 months ending on the last day of any month other than December. A fiscal year will be recognized by the IRS only if it is established as the annual accounting period for the taxpayer and the taxpayer’s books are kept on the same basis. Therefore, to establish and maintain a fiscal year as the tax year, the taxpayer must correlate accounting, financial, and business practices with the fiscal year used for tax returns.

The keeping of books means keeping records that are sufficient to reflect income adequately and clearly on the basis of an annual accounting period. Informal records consisting of check stubs, rent receipts, and dividend statements are not considered regular books of account.

When a return is required for a fractional part of a year, the “tax year” means the period for which such return is filed. This fractional period is referred to as a “short tax year.” A short tax year is any period for which a return has been filed that contains less than 12 months. Frequently, the first or the final tax period of a particular tax entity is a short tax year. Additionally, when a tax year is changed, the period between the end of the old tax year and the beginning of the new tax year is a short tax year for which a return must be filed.

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ELECTION OF THE TAX YEAR

Taxpayers, other than most C corporations, generally must use a “required taxable year”. Reg §1.441-1. There are a few exceptions. For example, a partnership, S corporation, or Personal Service Corporation may use a taxable year other than its required taxable year if it so elects under Code Sec. 444 or establishes a business purpose to the satisfaction of the IRS under Code Sec. 442.

A new taxpayer may adopt any tax year that satisfies the requirements of Code Sec. 441 and the regulations thereunder without obtaining prior approval of the IRS. A taxable year of a new taxpayer is adopted by filing its first Federal income tax return using that taxable year. An extension of time for filing the return does not extend the time for adoption of a tax year. Reg. §1.441-1.

Individuals

Since most individual taxpayers keep no books and records prior to filing a first tax return, the calendar year is the default tax year. The establishment and maintenance of adequate books of account may not be delayed beyond the end of the first accounting period if the taxpayer selects a fiscal year. Informal records do not meet this requirement, even if they become part of a formal system of accounting after the close of the fiscal year.

Income Averaging for Farming and Fishing Businesses

The above rules regarding tax periods apply to farmers. However, Code Sec. 1301 allows individual farmers and fisherman to elect to use income averaging over a three-year period when determining tax liability. The irrevocable election applies to farm income or fishing income attributable to a farm or fishing business. The tax liability in any tax year is equal to the tax on the taxpayer’s taxable income reduced by that year’s elected farm or fishing income to be averaged over the three preceding years and increased by the tax due on the increase in taxable income of the three prior years due to the one-third farm or fishing income averaged over the three preceding years.

Sole Proprietors

Sole proprietors of a business must use the same period for business tax reporting purposes that they use for their personal books.

EXAMPLE 13.1

Evelyn Aldo establishes a tax year when she files her first return. She begins business in a later year as a sole proprietor. Evelyn must use the same tax year for the business unless permission from the IRS to change is obtained.

Partnerships

Except for partnerships that qualify under the business purpose exception or make an election under Code Sec. 444, a partnership must use the same tax year as that of its partners who have a majority interest (an aggregate interest of greater than 50 percent) in partnership profits and capital. If partners owning a majority interest have different tax years, the partnership must adopt the same tax year as that of its principal partners. When neither condition is met, a partnership is required to adopt a year that results in the least aggregate deferral of income to the partners. Reg. §1.706-1. A principal partner is a partner having an interest of 5 percent or more in partnership profits or capital. Partnership income is considered to be earned by the partners on the last day of the partnership’s tax year. The least aggregate deferral method requires the partnership to calculate the income that would be deferred by the partners based on the partners’ tax years (and therefore the number of months from the partnership’s tax year-end to the partner’s tax year-end). The calculation is based on each partner’s ownership percentage and tax year-end. For each possible year-end, each partner’s ownership percentage is multiplied by the number of months the partner would defer income. The result for each partner is totaled, and the totals for all possible tax years are compared. The partnership tax year is the one with the smallest total. These tax year requirements are designed to reduce the partners’ income deferral opportunities via tax year selection.

The partnership must adopt the tax year of its majority interest partner or partners if that interest has a common tax year on the first day of the partnership’s existing tax year. Further, if a change in the tax year is required under this rule, no additional change is required in the next two years following the year of change.

EXAMPLE 13.2

A partnership is formed by an individual and a corporation, each owning a 50 percent interest. The individual has a calendar year as its tax year, and the corporation has a tax year that ends on August 31. The partnership must determine its tax year using the least aggregate deferral method because neither the majority interest rule nor the principal partnership rule applies. If the corporation owned more than a 50 percent interest in the partnership, the partnership would have to adopt a tax year ending on August 31.

EXAMPLE 13.3

A partnership is owned by numerous individuals and corporations. All of the individuals have calendar years and none of the individuals are principal partners. One corporation owns 45 percent and has a fiscal year ending on May 31. The other corporations have various other fiscal years and none are principal partners. If the individuals together own more than 50 percent of the partnership, the partnership must adopt the calendar year because the majority partners have a calendar year. If the individuals do not own more than 50 percent, the partnership must adopt a fiscal year ending on May 31 because the principal partners have a fiscal year ending May 31.

EXAMPLE 13.4

The BPT partnership has three owners, Barry, Pete, and Tom. Barry and Pete each own 30 percent, and Tom owns 40 percent. Their tax years end on March 31, September 30, and December 31, respectively. In this situation neither the majority interest nor the principal partner methods can be used to determine BPT’s tax year; thus, the least aggregate deferral method must be used, and it is determined as follows.

			Possible Tax Year-Ends
Partnership	Partner	3/31		9/30		12/31
Partner	Interest	Tax Year	Months Deferred	Total	Months Deferred	Total	Months Deferred	Total
Barry	30%	3/31	0	0	6	1.8	3	0.9
Pete	30%	9/30	6	1.8	0	0	9	2.7
Tom	40%	12/31	9	3.6	3	1.2	0	0
				5.4		3.0		3.6
Note: Months deferred equals the months from the possible partnership tax year-end to the partner’s tax year-end. Total equals the months deferred multiplied by the partner’s ownership interest.

Thus, the BPT partnership must use a September 30 tax year-end because it has the lowest total amount (3.0) and, therefore, the least aggregate deferral.

A newly-formed partnership that wants to adopt a taxable year other than its required taxable year or a tax year elected under Code Sec. 444 must establish a business purpose and obtain the approval of the IRS. A partnership’s selection of a tax year to coincide with a natural business year would constitute sufficient business purpose.

The natural business year is established by the partnership showing that it received at least 25 percent of its gross receipts in the last two months ending on the proposed year’s end and for the corresponding time period of each of its two preceding years. See discussion of Business Year below.

Corporations

A corporation may select a fiscal year or a calendar year as its tax year. The tax year of a corporation may differ from that of its shareholders.

A corporation in existence during any portion of a tax year must file a return. If a corporation is not in existence throughout an entire accounting period, the corporation must file a return for that fractional part of a year during which it is in existence. A new corporation comes into existence on the date of its incorporation. This may cause problems for a corporation that is inactive for a period of time after incorporation. Unless the corporation files a return selecting a tax year during the initial period, the time period may pass for electing a tax year, and the corporation may be forced to file a calendar-year return. This will happen if the first tax year ends more than 12 months after incorporation.

S Corporations

The tax year of an S corporation is generally required to be a calendar year. However, a tax year other than a calendar year may be used if the S corporation can satisfy the IRS that there is a legitimate business purpose for such use. Code Sec. 1378(b).

Estates

An estate is a new taxpayer, and it may adopt any tax year without obtaining prior approval. The ability to select a fiscal period enables the executor to do two things: (1) control the number of months in the first and final returns of the estate, thereby controlling the amount of income taxable to the estate during this period, and (2) postpone the time of realization of income by the beneficiaries due to the timing of distributions.

Trusts

Trusts, other than charitable and tax-exempt trusts, must use the calendar year. Code Sec. 644.

Business Year

The intent of an entity to make its tax year coincide with its natural business year constitutes a valid business purpose. Where a business has a nonpeak and a peak period, the natural business year usually ends at, or soon after, the close of the peak period. A business with a steady monthly income does not have a natural business year.

A natural general business year generally exists if, in the last two months of the selected tax year, a taxpayer receives at least 25 percent of its gross receipts and has done so for three consecutive 12-month periods.

Approval to adopt or change to a natural business year is secured by automatic consent procedures under Rev. Proc. 2006-46 by filing Form 1128 (Application To Adopt, Change, or Retain a Tax Year).

Election of Tax Year Other Than Required Tax Year

Code Sec. 444 allows certain partnerships, S corporations, and personal service corporations to elect a tax year that is different from their required tax year. The deferral period that is created by adopting the tax year must be the lesser of the deferral period currently in use or three months. Taxpayers making this election are required to follow procedures and make enhanced estimated tax payments to the IRS that are intended to represent the value of the tax deferral obtained by the partners and shareholders through the use of a tax year different from the required tax year. A Code Sec. 444 election is made by filing Form 8716 (Election to Have a Tax Year Other Than a Required Tax Year) with the IRS by the earlier of: (1) the 15th day of the fifth month after the month that includes the first day of the tax year for which the election is first effective, or (2) the due date (without extensions) of the income tax return resulting from the Code Sec. 444 election. A copy of the Form 8716 must also be attached to the income tax return for the first tax year for which the election is made. Willful failure to make enhanced estimated tax payments results in the cancellation of the election by the entity.

Change of Accounting Periods

Required tax years are defined by regulation for most types of business entities. If a taxpayer changes its annual accounting period, the new accounting period shall become the taxpayer's taxable year only if the change is approved by the IRS. Code Sec. 442. A change in accounting period may be approved if there are substantial business reasons for the change. While the IRS has authority to grant a taxpayer’s request to adopt, change, or retain an annual accounting period under a facts and circumstances test, it is expected to be applied only in “rare and unusual circumstances.” Deferral of income to owners will not be treated as a business purpose. In addition, administrative and convenience business reasons such as the following are not sufficient to establish a business purpose: (1) the use of a particular year for regulatory purposes; (2) the hiring patterns of a particular business; (3) the use of a particular year for administrative purposes, such as promotion, compensation or retirement arrangements with staff, partners, or shareholders; and (4) the fact that a particular business involves the use of price lists, model years, or other items that change on an annual basis. Rev. Proc. 2002-39.

If a taxpayer’s records are inadequate or there is an accounting period that does not meet the requirements for a fiscal year, the tax year must be the calendar year. In this instance, the adoption of a fiscal year is treated as a change in the annual accounting period and prior approval from the IRS is required.

A change in accounting period usually involves a short-period tax year. This period begins with the first day after the close of the former accounting period and ends at the close of the day preceding the beginning of the new accounting period.

EXAMPLE 13.5

Mita Corporation wishes to change its tax year from a calendar year to a tax year ending on May 31, 2020. Mita Corporation will have a short tax year for the period January 1 to May 31, 2020.

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IRS PERMISSION OR CONSENT

In order to secure IRS approval to change accounting period, the taxpayer must file Form 1128 (Application To Adopt, Change, or Retain a Tax Year) by the due date (not including extensions) of the Federal income tax return for the first effective year. In the case of a change in tax year, the first effective year is the short period required to effect the change. Part II of Form 1128 is completed by those seeking automatic IRS approval for a change in tax year under various Revenue Procedures. Part III of Form 1128 is a ruling request that requires payment of the appropriate user fee and is used by those seeking to change to a tax year for which no automatic consent procedures apply.

To prevent substantial distortion of income that may result from a change in tax period, an agreement between the taxpayer and the IRS is required. This agreement must provide the terms, conditions, and adjustments necessary to implement the change. The following examples of income distortion are given in Reg. §1.442-1(b):

1. Deferring a substantial portion of income, or shifting a substantial portion of deductions, from one year to another so as to reduce the tax liability

2. Causing a similar deferral in the case of a related taxpayer, such as a partner, a beneficiary, or a shareholder in an S corporation

3. Creating a short period in which there is a substantial amount of income to offset an expiring net operating or capital loss

If approval is granted, the taxpayer must file an income tax return for the short period. There are special rules for computing the tax for a short year caused by a change in the accounting period. These are discussed later in the chapter.

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EXCEPTIONS TO PERMISSION REQUIREMENTS

Despite the prior approval requirements, there are some instances when a tax year may be changed without receiving advance approval.

Individuals

A newly married husband or wife can obtain automatic approval to change his or her tax year in order to use the tax year of the other spouse so that a joint return can be filed for the first or second tax year of that spouse ending after the date of marriage. Reg. §1.442-1(d)(1). Also, individuals who file income tax returns on a fiscal year basis may obtain automatic IRS approval to change their annual accounting period to a calendar year. Rev. Proc. 2003-62.

EXAMPLE 13.6

Larry Raser and Donna Chilton marry on September 24, 2020. Donna is on a fiscal year ending June 30, and Larry is on a calendar year. Donna wishes to change to a calendar year in order to file a joint return with Larry. Donna may not change to a calendar year for 2020 since she would have to file a return for the short period from July 1 to December 31, 2019, by April 15, 2020. Since the date of marriage occurred after this due date, the return could not be filed under the special rule for newly married couples.

Donna, however, may change to the calendar year for 2021 by filing a return by April 15, 2021, for the short period from July 1 to December 31, 2020. If Donna files such a return, Larry and Donna may file a joint return for calendar-year 2021, which is Larry’s second tax year ending after the date of marriage. Of course, Donna could request and receive permission to change to the calendar year before the marriage and thus be allowed to file a joint return for the calendar-year 2020.

Any other husband and wife wishing to change to the accounting period of the other spouse so that they may file a joint return must make proper application. Permission may be granted for this reason in appropriate cases, even though no substantial business purpose for requesting the change is established.

Partnerships, S Corporations, and Personal Service Corporations

All partnerships, S corporations, and personal service corporations generally must conform their tax years to the tax year of their owners, unless such entities can establish a business purpose for having a different year. An entity that must change its tax year to match that of its owner is required to file a return for the resulting short tax year.

Corporations

Rev. Proc. 2006-45, provides procedures for a corporation (other than an S corporation) to obtain automatic approval to change its annual accounting period. The automatic approval rules generally do not apply to the following classes of corporations, although there are exceptions under each category.

· A corporation that has changed its annual accounting period within the most recent 48-month period ending with the last month of the requested taxable year;

· A corporation that has an interest in a pass-through entity;

· A corporation that is a shareholder of a foreign sales corporation (FSC) or interest charge domestic international sales corporation (IC-DISC), as of the end of the short period (although there are exceptions);

· A corporation that is a FSC or an IC-DISC;

· A corporation that is a personal service corporation. (Rev. Proc. 2006-46 2006-2 CB 859 contains procedures for certain automatic changes);

· A corporation that is a controlled foreign corporation;

· A corporation that is a tax-exempt organization (other procedures apply to tax-exempt organizations);

· A corporation that is one of several other types listed in Rev. Proc. 2006-45 such as a cooperative association, a REIT, a Qualified Settlement Fund or Designated Settlement Fund, a Code Sec. 936 possessions corporation, a corporation exiting a consolidated group, and certain members of consolidated groups.

If the corporation has a capital loss (CL) in the short period resulting from the change then the CL may not be carried back but must be carried forward beginning with the first taxable year after the short period. However, the CL may be carried back if it is $50,000 or less or results from a short period of nine months or longer and is less than the CL for a full 12-month period beginning with the first day of the short period.

EXAMPLE 13.7

In 2020, Jeffco changed its accounting period from a September year end to a December year end. It had a $100,000 CL for the three-month short period ending December 31, 2020. Jeffco cannot carry back the CL. It must carry it forward to the new accounting period (calendar-year 2021).

If Jeffco is changing from a March 31 year end to a December 31, it might be able to carry back the CL. Jeffco’s short period would start on April 1 and end on December 31, a period of 9 months. If its results from operations for April 1, 2020 to March 31, 2021 produce a CL that is less than $100,000, then Jeffco may carryback the CL. Alternatively, if Jeffco’s CL had been $45,000, then it would be able to carry back its CL.

A statement on behalf of the corporation must be filed on or before the time for filing the return for the short period. The statement must indicate that the corporation is changing its annual accounting period under Reg. §1.442-1(b) and must contain information indicating that all the above conditions have been met.

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SHORT TAX YEARS

When a change in an accounting period is instituted, a separate return is filed for the short period beginning with the day following the close of the old tax year and ending with the day preceding the first day of the new tax year. The return is filed within the time prescribed for filing a return for a tax year of 12 months ending on the last day of the short period.

General Rule

The general rule calls for the tax to be computed for the short period by placing the short period’s taxable income on an annual basis. This is accomplished by multiplying the modified taxable income by 12 and dividing the result by the number of months in the short period. The tax for the short period is the same as the tax computed on an annual basis. Without this provision, taxpayers would be able to avoid a large tax liability by having a portion of the income taxed for a shorter period. Tax preferences must be annualized to determine the applicability of the alternative minimum tax. Code Sec. 443(d).

A change in accounting period could result in tax savings during a period of progressive tax rate structures. Some income would be “sheltered” by avoiding a higher tax rate. To prevent this from happening, the tax for the short period is based on annualized income. The procedures are as follows:

1. Annualize the short-period income

2. Determine the tax on the annualized income

3. Determine the short-period tax

EXAMPLE 13.8

Xeno Corporation files a return, because of a change in its accounting period, for the three-month short period ending June 30, 2020. It has taxable income of $20,000 during the short period. Its tax liability is computed as follows:

1.	Taxable Income Annualized ($20,000 × 12/3)	$80,000
2.	Tax on Annualized Income ($80,000 × 21%)	$16,800
3.	Tax for Short Period ($16,800 × 3/12)	$4,200

In the flat tax rate environment for corporations, there is no effect of annualizing tax computations.

Individuals must use the tax rate schedules to compute their tax liabilities for the short period. Also, they cannot use the standard deduction; instead they must reflect the itemized deductions incurred in the short period. Very few individuals change their accounting period.

The short tax year which results from a change in accounting period is treated as a full tax year for other purposes of the tax rules such as carrybacks and carryforwards. Tax planners must be careful that the creation of a short tax year return does not reduce the benefits a taxpayer would obtain from loss and credit carrybacks and carryforwards which could otherwise be obtained without the short tax year.

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ACCOUNTING PERIOD TAX PLANNING

A taxpayer should consider the various factors influencing the choice of accounting period and select the accounting period as soon as possible after beginning operations. The significant factor in selecting an accounting period is timing. Most frequently, total income and total deductions over the long run will generally be the same regardless of the period used. However, yearly determinations of taxable income may differ materially depending on the accounting period selected.

Business Factors

The choice of an annual accounting period depends on several business factors, such as a slack season when personnel are available, or a date when inventories and bank loans are low, which in turn presents a favorable balance sheet for credit purposes. For taxpayers subject to income tax rates on a graduated basis, the lowest taxes over a period of years will be achieved if income can be kept as level as possible over this period of time. Generally, this objective can be obtained if the expenses incurred in earning income are charged off in the same year the income is earned.

Natural Business Year

It is desirable that the accounting period chosen be in agreement with the natural business year. That is, the tax period should include both the income earned and the expenses incurred in generating that income. For example, if a business earns most of its income in the fall while most of the expenses are incurred or paid in the following spring, the calendar year should not be selected as the accounting period, since income would be perpetually distorted. Some advantages of closing a tax period at the end of the natural business year are: (1) inventories are at their lowest point and may be inspected and tabulated more quickly and valued more accurately, (2) receivables are at their minimum and bad debt adjustments can be determined more accurately, and (3) bank loans usually have been liquidated or reduced to their minimum for the tax period. Additionally, financial statements prepared at the end of a natural business year more accurately reflect the results of activities over one complete cycle of operations.

The accounting method adopted by the taxpayer may well be an important factor. Since income and expenses generally accrue before they are received or paid, it may be possible to close the accounting period earlier if the accrual method is used rather than the cash receipts and disbursements method, thereby reflecting a more accurate picture of the income for the period.

Corporations

A corporate taxpayer can select its year based on the particular circumstances of the initial period, rather than any adherence to the concept of the natural business year. In the case where a new corporation is a subsidiary or a parent of an affiliated group, the accounting period selected should conform to that of the existing members of the group. The consolidated return regulations require that the tax year of all members of an affiliated group be the same as that of the common parent corporation. Accordingly, recognition of this possibility may avoid the trouble of changing the accounting period for the new corporation, the subsidiary, or the entire group, if the new corporation is the parent.

¶13,180

SPECIAL RULES—THE TAX YEAR

Among the most important tax principles supplementing or providing relief from the integrity of the taxable year are the following:

Carrybacks and Carryforwards. Net operating losses generally are carried forward. Capital losses of corporations are carried back three years and forward five years. Charitable contributions in excess of annual limits are carried forward five years. Unused credits also are carried back and forward.

Installment Method. Certain taxpayers may defer tax payments until sales proceeds are collected.

Mitigation Provisions. To prevent double taxation or double deductions, special rules are provided. Code Secs. 1311-1314.

Arrowsmith Doctrine. A judicially developed rule allows the character of an item in the current year to be determined by looking back to a related transaction in a prior year.

Claim-of-Right Doctrine. If a taxpayer must pay back an amount in the current year which was included in income in a previous year, a deduction in the current or previous year is permitted. Code Sec. 1341.

Tax Benefit Rule. If a taxpayer recovers an amount deducted in a previous year, then this amount is included in income in the year recovered to the extent a deduction was allowed in the previous year. Code Sec. 111.

Cost recovery. Capital expenditures may have to be written off over a number of years through amortization (intangibles), depletion (natural resources), or depreciation or cost recovery (tangibles). Upon disposition, previous write-offs may have to be taken into ordinary income, in full or in part (“recapture”).

Accounting Methods

¶13,201

OVERALL METHODS

In computing taxable income, taxpayers frequently follow those general tax accounting procedures that are well publicized. Unfortunately, this often results in lost opportunities to improve cash flow and/or minimize tax liability.

In addition to selecting one general method of accounting, a taxpayer must select many specific accounting procedures and conventions to be utilized in implementing a single method of accounting. Once a taxpayer knows that a choice exists, the alternative most appropriate to the particular set of circumstances may then be selected. Each election may have a significant impact on the tax liability ultimately reported for any taxpayer.

Section 446 specifies that taxable income is to be computed in accordance with the accounting method regularly used in keeping books. A “method of accounting” includes not only the overall system of accounting of the taxpayer but also the accounting treatment of any item. No uniform method of accounting can be prescribed for all taxpayers. A taxpayer may adopt the forms and systems of accounting that are best suited to the taxpayer’s purpose. Informal records are not sufficient; regular books of account are necessary.

A taxpayer whose sole source of income is wages need not keep formal books in order to have an accounting method. Tax returns or other records may be sufficient to establish the use of the method of accounting utilized in the preparation of the taxpayer’s tax returns.

If the accounting method regularly used by the taxpayer in keeping books for tax purposes clearly reflects income, that method must be used in the annual return. However, no method of accounting will be regarded as clearly reflecting income unless all items of gross profit and deductions are treated with consistency from year to year.

Approved standard methods of accounting ordinarily will be regarded as clearly reflecting income. Where the method used by the taxpayer does not clearly reflect income, or if no method of accounting has been regularly used by the taxpayer, then the tax computation is to be made under a method that the IRS agrees will clearly reflect income. “Clearly reflects income” means that income should be reflected with as much accuracy as standard methods of accounting practice permit, not merely that the taxpayer’s books should be kept fairly and honestly.

The two most commonly used overall methods that are specifically authorized are (1) the cash method and (2) the accrual method. Code Sec. 446. Other permissible methods of accounting for income and expenses are the long-term contract method and the crop method for farmers.

Special treatment is accorded various types of revenue (e.g., installment sales, prepaid subscription income, and obligations issued at a discount) and many types of expenses (e.g., bad debts, real estate taxes, redemption of trading stamps, and expenses whose benefits are received over a period of years). In addition, any combination of permissible methods may be authorized under the regulations.

Subject to the limitations on the cash method of accounting discussed below, a taxpayer filing a first return is allowed to adopt any permissible method of accounting in computing taxable income for the tax year covered by such return. These requirements are sufficiently flexible to permit every taxpayer a maximum opportunity to select the most favorable method of accounting. Except for an occasional refusal to authorize a change in accounting method, the statutory requirements have been interpreted rather liberally.

¶13,215

CASH METHOD

The vast majority of individuals and many businesses use the cash method, primarily because of its simplicity. It generally is used by taxpayers whose principal income is derived from the performance of a service. Unless other restrictions apply, the cash method must be used if the taxpayer keeps no regular books or has inadequate books for the accrual method. Income is recognized in the tax year when cash and/or cash equivalents are actually or constructively received. Expenses generally are deductible in the year paid unless they are attributable to more than one year.

Income may be received in the form of cash, a check, or cash equivalents. Reg. §1.446-1(a)(3). The fair market value of the property is the measure of income. Thus, if a taxpayer receives stock in return for the performance of a service, then the taxpayer’s income is equal to the fair market value of the stock, regardless of accounting method. Similarly, the receipt of a negotiable promissory note produces taxable income in the year of receipt equal to the note’s fair market value. Mere promises to pay, not represented by notes or secured, are not regarded as income when received. A.M. Bedell, 1 USTC ¶359, 30 F.2d 662 (CA-2 1929).

Income also may be received in other forms. A taxpayer may receive the right to use another’s property; that is, the taxpayer does not receive the property outright but is allowed to use the property. In this situation the taxpayer recognizes income equal to the fair rental value of the property. Alternatively, a taxpayer may receive services from another taxpayer. Instead of receiving cash or property, the taxpayer enters into a bartering agreement whereby the form of payment is the rendering of services to the taxpayer. In this situation the taxpayer recognizes income equal to the fair market value of the services received. Finally, the form of income may be the discharge of indebtedness; the taxpayer does not receive cash directly but instead has debt forgiven. Depending on the circumstances, all, some or none of the forgiven debt may be included in income. Code Sec. 61. Thus, cash equivalents may take many different forms.

Cash or cash equivalents are income in the year actually or constructively received. Reg. §1.446-1(c)(1)(i). Income is constructively received in the tax year in which it is credited to the taxpayer’s account, set apart for the taxpayer, or made available to the taxpayer to draw upon if the taxpayer’s control of its receipt is not subject to substantial limitations or restrictions. Reg. §1.451-2(a). The payer must have the ability to pay, must set aside funds for payments, and must not place substantial restrictions on the taxpayer’s ability to access the funds (or property). If these conditions are met, then the taxpayer cannot deliberately turn his or her back on income and thus select the year of reporting. Hamilton National Bank of Chattanooga, 29 BTA 63, Dec. 8240 (1933).

EXAMPLE 13.9

In 2020, Fry Company credits its employees with bonus stock, but the stock is not available to them until 2023. The employees have not constructively received the stock in 2020.

EXAMPLE 13.10

Sally James received a $700 dividend check from Astin Company on December 26, 2020. Sally did not cash the check until January 4, 2021. Sally must include the $700 in her gross income for 2020. If Astin Company had mailed the check on December 29, 2020, and it was not received until January 2021, then Sally would not include it in her gross income for 2020 because she has no constructive or actual receipt until 2021.

The deductibility of expenses does not coincide with the recognition of income under the cash method. There is no such thing as constructive payment. Expenses are recognized in the year they are paid. However, special rules can apply to an expenditure attributable to more than one tax year. If an expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the tax year, the expenditure may not be deductible, or may be deductible only in part, for the tax year in which made. A special rule requires prepaid interest to be capitalized (treated as an asset) and recognized as an expense over the time period to which it relates. Code Sec. 461(g).

EXAMPLE 13.11

Smith Co. uses the cash basis of accounting. On July 1, 2020, Smith Co. borrows $200,000 to buy equipment. The loan will be repaid over 5 years. The lender charges interest over the term of the loan plus 1 point ($2,000) at the time of the borrowing. The $2,000 is prepaid interest that must deducted over the life of the loan. Even though Smith Co. uses the cash basis of accounting, Smith Co. will deduct $200 of the points in 2020 ($2,000/60 months = $33.33 per month; $33.33 x 6 months =$200).

Regulations on expenditures to acquire or create intangible assets include a 12-month rule that applies to many prepaid expenses. Reg. §1.263(a)-4(f). Under the regulations, a taxpayer does not have to capitalize amounts paid to create or facilitate the creation of any right or benefit for the taxpayer that does not extend beyond the earlier of: (1) 12 months after the first date on which the taxpayer realizes the right or benefit; or (2) the end of the tax year following the tax year in which payment is made.

EXAMPLE 13.12

Umbrella Corporation purchases casualty insurance from Weather Inc. at a monthly rate of $2,000. On August 1, 2020, Umbrella prepays its insurance expense for the first six months of 2021 in the amount of $12,000. The 12-month rule applies to the $12,000 payment because the rights or benefits attributable to Umbrella’s prepayment of its insurance do not extend beyond December 31, 2021. Accordingly, Umbrella is not required to capitalize its prepaid insurance.

EXAMPLE 13.13

Leaman Co. uses the cash basis of accounting. On August 1, 2020, Leaman Co. leases office space from Timbell Co. for $4,000 per month and prepays $40,000 of its office rent for the period August 1, 2020 through May 31, 2021. The 12-month rule applies to the $40,000 payment and Leaman may deduct the $40,000 in 2020.

An expense may be “paid” in cash or in property but not by the note of the taxpayer even if secured by collateral. Generally, unconditional delivery of a check has the same consequences as delivery of cash. Delivery means actual delivery of the check to the payee or an agent. However, one court has held that a check is considered delivered when it is put in the mail on the theory that the postal service is acting as the agent for both the sender and receiver. Estate of E.B. Witt v. Fahs, 56-1 USTC ¶9534, 160 F.Supp. 521 (DC Fla. 1956).

If a cash-basis taxpayer borrows funds with which to pay deductible expenses (as opposed to directly giving the creditor a note for repayment)—whether the funds are paid to the taxpayer first or directly to the creditor (subject to an understanding that the taxpayer will make repayment to the lender)—the payments are deductible in the year made, not in the later year when the taxpayer makes repayment to the person who advanced the funds to the taxpayer or paid the expenses on the taxpayer’s behalf.

For tax years beginning after December 31, 2017, taxpayers that meet the gross receipts test of Code Sec. 448(c) may use the cash method of accounting as described below at  ¶13,225 . The gross receipts test significantly expands the universe of taxpayers eligible to use the cash method. Taxpayers may change from the accrual method to the cash method to take advantage of this expansion by following the procedures to change accounting methods. See  ¶13,301 .

¶13,225

LIMITATIONS ON USE OF CASH METHOD

Three types of taxpayers cannot use the cash method of accounting for tax purposes. (Code Sec. 448). These three types of taxpayers include:

1. C corporations

2. Partnerships which have a C corporation as a partner

3. Tax shelters

The prohibition on use of the cash method does not apply to farming and timber businesses, qualified personal service corporations, and entities that meet the gross receipts test. A corporation or partnership meets the gross receipts test if annual average gross receipts do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years. Code Sec. 448(c). The indexed amount for 2020 is $26 million. The $26 million exemption does not apply to any tax shelter. Individuals, partnerships that do not have a C corporation as a partner, and S corporations are not prohibited from using the cash method. Code Sec. 448.

A tax shelter is defined as: (1) any enterprise, other than a C corporation, for which, at any time, interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state securities agency; (2) any partnership or other entity if more than 35 percent of the losses of such entity during the tax year are allocable to limited partners or limited partnerships; or (3) any partnership, investment plan, or other plan or arrangement the principal purpose of which is the avoidance of federal income tax. Reg. §1.448-1T(b).

When computing annual average gross receipts the three-year period does not include the current tax year in which the determination is being made. The enterprise is required to change to the accrual method in the year following the year it fails to meet the small business test. A business may change back to the cash method when its average receipts later fall below $26 million.

Average annual gross receipts are computed by dividing the sum of the gross receipts for so many of the previous three years as the taxpayer conducted business by the number of such tax years. In those cases where the enterprise has not been in existence for the entire three-year period, the test will be based on the number of tax years the enterprise was in existence.

Gross receipts are computed by deducting sales returns and allowances from gross receipts. Gross receipts, as defined in the Form 1120 instructions, include gross receipts or sales from business operations with the exception of dividends, interest, gross rents, other income, and net gains and losses from sales of capital and business assets. Gross receipts for a short tax year of less than 12 months are annualized for purposes of the $26 million test. This annualization is computed by multiplying the gross receipts by 12 and dividing the result by the number of months in the short tax year. Code Sec. 448(c).

A qualified personal service corporation may use the cash method of accounting. A corporation is treated as a qualified personal service corporation only if it meets both a function test and an ownership test. The function test is met if substantially all of the corporation’s activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. The ownership test in general limits stock ownership in the corporation to certain types of persons. Specifically, this test requires that “substantially all” of the value of the corporation’s stock must be owned by (1) current or retired employees, (2) the estates of current or retired employees, or (3) persons who acquired the stock by reason of the death of such employees within the prior 24 months. For purposes of applying the ownership test, community property laws are disregarded, and stock owned by an ESOP or a pension plan is considered to be owned by the beneficiaries of the plan. At least 95 percent of the value of the stock must be held directly or indirectly by the required individuals in order for the “substantially all” requirement to be met. Reg. §1.448-1T(e).

¶13,230

SPECIAL RULES—CASH METHOD

Among the most important tax rules interacting with the cash method of accounting are:

Exchanges of Property. In the absence of a nonrecognition provision, both parties recognize gain or loss even if no cash changes hands. The gain or loss equals value received less the adjusted basis of property relinquished. Code Sec. 1001.

Exchanges of Services. If a CPA renders accounting services to a dentist who settles the account with “free” dental services then each party has income equal to the fair market value of the service received.

Constructive Receipt. Actual receipt is not required. Thus, a paycheck is taxable on receipt even if not cashed until the next tax year and interest credited to a savings account is taxed immediately, even if not withdrawn until the next tax year.

Prepaid Interest. Interest expense is deductible in the periods during which the use of the money occurs.

Prepayments of Services. Generally, no deduction is allowed until services have been rendered, except for de minimis amounts.

Capital Expenditures. Cash and accrual method taxpayers alike must amortize, deplete, depreciate and cost recover assets with a life extending “substantially beyond” the current tax year. Reg. §1.461-1(a)(1).

Farmers. Farmers generally may use the cash method even if inventories are substantial. Reg. §1.471-6(a). Limitations are imposed on farming “tax shelters.” Code Secs. 447, 448, and 464.

Checks. A deductible payment made by check is deductible in the year the check is mailed or delivered, even if not cashed until the next tax year.

¶13,235

ACCRUAL METHOD

In general, two tests (the all-events test and economic-performance test) must be met before income or an expense is recognized under the accrual method. Under the accrual method, income is reported when the right to receive income comes into being, that is, when all the events which determine the right to receive income have occurred and the amount can be determined with reasonable accuracy. Reg. §1.451-1(a). For taxable years beginning after December 31, 2017, the all-events test is met no later than the tax year in which such income is recognized as income on an applicable financial statement, or another financial statement under rules specified by IRS, of the taxpayer. Deductions are taken in the year when the legal obligation to make payments comes into existence and all the events have occurred that determine the fact of the liability and the amount can be determined with reasonable accuracy, unless properly allocable to another year. Reg. §1.461-2. The all events test is not met until economic performance with respect to the item has occurred. Code Sec. 461(h).

The main disadvantage of the accrual method of accounting is a reduction in the taxpayer’s control over the timing of both gross income and tax deductions. Under accrual accounting, a taxpayer may have to recognize income prior to the receipt of cash with which the taxpayer can pay the tax liability.

INCOME INCLUSION WITH AN APPLICABLE FINANCIAL STATEMENT

The all-events test is satisfied for accrual method taxpayers no later than when an item is included in income on an applicable financial statement. Code Sec. 451(b). This book-conformity rule does not apply to taxpayers who do not have a financial statement as defined in the statute or by the IRS, nor to income in connection with mortgage servicing contracts, nor to certain other items of income for which the taxpayer uses a special method of accounting, such as long-term contracts and installment agreements. An applicable financial statement is one that is certified as being prepared in accordance with generally accepted accounting principles and is either: 1) filed with the Securities and Exchange Commission (SEC); 2) used for credit purposes, or reporting to owners or beneficiaries, or any other substantial non-tax purpose; or 3) filed by the taxpayer with any other Federal agency for purposes other than Federal tax purposes. An applicable financial statement also includes those made on the basis of international financial reporting standards and filed by the taxpayer with an agency of a foreign government which is equivalent to the SEC and which has reporting standards not less stringent than the standards required by the SEC and those filed by the taxpayer with any other regulatory or governmental body specified by the IRS. If the company files a financial statement with the SEC, that is the applicable financial statement to use for the all-events test. Code Sec. 451(b).

On May 28, 2014, the Financial Accounting Standards Board and the International Accounting Standards Board jointly announced new financial accounting standards for revenue recognition, titled “Revenue from Contracts with Customers (Topic 606).” Under the new standards, items of income may be included as revenue in an applicable financial statement earlier than they would have been included in income under the all events test prior to the Act. On September 5, 2019, the IRS released proposed regulations to address how the applicable financial statement inclusion rule applies. Prop. Reg. §1.451-3. The applicable financial statement inclusion rule operates only to accelerate income; the rule can never cause income inclusion to occur later than when the all events test is satisfied.

THE ALL EVENTS TEST WITHOUT AN APPLICABLE FINANCIAL STATEMENT

If the taxpayer does not have a financial statement that satisfies the all-events test and the income has not been reduced to possession or constructively received, income becomes taxable under the accrual method when three circumstances are present: (1) there is an unconditional right to receive it, (2) the amount is determinable with reasonable accuracy, and (3) the amount is collectible.

Thus, in order that income be accruable, existence of the right to the income, subject to no contingencies, is the primary essential. If a taxpayer’s right to receive is dependent upon future events, there is no accrual until those contingencies occur or lapse.

Second, it also is essential to first provide the general formula (or rules for determining the amount of the income) even if the precise amount has not been determined at this time. The taxpayer may make his or her own determination and accrue the amount so determined, even though the actual determination for payment purposes may show it to be in error or even though some portion of the money received by the taxpayer might have to be refunded in some future year.

The third and final condition is that the amount must be collectible. Even though notes or other receivables may not be marketable, they may be collectible. If the right to receive arises from a sale of real property, an accrual-basis seller should report such right at its fair market value. However, if the sale is of personal property, the full face value of the right must be reported as income.

EXAMPLE 13.14

Darryl Harris sells a building for $200,000, receiving $50,000 in cash and a $150,000 mortgage note due in five years with a 10 percent interest rate. The mortgage note has a $135,000 fair market value. The basis of the building is $95,000. Darryl will report a gain of $90,000 ($50,000 cash + $135,000 fair market value of the mortgage note = $185,000 selling price minus $95,000 basis). If the full $200,000 is collected, $15,000 will be reported as interest income. If the asset sold were personal property rather than the building, the selling price would be $200,000.

Only if there is clear and convincing evidence that real doubt and uncertainty exist as to whether the amount due will ever be collected can there be postponement of reporting income. The possibility of default is not sufficient. The courts have held that year-end is the time to test collectibility on unpaid items. An event occurring subsequent to that time has no effect on the accountability.

An accrual-basis taxpayer need not accrue as income any portion of amounts billed for the performance of services which, on the basis of experience, it will not collect. However, the income must be accrued if the taxpayer charges any interest or penalty for failure to make timely payments in connection with the amount billed. The offering of a discount for early payment of an amount billed will require the reporting of income as long as the full amount of the bill is otherwise accrued as income and the discount for early payment treated as an adjustment to income in the year such payment is made.

The amount of billings that, on the basis of experience, will not be collected is equal to the total amount billed, multiplied by a fraction whose numerator is the total amount of such receivables that were billed and determined not to be collectible within the most recent five tax years of the taxpayer and whose denominator is the total of such amounts billed within the same five-year period. If the taxpayer has not been in existence for the prior five tax years, the portion of such five-year period that the taxpayer has been in existence is to be used.

EXAMPLE 13.15

Assume that an accrual-basis taxpayer has $150,000 of receivables that have been created during the most recent five tax years. Of the $150,000 of accounts receivable, $3,000 has been determined to be uncollectible. The amount, based on experience, which is not expected to be collected is equal to 2 percent ($3,000 divided by $150,000) of any receivables arising from the provision of services that are outstanding at the close of the tax year.

A taxpayer who has not recognized income on amounts not expected to be collected must recognize additional income in any tax year in which payments on amounts not recognized are received. If a receivable is determined to be partially or wholly uncollectible, no portion of the loss arising as a result of such determination that was not recognized as income at the time the receivable was created is allowed as a deduction.

Prepaid Income

Although the general rule of Code Sec. 451(c) requires an accrual method taxpayer who receives an advance payment to include the amount in income in the year of receipt, it also allows taxpayers to elect deferral of income for certain advance payments. The amount of the advance payment that is not taken into income in the year of receipt will be included in income the following taxable year.

Advance payments received for services, the sale of goods, the use of intellectual property, and several other items identified in proposed regulations are eligible for the deferral method. A taxpayer with an applicable financial statement must include: (1)the advance payment in income in the taxable year of receipt to the extent that it is included in revenue in its applicable financial statement, and (2) the remaining amount of the advance payment in income in the next taxable year. If an accrual method taxpayer does not have an applicable financial statement receives an advance payment, then the taxpayer must include: (1) the advance payment in income in the taxable year of receipt, to the extent that it is earned, and (2) the remaining amount in the next taxable year. Prop. Reg. §1.451-8.

EXAMPLE 13.16

On October 1, 2020, Maria Juarez, a calendar-year, accrual-basis taxpayer who runs a dance school, receives a $1,200 payment for a one-year contract beginning on that date to provide 48 dance lessons. Maria does not have an applicable financial statement. Ten lessons were provided in 2020 and 38 are provided in 2021. Maria elects to recognize income as earned; so she recognizes $250 ($1,200/48 × 10) in 2020 and $950 in 2021. Even if Maria only provided 25 lessons in 2021 she still would recognize $950 in 2021 because the maximum deferral is to the next tax year.

Certain types of prepaid income are specifically excluded from the deferral method. The most commonly encountered exclusion is prepaid rent. Prepaid rent is always included in income when it is received. Other items are listed in Code. Sec. 451(c)(4)(B).

EXAMPLE 13.17

On July 1, 2020, Mark Schreiber, a calendar-year, accrual-basis taxpayer who owns a self-storage facility, receives a $4,800 payment for a two-year lease of a storage unit beginning on that date. Mark will recognize all $4,800 income in 2020 even though only $1,200 will be earned by year end.

Other areas that under certain circumstances and within certain limits that receive special treatment include:

1. (1) prepaid subscription income—under Code Sec. 455, the taxpayer may elect to recognize income over the subscription period, and

2. (2) prepaid membership dues—under Code Sec. 456, the taxpayer may elect to recognize income ratably over the time period it is liable (if not more than 36 months).

 

EXAMPLE 13.18

On November 1, 2020, a calendar-year, accrual-basis membership organization sells a two-year membership for $2,400 payable in advance. It elects to recognize income over the life of the membership; so it recognizes $200 ($2,400 × 2/24) in gross income in 2020, $1,200 ($2,400 × 12/24) in 2021 and $1,000 ($2,400 × 10/24) in 2022.

EXPENSES UNDER THE ACCRUAL METHOD

An accrual method taxpayer does not satisfy the all-events test regarding expenses until economic performance occurs. If a liability arises because a service or property is provided to the taxpayer, then economic performance occurs when the other party provides such service, such property, or the use of such property. If the liability requires the taxpayer to provide a service or property, then economic performance occurs when said service or property is provided. However, Code Sec. 461(h)(3) provides an exception for recurring items if the all events test is met. In such situations the item is deductible during the year if economic performance occurs within eight and one-half months after the close of the tax year.

If a taxpayer is contesting a liability of a claimed amount, the deduction cannot be taken until the contest is settled by court decision, compromise, or otherwise. However, if the taxpayer pays the disputed amount or places it beyond its control (e.g., in an escrow account) then the taxpayer can claim a deduction when payment is made. Any difference between what was placed in escrow and the actual settlement amount is either deducted (if settlement was greater than escrow payment) or included in income (if settlement was less than escrow payment) in the year of settlement.

TAX BLUNDER

Bob Mumper is an accrual-basis, calendar-year taxpayer who performs a service. In 2020, he received prepayments of $200,000 for services he will perform in 2021. Mumper is in the 37% tax bracket in 2020, and he is uncertain about future years’ tax brackets. Mumper assumed that under the claim of right doctrine he had to include the $200,000 in gross income in 2020 and did so accordingly.

Mumper could have and should have used the deferral method for advance payments. This would have deferred income recognition until 2021, which would have reduced his tax liability by at least $74,000 (37% × $200,000) in 2020. Even if Mumper is in the 37% bracket in 2021, the time value of money would have worked in his favor and would have increased the present value of his after-tax cash flows.

¶13,240

ACCRUAL METHOD TAX PLANNING

Tax planning by accrual method taxpayers can affect the amount of taxable income being reported for the year. Listed below are various techniques that taxpayers may use to increase or decrease taxable income for the tax year.

Income may be deferred by the following techniques:

1. Delays in shipping goods sold (if shipping time is accrual time)

2. Shipping F.O.B. destination, delaying the title change (if title change is accrual point)

3. If allowed, switching from accrual to installment reporting

4. Sales and leasebacks at a loss (e.g., Section 1231 property)

5. Lease with option to buy or just sales of options

6. Using an independent escrow account beyond year end

7. Deferring December billings for services until January (if billing is accrual point)

8. Advanced payments may be structured as conditional prepayments or as loans.

Income may be accelerated by the following techniques:

1. The reverse of the above reduction techniques

2. The sale of installment notes

3. Sales and leasebacks of appreciated assets

4. Increased year-end orders through payment deferrals, next year discounts, and special promotions

5. Electing out of the installment method for casual sales.

Deductions may be increased by the following techniques:

1. Paying bonuses to officers and/or shareholder-employees

2. Prepaying nonrefundable commissions

3. Increasing deferred compensation contributions, such as to an ESOP or a Code Sec. 401(k) plan

4. Incurring expenses before the end of the year, such as charitable contributions, advertising, accelerating repairs, settling disputed amounts

5. Purchasing business equipment and autos at year-end. The depreciation deduction generally is the same as if the property were purchased at the beginning of the year (if the mid-quarter rules do not apply)

6. Making use of all travel and entertainment expenses.

Deductions generally will be decreased if the reverse of the above is done. If a deduction will be more beneficial next year then its incurrence should be deferred.

¶13,245

SEPARATE SOURCES OF INCOME

Where a taxpayer has two or more separate and distinct businesses, a different method may be used for each business, provided separate books and records are maintained clearly reflecting the income of each. But the taxpayer may not shift profits and losses between businesses through inventory adjustments, sales, purchases, or expenses. Reg. §1.446-1(d).

EXAMPLE 13.19

Olivia Lee operates a beauty shop and a shoe store as separate sole proprietorships. The income and deductions of the beauty shop can be accounted for under the cash method of accounting, while those of the shoe store may be under the accrual method of accounting (see  ¶13,265 ).

In a situation where there are overlapping costs, expenditures on behalf of each activity are to be taken up in the books or tax return for that activity in accordance with the applicable method of accounting. As to any business for which separate records are maintained, the rule of consistency would continue to apply.

This principle has been extended to situations where the taxpayer uses one method for business income and another for personal income. The Regulations state that a taxpayer using one method of accounting in computing items of income and deductions for trade or business may compute other items of income and deductions not connected with the trade or business under a different method of accounting.

¶13,265

HYBRID METHODS

Many combinations of permissible accounting methods may be used. But a taxpayer’s choice is not unlimited. If the cash method is used for income, it must also be used for expenses. And if the accrual method is used for expenses, it must also be used for income.

Taxpayers that meet the gross receipts test of Code Sec. 448(c) ($26 million in 2020) may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories. Code Sec. 471(c). A deduction is generally permitted for the cost of non-incidental materials and supplies in the tax year in which they are first used or are consumed in the taxpayer’s operations. Reg. §1.162–3(a)(1). The taxpayer’s financial accounting treatment of inventories is the method of accounting used in the taxpayer’s applicable financial statement or, if the taxpayer does not have an applicable financial statement, the method of accounting used in the taxpayer’s book and records prepared in accordance with the taxpayer’s accounting procedures.

EXAMPLE 13.20

Jay Thomsen is a nutritionist who specializes in treating cancer survivors. During the year he opened several stores where he employs staff to meet with customers. At each location he maintains an inventory of protein, vitamin and herbal supplements for sale to customers. Jay’s gross receipts are about $5 million, he uses the cash method of accounting and does not have an applicable financial statement. He accounts for inventory as a non-incidental supply. During the year he acquired and paid for $2,000,000 of inventory and at the end of the year the remaining inventory was $300,000. Jay will deduct the $1,70,000 of inventory that was sold to customers during the year.

Qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the gross receipts test, so long as the use of such method clearly reflects income. However, the cash method generally may not be used by taxpayers, other than those that meet the gross receipts test, if the purchase, production, or sale of merchandise is an income-producing factor. Reg. §1.446-1(c)(2)(i). If the use of the accrual method for inventory were not mandatory, a cash-basis taxpayer could very easily reduce reported net income by increasing stock of inventory and could increase reported net income by depleting normal inventory.

The fact that inventories are essential does not necessarily mean that an accrual method of accounting is needed on an overall basis. For example, the accrual method may be used for purchases and sales of inventory and be combined with the cash method for other items of income and expense.

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TANGIBLE PROPERTY REGULATIONS

Section 263(a) generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property. Section 162 allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the costs of certain supplies, repairs, and maintenance. Regulations, commonly referred to as the repair regulations, the tangible property regulations, or the capitalization regulations, provide guidance for distinguishing currently deductible repair expenses from expenditures required to be capitalized as an improvement to the property and thus depreciated over the asset's recovery period. Costs that result in the betterment to a unit of property must be capitalized. These regulations apply to all businesses, regardless of size, industry, or legal entity. TD 9636.

EXAMPLE 13.21

Olivia Lee operates a beauty shop. The roof of her shop suffered damage during a hail storm. She hired a roofer to replace the shingles with similar shingles. The total cost of the repair was $7,000. Olivia will expense the cost of the repair because it did not result in a betterment. The repair is not expected to materially increase the strength or quality of the roof.

The regulations apply to costs incurred throughout the entire life cycle of the taxpayer’s tangible property, from the time the taxpayer (1) first begins considering whether (and which) property to acquire, (2) through maintaining and improving the property during its operational life, and (3) finally to the treatment of the property’s remaining basis when the taxpayer disposes of the property.

The regulations generally require a taxpayer to capitalize amounts paid to acquire or produce a unit of real or personal property, including the related investigation and transaction costs. Reg. §1.263(a)-2. De minimis provisions allow taxpayers to expense items costing $5,000 or less if the taxpayer has an applicable financial statement and written accounting procedures to expense an item for books if it costs less than a specified amount or has a useful life of less than 12 months. The amount paid for the property is measured per invoice (or per item as substantiated by the invoice). Reg. §1.263(a)-1(f). Taxpayers without an applicable financial statement generally may elect to apply the de minimis safe harbor to property expensed for book purposes as long as the cost of the property does not exceed $2,500. Notice 2015-82.

The rules governing the distinction between currently deductible maintenance costs and capital improvements are applied to a “unit of property.” Components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer. The regulations generally require a taxpayer to capitalize expenditures to improve a pre-existing unit of property. Reg. §1.263(a)-3.

EXAMPLE 13.22

Olivia Lee operates a beauty shop. She rents ten stations to cosmetologists. To improve the functionality of each station, she adds a rolling cart with storage drawers specially designed to hold tools and supplies used in providing services. Each cart costs $1,200 for a total cost of $12,000. Each cart is a unit of property. Olivia does not have an applicable financial statement and elects to apply the de minimis safe harbor of Reg. §1.263(a)-1(f). Olivia will deduct the $12,000 since each cart costs less than $2,500. If the carts costed more than $2,500 each, Olivia would not be able to deduct the cost under the de minimis election.

Change of Accounting Methods

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IRS PERMISSION OR CONSENT

While there is no prohibition against changing the method of accounting, Code Secs. 446 and 481 require that permission be obtained from the IRS before adopting the new method for income tax purposes. The purpose of the prior consent provision is to promote consistency in accounting practices from year to year, thereby securing uniformity in the collection of revenue. Rev. Proc. 2015-13 as modified provides general procedures to obtain the consent of the IRS to change a method of accounting. The revenue procedure provides the procedures to obtain both advance (non-automatic) and automatic consent of the IRS to change a method of accounting. The list of changes for which the automatic change procedure can be followed is extensive and is frequently updated; the current list is found in Rev. Proc. 2019-43. For most voluntary accounting method changes, taxpayers use the automatic consent procedures. There are several advantages to making a voluntary accounting method change under the automatic consent procedures as opposed to the advance consent procedures. There is no user fee, notice of IRS approval of the change is not required, and Form 3115 (Application for Change in Accounting Method) can be submitted up to the extended filing date of the tax return for the year of change.

An advance consent accounting method change is a change that cannot be made under the automatic consent procedures. Permission to change the method of tax accounting will not be granted unless the taxpayer and the IRS agree to the terms and conditions under which the change will be effected. Where two methods clearly reflect income, the IRS has considerable discretion in prescribing the conditions under which it will consent to a change from one to the other.

Change in Overall Plan or Material Items

A change of accounting method includes a change in the overall plan of accounting as well as a change in the treatment of any material item used in the plan. In most instances, a method of accounting is not established for an item unless there is a pattern of consistent treatment. Major changes in accounting method include:

1. Change to or from the cash-basis method

2. Change in the method of valuing inventory

3. Change from the accrual method to a long-term contract method or vice versa

4. Change involving the adoption, use, or discontinuance of any other specialized method of computing income, such as the crop method by farmers

5. Certain changes in computing depreciation or amortization

6. Change for which the Code or Regulations specifically require that the consent of the IRS be obtained (Reg. §1.446-1(e)).

A material item is any item that involves the timing of inclusion or deduction. According to the Tax Court, the term means a “material item of gross income or deductions,” not “a material item of net income” or “a material difference in income” resulting from the computation under two different methods of accounting. Connors, Inc., 71 TC 913 (1979).

Correction of Mathematical Errors

A change in method does not include correction of mathematical and posting errors, or of errors in the computation of tax liability. For example, corrections of items that were deducted as interest or salary, but which are in fact payments of dividends, and of items that were deducted as business expenses, but which are personal expenses, are not changes in method. An adjustment to the useful life of a depreciable asset also is not an accounting method change. Although such adjustments may involve the question of the proper timing of a deduction, these items are traditionally corrected by adjustments in the current and future years.

Change in Underlying Facts

An accounting change does not include a change in treatment resulting from a change in underlying facts. On the other hand, a correction to require depreciation in lieu of a deduction for the cost of a class of depreciable assets which had been consistently treated as an expense in the year of purchase involves the question of the proper timing of an item and is to be treated as a change in method of accounting. Reg. §1.446-1(e).

IRS-Directed Changes

Although taxable income is to be computed according to a taxpayer’s regular accounting method used in keeping the books, if that method does not clearly reflect income, then the IRS may prescribe a method which does.

The IRS’s authority to require a taxpayer to adopt an overall or specific change in accounting method necessary to clearly reflect income does not justify an arbitrary requirement of change. If a taxpayer’s accounting method clearly reflects income, the IRS may not determine income by another method which would also clearly reflect income. Presumably, this rule would also apply to the method of treating a particular item of income or expense, such as depreciation. A taxpayer may, of course, conform books or returns to a suggestion by an Internal Revenue agent, for convenience, to cooperate with the local office of the IRS and facilitate audits of returns, or to avoid the expense of an appeal or refund proceedings, but the taxpayer cannot be required to make the change.

The IRS can change an incorrect method, but the change must be to a correct method. If the IRS has directed a taxpayer to change the method of accounting and the taxpayer has complied, the IRS cannot later argue that the change was improper because the taxpayer had not obtained formal permission to make it. And where an unusual method of accruing expenses on construction contracts was proposed by the IRS and the taxpayer followed that method, the IRS was not allowed to object in later years that the method did not clearly reflect income.

The Fifth Circuit has held that, where a taxpayer changed the accounting method and not the basis of the tax returns, the IRS may not require the returns to be filed on the new basis if both methods clearly reflect income despite the Code requirement that the book method must be used in computing income. J.C. Patchen, 58-2 USTC ¶9733, 258 F.2d 544 (CA-5 1958).

Combination of Methods

A combination of acceptable methods of accounting will be permitted if such combination clearly reflects income and is consistently used. However, if the taxpayer uses a hybrid method that is not authorized by the Regulations, the IRS may make adjustments to conform to either the cash or accrual basis, whichever more closely resembles the taxpayer’s method of keeping books. The burden is on the taxpayer to show errors in determining which method predominates for book purposes, or to show that the hybrid method is acceptable. The fact that a taxpayer has filed returns on a hybrid basis for a number of years, without objection, does not bar the IRS from requiring a change.

Cash to Accrual Method

Taxpayers desiring to change their overall method of accounting from the cash receipts and disbursements method of accounting to the accrual method may do so by filing a timely Form 3115 (Application for Change in Accounting Method) under the automatic consent procedures.

Net operating losses and tax credit carryforwards can reduce the amounts of any positive adjustment. For purposes of determining estimated payments, adjustments are recognized as occurring ratably throughout the year.

Denial of Change

Refusal to consent to a change in accounting method is ordinarily within the IRS’s administrative discretion and cannot be reversed unless the taxpayer can prove the IRS abused its discretion. The IRS is not required to permit a change of accounting method for tax purposes just because the taxpayer is ordered to change the accounting method by another administrative agency. The Tax Court stated “that a taxpayer may be required to account one way for one government agency and another way for a different government agency may well be a hardship, and we have no doubt it is, but we are certain that the remedy does not lie with us as a judicial byproduct of a tax determination.” National Airlines, Inc., 9 TC 159 (1947).

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ADJUSTMENT—VOLUNTARY/REQUIRED CHANGE

When a taxpayer computes taxable income under a different accounting method than that used in the preceding year, adjustments must be made in order to prevent items from being duplicated or entirely omitted. The general intent is that no item may be omitted and no item may be duplicated as a result of a change. These adjustments apply not only when the taxpayer voluntarily changes the accounting method with the consent of the IRS, but also when a change in method is required by the IRS.

The term “adjustments” is defined as the net amount of all adjustments, taking only the net dollar balance into account. The net amount of the adjustments would be the result of the consolidation of adjustments (both plus and minus) for the various accounts, such as inventory, accounts receivable, and accounts payable at the beginning of the tax year. In the case of a change in the treatment of a single material item, the amount of the adjustment is determined by the net dollar balance of that particular item. Reg. §1.481-1(c).

EXAMPLE 13.23

Jones Co. is on the calendar year and uses the cash method of accounting. Jones Co. changed to the accrual method in 2020. Net income for 2020 under the accrual method was $60,000, computed as follows:

Sales	$200,000
Cost of goods sold	120,000
Gross profit	$80,000
Expenses	20,000
Net income	$60,000

In December 2019, there was $10,000 inventory on hand. Also, accounts receivable and accounts payable were $6,000 and $4,000, respectively.

The $60,000 net income must be adjusted for amounts which would be duplicated or be omitted because of the change in accounting methods. The net adjustment is $12,000; therefore, adjusted net income for 2020 would be $72,000. The adjustments are as follows:

Positive adjustment for the ending inventory balance because this amount was deducted when acquired	$10,000
Positive adjustment for the ending accounts receivable because this amount has never been included in income	6,000
Negative adjustment for the ending accounts payable because this amount has never been deducted	(4,000)
Net adjustment	$12,000

Rev. Proc. 2015-13 provides a single adjustment period for positive and negative adjustments. In general, the adjustment period for taxpayer-initiated changes that result in a positive adjustment is four years of which the tax year is the first year. However, if the adjustment is less than $50,000, the taxpayer may elect a one-year adjustment period. If the taxpayer ceases business operations (e.g., the firm liquidates) prior to the end of the four-year period, then any remaining adjustment is taken into consideration in the year of cessation. The adjustment period is one year for negative adjustments. Finally, a positive adjustment due to a change initiated by the IRS generally is recognized over the four-year period as noted above. However, the IRS can require that it be recognized over a shorter time period. Under Rev. Proc. 2002-18, a negative adjustment due to an IRS-initiated change can be recognized in the year of the change.

EXAMPLE 13.24

In  Example 13.23 , Jones Co. has two options regarding the $12,000 adjustment. It can spread the $12,000 over four years, increasing net income for 2020 to $63,000 and increasing net income by $3,000 in 2021, 2022, and 2023. Alternatively, since the adjustment is less than $50,000, Jones could elect to use a one-year adjustment period and add the $12,000 to its $60,000 in 2020. If Jones has losses from other activities or a net operating loss carryover, then it might want to select this option.

EXAMPLE 13.25

Harry Co. changed its method of accounting in 2020. The net adjustment due to the change was $60,000. Since this amount exceeds the less-than-$50,000 threshold, Harry Co. is not eligible to elect the one-year adjustment period. Thus, Harry Co. must use the four-year adjustment period, and one-fourth of the $60,000 will be included in income in 2020, 2021, 2022, and 2023.

If a taxpayer has claimed insufficient depreciation in prior years, the taxpayer may change his or her depreciation method to claim allowable depreciation. This is considered to be a change in accounting method, and the omitted depreciation from previous years is considered to be an adjustment which the taxpayer may elect to use the one-year adjustment period. The taxpayer is required to own the asset on the first day of the tax year in which the change of accounting method applies. Rev. Proc. 2008-52.

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TIME AND FORM OF APPLICATION

A taxpayer requesting to change a method of accounting under the automatic change procedures must file a Form 3115 (Application for Change in Accounting Method) in duplicate, as follows: (1) the original completed Form 3115 must be attached to the taxpayer's timely filed (including any extension) original tax return implementing the requested change for the year of change; and (2) a signed copy must be filed with the IRS in Ogden, UT no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115. A taxpayer requesting to change a method of accounting under the non-automatic change procedures must file a Form 3115 with the appropriate user fee during the requested year of change, except as specifically provided in published guidance. If the taxpayer is under examination, before an Appeals office, or before a federal court with respect to any income tax issue, the taxpayer must provide additional signed copies to relevant officials.

The taxpayer should, to the extent applicable, furnish (1) all information requested on the form, disclosing in detail all classes of items which would be treated differently under the new method and showing all amounts which would be duplicated or omitted as a result of the proposed change, and (2) the computation of the adjustments to take into account such duplications and omissions.

It should also be stated in the application that the taxpayer proposes to take the adjustment into account over the appropriate period as required by the IRS in accordance with rules that have been discussed previously. Code Sec. 481; Rev. Proc. 2015-13. Permission will not be granted unless the taxpayer and the IRS agree to the terms, conditions, and adjustments under which the change will be effected.

There is no requirement that, once the IRS has approved the change, the taxpayer must use the new accounting method in filing returns thereafter. However, the IRS, in its letter granting the change of accounting method, states that if the taxpayer does not wish to make the change, the IRS should be advised within 30 days of the date of the letter. The taxpayer who decides not to change a method of accounting after the 30-day period is not precluded from keeping the present method in effect.

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ACCOUNTING METHOD TAX PLANNING

Keeping income levels near average from year to year is a major tax saver for taxpayers subject to a graduated scale of tax rates. Two persons having the same total taxable income over a number of years may pay widely different taxes because of the progressive rate structure. A taxpayer should choose accounting methods and procedures that will stabilize taxable income over the years so as to produce minimum taxes. Of course, where there are greater ups and downs in taxable income at higher rates, the tax savings become greater as taxable income is leveled out. The cash-basis taxpayer may time the receipt of income either by accelerating it to boost an otherwise poor year or by postponing it so as not to overburden the current year. There is nothing in income tax law that requires a creditor to press or decline to press for payment of an obligation in a particular tax year.

Income from sales arises when title to the goods passes to the customer; that is, in the case of most regular sales, at the time of delivery to a common carrier. By withholding shipment until after the end of the accounting period, a taxpayer may keep the amount of sales for the year down and thereby reduce income. In other instances, the seller may defer income by shipping goods on approval or on consignment subject to acceptance or sale in the following year.

A taxpayer may also reduce taxable income by accelerating business expenses for replenishment of supplies that are not part of inventory, performance of repairs, advertising, or business trips. Remember, however, that only ordinary and necessary expenses are deductible.

For an individual who engages in investment activities in occasional “business” ventures, the cash basis of accounting may offer substantial tax advantages through its ability to control year-end expenditures and receipts. For a business activity, the accrual method of accounting may offer advantages by its tendency to level out income, thus avoiding high-bracket peak income periods. There is no rule that would preclude a taxpayer from using the cash basis for nonbusiness items and salary and the accrual method for business income.

The number of alternative accounting procedures and conventions is substantially greater than the number of alternative general methods of accounting. The Code authorizes a number of accounting procedures to determine the cost allocation available for depreciation. The cost-of-goods-sold determination can be made under any of several alternative inventory costing conventions. Each of these accounting conventions or procedures will yield a different taxable income for a given tax year.

TAX BLUNDER

Dean Chips operated a successful garage as a sole proprietorship on the cash basis. He obtained IRS permission to change to the accrual method, which resulted in a net increase in income under Code Sec. 481(a). Pursuant to Code Sec. 481(c), he spread the adjustment over 10 years (the adjustment period used at that time—it now is four years), starting with the year of change. Two years later, he incorporated his business in a “tax-free” Code Sec. 351 transaction. The IRS argued that the remaining 70 percent of the adjustment was accelerated upon incorporation, resulting in taxable income to Dean immediately. The Ninth Circuit agreed with the IRS that Code Sec. 481 requires continuity of the taxpayer, rather than the business. D.R. Shore, 80-2 USTC ¶9759, 631 F.2d 524 (CA-9 1980); Rev. Rul. 77-264. Furthermore, the exception under Code Sec. 381 does not apply to corporate organization, only to corporate reorganization. Thus, even if Dean was the sole shareholder and even though the incorporation did not result in gain, it did accelerate income (so much for tax-free incorporations).

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TIMELINESS

Making an accounting election usually requires some overt act on the part of a taxpayer. Proper timing is critical to making a valid election. Failure to make a timely election precludes a consideration of procedural compliance since the election will not be effective. To this extent, then, timing should be deemed of paramount importance.

The Code contains many elections that pertain to newly organized businesses. Failure to make the election on a timely basis may result in higher immediate taxes.

Inventories

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USE OF INVENTORIES

Taxpayers who are required to use the accrual method of accounting for inventory (i.e., those who do not meet the $26 million gross receipts test) defer a major deduction, cost of goods sold, until the inventory is sold. Because cost of goods sold equals opening inventory, plus inventory purchased or produced, less ending inventory, an incentive exists to value ending inventories as low as possible. A low valuation results in an immediate tax benefit through a higher cost of goods sold deduction. Although the benefit is theoretically a mere deferral, the deferral is of indefinite duration. Also, as inventories grow with the expansion of the business, more and more profits are deferred. The value of ending inventory is a function of (1) what costs are included and (2) the cost flow assumptions made. The details are discussed below.

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VALUATION OF INVENTORY

An inventory is an itemized list, with valuations, of goods held for sale or consumption in a manufacturing or merchandising business. The inventory should include all finished or partly finished goods, and only those raw materials and supplies that have been acquired for sale or that will physically become a part of merchandise intended for sale. Goods in transit to which the taxpayer has title should be included in inventory, and goods on hand in which title has passed to the buyer should not be included in inventory. Reg. §1.471-1.

There are two fundamental requirements for valuation of inventory: (1) it must conform as nearly as possible to the best accounting practice in the trade or business and (2) it must clearly reflect income. Code Sec. 471. In determining whether income is clearly reflected, great weight is given to consistency in inventory practice. Reg. §1.471-2. Nevertheless, a legitimate accounting system will be disallowed where it distorts income.

Inventory may be valued at cost or lower-of-cost-or-market. Reg. §1.471-2. However, if the LIFO method (discussed later) is used, then the taxpayer cannot use lower-of-cost-or-market. Also, lower-of-cost-or-market must be applied to each item in inventory; a taxpayer cannot value the entire inventory at cost and at market and then select the lower amount.

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COST METHODS

The cost of merchandise on hand at the beginning of the period (beginning inventory) is its inventory price as of the last day of the previous year. The cost of merchandise purchased is the invoice price, less trade discounts, plus incidental costs incurred to acquire the goods (such as transportation and other handling costs). Reg. §1.471-3. Additionally, the following indirect costs must be capitalized under the uniform capitalization (UNICAP) rules unless the taxpayer’s average annual gross receipts for the preceding three taxable years do not exceed $26 million: storage and warehousing; purchasing; handling, processing, assembly, and repacking; and administrative costs. Code Sec. 263A(b).

The cost of merchandise produced by the taxpayer includes the cost of direct materials, direct labor, and indirect costs. Reg. §1.471-3. Manufacturers must use absorption costing (full costing) to value inventories; they cannot use direct costing or prime costing. Indirect costs that must be capitalized include repairs, maintenance, utilities, rent, and indirect labor and materials. Indirect costs do not include marketing expenses, advertising and selling expenses, and research and experimentation costs. Reg. §1.471-11. Additionally, Code Sec. 263A expanded the definition of includible costs by requiring most entities to use the UNICAP rules. This expanded list requires the capitalization of more items than does financial accounting.

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UNIFORM CAPITALIZATION RULES

UNICAP generally applies to real or personal property produced by the taxpayer and real or personal property acquired by the taxpayer for resale. Code Sec. 263A(b). Costs to be capitalized include direct costs and an expanded list of indirect costs. Reg. §1.263A-1(b)(2). Under UNICAP, indirect costs include:

1. Factory repairs and maintenance; utilities; rent; depreciation, amortization, and depletion; small tools; and insurance;

2. Indirect labor and production supervisory labor; administrative costs; indirect materials and supplies; rework, scrap, and spoilage; storage and warehousing costs; purchasing costs; handling, processing, assembly, and repacking costs; and quality control and inspection costs;

3. Taxes (other than income taxes);

4. Deductible contributions to pension, profit-sharing, stock bonus, or annuity plans; and

5. Interest, but only for real property, long-lived property, or property requiring more than two years to produce (one year for property costing more than $1 million).

Costs not required to be capitalized include nonmanufacturing costs such as marketing, selling, advertising and distribution expenses, and research and experimentation costs.

Cost Allocation Procedures

After identifying all costs that are required to be capitalized (known as total additional Code Sec. 263A costs), the next step in costing inventory is to allocate these costs. The Regulations provide allocation methods for direct labor, direct materials, and indirect costs. The allocation method should result in the capitalization of all costs that directly benefit or are incurred because of production or resale activities. Reg. §1.263A-1(b)(3).

All direct labor costs must be capitalized. The costs should be associated with specific production activities and products, and allocated to them accordingly (using specific identification or tracing). All direct material costs also should be capitalized. These costs should be allocated to products using the taxpayer’s method of accounting for inventories that contain the direct materials (e.g., FIFO, LIFO, specific identification). The above mentioned allocation methods are not mandatory; the taxpayer may use any other method which reasonably allocates such costs.

Indirect costs are allocated to activities and products using one of three methods: specific identification (in which the costs are specifically identified with activities or products that directly benefit from the costs), standard costing (in which the costs are allocated to products based upon established standards), or burden rates (in which the costs are allocated based on direct labor hours, direct labor costs, and similar expenses).

Simplified Retail Method

Taxpayers who acquire property for resale and are required to capitalize costs under Code Sec. 263A may elect to use the simplified retail method to allocate costs. Under this method, costs for off-site storage and warehousing; purchasing; and handling, processing, assembly, and repacking are fully capitalized. Determining the amount of mixed service costs (general and administrative costs) to be allocated requires two steps. First determine the amount of mixed service costs that are additional Code Sec. 263A costs, then allocate this amount to ending inventory.

The amount of mixed service costs included under Code Sec. 263A is determined by multiplying such costs by the ratio of

1. Total labor costs included in off-site, storage, purchasing, and handling cost, to

2. Total labor costs incurred in the taxpayer’s business, excluding the labor included in the mixed service costs.

Once this amount is determined, then it is allocated to ending inventory by multiplying the amount in ending inventory that was purchased during the year by the ratio of

1. Total additional Code Sec. 263A costs, to

2. Taxpayer’s total purchases during the year.

EXAMPLE 13.26

Kimby Co. uses the first-in, first-out (FIFO) method of accounting for its inventory. During the year it incurred $200,000 of storage costs, $300,000 of purchasing costs, $100,000 in handling and processing costs. The labor costs included in these amounts were $180,000. The company also incurred $250,000 of mixed service costs. Kimby Co.’s total labor costs, excluding amounts included in mixed service costs, were $2,000,000. Kimby’s beginning inventory (excluding additional Code Sec. 263A costs) was $1,000,000. Total purchases during the year were $7,000,000 and ending inventory was $1,500,000 (excluding additional Code Sec. 263A costs). Since Kimby Co. uses the FIFO method, the full $1,500,000 of ending inventory is considered purchased during the year.

Kimby Co.’s ending inventory is $1,633,350, consisting of the original cost of $1,500,000, increased by capitalized additional Code Sec. 263A resale costs of $133,350. This is determined as follows. First, determine the amount of mixed service costs that are considered to be additional Code Sec. 263A costs using the labor ratios:

Labor ratio	=	$180,000/$2,000,000 = 9%
Mixed service costs considered additional Code 263A costs	=	9% × $250,000 = $22,500.

Next, determine total additional Code Sec. 263A and allocate this amount to ending inventory using the additional Code Sec. 263A costs to purchases ratio.

Costs to purchase ratio	=	$622,500/$7,000,000 = 8.89%
Additional Code Sec. 263A costs allocated to ending inventory	=	8.89% × $1,500,000 = $133,350.

Simplified Production Method

Taxpayers may elect to use the simplified production method to allocate capitalized costs for property produced. This method can only be used for property that is the taxpayer’s stock in trade or includible in inventory, or for property held by the taxpayer primarily for sale to customers in the ordinary course of business. The method cannot be used for property acquired for resale and for property produced by the taxpayer for use in its business. Reg. §1.263A-1(b)(5). Under this method, additional Code Sec. 263A costs are allocated based on an absorption ratio and the allocation requires two steps. First, compute the absorption ratio. This is the ratio of

1. total additional Code Sec. 263A costs incurred during the year, to

2. total Code Sec. 471 costs incurred during the year.

(Code Sec. 471 costs are those costs that otherwise would be capitalized under absorption costing.) Once this ratio is determined, then the amount of additional Code Sec. 263A costs required to be capitalized is determined by multiplying the absorption ratio times the amount of Code Sec. 471 costs incurred during the year which, under the taxpayer’s method of accounting for inventory (e.g., FIFO or LIFO), are included in the taxpayer’s ending inventory.

If the taxpayer uses FIFO, then the absorption ratio is applied to the Code Sec. 471 costs included in ending inventory. However, if the taxpayer uses LIFO, then the absorption ratio is applied to the Code Sec. 471 costs included in this year’s increase in inventory (the incremental layer).

EXAMPLE 13.27

Nifo Co. produces widgets. It began operations this year. It uses the FIFO method to account for its inventories. During the year it incurred $15,000,000 of Code Sec. 471 costs and $2,000,000 of additional Code Sec. 263A costs. Ending inventory consisted of $1,000,000 of Code Sec. 471 costs.

Nifo Co.’s ending inventory is $1,133,333, consisting of $1,000,000 of Code Sec. 471 costs, increased by capitalized additional Code Sec 263A costs of $133,333. This is determined as follows:

Absorption ratio	=	$2,000,000/$15,000,000 = 13.33%
Additional Code Sec. 263A costs allocated to ending inventory	=	13.33% × $1,000,000 = $133,333.

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LOWER-OF-COST-OR-MARKET (LCM) METHOD

Unless the taxpayer is using LIFO, the ending inventory may be written down to a lower market value (e.g., replacement cost). Reg. §1.472-4. In addition, damaged or obsolete goods may be written down to realizable prices less costs of disposition. Reg. §1.471-2(c). The determination of lower cost or market must be applied to each item of inventory. Reg. §1.471-4(c).

EXAMPLE 13.28

A lumber dealer has three grades of lumber at the end of the tax year. They are valued as follows:

Grade	Cost	Market	LCM
1	$3,000	$5,000	$3,000
2	2,000	1,500	1,500
3	5,000	4,000	4,000
	$10,000	$10,500	$8,500

The ending inventory is $8,500, written down from $10,000, even though the inventory as a whole has increased in value.

¶13,453

VALUATION OF INVENTORY ITEMS

Taxpayers may use one of four cost flow assumptions to value their inventories: specific identification; first-in, first-out (FIFO); last-in, first-out (LIFO); or weighted average. The accounting method selected does not have to agree with the actual physical flow of goods. Specific identification usually is impractical because each item in inventory must be tracked very carefully. Generally, it is used for large items, such as appliances, which are more easily tracked. It is more convenient in many instances to use one of the other cost flow assumptions.

The FIFO method assumes that goods on hand in beginning inventory and the first goods purchased are the first goods sold to customers. Thus, ending inventory is valued at the price of most recent purchases. Cost of goods sold is based upon the cost of beginning inventory and the prices of goods purchased earlier in the year. Taxpayers using FIFO also may use the lower-of-cost-or-market method.

The LIFO method assumes that the goods most recently purchased are the first goods sold to customers. Thus, ending inventory is valued at beginning inventory amounts and at the price of goods acquired earlier in the year. Cost of goods sold is based upon the prices of the most recent purchases.

The LIFO method can be adopted in the taxpayer’s first year of business or in the initial year that inventories are maintained by using it on that year’s tax return. Code Sec. 472. The taxpayer can change to the LIFO method by attaching Form 970 (Application to Use LIFO Inventory Method) with the tax year for the year of change. If LIFO is used for tax purposes then it also must be used for financial reporting purposes. LIFO produces a smaller taxable income when prices are rising, so there is an incentive (tax savings) to select this method. However, because of the conformity requirements for tax and financial reporting purposes, some firms do not select LIFO because it also produces a smaller net income on the financial statements. However, those taxpayers using LIFO are permitted to use other methods in the footnotes, appendices or supplements to the financial statements. Reg. §1.472-2(e)(3). Also, taxpayers using LIFO may not use the lower-of-cost-or-market method.

The weighted average method values ending inventory (and cost of goods sold) based on the weighted average price of all goods available for sale during the year. The value of ending inventory generally is between those amounts obtained under the FIFO and LIFO methods.

EXAMPLE 13.29

James Co. sells desks. Inventory on January 1 consisted of 300 desks valued at $400 per desk ($120,000). It purchased 700 desks on April 3 at $425 per desk ($297,500) and 900 desks on September 3 at $500 per desk ($450,000). During the year it sold 1,500 desks at a total sales price of $1,050,000. Ending inventory, cost of goods sold and gross profit using FIFO, LIFO and weighted average are as follows:

	FIFO	LIFO	Weighted Average
Sales	$1,050,000	$1,050,000	$1,050,000
Beginning inventory	$120,000	$120,000	$120,000
Purchases	747,500	747,500	747,500
Cost of goods available for sale	$867,500	$867,500	$867,500
Ending inventory
FIFO (400 $500)	200,000
LIFO (300 $400; 100 $425)		162,500
Weighted average
($867,500/1,900 = $457/unit)
(400 $457)			182,800
Cost of goods sold	$667,500	$705,000	$684,700
Gross profit	$382,500	$345,000	$365,300

If a taxpayer changes his or her inventory method, an adjustment is needed to account for the differences at date of conversion. The change could be from LIFO to FIFO, FIFO to LIFO, lower-of-cost-or-market to LIFO, etc. In such a situation, the adjustment is spread over four years (unless the adjustment is less than $50,000, in which case the taxpayer may elect to use the one-year adjustment period).

KEYSTONE PROBLEM

Financial management has traditionally been opposed to adopting LIFO because it would result in reporting lower earnings in the financial statements to shareholders.

1. Are they correct in the short run? Why?

2. Are they correct in the long run? Why?

¶13,473

DOLLAR-VALUE LIFO METHOD

Instead of determining quantity increases of each item in the inventory and then pricing each item, as is required under regular LIFO, the dollar-value LIFO method may be used. The increase in LIFO value is determined by comparing the total dollar value of the beginning and ending inventories at base-year (first LIFO year) prices and then converting any dollar-value increase to current prices by means of an index. Taxpayers are allowed, under the dollar-value LIFO method, to determine base-year dollars through the use of government indexes. Code Sec. 472(f). The Regulations permit the use of several price index methods. Reg. §1.472-8. The “double extension method,” the most frequently used, works as follows:

1. Determine opening inventory at base-year prices (the prices in effect when LIFO was adopted).

2. Determine ending inventory at base-year prices.

3. Compute the difference. The result is either an increase (increment) or a decrease (decrement).

4. Determine a price index to value the increment, if any. The index equals ending inventory at current prices/ending inventory at base-year prices.

5. Adjust the inventory “layers” for any increment or decrement. Every increment represents a new layer. Any decrement uses up the most recently added layer or layers first.

The following example is adapted from Reg. §1.472-8(e)(2)(v), Examples (1) and (2).

EXAMPLE 13.30

Skylark Inc. adopts LIFO in Year 1. Opening inventory was $14,000, which became the base period price. Ending inventory was $24,250 at actual prices, $20,000 at base-year prices. Thus, keeping prices constant, the increment was $6,000. The index was:

The increment is therefore $6,000 × 1.2125, or $7,275, and the ending inventory is $21,275, as opposed to $24,250 under FIFO, resulting in an increased cost of goods sold of $2,975. To summarize:

	1/1/Year 1	Index	12/31/Year 1
Opening inventory	$14,000	1.0	$14,000
Increment	6,000	1.2125	7,275
Ending LIFO inventory	$20,000		$21,275

If, at the end of Year 2, ending inventory was $18,000 at base period prices and $27,000 at current prices, there was a decrement with the following result:

	1/1/Year 1	Index	12/31/Year 2
1/1/Year 1 inventory	$14,000	1.0	$14,000
Remaining Year 1 increase	4,000	1.2125	4,850
LIFO inventory	$18,000		$18,850

At the end of Year 3, ending inventory was $25,000 at base period prices and $30,000 at current prices (30/25 = 1.2). The Year 3 year-end inventory consists of three “layers” as follows:

	1/1/Year 1	Index	12/31/Year 3
1/1/Year 1 inventory	$14,000	1.0	$14,000
Year 1 increase	4,000	1.2125	4,850
Year 3 increase	7,000	1.2	8,400
LIFO inventory	$25,000		$27,250

The computations above assume that only one “pool” was used. If substantially heterogeneous products exist, more than one pool must be used. Since each pool generates its own index and each pool may have numerous layers, the feasibility of dollar-value LIFO techniques depends on the availability of computers.

¶13,481

SIMPLIFIED DOLLAR-VALUE LIFO METHOD

Taxpayers may elect to use the simplified dollar-value LIFO method, but it then must be used to value all LIFO inventories. The simplified dollar-value LIFO method is designed to enable small businesses to use the LIFO method but avoid the extra costs and burden of maintaining records needed for the other LIFO methods. A taxpayer may elect the method for any year in which its average annual gross receipts for the preceding three years do not exceed $5 million. Code Sec. 474(c). Since taxpayers with less than $26 million in gross receipts are not required to keep inventories, continued use of the simplified dollarvalue LIFO method is unlikely.

Using the method is relatively easy and straightforward. The taxpayer groups its inventory into pools for each major category in the applicable government price index provided by the Bureau of Labor Statistics (11 categories for retailers and 15 categories for all other taxpayers). Each pool then is separately adjusted using the appropriate government index. Retailers use the Consumer Price Index, and all other taxpayers use the Producer Price Index.

The taxpayer does not compute base period prices. Instead, the taxpayer uses year-end inventory values and determines an assumed base period value by applying the government price index. If the resulting base period value exceeds the opening inventory value at base period prices, then the increment is valued using the same index.

EXAMPLE 13.31

Susan Co. adopted the simplified dollar-value LIFO method. Inventory at actual prices in Year 1 and Year 2 was $200,000 and $300,000, respectively. The Consumer Price Index for Years 1 and 2 was 115 percent and 125 percent, respectively. Susan Co.’s ending inventory for Year 2 would be valued at $282,609, consisting of $200,000 from Year 1 plus the Year 2 increment of $82,609. The Year 2 increment is determined as follows:

Year 2 ending inventory at assumed base-year prices	=	$300,000 × 1.15/1.25 = $276,000
The increment at Year 1 base price	=	$276,000 – $200,000 = $76,000
The increment at Year 2 base price	=	$76,000 × 1.25/1.15 = $82,609

¶13,485

ESTIMATES OF INVENTORY SHRINKAGE

Code Sec. 471 permits a business to determine its year-end closing inventory by using estimates for shrinkage (e.g., loss due to theft). A year-end physical count is not necessary if the business: (1) normally takes a physical count of its inventories at each business location on a regular and consistent basis and (2) makes proper adjustments to its inventories and to its estimating methods to the extent its estimates differ from actual shrinkage.

Using this method results in a change in accounting method, but IRS permission is not required to make the change. Also, any adjustments to income due to this change are taken into account over a four-year period.

EXAMPLE 13.32

SQ Co., a calendar-year taxpayer, generally takes a physical count of inventory every three months. In 2020, it claimed a $30,000 deduction for inventory shrinkage based on an estimate of shrinkage on December 31, 2020. Since it takes a physical count on a regular basis, it is permitted to use an estimate for inventory shrinkage.

PLANNING POINTER

A widely-held view is that a major potential cost in changing from the “lower-of-cost-or-market” method of valuing inventories to LIFO is that opening inventory must be written back up to cost and the write-up taken into income. This adverse tax aspect may be avoided or may be nonexistent in the following situations:

No inventory on hand at the end of the year prior to the year of change was written down from cost.

The portion of the inventory written down may be (any of the following):

1. Sold before year-end at a discount or disposed of as giveaways, prizes, or bonuses to customers

2. Given to employees as deductible compensation

3. Contributed to charity, resulting in nonrecognition of income as well as a deduction (prior to year-end)

4. Abandoned (i.e., “dumped”)

Thus, with proper tax planning, no income will have to be recognized.

TAX BLUNDER

Hind Co. uses the FIFO inventory method because this method reflects the true physical flow of inventory. Ending inventory under FIFO was $400,000. Had Hind Co. used LIFO, ending inventory would have been $240,000.

Actual physical flow of inventory is irrelevant for costing purposes. The cost flow used (assumed) is artificial and does not need to coincide with the actual physical flow. Had Hind Co. used LIFO, it would have increased cost of goods sold by $160,000, and taxable income would have decreased by $160,000, producing a tax savings of $33,600 (21% × $160,000). Again, given the time value of money, this would be preferable.

Long-Term Contracts

¶13,501

ALTERNATIVE ACCOUNTING METHODS

The term long-term contract means any contract for the manufacture, building, installation, or construction of property if such property is not completed within the taxable year into which the contract is entered. A contract for the manufacture of property will not be treated as a long-term contract unless it involves the manufacture of any unique item which is not normally included in finished goods inventory or requires more than 12 calendar months to complete. Code Sec. 460(f). A taxpayer generally has two alternatives to account for long-term contracts: the percentage-of-completion method (or modified percentage-of-completion method in some cases) and the completed-contract method (in limited circumstances). The accounting method selected must be used for all long-term contracts in the same trade or business. Reg. §1.451-3(a).

Under the percentage-of-completion method taxpayers report income under the contract annually based on estimated progress. The percentage of completion is determined by comparing costs allocated to the contract and incurred by the close of the year to the estimated total contract costs. Code Sec. 460(b). The total contract price is multiplied by the percentage to determine the amount of income reported in that year.

Under the percentage-of-completion method the taxpayer must use a look-back method in the year the contract is completed. This method requires the taxpayer to compare the actual completion level to the claimed level (to reflect the actual profit for each year of the contract) and to redetermine taxable income and tax liability accordingly. Interest is charged on any underpayment and is received for any overpayment. However, long-term contracts completed within two years of contract commencement are exempt from the look-back method if the gross contract price does not exceed the lesser of $1,000,000 or 1 percent of the taxpayer’s average gross receipts for the last three years preceding the year in which the contract was entered. Code Sec. 460(b).

Code Sec. 460 permits taxpayers to elect not to apply the look-back method for long-term contracts completed during the year and in all subsequent years if the actual contract taxable income is within 10 percent of estimated taxable income under the percentage-of-completion method (using estimated contract price and costs).

EXAMPLE 13.33

Jones Co. enters into a three-year construction contract in 2020. Jones Co. estimated (reported) net income using the percentage-of-completion method was $100,000, $200,000, and $300,000 for 2020, 2021, and 2022 respectively. In 2022, when the contract is completed, Jones Co. determines that actual net income for each year was $108,000, $210,000, and $282,000, respectively, for the three years. Ten percent of $108,000 is $10,800, and 10% of $318,000 is $31,800. Since the $100,000 claimed in 2020 and the $300,000 cumulative income in 2021 ($200,000 in 2021 and $100,000 in 2020) are within the 10 percent range, Jones can elect not to apply the look-back method.

The modified percentage-of-completion method is available for contracts that are less than 10 percent complete at the end of the year. If this condition is met, then taxpayers may elect to defer reporting any income from the contract until at least 10 percent of the work is completed. Code Sec. 460(b)(5). In the year that 10 percent is completed, the taxpayer will report income on all the work completed in that year using the “regular” percentage-of-completion method described above. The rationale for this election is that it often is difficult to estimate the total costs of a long-term project at its beginning; the modified method gives the taxpayer some time and experience to provide a better estimate.

Under the completed-contract method taxpayers report no income until final completion of the contract, regardless of when the funds are collected. All costs are accumulated and recognized at completion. The use of this method provides substantial opportunity to defer income, and as such is severely restricted. Only small construction contractors and home construction contractors can use this method. Small contractors are those whose average gross receipts for the three preceding tax years do not exceed $26 million. Contracts of small construction must be expected to be completed within two years of the commencement date. Code Sec. 460(e).

Final completion of the contract is based on an analysis of all the facts and circumstances. However, a taxpayer may not delay completion of a contract for the principal purpose of deferring federal income taxes. Reg. §1.460-1(c)(3). Additionally, if the buyer reasonably disputes the work, then income or deduction with respect to said dispute is recognized in the year the dispute is resolved. If the amount reasonably in dispute is extensive and so affects the contract price that it is not possible to determine whether a gain or loss will result from the contract, then no gain or loss is recognized until the dispute is settled. Reg. §1.460-4(d)(4).

¶13,515

COMPARISON OF THE METHODS

The following, simplified example illustrates the difference between the percentage-of-completion and completed-contract methods:

EXAMPLE 13.34

In Year 1, Building Construction Co. entered into a contract to build a small warehouse for $2,500,000. Total estimated costs to complete are $2,000,000, and the project is expected to be completed in Year 2. Actual costs incurred in Year 1 and Year 2 were $800,000 and $900,000, respectively. Results for Year 1 and Year 2 are shown below.

Percentage-of-Completion Method	Year 1	Year 2
Gross Revenue	$1,000,000a	$1,500,000b
Actual Costs	(800,000)	(900,000)
Gross Profit Reported	$200,000	$600,000
a. ($800,000/$2,000,000) × $2,500,000
b. $2,500,000 – $1,000,000
Completed-Contract Method
Gross Revenue	$0	$2,500,000
Actual Costs	0	(1,700,000)
Gross Profit Reported	$0	$800,000

¶13,535

CAPITALIZATION OF EXPENSES

All costs associated with the contract are capitalized and are deducted as profits are recognized. This principle applies to direct costs, such as material and direct labor costs, as well as to overhead, such as repairs and maintenance, utilities, rent, cost recovery, shipping costs, general and administrative expenses, scrap and spoilage costs, etc. Construction period interest must always be capitalized. The following expenses must be capitalized; they may not be expensed if the percentage-of-completion method is used:

1. Cost recovery of assets employed for work on specific contracts

2. Pension costs representing current service costs

3. General and administrative expenses relating to specific contracts

4. Research and development expenses with respect to specific contracts

5. Scrap and spoilage costs

In any event, bidding expenses, indirect research and development expenses, and marketing, advertising, and selling expenses may be deducted currently.

¶13,540

SPECIAL RULES

The Regulations provide guidance in those situations where a long-term contract is either being disputed in amount or is delayed beyond its scheduled date of completion.

Disputed Amounts

Generally, the disputed amount, if any, simply reduces gain or increases a loss in the year of completion. However, if the disputed amount is “substantial” then no gain or loss is recognized until the controversy is settled. Reg. §1.460-4(d)(4).

Unreasonable Delays

The completion of a contract may not be delayed (e.g., by deferring the formal acceptance of the project) for the principal purpose of tax postponement. Reg. §1.460-4(d)(4). Because of the time value of money, a deferral of the income from the last month of one year until the first month of the next year may be quite valuable, even with no change in the marginal tax rate.

Installment Sales

¶13,601

USE OF INSTALLMENT METHOD

An installment sale is a disposition of property where at least one payment is received after the close of the taxable year in which the disposition occurs. Code Sec. 453(b). Thus, there is no requirement for numerous payments over several years; one payment in a subsequent year would qualify as an installment sale. The installment method may be used by cash-basis taxpayers as a means to defer gain recognition or to spread gain recognition over several tax periods. The method may not be used if the property is disposed of at a loss. Additionally, the installment method only affects when the gain is recognized, it does not change the character of the gain (capital or ordinary). How this gain is taxed is determined by the applicable laws in the year the installment payment is received, not in the year of sale. The seller reports gains under the installment method on Form 6252 (Installment Sale Income).

Any depreciation recapture coming under Sections 1245 and 1250 must be taken into income in the year of sale. If a portion of the capital gain from an installment sale is 25 percent gain and a portion is 15 percent or 0 percent gain, the taxpayer is required to take the 25 percent gain into account before the 15 percent or 0 percent gain, as payments are received.

The installment method is not available to all taxpayers. It cannot be used: by dealers in real and personal property; for any sale of personal property under a revolving credit plan; for sales of depreciable property to a controlled entity (e.g., to a corporation in which the taxpayer owns directly and indirectly more than 50 percent of the value of the outstanding stock), unless the taxpayer can establish that tax avoidance was not a principal purpose of the disposition; and for sales of stock or securities which are traded on an established securities market (or to the extent provided in the regulations for property other than stock or securities regularly traded on an established market). Code Sec. 453.

Although nondealers may use the installment method, Code Sec. 453A imposes a special interest charge if the sale price of the real or personal property (other than personal-use and farm property) exceeds $150,000. This interest charge is on the tax liability deferred on the property sold. However, the interest charge only applies if the installment obligation is outstanding at year-end and if the face amount of all installment obligations which arose during the year and are outstanding at year end exceeds $5 million.

The taxpayer must use the installment method for tax purposes if the taxpayer disposes of property under an installment contract and the disposition qualifies for the installment method. However, the taxpayer may make an irrevocable election not to use the installment method. Code Sec. 453(d). In such a case, the gain would be recognized in the year of disposition. Finally, all depreciation recapture occurs in the year of sale, regardless of the fact that the taxpayer uses the installment method.

EXAMPLE 13.35

James Hoffman sold a truck in Year 1 for $36,000. The truck’s adjusted basis was $15,000 at the time of sale, and $9,000 had been claimed in depreciation. James collected $12,000 in Year 1 and will receive $12,000 in Year 2 and Year 3. James uses the installment method for this sale.

Amount realized	$36,000
Adjusted basis	15,000
Realized gain	21,000
Code Sec. 1245 gain	$9,000
Gross profit percentage = 33.33% ($12,000/$36,000)

In Year 1, James will recognize a $9,000 Code Sec. 1245 gain and a $4,000 Code Sec. 1231 gain ($12,000 x 33.33%). James also will recognize a $4,000 Code Sec. 1231 gain ($12,000 x 33.33%) in Year 2 and in Year 3.

¶13,655

COMPUTATION OF GAIN

The installment method recognizes income as payments are received. There are several steps to follow.

Step 1.	Determine the gross profit from the sale. Gross profit equals the selling price minus the property’s adjusted basis, selling expenses, and depreciation recapture (if any).
Step 2.	Determine the contract price. The contract price generally equals the amount the seller will receive. If there are no liabilities on the property, then contract price equals selling price. If there are liabilities on the property which the buyer assumes, then the contract price equals all payments to be received by the seller (i.e., the selling price reduced by the mortgage assumption). If the liabilities exceed the property’s adjusted basis (increased by selling expenses for this comparison only), then such excess increases the contract price (it equals all payments to be received by the seller plus the excess). The contract price can never be less than the gross profit.
Step 3.	Compute the gross profit percentage (which can never be greater than 100 percent). Gross profit percentage = Gross profit/Contract price.
Step 4.	Determine the amount of gain to be recognized in the year of sale. Recognized gain = Payments received × Gross profit percentage.

EXAMPLE 13.36

Ann Rogers, 45 years old, sold property for $125,000. Her selling expenses were $5,000 and her basis was $40,000. She received $25,000 down and will receive $20,000 in each of the following five years. Ann’s gross profit is $80,000 ($125,000 – ($5,000 + $40,000)). The contract price is $125,000, and the gross profit percentage is 64 percent ($80,000/$125,000). She will recognize a gain of $16,000 in the year of sale (64% × $25,000) and $12,800 in each of the following five years (64% × $20,000). Thus, total gain recognized over the six years is $80,000 ($16,000 + (5 × $12,800)). Ann also will recognize income for the interest she receives over this period.

EXAMPLE 13.37

Assume the same facts as in  Example 13.36  except that the property was depreciable property subject to $15,000 of depreciation recapture under Code Sec. 1245. Ann’s gross profit is $65,000 ($125,000 – ($5,000 + $40,000 + $15,000)). The contract price is still $125,000. The gross profit percentage is 52 percent ($65,000/$125,000). She will recognize a $13,000 gain in the year of sale (52% × $25,000) and $15,000 ordinary income from the depreciation recapture. In each of the following five years she will recognize a gain of $10,400 (52% × $20,000). Total gain recognized over the six years also is $80,000 ($13,000 + $15,000 + (5 × $10,400)). Ann also will recognize income for the interest she receives over this period.

EXAMPLE 13.38

Assume the same facts as in  Example 13.36  except that there is a $5,000 mortgage on the property which the buyer assumes. Additionally, Ann will receive $20,000 in the year of sale and $20,000 in each of the following five years. In this case, Ann’s gross profit is $80,000 ($125,000 – ($5,000 + $40,000)). The contract price is $120,000 ($125,000 – $5,000); Ann will receive $120,000 in cash payments from the buyer. The gross profit percentage is 66.67 percent ($80,000 ÷ $120,000). She will recognize a gain of $13,333 ($20,000 × 66.67%) in the year of sale and in each of the following five years. Total gain recognized over the six years is $80,000 ($13,333 × 6), allowing for a $2 roundoff. Ann also will recognize income for the interest she received over this period.

 

EXAMPLE 13.39

Assume the same facts as in  Example 13.36  except the property is subject to a $50,000 mortgage which the buyer assumes. Additionally, Ann will receive $15,000 in the year of sale and $12,000 in each of the following five years. In this case the liability exceeds the adjusted basis by $5,000 ($50,000 – ($40,000 + $5,000 selling expenses)). Whenever the liability exceeds the adjusted basis (increased by selling expenses), the gross profit percentage is 100 percent. Also, the excess is treated as a payment in the year of sale. Thus, Ann recognizes a gain of $20,000 (100% × ($15,000 + $5,000)) in the year of sale and $12,000 (100% × $12,000) in each of the following five years. Total gain recognized over the six years is $80,000 ($20,000 + (5 × $12,000)). Ann also will recognize income for the interest she received over this period.

EXAMPLE 13.40

Sal Weintraub sold $20 million of nondealer real estate during the year under the installment method. At yearend $15 million is outstanding. Deferred gross profit on the outstanding obligations is $4 million. The maximum tax rate in effect during the year was 35 percent. Code Sec. 453A applies in this situation, and Sal must pay the special interest charge. Assume that the federal short-term interest rate in December was 8 percent. The interest due is $102,672, computed as follows:

1. Determine the portion of installment obligations outstanding at year-end in excess of $5 million and divide this by the total amount of installment obligations outstanding at year-end.

($15,000,000 – $5,000,000)          ÷    $15,000,000     =     66.67%

2. Determine the tax liability deferred on all installment obligations outstanding at year-end by multiplying the deferred gross profit on such obligations by the maximum tax rate in effect for the tax year.

($4,000,000 × 37%)                       =   $1,480,000

3. Determine the applicable interest rate, which is equal to the federal short-term interest rate for the last month of the tax year, increased by 3 percentage points.

(3% + 3%)                                      =   6%

4. Determine the interest due (which is considered personal interest expense).

(66.67% × $1,480,000 × 6%)       =    $59,203

¶13,675

ELECTING OUT OF INSTALLMENT REPORTING

As noted earlier, a taxpayer may elect not to use the installment method. This election must be made by the due date (including extensions) for filing the tax return for the year of the installment sale. Reg. §15A.453-1(d)(3). However, there are potential drawbacks to such an election. For example, if a capital asset or a Section 1231 asset is sold at a gain on the installment plan and the seller elects not to use installment reporting, there are at least two obvious drawbacks:

1. The gain is accelerated and the tax is due in the year of sale before the proceeds are received.

2. If the value of the note is less than its face value, a cash-basis taxpayer will limit the capital gain and may convert the discount into ordinary income on collection if the collection of a note does not qualify as a “sale or exchange.” (This problem does not affect accrual-method sellers since they accrue the face value.) Under Code Sec. 1271(a)(1) and (b)(1), retiring a debt instrument is a sale or exchange, unless issued by a natural person.

EXAMPLE 13.41

Rita Brown sells a painting held for five years as an investment. The painting was purchased for $5,000 and sold to Joe Smith for $15,000, $6,000 down and a $9,000 face value note worth $7,000 due in three years together with 10 percent interest. If she opts for installment reporting, her gross profit percentage is 66 2/3:

resulting in a capital gain of $4,000 in the year of sale and $6,000 upon collection of the note (plus interest).

If Rita elects not to use installment reporting, the result is as follows:

Year of Sale:
Amount realized
Cash	$6,000
Fair market value of note	7,000
	$13,000
Less adjusted basis	5,000
Long-term capital gain	$8,000
Year of Collection:
Collection of principal	$9,000
Less basis in note	7,000
Ordinary income	$2,000

Which action is preferable depends on Rita’s tax bracket (and the rate applicable to her capital gain).

The Regulations are flexible enough to permit installment reporting even if the selling price and, therefore, gross profit percentage are unknown at the initial sale. Reg. §15A.453-1(c). Three main situations can be identified:

1. Maximum selling price. If payments are contingent, but subject to a ceiling, the ceiling is presumed to be the selling price. The gross profit percentage is initially based on this maximum and is subsequently modified as more facts become available.

2. Given payment period. Here the seller’s basis is prorated over the term. The result may be gains in some years, losses in others.

3. No maximum price, no given term. Here the seller recovers basis over 15 years, which may also lead to gain or loss in any given year, presumably of the same character.

In view of this expansion of the scope of the installment reporting provisions, the cost recovery method (the “open transaction” approach) is likely to have even less applicability than before.

PLANNING POINTER

The taxpayer’s current and expected future tax rates should be carefully considered when deciding to use the installment method of reporting. If the taxpayer’s future tax rates are expected to decline, then using the installment method could produce significant tax savings. Conversely, if the taxpayer expects to be in higher tax brackets in the future, then the installment method could result in significant increases in taxes. Remember, the time value of money also must be considered.

 

EXAMPLE 13.42

Jennifer Lynn sold a short-term capital asset in Year 1. She has no capital loss carryovers and sold no other capital assets during the year. She does not plan to sell any capital assets during the next four years. The amount realized from the sale was $40,000, and the property’s adjusted basis was $20,000. Her realized and recognized gain is $20,000. Jennifer will receive $8,000 at the date of sale and $8,000 (plus interest) per year for the four years after the year of sale. The value of the note is equal to its face value. The gross profit percentage is 50 percent ($20,000/$40,000). If she uses the installment method of reporting, then she will recognize a $4,000 ($8,000 x 50%) short-term capital gain (plus interest income) in each of the five years. If she elects out of the installment method of reporting, then she will recognize a $20,000 short-term capital gain (which will be taxed as ordinary income since she has no other capital asset transactions) in Year 1, plus interest income as received.

If Jennifer is in the 33 percent bracket in Year 1 but expects to be in the 15 percent bracket in Year 2 through Year 5, then she would save $2,400 in taxes by using the installment method (ignoring the time value of money).

Tax on $20,000 if recognized in Year 1 ($20,000 x 33%)		$6,600
Tax on $4,000 in Year 1 ($4,000 x 33%)	$1,320
Tax on $4,000 in Year 2 through Year 5 ($4,000 x 15% = $600 x 4)	2,400	3,720
Tax savings from using the installment method of reporting		$2,880

If Jennifer is in the 15 percent bracket in Year 1 but expects to be in the 28 percent bracket in Year 2 and Year 3 and the 25 percent bracket in Year 4 and Year 5, then she would save $2,320 in taxes by electing out of the installment method (ignoring the time value of money).

Tax on $20,000 if recognized in Year 1 ($20,000 x 15%)		$3,000
Tax on $4,000 in Year 1 ($4,000 x 15%)	$600
Tax on $4,000 in Year 2 and Year 3 ($4,000 x 28% = $1,120 x 2)	2,240
Tax on $4,000 in Year 4 and Year 5 ($4,000 x 25% =$1,000 x 2)	2,000	4,840
Tax savings from electing out of the installment method of reporting		$1,840

¶13,685

DISPOSITIONS OF INSTALLMENT OBLIGATIONS

There are times when a taxpayer who sold property on the installment method needs or wants to dispose of the installment obligation prior to maturity. In this instance, the taxpayer must determine the obligation’s adjusted basis and determine the gain or loss on the disposition. The adjusted basis of the installment obligation is equal to the face amount of the obligation in excess of the income that would have been reported if the obligation had been paid in full. To determine gain or loss, the adjusted basis is compared to the amount realized if the obligation is sold and to the obligation’s fair market value if it is disposed of other than by sale. The character of the gain or loss is based upon the property which was sold under the installment method. Code Sec. 453B(a).

EXAMPLE 13.43

In 2020, Katherine Beales sold a piece of art for $50,000. She received $10,000 in 2020 and in 2021. She purchased the piece in 2010 for $8,000; thus, her gross profit was $42,000 and the contract price was $50,000. The gross profit percentage was 84 percent ($42,000/$50,000). In 2022, she sold the installment obligation for $28,000. Her basis in the obligation is $4,800 (unpaid balance of $30,000 minus amount of income reported if unpaid balance paid in full (84% × $30,000)). Thus, Katherine’s gain on the sale of the installment obligations is $23,200 ($28,000 – $4,800). The gain is a long-term capital gain since the art piece was a longterm capital asset when it was sold in 2020. Katherine also will recognize income for the interest she received while the obligation was outstanding.

In addition to a sale, there are several other situations where a disposition of an installment obligation results in a recognized gain or loss, primarily to prevent income-shifting among taxpayers. In each of these, the fair market value of the obligation is used as the amount realized. Code Sec. 453B(a).

The following lead to income recognition at the time the installment obligation is transferred: gifts or forgiveness of payments, especially if the obligee and obligor are related; taxable exchanges; and corporate distributions. Additionally, gain recognition occurs on “second dispositions,” whereby the taxpayer sells the property to a related party and within two years of the sale and before the taxpayer receives all payments with respect to such sale, the related party disposes of the property (i.e., the “second” disposition). At the time of the second disposition, the amount realized from the second distribution is treated as being received by the original taxpayer. Code Sec. 453(e).

Gain or loss is not recognized in the following situations: transfers to a controlled corporation under Code Sec. 351; transfers in certain corporate reorganizations and liquidations; certain transfers to and from partnerships; transfers upon the death of a taxpayer; transfers incident to a divorce; and transfers to a spouse.

EXAMPLE 13.44

Jack Moore purchased land in 2012 for $40,000. Jack sold the land to his daughter in 2019. The terms of the sale call for Jack to receive $20,000 in 2019 and $15,000 in 2020, 2021, 2022, and 2023, plus interest. The gross profit is $40,000, the contract price is $80,000 and the gross profit percentage is 50 percent. Jack received payments in 2019 and 2020, recognizing $10,000 and $7,500, plus interest, respectively, in 2019 and 2020. In 2021, Jack forgave the remaining payments. The forgiveness is a taxable disposition. Jack is considered to have received the remaining payments ($45,000) and his recognized gain in 2021 is $22,500 (50% × $45,000).

¶13,695

REPOSSESSIONS

The repossession of personal property sold under the installment method is a taxable event. Gain or loss is recognized equal to the difference between the fair market value of the property repossessed and the adjusted basis of the installment obligation. Any costs incurred during the repossession increase the adjusted basis of the installment obligation. The character of the gain or loss recognized is the same as the character of the gain or loss recognized on the original sale of the property. The basis of the repossessed property is its fair market value. Code Sec. 453B.

Loss is not recognized and no bad debt deduction is allowed on the repossession of real property. Gain is recognized to a limited extent. Code Sec. 1038 limits gain recognition to the lesser of (1) the cash and fair market value of property received from the buyer in excess of gain previously recognized by the holder of the installment obligation or (2) the gain not yet recognized by the holder of the installment obligation (deferred gross profit), reduced by the costs incurred during the repossession. The character of the gain is the same as that recognized under the original sale of the property. The basis of the repossessed real property is the adjusted basis of the installment obligation, increased by costs incurred during the repossession and by any gain recognized from the repossession.

EXAMPLE 13.45

John Wells sold a car in January Year 1 for $20,000. He received $4,000 down and $16,000 was due in Year 2 His basis in the car at the time of sale was $12,000. John made numerous attempts to collect the $16,000 and in December he repossessed the car. He incurred $700 in repossession costs and the car’s fair market value at time of repossession was $15,000. In Year 1, John reported a capital gain of $1,600 (40% × $4,000). The adjusted basis of the installment obligation at the time of repossession was $9,600 ($16,000 – (40% × $16,000)). To determine John’s gain on the repossession, this basis is increased by the repossession costs. Thus, John recognizes a $4,700 capital gain in December Year 2 ($15,000 – ($9,600 + $700)). John’s basis in the repossessed car is $15,000, its fair market value.

EXAMPLE 13.46

Tom O’Brien sold land in January Year 1 for $50,000. He received $20,000 down and $30,000 was due in January Year 2. Tom acquired the land seven years ago for $10,000. The gross profit percentage is 80 percent. Tom recognized a $16,000 long-term capital gain in Year 1. Tom was unable to collect the $30,000 and repossessed the land in October Year 2, incurring $1,000 in the process. The land’s fair market value in October Year 2 was $52,000. Tom’s recognized long-term gain is $4,000, equal to the lesser of $4,000 ($20,000 received – $16,000 gain previously recognized) or $23,000 ($24,000 gain not yet recognized – $1,000 repossession costs). His basis in the repossessed land is $11,000 (the basis of the installment obligation ($30,000 – (80% × $30,000)) plus the gain recognized on repossession ($4,000) plus the costs incurred to repossess ($1,000).

¶13,699

INTEREST ON DEFERRED PAYMENT SALES

A seller of capital assets historically had an incentive to charge little or no interest while inflating the selling price, thus converting ordinary interest income into capital gains or a reduced capital loss. Section 483 limits the taxpayer’s opportunity to do so, but does not eliminate it altogether. Unless the seller charges at least a rate equal to the “applicable federal rate” the IRS will impute interest at such a rate compounded semiannually, resulting in additional interest income to the buyer and a lower selling price (and a lower gross profit), but also providing the buyer with higher interest deductions (and a lower basis). Interest will not be imputed to a sale where all the payments are due within six months. Additionally, there are several special rules, including:

1. Unlike installment reporting, Code Sec. 483 applies to sales at a loss.

2. No interest is imputed unless the selling price is in excess of $3,000.

3. Sales of patents where the selling price is contingent on the use, production, or disposition of such patents, and private annuity sales are excluded.

4. Only 6 percent interest need be charged for sales of up to $500,000 of real property to a family member, including siblings, spouses, an ancestor, or a lineal descendant.

EXAMPLE 13.47

Antoinette Clerici sold land in Year 1 for $40,000. The adjusted basis of the property was $50,000. Antoinette received $12,000 in Year 1 and will receive $28,000 in Year 2. No interest was charged. Antoinette has a $10,000 loss and cannot use the installment method to report it. However, since it is a deferred contract she must charge interest; thus, the IRS will impute interest and reduce the selling price accordingly. This increases her loss, causes her to recognize interest income, reduces the buyer’s basis in the land, and causes interest expense for the buyer which may or may not be deductible.

Since the statutory rate may be below the market rate for second mortgages and unsecured personal loans, some flexibility of designing a price/terms combination that is attractive for tax purposes still exists.

¶13,710

ADVANTAGES AND DISADVANTAGES OF INSTALLMENT METHOD

There are several advantages and disadvantages associated with the installment method of reporting.

Advantages of engaging installment sales and reporting profits when collections are made include:

1. Tax liabilities are deferred until the proceeds from the sales are available

2. Marginal tax rates may decline in future years

3. Interest income, to some extent, may be converted to capital gains by charging a lower interest rate and a higher price (but the imputed interest rules affect this)

4. Since the seller finances the purchase, sales are more easily made.

Disadvantages of installment sales include:

1. There is a default risk and potential collection costs

2. In periods of inflation there is a loss of purchasing power

3. Although taxes are deferred, so are collections. Because the after-tax proceeds are likely to far exceed the taxes payable, an installment sale is unlikely to be made merely for tax purposes

4. Marginal tax rates may increase during the collection years

5. Although the holding period in the year of sale determines whether the transaction is short-term or long-term, the character of the gain is determined in the year of collection. In one case, the taxpayer sold a capital asset but wound up with ordinary income, in part, in the years of collection. Z. Klien, 42 TC 1000, Aug. 31, 1964.

6. All depreciation recapture takes place in the year of sale.

PLANNING POINTER

Olga Lopez purchased some land years ago as an investment for $40,000. She owns it free and clear, wishes to sell it for its value of $100,000 and would like as much cash up front as possible while deferring the tax as long as possible. Any potential buyer would most likely wish to finance the acquisition. If Olga sells the land on the installment plan, her gross profit of 60 percent will apply to payments in the year of sale as well as to future collections. After competent tax advice, she did the following:

1. She borrowed $40,000 with the property as collateral. The receipt of the loan proceeds is tax free.

2. After a reasonable time, she sold the property for $100,000 by letting the buyer take over the $40,000 loan and taking back a second mortgage below the market rate.

3. Even though her gross profit is now 100 percent, she received $40,000 tax free and converted interest income and favorable terms into an additional long-term capital gain on a tax-deferred basis.

SUMMARY

· Taxable income must be computed on the basis of the taxpayer’s tax year.

· The annual accounting period may be either a calendar year or a fiscal year.

· The tax year cannot exceed 12 months except where a 52-53-week tax year is adopted.

· A fiscal year is a period of 12 months ending on the last day of any month other than December or a 52-53-week annual accounting period.

· A fiscal year is permitted only if the taxpayer’s books are kept on the same basis.

· Usually the taxpayer needs a business purpose for approval of a change in tax periods.

· Prior approval must be obtained before changing to a new tax year.

· A return required for a fractional part of the year (due to a change in accounting periods) is known as a short-period return.

· To obtain IRS approval to change accounting periods, Form 1128 must be filed by the due date of the Federal income tax return for the first effective year.

· The taxpayer’s method of accounting must “clearly reflect income.”

· A taxpayer may change accounting methods voluntarily or may be required to change.

· To obtain advance IRS permission to change accounting methods, Form 3115 must be filed anytime during the year in which the change is desired.

· The taxpayer faced with a substantial tax due to a change of accounting methods generally has a four-year adjustment period.

· An understanding of accounting periods and methods is crucial to understanding the taxation of any entity.

· Many accounting methods used for financial accounting are similar to those used for tax accounting, but there are many differences too.

· Several inventory methods are available to the taxpayer: specific identification, FIFO, and LIFO, and variations thereto.

· Certain costs with respect to inventory must be capitalized.

· The percentage-of-completion method must be used for long-term contracts.

· The installment method of accounting is used when proceeds from the sale of certain property are received in a year other than the year of sale.

· A taxpayer may elect not to use the installment method.

· Accrual-basis taxpayers may not use the installment method.

PROBLEMS

31. What are the accounting period options for the following businesses?

a. C corporation starting business on March 11

b. Sole proprietorship starting business on May 27 with a proprietor on the calendar-year basis and a natural business year ending January 31

c. Partnership owned by three calendar-year individuals and a natural business year ending April 30

d. S corporation with a natural business year ending March 31

39. Wagner Co. is a cash-basis, calendar-year taxpayer. On August 1, 2020, it paid an insurance premium of $4,800 for coverage from August 1, 2020 to July 31, 2021. What is the largest deduction Wagner Co. can take in 2020?

Chapter 14

Taxation of Corporations—Basic Concepts

OBJECTIVES

After completing Chapter 14, you should be able to:

1. Identify which entities are classified as corporations.

2. Discuss tax-free organizations and transfers to controlled corporations.

3. Understand the use of debt in the corporate capital structure.

4. Apply the ordinary loss deduction rules of Code Sec. 1244 on dispositions of stock.

5. Use the gain exclusion of Code Sec. 1202 on dispositions of stock.

6. Determine corporate taxable income, including special deductions available to corporations.

7. Compute corporate income tax.

8. Describe controlled and affiliated groups and the filing of consolidated returns.

9. Know corporate income tax return requirements.

10. Understand how corporations account for differences between book income and taxable income.

OVERVIEW

Corporate taxation is divided into six areas. They are (1) formation, (2) operation, (3) distributions, (4) redemptions, (5) liquidations, and (6) reorganizations. In this chapter, the formation and operation of corporations are discussed. Chapter 15 describes distributions and redemptions, Chapter 16 presents liquidations, and Chapter 17 details reorganizations. Chapter 18 discusses the penalty taxes, such as the accumulated earnings tax and the personal holding company tax, that may be imposed on corporations.

Chapters 14 through 18 limit their discussion to regular corporations taxed under Subchapter C of the Internal Revenue Code. Special corporations taxed under Subchapter S are discussed in Chapter 21. These S corporations have features closer to the partnership form of organization than the corporate form of organization.

Special rules allow assets and liabilities to be transferred to corporations tax free. There is a carryover of basis and tacking of holding periods in these tax-free exchanges.

Code Sec. 1244 allows the original shareholders of small business stock to obtain an ordinary deduction for a loss on dispositions of the stock rather than receive capital loss treatment. Gain on the sale still remains capital gain. Code Sec. 1202 also enables noncorporate taxpayers to exclude 50, 75, or 100 percent on any gain from the sale or exchange of qualified small business stock held for more than five years which was originally issued after August 10, 1993.

A corporation is a separate legal entity and taxpayer. A corporation computes its taxable income in much the same manner as an individual. However, there are special deductions available to corporations. Dividends received by a corporation from other domestic corporations are deductible to the extent of 50 to 100 percent. The first $5,000 of organizational expenditures may be expensed in the first year and the remaining expenditures may be deducted ratably over a period of 180 months. Charitable contributions are limited to 10 percent of taxable income. Corporations may claim capital losses only against capital gains. Disallowed capital losses are carried back three years and forward five years. Net operating losses are normally carried forward.

For taxable years beginning after December 31, 2017, the corporate tax rate is 21 percent. Dividends must be paid out of after-tax income and included in taxable income of the shareholders receiving the dividends.

Affiliated groups may elect to file consolidated returns rather than separate returns. Members of controlled groups must share certain tax benefits. Corporations use Form 1120 in filing their annual income tax returns.

Entity Choice

Many issues must be addressed when forming a business. A major concern is the type of entity. The major types are sole proprietorships, partnerships, corporations and limited liability corporations. Each entity has certain tax and nontax advantages and disadvantages; therefore, a decision must be made regarding which entity is most beneficial. The initial choice of entity is very important. However, under certain circumstances, the entity structure can be changed at a later date. Following is a brief discussion of each entity.

¶14,001

SPECIFIC ENTITIES

Sole Proprietorships

A sole proprietorship is a form of business in which one person owns all the assets and is fully responsible for all the liabilities. While this entity is treated as a separate entity for accounting purposes, it is not a separate legal entity. As such, a separate tax return is not filed for a sole proprietorship. Instead, its results from operations are reported on Schedule C (Profit or Loss From Business (Sole Proprietorship)) of Form 1040 (U.S. Individual Income Tax Return). The net income or loss is included with the taxpayer’s other income, losses, and deductions for the year, including the qualified business income deduction, and is subject to a tax rate from 10 percent to 37 percent.

Partnerships

A partnership is a form of business in which two or more persons or entities own all the assets and are responsible for the liabilities. It is based on a voluntary contract between these parties. The partnership is formed with the intent that the owners (partners) will contribute assets and/or labor in return for a share of the profits. Most states have adopted the Uniform Partnership Act which governs partnership activities.

A partnership is similar to a sole proprietorship in that it is not a separate entity. However, for accounting and tax-reporting purposes, it is treated as a separate entity. Thus, a tax return, Form 1065 (U.S. Partnership Return of Income), is filed for the partnership. Although a tax return is filed, a partnership is not a taxpaying entity; rather, it is a conduit entity. The income, expenses, gains, losses, credits, etc. pass through to its owners. Schedule K-1 (Partner’s Share of Income, Credits, Deductions, etc.) of Form 1065 contains an indication of each partner’s share of such items. The partner includes these items with her personal activities reported on Form 1040.

Corporations

A corporation is a legal entity created by the authority of state law. It is separate and distinct from its owners (shareholders). A corporation may be owned by one or more persons or entities. For income tax purposes, there are two business types of corporations: regular corporations (C corporations) and electing corporations (S corporations). Both corporations are separate legal entities. The distinction between them is for income tax purposes only.

A C corporation is a separate taxpaying entity. It files Form 1120 (U.S. Corporation Income Tax Return). All its income and expenses are reported in this return and it pays a tax of 21 percent. The shareholders are not liable for a tax based on the corporation’s income. However, shareholders must include dividend distributions in their taxable income.

An S corporation is not a separate taxpaying entity. It files Form 1120S (U.S. Income Tax Return for an S Corporation), but in general does not pay an income tax. Like a partnership, the income, expenses, gains, losses, credits, etc. pass through to the shareholders. Schedule K-1 (Shareholders’ Share of Income, Credits, Deductions, etc.) contains each shareholder’s share of these items.

Limited Liability Companies

In 1977, Wyoming passed the first limited liability company (LLC) legislation. In 1988, the IRS issued Rev. Rul. 88-76, 1988-2 CB 360, holding that a Wyoming LLC would be treated as a partnership for federal income tax purposes. All 50 states now recognize LLCs. However, the legislation is not the same across all jurisdictions, and technical requirements vary. Regardless, the number of LLCs in the United States continues to grow at a very fast pace.

The LLC has corporate and partnership characteristics. From a nontax perspective, LLCs provide flexibility to a firm’s structure and operations, and they also provide their owners (members) with limited liability with respect to firm debts and obligations. For tax purposes, the LLC defaults to being treated as a conduit entity whereby its income passes through to its owners, thereby eliminating the double taxation associated with corporations other than S corporations; however, it may elect to be taxed as a corporation. See ¶14,015 for a discussion.

Limited Liability Partnerships

A limited liability partnership (LLP) is similar to an LLC and is organized under each state’s statutes. These statutes generally apply to service organizations that are organized as partnerships and are most beneficial to large partnerships such as large public accounting firms. LLP status enables the firm to achieve limited liability benefits but be taxed as a partnership.

Comparative Advantages and Disadvantages

Each entity has certain tax and nontax attributes associated with it. Knowledge of these attributes enables taxpayers to select an entity which is most appropriate for them. Some of these attributes are briefly discussed below.

Limited Liability

Limited liability is one of the major advantages of a corporation. The shareholders’ personal assets are not subject to claims of the corporation’s creditors; only their investment in the corporation is subject to these claims. However, certain professional corporations do not have limited liability. Similarly, owners of small corporations usually have to guarantee the loans of their corporations. Partners and sole proprietors have unlimited liability unless the partners are limited partners in a limited partnership or unless the firm is organized as a limited liability partnership (LLP) or a limited liability company (LLC).

Employee Status

Sole proprietors and partners are not considered employees of their firms. This is a disadvantage because certain tax-exempt fringe benefits are not available to them and the firm cannot deduct the costs of these benefits. Similarly, their shares of self-employment income are subject to the self-employment tax of 15.3 percent on a maximum of $137,700, plus 2.90 percent on amounts over $137,700. The 15.3% is composed as follows: 12.4% for old age, survivors, and disability insurance (OASDI) and 2.9% for Medicare. Once the taxpayer reaches the $137,700, only Medicare is due on subsequent earnings. However, one-half of this amount qualifies as a deduction for adjusted gross income in computing taxable income. Shareholders employed by their corporation have employee status, although there are restrictions on shareholders who also are employees of their S corporation. Code Sec. 1372(a).

Additionally, starting in 2013, all taxpayers are subject to an additional 0.9% Medicare tax (so effectively the Medicare tax for these taxpayers is 3.80% (2.90% + 0.9%)). The additional Medicare tax applies once a taxpayer's income exceeds a threshold. The threshold is $200,000 for single and head of househould taxpayers and $250,000 for married taxpayers filing a joint return and surviving spouses.

Double Taxation

A disadvantage of C corporations is that they are subject to a form of double taxation. An income tax is imposed on the taxable income of the corporation, and no deduction is allowed for distributions to shareholders. When after-tax profits are distributed to shareholders as dividends, the shareholders generally must include the amounts in their taxable income. However, the tax rate applied to dividends received by shareholders is the same that applies to net capital gains at zero, 15 or 20 percent. Partnerships, S corporations, and sole proprietorships are not subject to this because they are conduits. Their income passes through to the owners and is taxed at that level only.

Pass-Through Benefits

Corporate losses cannot pass through to shareholders. Also, qualified dividend distributions to shareholders are taxed at capital gains rates, regardless of the type of income (tax-exempt, capital gains, etc.) that generated the earnings and profits from which the dividends came. Since sole proprietorships, partnerships, and S corporations are conduits, all income, gains, losses, credits, etc. pass through to their owners. These items retain their identity when they pass through. Thus, the firms’ net losses can be used to offset personal income. Also, tax-exempt income passes through as such and is not taxable to the sole proprietor or partner. Additionally, the owners can use their shares of capital losses to offset their personal capital gains. Conversely, their shares of capital gains could be offset by their personal capital losses (or carryovers). Regular corporations do not provide these benefits.

Capital Formation

Corporations are better able to raise funds via owner-financing because of the comparative ease to expand ownership. If a large amount of additional capital is needed, a corporation can issue stock. The issuance of stock does not change the entity. A proprietor is solely responsible for owner-financing. The issuance of ownership interest in return for funds terminates the sole proprietorship. A partnership is better able to owner-finance than is a sole proprietorship because it has more owners.

Fiscal Period

A regular corporation can elect a fiscal period different from that of its owners. A sole proprietorship must have the same fiscal period as its owner. A partnership must have the same fiscal period as its partners who have a majority interest. In general, an S corporation must use a calendar year as its tax year unless it can establish a business purpose for using another tax year.

¶14,015

DEFINITION OF A CORPORATION

If the corporate form of business is selected, the owners must be certain that their entity is treated as a corporation for federal income tax purposes. A corporation is a legal entity owing its existence to the laws of the state in which it is incorporated. The state laws define all legal relationships of the corporation. Prior to 1997, a legal corporation was not guaranteed corporate status for federal tax purposes unless it had a majority of corporate characteristics (centralized management, continuity of life, free transferability of interests, and limited liability). Similarly, noncorporate entities sometimes could and would be taxed as corporations if they had a majority of these characteristics. This created uncertainty for many organizations regarding their tax status.

Regulations to Code Sec. 7701 have simplified the entity classification issue. Under the “check-the-box” system, certain business entities (entities other than trusts or those subject to special rules) automatically will be treated as corporations for federal tax purposes. These entities are: firms incorporated under federal or state law, associations, joint-stock companies, or joint-stock associations (as organized under a state statute), insurance companies, banks, business entities wholly owned by a state or political subdivision of the state, business entities that are taxed as corporations under another Code section, and certain foreign entities. Eligible entities (entities other than trusts or those subject to special rules) that are not automatically treated as a corporation may elect (“check-the-box”) to be treated as a corporation for federal tax purposes.

If an entity has one owner, it may elect to be treated as a corporation or by default it will be treated as an entity not separate from its owner (sole proprietorship). If an entity has two or more owners, it can elect to be taxed as a corporation for federal tax purposes, otherwise it will be taxed as a partnership.

An eligible entity makes its election to change its default classification by filing Form 8832 (Entity Classification Election). The entity also indicates the effective date of the election. The effective date cannot be more than 75 days prior to the date Form 8832 is filed nor more than 12 months after it is filed. Also, a copy of Form 8832 must be attached to the entity’s tax return for the year of election. Finally, once the election is made, the election cannot generally be changed for five years.

EXAMPLE 14.1

Gary, Richard, and Tom formed GRT partnership on February 1, 2020. GRT is an eligible entity; thus, if it wants to be taxed as a corporation for federal tax purposes, it must file Form 8832 within 75 days.

Organization of and Transfers to a Corporation

¶14,101

USE OF CORPORATE FORM

If the corporate form is desired, the owners must be certain that they meet all filing requirements of the state in which the company is organized. After completing this, the owners must decide what type of property to transfer to the corporation and how this property should be transferred. For example, should the owners transfer cash to purchase stock or make loans to the corporation? Similarly, should land or other assets be sold to the corporation, contributed in return for its stock, or leased to the corporation? The answers to these questions have significant tax implications.

In general, taxpayers who exchange property other than cash for other property recognize a gain or loss. The difference between the value of the property received and the adjusted basis of the property given up produces a realized gain or loss. Under Code Sec. 1001 this gain or loss is recognized by the taxpayer unless another section of the Internal Revenue Code provides for nonrecognition of the gain or loss.

There are several reasons why nonrecognition treatment is preferable with respect to corporate formation and transfers to corporations. The owners who receive stock in return for their property are not cashing in on their investment. There has been no change in their wherewithal to pay taxes, rather the stock represents a continuation of their investment in a different form. There is no substantive change in the owners’ investments. Additionally, the government does not want to discourage corporate formation and subsequent transfers to corporations. Taxing such transfers when there has been no change in wherewithal to pay would act as a deterrent. Thus, under certain conditions Code Sec. 351 provides for nonrecognition of gain or loss upon transfer of property to a corporation in return for its stock.

¶14,105

GENERAL REQUIREMENTS

The rule under Code Sec. 351 is mandatory and provides that no gain or loss is recognized upon the transfer of property to a corporation solely in exchange for its stock if the taxpayer transferring the property (the transferor) is in control of the corporation immediately after the exchange. The basis rules provided in Code Secs. 358 and 362 assure that the nonrecognition is deferred and not permanent. These sections generally apply a carryover basis to the stock received by the transferor and to the property received by the transferee corporation. Code Sec. 1223 also enables both parties to tack on the holding period of the property transferred to the stock and the property, respectively, if they constitute capital assets or Section 1231 assets.

There are three major requirements of Code Sec. 351: (1) the transfer must consist of property, (2) the transfer must be solely in exchange for stock, and (3) the transferors must be in control immediately after the exchange. Each requirement is discussed separately.

TAX BLUNDER

Susan Jones is in the 35 percent tax bracket. She transfers property with an adjusted basis of $50,000 and a fair market value of $30,000 to X Co. in a transaction that qualifies under Code Sec. 351. Under Code Sec. 351, Jones will not recognize a loss on the transfer. Jones should not have transferred the property. She would have been better off selling the property to the corporation (assuming the related-party loss rules of Code Sec. 267 do not apply) and recognizing the $20,000 loss this year. Both the time value of money and her tax bracket favor such action.

¶14,111

TRANSFERS OF PROPERTY

Code Sec. 351 does not define property. However, it does indicate what is not property. Services, certain debt of the transferee corporation, and certain accrued interest on the transferee’s debt are not treated as property. Code Sec. 351(d). Other than these exceptions, the definition of property is very comprehensive and includes all types of property such as cash, accounts receivables, inventories, patents, installment obligations, equipment, and buildings.

EXAMPLE 14.2

Jerome Smith transfers land to North Corporation in return for 90 percent of its stock. The adjusted basis of the land is $40,000. The fair market value of the stock is $90,000. Jerome has a realized gain of $50,000 ($90,000 – $40,000) and no recognized gain. Jay Jones performs accounting services for North Corporation in return for 10 percent of its stock (fair market value is $10,000). Jay has $10,000 of ordinary income. The receipt of the stock is treated as compensation for services rendered. Jay’s basis in the stock is its fair market value, $10,000.

¶14,115

TRANSFERS FOR STOCK

Code Sec. 351 requires that the transferor receive the corporation’s stock. The receipt of securities in exchange for property does not qualify as a Section 351 transfer. If the transferor receives stock and securities, (assuming other conditions are met) the exchange qualifies under Code Sec. 351, but the securities are treated as boot, regardless of the life of the securities. Also, receipt of anything else constitutes boot and may cause gain recognition. Common and preferred stock and voting and nonvoting stock are acceptable.

However, “nonqualified preferred stock” is considered boot. Nonqualified preferred stock is preferred stock that: (1) the holder has the right to require the issuer or a related party to redeem or purchase; (2) the issuer or a related party is required to redeem or purchase; (3) the issuer or a related party has the right to redeem or purchase, and, as of the issue, it is more likely than not that such right will be exercised; or (4) the dividend rate varies in whole or in part with reference to interest rates, commodity prices, or other similar indices. There are a few exceptions to this definition (and exceptions to these exceptions), such as the right cannot be exercised for 20 years or the right only may be exercised upon the death, disability, or mental incompetence of the holder. Finally, for Code Sec. 351 purposes, stock rights and stock warrants are not considered stock. Reg. §1.351-1(a)(1)(i) and (ii).

Stock that enables the shareholder to participate in corporate growth to a significant extent avoids being classified as preferred stock for Code Section 351 purposes, and therefore qualifies as stock for nonrecognition purposes. Such stock is not treated as participating in corporate growth unless there is a real and meaningful likelihood of the shareholder participating in the earnings and growth of the corporation. Code Sec. 351(g).

EXAMPLE 14.3

Jay Smith transfers land to Hext Corporation in exchange for 100 percent of its stock and four 10-year bonds. The exchange qualifies under Code Sec. 351, but the receipt of the four bonds constitutes boot.

EXAMPLE 14.4

Gina West contributes property to Franken Inc. in a transaction that qualifies as a Code Sec. 351 transfer. In return for the property, she received common stock worth $20,000 and nonqualified preferred stock worth $15,000. The nonqualified stock is considered boot; thus, Gina has received $15,000 boot in the exchange and may be required to recognize a gain. (See ¶14,135 for the treatment of boot.)

¶14,125

CONTROL OF THE CORPORATION

For purposes of Code Sec. 351, control is defined in Code Sec. 368(c). The transferors must be in control immediately after the transfer, regardless of whether they were in control prior to the transfer. Further, the transferors must possess at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. With respect to the nonvoting stock, the IRS has indicated that control requires the ownership of at least 80 percent of the total number of shares of each class of outstanding nonvoting stock. Rev. Rul. 59-259.

Control can apply to one person or a group of people. If more than one person transfers property, the aggregate ownership of the group is used to determine if control exists immediately after the exchange. “Persons” is defined as including individuals, trusts, estates, partnerships, associations, companies, or corporations. Reg. §1.351-1(a)(1). This Regulation also indicates that the term “immediately after the exchange” does not require simultaneous exchanges by two or more persons as long as the rights of each party have been previously defined. The execution of this prearranged plan also must proceed in an expeditious and orderly manner.

EXAMPLE 14.5

Roger Caldwell and Charles Mann transfer property to Bond Corporation in return for 60 percent and 40 percent of its stock, respectively. Although neither has control individually, together they own 100 percent of the stock and meet the control requirements.

The stock received by the transferors does not have to be in proportion to the value of the property transferred. However, if the stocks received are disproportionate to the value of properties transferred, the transaction will be closely scrutinized to determine the true nature of the transaction. If the disproportionality is suspect, the transaction may be treated as if the stock had first been received in proportion and then been used to make gifts, to pay compensation, or to satisfy liabilities among the transferors. Reg. §1.351-1(b)(1).

EXAMPLE 14.6

Mark Smith and Ralph Jones transfer property worth $150,000 and $50,000, respectively, to Best Corporation in return for 100 percent of its stock. Mark and Ralph each receive 100 shares of stock. The exchanges qualify under Code Sec. 351 because together Mark and Ralph are in control immediately after the exchange. However, the IRS may tax the transaction as if Mark had received 150 shares and then transferred 50 shares to Ralph. This subsequent transfer to Ralph might be treated as a compensation payment to Ralph, in which case Ralph would have ordinary income of $50,000. Mark would have income (loss) if the value of the stock ($50,000) is different from Mark’s adjusted basis. Also, Ralph’s basis in the 50 shares would be $50,000. Recasting the transaction as, in part, a gift or loan repayment also would impact income and/or basis computations.

If stock is received for property and services rendered, all of the stock received by the transferor is used in determining whether the transferors are in control immediately after the exchange. However, stock issued for property which is of relatively small value in comparison to the value of the stock already owned (or to be received for services) by the person who transferred such property will not be counted in determining whether the transaction meets the 80 percent control tests. Reg. §1.351-1(b)(1).

EXAMPLE 14.7

Bill Roe transfers property to a new corporation for 70 percent of the stock. Joe Brown receives 30 percent of the stock in the corporation for his work in organizing the corporation. Joe must recognize income upon receipt of his stock and the stock does not qualify for the 80 percent control test. Bill’s transfer is a taxable event since he does not have at least 80 percent control after the transfer.

EXAMPLE 14.8

Sebastian Corporation has 100 shares of stock outstanding. Jan Kruger contributes an asset with a basis of $10,000 and a fair market value of $19,000 along with services worth $1,000 to the corporation for 400 shares of the corporation’s stock. The transfer would qualify under Code Sec. 351 since, as the transferor, she has 80 percent of the stock in the corporation. Jan would have to recognize $1,000 of income from the services but would not recognize the $9,000 gain on the asset. If the property were worth only $1,000 and the services $19,000, the transfer would not qualify under Code Sec. 351.

A loss of control shortly after the transfer could cause the transaction to fail to qualify under Code Sec. 351. If the loss of control was due to the disposition of stock according to a prearranged plan, the transferors will not, in most cases, have control immediately after the exchange.

EXAMPLE 14.9

Bill Bradley and Joe Crawford each receive 50 percent of the stock of Block Corporation upon incorporation. Unknown to Bill, Joe has committed himself to sell more than 40 percent of his stock (bringing Joe’s and Bill’s control under 80 percent) to Max even before the transfer. Section 351 treatment will be denied to both parties.

PLANNING POINTER

Once the stock is received, the transferor may, of course, do whatever is desired with it, after a reasonable time. A highly recommended device is to set the stage for future capital gains by giving some stock, say 10 or 20 percent, to a spouse and/or children. After more than 10 years, the corporation may purchase back this stock (a redemption), resulting in capital gains to the family members upon the termination of their interest. Code Sec. 302(b)(3). Alternatively, property may be gifted so as to qualify donees as transferors.

¶14,135

RECEIPT OF BOOT

If all the requirements of Code Sec. 351 are met, the transferors recognize no gain or loss. Also, their basis in stock received is equal to the adjusted basis of property surrendered.

EXAMPLE 14.10

Larry Lewis and Lance Thompson decide to form Sands Corporation. Larry transfers $10,000 in cash and property with an adjusted basis of $25,000 and a fair market value of $90,000 in return for 100 shares of stock. Lance transfers $20,000 in cash and property with an adjusted basis of $110,000 and a fair market value of $80,000. Lance also receives 100 shares of stock. Since they own 100 percent of the stock, they are in control and the transaction qualifies under Code Sec. 351. Larry has a realized gain of $65,000 ($100,000 – $35,000) and no recognized gain. His basis in the 100 shares of Sands Corporation is $35,000 ($10,000 + $25,000). Lance has a realized loss of $30,000 ($100,000 – $130,000), of which none is recognized. His basis in the 100 shares of Sands Corporation is $130,000 ($20,000 + $110,000).

Property other than stock is considered boot. (Although, as noted earlier, nonqualified preferred stock is considered to be boot.) The receipt of limited amounts of boot does not disqualify a transfer from Code Sec. 351. However, gain must be recognized to the extent of the lesser of the realized gain or the fair market value of the boot received. Code Sec. 351(b). The character of the gain depends on the property transferred. Losses are never recognized under Code Sec. 351.

EXAMPLE 14.11

Max Murphy and Jake Jones form Small Corporation. Max transfers land with an adjusted basis of $10,000 for stock worth $15,000 and $5,000 cash. Jake transfers equipment with an adjusted basis of $25,000 for stock worth $10,000 and $7,000 cash. Max has a realized gain of $10,000, but only $5,000 is recognized. Jones has a realized loss of $8,000 and none of it is recognized.

EXAMPLE 14.12

Same as Example 14.11, except that Max’s land has an adjusted basis of $16,000. Max has a realized gain of $4,000 which is fully recognized. Jake has an unrecognized $8,000 loss because Code Sec. 351 still applies to the exchange.

If more than one asset is transferred, the boot must be allocated among the assets. The IRS endorses the view that the boot is to be allocated in accordance with fair market values. Reg. §1.358-2(b). This is necessary because gain or loss must be computed on each asset. Rev. Rul. 68-55. Since no losses are recognized in a Section 351 transaction, and there are assets transferred with realized losses, less gain will be recognized on the appreciated assets because boot is allocated to loss assets as well. In addition to affecting the amount of gain recognized, the allocation also impacts the character of gain (e.g., ordinary income, capital gain, Section 1231 gain) because the character depends on the asset transferred.

EXAMPLE 14.13

George Anderson transfers land and inventory to Candle Corporation in return for 100 percent of its stock. The land has a fair market value of $120,000 and an adjusted basis of $40,000. The inventory has a fair market value of $80,000 and an adjusted basis of $90,000. George receives stock worth $150,000 and $50,000 in cash. The effects of this transfer are illustrated below.

	Land		Inventory		Total
Fair market value	$120,000		$80,000		$200,000
Adjusted basis	40,000		90,000		130,000
Realized gain (loss)	$80,000		$(10,000)		$70,000
Boot allocation	$30,000		$20,000		$50,000
	(60%)		(40%)
Recognized gain (loss)	$30,000		$None		$30,000

Thus, if the land is a capital asset to George, he would recognize a $30,000 capital gain.

¶14,141

TRANSFERS OF LIABILITIES

There are many instances when property transferred to a corporation is subject to a liability. The corporation usually assumes the liability as part of the transaction. Because transfers to controlled corporations usually involve transfers of liabilities, especially when existing businesses such as sole proprietorships or partnerships incorporate, taxing the transfer could be a deterrent to corporate formation. Code Sec. 357 provides relief in this situation by not treating the transfer of liabilities as boot if the transaction qualifies under Code Sec. 351. The assumption of a liability by the transferee corporation will not be treated as boot for gain recognition purposes and will not disqualify Code Sec. 351 treatment. Code Sec. 357(a). (As discussed later, the assumption of the liability will affect basis considerations).

EXAMPLE 14.14

Sally Flowers transfers a building with an adjusted basis of $100,000 and a fair market value of $140,000 to Inter Corporation in return for all of its stock worth $60,000. The building is subject to a mortgage of $80,000 which Inter Corporation assumes. The transaction qualifies as a Code Sec. 351 transfer. Sally has a realized gain of $40,000 ($60,000 + $80,000 – $100,000). None of the gain is recognized.

There are two exceptions to the general rule under Code Sec. 357(a). These exceptions result if the transfer of liabilities had a tax avoidance purpose or if the sum of liabilities assumed exceeds the adjusted basis of all properties transferred by the transferor.

Tax Avoidance or No Business Purpose

All liabilities transferred to the corporation will be treated as boot if the principal purpose of the liability assumption was to avoid federal income tax or if there was no bona fide business purpose for the transfer. Code Sec. 357(b). The taxpayer must overcome these appearances by the clear preponderance of the evidence.

Tax avoidance generally is not a problem. The lack of a bona fide business purpose also is not a problem if the liabilities were incurred in the normal course of business. The time between when the funds are borrowed and when the transfer to the corporation occurs is an important factor.

If funds were borrowed just prior to the transfer, it will be difficult to overcome the lack of a business purpose, especially if the proceeds were used for personal benefit. In such instances, the transferor should be prepared to provide clear evidence to verify the business purpose for the loan and its transfer.

EXAMPLE 14.15

George Small transfers land with an adjusted basis of $40,000 and a fair market value of $95,000 to Giant Corporation in return for all of its stock. The stock is worth $65,000. Two days prior to the transfer, George borrowed $30,000 against the land. The $30,000 liability was assumed by Giant Corporation as part of the exchange. George has a realized gain of $55,000 (($65,000 + $30,000) – $40,000). George has a recognized gain of $30,000 because it appears that there was no business purpose for the loan or its transfer.

Liability in Excess of Basis

If the sum of the liabilities assumed exceeds the total adjusted basis of all properties transferred, the transferor must recognize gain on the exchange to the extent of such excess. Code Sec. 357(c). Without the recognition of gain, the stock received by the transferor would have a negative basis. With the application of this provision and related basis rules, the transferor’s basis in the stock is zero.

EXAMPLE 14.16

Sara Topper transfers a building with an adjusted basis of $30,000 and a fair market value of $100,000 to Sunny Corporation in return for 100 percent of its stock. The building is subject to a $50,000 mortgage which Sunny Corporation assumes. Sara must recognize a gain of $20,000 equal to the excess of the mortgage over the adjusted basis of the building.

If there is more than one transferor, gains should be recognized on a person-by-person basis.

EXAMPLE 14.17

Fred Smart transfers property with an adjusted basis of $45,000, a fair market value of $80,000, and a mortgage of $59,000 to a new corporation. Ginger Snow simultaneously invests $14,000 in cash. Fred must recognize a gain of $14,000 because the liability exceeds his basis in the asset. He is not allowed to count Ginger’s investment in the total basis contribution.

PLANNING POINTER

An individual wishes to incorporate by transferring an asset to the corporation for all of the corporation’s stock. The asset has a fair market value of $200,000 and a basis of $50,000. The asset has a liability attached in the amount of $80,000. This transfer would result in a $30,000 recognition of income because the liability exceeds the basis of the asset. The individual would be well advised to include other assets in the transfer with a net basis of at least $30,000 to avoid any income recognition.

If the transferor transfers more than one asset and fewer than all of them are encumbered, but liabilities exceed aggregate basis, gain is recognized on all assets. The recognized gain is to be allocated among the assets in accordance with fair market values.

EXAMPLE 14.18

Mary Meyers transfers inventory worth $20,000 with an adjusted basis of $10,000 and a building worth $100,000 with an adjusted basis of $50,000 and a mortgage of $90,000 in return for 100 percent of Sage Corporation’s stock. Sage Corporation also assumes the mortgage. Mary’s recognized gain is $30,000 ($90,000 – ($50,000 + $10,000)). $5,000 is recognized on the inventory ($30,000 × 20/120) and $25,000 is recognized on the building ($30,000 × 100/120). Without the transfer of inventory, Mary would have recognized a $40,000 gain on the building ($90,000 – $50,000).

Code Sec. 357(c) presents potential problems for taxpayers who incorporate their cash-basis businesses. Usually, these firms have a large amount of unrealized accounts receivables (zero basis). They also have unrealized accounts payable, which are treated as liabilities, and could create a liability in excess of basis problem. However, liabilities that would give rise to a deduction when paid (i.e., accounts payable of a cash-basis taxpayer) and amounts payable under Code Sec. 736 (i.e., payments to a retiring partner or to liquidate a deceased partner’s interest) are excluded in determining the amount of liabilities assumed by the corporation. Code Sec. 357(c)(3).

EXAMPLE 14.19

Matilda Worth incorporates her sole proprietorship operated on the cash method of accounting. She transfers equipment with an adjusted basis of $10,000 and zero basis accounts receivable and accounts payable. The accounts payable have an outstanding balance of $17,000 but no basis because of the cash method of accounting. Without the relief provision, an automatic gain of $7,000 would result (liabilities in excess of basis). Under Code Sec. 357(c), Matilda will recognize no gain. The corporation succeeds to her zero basis in the accounts receivables and accounts payable. Upon payment, the corporation will deduct the accounts payable as a business expense.

PLANNING POINTER

Transfer of zero basis receivables will result in double taxation of the receivables. A tax will be imposed when the corporation collects the receivables and there will be a second tax imposed on the shareholders when dividends are paid by the corporation. It would be better not to transfer the zero basis receivables to the corporation. The shareholder will then report the income upon collection, and the receivables are taxed only once.

Recourse vs. Nonrecourse Debt

Code Sec. 357(d) addresses recourse and nonrecourse liabilities. Recourse liabilities are considered to be assumed if the transferee-corporation has agreed (and is expected) to satisfy the obligation, regardless of whether the transferor-shareholder has been relieved of such liability. In general, nonrecourse liabilities also are treated as having been assumed by the corporation for property subject to the liability. However, if the nonrecourse liability is on multiple assets and some of those assets were not transferred to the corporation then the amount of liability considered assumed is reduced by the amount that the shareholder and corporation agree will be satisfied by the shareholder. This reduction is limited to the fair market value of the assets not transferred.

EXAMPLE 14.20

Jessica owns four assets (A, B, C and D). Each asset’s adjusted basis and fair market value is as follows:

Asset	Adjusted Basis	Fair Market Value
A	$300,000	$500,000
B	400,000	700,000
C	600,000	900,000
D	200,000	300,000
Total	$1,500,000	$2,400,000

The assets are encumbered with a $1,000,000 nonrecourse debt. Jessica transferred assets A, B, and C to Mumper Corporation in a transaction that qualified under Code Sec. 351. Jessica and Mumper agree that she will satisfy $150,000 of the nonrecourse debt; as such, Mumper is treated as having assumed $850,000 of the nonrecourse debt. The most that Mumper will be considered as assuming is $700,000, regardless of what Jessica and it agree to because the amount assumed cannot be reduced by more than asset D’s fair market value.

¶14,155

BASIS DETERMINATION

Shareholder’s Basis

Code Sec. 358 provides that the shareholder’s basis in stock received in a Section 351 transfer is equal to the adjusted basis of property exchanged, increased by the amount of gain recognized on the exchange, and decreased by the fair market value of boot received. Code Sec. 358. The basis of the boot received is its fair market value. Also, the assumption of a liability is considered boot for basis purposes even though it was not for gain purposes under Code Sec. 357. If more than one class of stock is received, the property basis must be allocated to the classes of stock in proportion to their fair market value.

EXAMPLE 14.21

Bob Ripon transfers land with an adjusted basis of $5,000 and a fair market value of $14,000 to Wendy Corporation in return for all its stock. Bob has a realized gain of $9,000, but no gain is recognized. Bob’s basis in the stock is $5,000.

EXAMPLE 14.22

Same as Example 14.21, except that Bob also receives a $1,000 short-term note (boot). Bob has a realized gain of $9,000 and a recognized gain of $1,000 (the lesser of the realized gain or the fair market value of the boot received). Bob’s basis in the stock is $5,000 ($5,000 + $1,000 – $1,000). Bob’s basis in the short-term note is $1,000, its fair market value.

EXAMPLE 14.23

Jane Seaman transfers land with an adjusted basis of $7,000 and a fair market value of $5,000 to Wall Corporation. Jane receives $800 in cash and all of Wall Corporation’s stock. Jane has a realized loss of $2,000, and none of the loss is recognized. Jane’s basis in the stock is $6,200 ($7,000 – $800).

EXAMPLE 14.24

Harry Bold transfers land with an adjusted basis of $40,000 and a fair market value of $50,000 to Handy Corporation in return for all its stock and $12,000 in cash. Harry has a realized gain of $10,000. Even though he received $12,000 in cash, Harry’s recognized gain is limited to the realized gain; thus, he has a recognized gain of $10,000. Harry’s basis in the stock is $38,000 ($40,000 + $10,000 – $12,000).

EXAMPLE 14.25

Hal Lamb transfers property with a fair market value of $90,000 and an adjusted basis of $50,000 to X Corporation for all its stock. The land is subject to a $30,000 mortgage. Hal has a realized gain of $40,000 but no recognized gain. His basis in the stock is $20,000 ($50,000 – $30,000).

EXAMPLE 14.26

Assume the same facts as Example 14.25, except that the mortgage is $70,000. Hal’s realized gain is $40,000 and his recognized gain is $20,000 (liability in excess of basis). Hal’s basis in the stock is zero ($50,000 + $20,000 – $70,000).

EXAMPLE 14.27

Susan Anders transferred assets with a fair market value of $100,000 and an adjusted basis of $60,000 to a corporation in return for 100 shares of its Class A stock (100 percent) and 100 shares of its Class B stock (100 percent). The fair market value of the Class A stock was $80,000. The fair market value of the Class B stock was $20,000. Susan had a realized gain of $40,000 (($80,000 + $20,000) – $60,000) but no recognized gain. Her basis in both classes of stock was $60,000. This was allocated to the classes in accordance with their relative fair market values. Thus,

EXAMPLE 14.28

Assume the same facts as in Example 14.27, except that Susan received five 10-year bonds instead of Class B stock. Susan’s realized gain still is $40,000. However, her recognized gain is $20,000, the lesser of the $40,000 realized gain or the fair market value of boot received ($20,000 bonds). Her basis in the bonds is $20,000 (fair market value) and her basis in the stock is $60,000 ($60,000 + $20,000 – $20,000).

Stockholder’s Holding Period

The shareholder’s holding period in stock received in a Section 351 transfer includes the holding period of property transferred if the assets were capital assets or Section 1231 assets (recapture potential is irrelevant). Code Sec. 1223(1). If both ordinary income property and capital or Section 1231 assets are transferred, the shareholder winds up with two holding periods in the stock since the holding period of stock issued for ordinary income property begins on the day following receipt. Tacking is permitted even if realized gains are recognized in full or in part because of the receipt of boot. The holding period for boot received begins on the next day of the transaction.

EXAMPLE 14.29

Kerry Brooks transfers a capital asset to a corporation under Code Sec. 351. Kerry held the capital asset long term before the transfer. The stock received from the transfer is considered held long term regardless of the length of time held before any sale of the stock. The holding period of the capital asset tacks on to the holding period of the stock.

Corporation’s Basis

The corporation’s basis in property received is equal to the transferor’s adjusted basis increased by any gain recognized by the transferor. Code Sec. 362. Liabilities assumed by a corporation do not affect the basis of the assets received from shareholders in Section 351 transfers. If the liability exceeds the basis of the asset transferred, gain equal to the excess liability will be recognized by the transferor and cause the property’s basis to increase.

EXAMPLE 14.30

Peter Rhone transfers property with an adjusted basis of $3,000 and a fair market value of $5,000 to Pest Corporation in a Section 351 transfer. Peter’s realized gain is $2,000, of which none is recognized. His basis in the stock is $3,000. Pest Corporation’s basis in the property is $3,000.

EXAMPLE 14.31

Assume the same facts as Example 14.30, except that the property is subject to a $1,000 liability which Pest Corporation assumes. Peter has a realized gain of $2,000. None of the gain is recognized. His basis in the stock is $2,000 ($3,000 – $1,000). Pest Corporation’s basis in the property is $3,000.

EXAMPLE 14.32

Assume the same facts as Example 14.31, except that the property is subject to a liability of $3,500. Peter has a realized gain of $2,000 and a recognized gain of $500 (liability in excess of basis). Peter’s basis in the stock is zero ($3,000 + $500 – $3,500). Pest Corporation’s basis in the property is $3,500 ($3,000 + $500).

Transfers of Property with Built-In Losses

Sometimes property whose adjusted basis exceeds its fair market value is transferred to a corporation (a built-in loss at the time of transfer). The normal basis rules would give the corporation a basis in such property that is greater than its fair market value, effectively creating a built-in loss for the corporation. Code Sec 362(e) prohibits this by requiring the corporation to reduce its basis in such property. If the corporation’s aggregate adjusted basis of property received exceeds the fair market value of such property then the corporation’s basis in such property is limited to the property’s fair market value. If more than one asset is transferred in the transaction then the corporation’s basis in each asset is reduced in proportion to each property’s built-in loss. However, the corporation does not have to make this basis reduction if both it and the transferor-shareholder elect to reduce the shareholder’s basis in the corporation’s stock (to the fair market value of the property transferred).

EXAMPLE 14.33

Jacob transfers a machine with an adjusted basis of $150,000 and a fair market value of $100,000 to Jules Corporation in return for its stock. The transfer qualified under Code Sec. 351. Under the general basis rules of Code Sec. 362, Jules Corporation’s basis in the machine would be $150,000 (the shareholder’s adjusted basis at the time of transfer); however, since the property’s adjusted basis exceeds its fair market value, Jules’s basis is limited to $100,000 (the property’s fair market value). Alternatively, Jacob may take a basis in his Jules Corporation stock of $100,000 (instead of $150,000) and Jules Corporation will take a $150,000 basis in the machine if both Jules and he elect this treatment.

EXAMPLE 14.34

Kristin transferred three machines (A, B and C) to Shull Corporation in a transfer that qualified under Code Sec. 351. Each asset’s adjusted basis and fair market value is as follows:

Asset	Adjusted Basis		Fair Market Value		Built-In Gain (Loss)
A	$200,000		$150,000		($50,000)
B	250,000		180,000		(70,000)
C	350,000		410,000		60,000
Total	$800,000		$740,000		($60,000)

The $60,000 built-in loss is distributed to assets A and B according to their relative built-in losses, so $25,000 ($60,000 x ($50,000/$120,000)) is allocated to A and $35,000 ($60,000 x ($70,000/$120,000)) is allocated to B. Accordingly, Shull Corporation’s basis in each asset is as follows:

Asset	Basis
A	$200,000 − $25,000	=	$175,000
B	$250,000 − $35,000	=	215,000
C	$350,000 − 0	=	350,000
Total			$740,000

Again, if Kristin and Shull Corporation elect, Shull Corporation will take a basis in each asset equal to its adjusted basis at the time of transfer ($200,000, $250,000 and $350,000 in A, B and C, respectively, if Kristin takes a $740,000 basis in the Shull Corporation’s stock).

Corporation’s Holding Period

The corporation tacks on the shareholder’s holding period in assets transferred. The transferor may transfer ordinary income property to a corporation, in whose hands it becomes a capital asset or vice versa.

¶14,165

RECAPTURE RULES

Depreciation Recapture

In a Section 351 transfer in which no boot is received and, therefore, no gain is recognized, there is no recapture of depreciation. Code Secs. 1245(b)(3) and 1250(d)(3). The recapture potential shifts to the corporation. If gain is recognized on the exchange because boot is received, it is characterized as ordinary income to the extent of depreciation recapture. If only part of the depreciation is recaptured, the remaining portion is shifted to the corporation.

EXAMPLE 14.35

Larry Bloom purchased a truck for $40,000 and took $23,000 in depreciation prior to transferring it to Vail Corporation in a Section 351 exchange. The truck had a fair market value of $20,000 at the time of the exchange. Larry has a realized gain of $3,000 but no recognized gain ($20,000 – $17,000). His basis in the stock is $17,000. Vail Corporation’s basis in the truck is $17,000. It also inherits the $23,000 recapture potential.

EXAMPLE 14.36

Assume the same facts as Example 14.35, except that in addition to receiving stock, Larry also receives $2,000 in cash. Total value received still is $20,000. Larry has a realized gain of $3,000 and a recognized gain of $2,000 as ordinary income. His basis in the stock is $17,000 ($17,000 + $2,000 – $2,000). Vail Corporation’s basis in the truck is $19,000 ($17,000 + $2,000). Vail Corporation also inherits the remaining depreciation recapture potential of $21,000.

EXAMPLE 14.37

Assume the same facts as in Example 14.35 except that the fair market value of the truck is $22,000, and Larry received stock worth $15,000 and $7,000 in cash. Larry’s realized gain is $5,000 ($22,000 – $17,000). Although he received $7,000 boot, his recognized gain is limited to the realized gain. Thus, Larry’s recognized gain is $5,000 of ordinary income. His basis in the stock is $15,000 ($17,000 – $7,000 + $5,000). Vail Corporation’s basis in the truck is $22,000 ($17,000 + $5,000), and it inherits $18,000 recapture potential.

General Business Credit Recapture

A premature disposition of business property in which the general business tax credit has been taken (i.e., Section 38 property) generally triggers recapture of the portion not earned. (See ¶9045 for a discussion of the credit.) Unlike depreciation recapture, the recapture of the general business tax credit occurs regardless of whether any gain was realized or recognized on the transaction. However, no recapture is triggered if the taxpayer changes only “the form of conducting the trade or business as Section 38 property and the taxpayer retains a substantial interest in such trade or business.” Code Sec. 50(a)(4).

What constitutes a substantial interest is not defined in the Internal Revenue Code and has been a source of contention and controversy. For example, exchanging a 50 percent interest in a partnership for a 35 percent interest in a corporation probably would qualify for exemption from recapture. However, in one case the Tax Court has held that exchanging a 48 percent partnership interest for a 7.22 percent stock interest did not qualify. J. Soares, 50 TC 909, CCH Dec. 29,138 (1968).

If no general business tax credit recapture is triggered on the transfer, the recapture potential stays with the shareholder. Future recapture is triggered when the corporation disposes of the property or when the shareholder disposes of a substantial interest in the business.

EXAMPLE 14.38

In 2020, Bill and Joe incorporated their equally-owned partnership and each received 50 percent of the stock in the new corporation, Fecowycz Incorporated. On January 2, 2018, the partnership had purchased energy property for $50,000 (five-year property) and had claimed a general business credit of $5,000. No general business credit was recaptured upon incorporation.

On January 3, 2021, Fecowycz Incorporated sold the energy property. The sale triggers a $2,000 recapture of the general business credit. Both Bill and Joe must recapture $1,000 of the credit in 2021.

TAX BLUNDER

Susan transferred equipment to ABC Co. in a Code Sec. 351 transfer. Susan purchased the equipment for $60,000. The adjusted basis of the equipment was $40,000 and its fair market value was $50,000. Susan had a choice; she could receive 100 shares of ABC Co. or 90 shares of ABC Co. and $5,000. She chose the stock plus cash option. Susan has a realized gain of $10,000 ($50,000-$40,000) and a recognized gain of $5,000 (boot received). Additionally, the recognized gain is all Code Sec 1245 gain (ordinary income) because of the depreciation recapture rules. Susan should have chosen the stock only option. This option would have shifted the depreciation recapture potential to ABC Co.

¶14,175

SECTION 351 TRANSFER OR TAXABLE EXCHANGE

Code Sec. 351 is a mandatory provision. Gain or loss is not recognized on a transfer which qualifies under Code Sec. 351. The corporation’s basis in the property is a carryover basis equal to the shareholder’s adjusted basis in the property. Also, the shareholder’s basis in the stock received is equal to the adjusted basis of property transferred.

There may be times when taxpayers want recognition on the exchange. If taxpayers have property whose fair market value is less than the adjusted basis, they may want to recognize this loss. Code Sec. 351 must be avoided to accomplish this. An arm’s-length sale or an exchange for short-term debt would be a transaction outside the purview of Code Sec. 351. The loss will not be recognized if the shareholder and corporation are related parties as defined in Code Sec. 267 (i.e., if the shareholder owns directly or indirectly more than 50 percent in value of the corporation’s outstanding stock).

The shareholder might want to recognize gain on the transaction because this provides the corporation with a stepped-up basis (fair market value), especially if the shareholder is in a lower tax bracket than the corporation. However, under Code Sec. 1239 capital gain treatment will be denied the shareholder if the property is depreciable property in the hands of the corporation and the shareholder and corporation are related parties. Thus, the ordinary income treatment under Code Sec. 1239 will apply if the shareholder directly or indirectly owns more than 50 percent of the value of the corporation’s stock.

EXAMPLE 14.39

Jim Jones, who owns 70 percent of Best Corporation, sells Section 1231 property to Best Corporation for $100,000 (the property’s fair market value). The adjusted basis of the property is $60,000. Jim has a realized and recognized gain of $40,000 ($100,000 – $60,000). The gain will be a Section 1231 gain. However, if the property is depreciable property for the corporation (e.g., a building), the $40,000 gain is ordinary income.

Shareholders must determine whether a Section 351 transfer is most advantageous for them. The transaction must be structured properly so that either it falls under Code Sec. 351 or is beyond its control, depending upon which result is desired.

KEYSTONE PROBLEM

The sole proprietor of a printing shop is in the fortunate position of having greatly appreciated assets (the land and building where the business is located) as well as an exceedingly competent business manager. The manager is in fact so good that another position elsewhere has been offered. The owner persuades the manager to stay by giving 25 percent of the business. This is accomplished by incorporating the business and signing over 25 percent of the common stock to the manager. No tax advice is sought and the tax consequences are rather severe:

1. Code Sec. 351 has not been met, so the owner has “sold” the assets to the corporation. The gain will equal the value of the full 100 percent stock interest less the basis in the assets on a item-by-item basis.

2. The manager has taxable compensation in the amount of the value of the 25 percent stock interest since property received for services is taxable under Code Sec. 83. (However, an offsetting deduction is available to the corporation.)

The two main requirements for incorporating tax free are that the transferors of property must be in at least 80 percent control after the transfer and that they received only stock for their property. In accordance with these two requirements, there are several alternative ways to handle this transaction so as to limit taxes or avoid them completely. Explain.

¶14,185

REPORTING REQUIREMENTS

Shareholders and corporations who are parties to a Section 351 exchange must attach statements to their income tax returns for the period in which the exchange occurred. Reg. §1.351-3(a) and (b). The shareholder’s statement must include the following:

1. A description of the property transferred and its adjusted basis

2. A description of the type and number of shares of stock received, including its fair market value

3. A description of the securities received, including principal, terms, and fair market value

4. An indication of the amount of money received

5. A description of any other property received (i.e., boot), including its fair market value

6. A description of the liabilities assumed by the corporation, including when and why they were created and the business reason for the assumption

The statement of the controlled corporation must include:

1. A description of all property received from transferors

2. An indication of the transferor’s adjusted basis in the property

3. An indication of the number and type of stock issued, including its fair market value

4. A description of the stock issued and outstanding prior to and immediately after the exchange

5. A description of the securities issued, including fair market value

6. A description of all securities outstanding prior to and immediately after the exchange

7. An indication of the amount of money distributed to the transferors

8. A description of any other property distributed, including its fair market value

9. A description of liabilities assumed by the corporation, including when and why they were created and the business reason for the assumption

Corporate Capital Structure

A corporation’s capital structure consists of the stock and debt it issues. Capital is raised from shareholders by issuing stock. Different classes of stock (i.e., common, preferred, voting, nonvoting) can be issued. Capital is raised from nonshareholders by issuing debt, in which case a formal debtor-creditor relationship is established. Additionally, shareholders and/or nonshareholders may contribute assets to the corporation not in return for stock or debt. These contributions to capital are motivated for different reasons. For example, a city might donate land to a corporation so that it may build a factory. The city will benefit from increased employment opportunities and tax revenues. Each method of raising capital can have significant consequences to the transferor and the corporation.

¶14,201

EQUITY IN THE CAPITAL STRUCTURE

Shareholder Contributions

A corporation does not recognize a gain or loss on the receipt of money or other property in exchange for its stock. Code Sec. 1032. Also, it does not recognize income when it receives money or other property as a contribution to capital (i.e., the corporation does not issue stock, debt, money, or property in return for the contributed property). Code Sec. 118. However, the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the corporation to limit production.

The corporation’s basis in the property depends upon the nature of the transaction. If stock is issued in return for the property and Code Sec. 351 applies to the transaction, the corporation’s basis equals the transferor’s adjusted basis increased by any gain recognized by said transferor. If the transaction is a taxable exchange (i.e., the corporation purchases land by issuing its stock), the corporation’s basis is the fair market value of the stock.

The shareholder’s basis in the stock is equal to the adjusted basis of the property transferred, increased by any recognized gain and decreased by the fair market value of boot received if it is a Section 351 transfer. The shareholder’s basis in stock received in a taxable exchange is equal to the fair market value of the property transferred.

The corporation’s basis of property received from a shareholder as a contribution to capital equals the shareholder’s adjusted basis increased by any gain recognized by the shareholder. Code Sec. 362. Since the shareholder receives no stock, the shareholder’s basis in the stock owned prior to the contribution is increased by the amount of cash and adjusted basis of the property transferred plus any gain recognized by the shareholder on the transfer. Usually shareholders do not recognize a gain or loss when they transfer property as a contribution to capital.

Similarly, amounts received from voluntary pro rata payments from shareholders are not income to the corporation even though no stock is issued. The payments represent an addition to the price paid for the shares of stock held by the shareholders. Reg. §1.118-1.

EXAMPLE 14.40

Cindy Blair, a sole shareholder in Alpha Inc., contributed land to be used by the corporation as a parking lot. She receives no additional stock in the corporation. The land has a fair market value of $100,000 and an adjusted basis of $40,000. Cindy has a $60,000 realized gain but no recognized gain. Her basis in Alpha stock is increased by $40,000. Alpha Inc. recognizes no gain or loss. The corporation’s basis in the land is $40,000.

EXAMPLE 14.41

Dancing Shoes Corporation requires additional funds for conducting its business and obtains such funds through voluntary pro rata payments by its shareholders. The payments are credited to a special paid-in capital account and no additional shares are issued. The amounts received from the shareholders do not constitute income to the corporation. The payments are in the nature of assessments upon the shareholders and represent an additional price paid for the shares of stock held by the individual shareholders.

Special rules apply to the forgiveness of corporate debts by shareholders. As a general rule, when a debt is cancelled, the debtor must recognize income. However, if a shareholder in a corporation which is indebted to the shareholder gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt.

EXAMPLE 14.42

Mary Sullivan owns stock in Dogette Corporation and also lent the corporation $10,000. Mary gratuitously cancels the $10,000 debt. The forgiveness of the debt is a nontaxable contribution to capital. The corporation recognizes no income and Mary increases her stock basis by $10,000.

Nonshareholder Contributions

Prior to the Tax Cuts and Jobs Act of 2017, contributions by nonshareholders were also excluded from gross income of the corporation as long as the transfer was not for goods and services, nor in aid of construction, nor any other contribution from a customer or potential customer. Cities often provided corporations with land or other property as an inducement to locate in their area. The Act, however, provides that any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such) is no longer a tax free contribution to capital. A special rule allows certain contributions in aid of construction received by a regulated public utility that provides water or sewerage disposal services to be treated as a tax-free contribution to the capital of the utility. Contributions by state and local governments as inducements to corporations made after the date of enactment, December 22, 2017, are included in the gross income of the corporation unless they are made pursuant to a master development plan that was approved by a governmental entity before passage of the Act.

EXAMPLE 14.43

Calumet City donates land to Wilder Corporation on May 1, 2020, as an inducement for the corporation to expand its operations. The land has a fair market value of $25,000. Wilder recognizes $25,000 of income and has a basis in the land of $25,000.

Where the corporation receives a contribution pursuant to an approved master plan, the basis to the corporation of property received is zero. When the corporation receives cash pursuant to the plan, the corporation is required to reduce the basis of any property acquired during the next 12-month period by the amount of cash received. When all of the money has not been spent in the 12-month period, the basis of other property must be reduced by the amount not spent. Property subject to depreciation must be reduced first, then property subject to amortization, then property subject to depletion, and finally any other remaining property. The reduction of the basis of each of the properties within each category is to be made in proportion to the relative basis of such properties. Code sec. 362(C)(1) and (2); Reg. §1.362-2.

EXAMPLE 14.44

Assume the same facts as in Example 14.43 except that the donation of the land was made pursuant to a master development plan that had been approved by Calumet City Council in September 2017. In this case, Wilder recognizes no income and will have a zero basis in the land.

The corporation recognizes no income from contributions made pursuant to an approved master plan. However, since any basis in the property received or acquired is zero, the normal benefits of cost recovery are denied. Thus in the long run, the corporation recognizes income when the asset is sold. The requirement for contributions by state and local governments to be made pursuant to an approved master development plan will likely lead to corporations working with governments to develop such plans.

¶14,215

DEBT IN THE CAPITAL STRUCTURE

In addition to issuing stock during corporate formation, the corporation also should issue long-term debt because debt has certain advantages over equity. Interest payments on the debt are generally deductible by the corporation while dividends are not deductible. Additionally, debt repayment is an acceptable reason for accumulating income and, therefore, avoiding the accumulated earnings tax under Code Sec. 531. Most redemptions of stock are not acceptable reasons. Repayment of the principal is tax free to the creditor, whereas payments made to shareholders for their stock may be considered dividends or taxable redemptions. Finally, should the debt instrument become worthless, then the loss may be an ordinary loss if the debt is business related (if nonbusiness bad debt, then it is treated as a short-term capital loss).

There are some disadvantages to debt. Interest payments are income to the debtholder. Similarly, the debtholder will have income for amounts received in excess of basis. Additionally, if the debtholder is a corporation, it is not entitled to the dividends-received deduction when it receives interest payments. Finally, the corporation issuing the debt must make timely payments of interest and principal in accordance with the terms of the debt instrument. Stock does not have this constraint; that is, dividends usually are voluntary distributions.

EXAMPLE 14.45

John Jones invests cash in Adams Corporation in return for stock and long-term debt in a Section 351 transfer. During the year, John receives a dividend of $5,000 and interest payments of $6,000. Jones has $11,000 of gross income. Adam Corporation has a $6,000 deduction for the interest payment. No deduction is allowed for the dividend payment. Assuming Adams Corporation’s tax rate is 21 percent, the after-tax cost of the interest payment is $4,740 ($6,000 × (1.00 – .21)); the deduction saved it taxes of $1,260 ($6,000 × .21). The after-tax cost of the dividend was $5,000 because it was not deductible.

However, the interest income is taxed at Jones’ regular tax rate, whereas the dividend income is taxed at a reduced rate. Assuming that Jones is in the 35 percent tax bracket, the interest income is taxed at 35%, or $2,100 ($6,000 x .35) and the dividend income is taxed at 15 %, or $750 ($5,000 x .15). Thus, the debt still is preferable but the benefit of interest versus dividends is not as great as it used to be because the difference in treatment at the individual shareholder level offsets some of the benefits at the corporate level.

Because of the advantages of debt financing, there are instances when taxpayers attempt to treat equity instruments as debt. Usually these instruments are debt in legal form but in substance are equity. Using the doctrine of substance over form, the IRS will attempt to reclassify this debt as equity. Code Sec. 385(a) authorizes the IRS to issue regulations to determine whether an interest in a corporation is debt or equity and Code Sec. 385(b) lists five nonexclusive factors that may be considered.

1. Does the instrument contain an unconditional promise to pay on demand or on a specified date a definite amount for adequate consideration and at a fixed rate of interest?

2. Is the debt preferred over or subordinated to other debts?

3. How high is the corporation’s debt to equity ratio (is the corporation thinly capitalized)?

4. Is the debt convertible into stock?

5. What is the relationship between stock and debt ownership (is it proportionate)?

Also, the classification of a corporate instrument issued after October 24, 1992, as stock or debt by the corporate issuer is binding on the issuer and all holders. Code Sec. 385(c). This conformity rule prevents the IRS from being whipsawed by the issuer (borrower) classifying an instrument as debt while the holder (lender) classifies the same instrument as equity. A borrower typically wants the interest expense deduction while the holder prefers tax-favored dividend income. The classification is not binding on the IRS.

EXAMPLE 14.46

Maurice Severs starts a new corporation with $50,000 and receives $45,000 of 12-year notes and $5,000 of stock. The full $50,000 will most likely be viewed as equity by the IRS because of the debt-to-equity ratio (9-to-1). If Maurice issued $25,000 of debt and $25,000 of equity, the arrangement would probably be respected. Thus, the corporation may deduct interest on the notes and Maurice may receive $25,000 tax free as repayment of principal.

Limitation of the deduction for interest expense

For taxable years beginning after December 31, 2017, the amount allowed as a deduction for business interest is limited. Business interest means any interest paid or accrued on indebtedness properly allocable to a trade or business. The limitation applies to business interest expense of all taxpayers, not just corporations. The amount of business interest deductible for any taxable year is the sum of: 1) the taxpayer’s business interest income; 2) 30% of the taxpayer’s adjusted taxable income; and 3) the taxpayer’s floor plan financing interest. The limitation is applied after other interest disallowance, deferral, capitalization or other limitation provisions. The amount not deductible is carried forward and treated as business interest paid or accrued in the succeeding taxable year. Code Sec. 163(j).

EXAMPLE 14.47

In Year 1, Whiteside Inc. has $10,000 of business interest income, $600,000 of adjusted taxable income and $230,000 of business interest expense. Whiteside can deduct $210,000 of business interest in Year 1 [$10,000 business interest income + $200,000 (30% x $600,000)]. The $20,000 of disallowed business interest expense is carried forward and treated as paid in Year 2.

The limitation does not apply to taxpayers that meet the gross receipts test. Taxpayers other than tax shelters meet the gross receipts test if annual average gross receipts do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years. Code Sec. 448(c). The indexed amount for 2020 is $26 million. The limitation also does not apply to the trade or business of performing services as an employee or to certain regulated public utilities and electric cooperatives. In addition, certain taxpayers may elect for the interest expense limitation not to apply, such as certain real estate businesses and certain farming businesses; businesses making this election are required to use the alternative depreciation system (ADS) to depreciate certain property.

Business interest income means the amount of interest includible in the gross income of the taxpayer that is properly allocable to a trade or business. Adjusted taxable income generally is a business’s taxable income computed without regard to: (1) any item of interest, gain, deduction, or loss that is not properly allocable to a trade or business; (2) business interest or business interest income; (3) the amount of any net operating loss deduction; (4) the 20% deduction for certain pass-through income under Code Sec. 199A, and (5) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion. A business’s adjusted taxable income may not be less than zero for purposes of the limitation.

EXAMPLE 14.48

Assume the same facts as in Example 14.47. In Year 2, Whiteside has $16,000 of business interest income, ($100,000) of adjusted taxable income and $220,000 of business interest expense. Because Whiteside’s adjusted taxable income is negative, 30% of its adjusted taxable income is deemed to be zero for purposes of the business interest limitation. Whiteside can deduct $16,000 of its business interest, an amount that equals its business interest income. Whiteside’s business interest expense carryover to Year 3 is $224,000 ($20,000 business interest carryover from Year 1 + $220,000 business interest in Year 2 - $16,000 deductible in Year 2).

The IRS issued proposed regulations that refer to the limit on the amount of business interest expense that a taxpayer may deduct in a tax year as the “section 163(j) limitation.” The proposed regulations clarify that, solely for purposes of Code Sec. 163(j), all interest expense of a taxpayer who is a C corporation is treated as properly allocable to a trade or business. Thus, all of a C corporation’s interest expense is subject to the Code Sec. 163(j) limitation, unless the expense is allocable to an excepted trade or business (e.g. an electing real estate business.) Prop. Reg. §1.163(j)-4.

Business interest income does not include investment interest within the meaning of section 163(d). For purposes of Code Sec. 163(j) limitation, a C corporation cannot have investment interest, investment expenses, or investment income. However, a partnership in which a C corporation is a partner may have these items. In such an instance, any investment interest allocated to a C corporation partner is recharacterized as business interest under the proposed regulations. Prop. Reg. §1.163(j)-4.

Floor plan financing interest is interest paid or accrued for “floor plan financing indebtedness,” which means indebtedness used to finance the acquisition of motor vehicles held for sale or lease. Floor plan financing interest is fully deductible.

EXAMPLE 14.49

Tripp Co. generates $200 million of noninterest income. Its only expenses are cost of goods sold of $100 million and $40 million of interest expense on outstanding bonds for a net income for books of $60 million. Tripp’s deduction for business interest is limited to 30% of adjusted taxable income, that is, 30% × $100 million = $30 million. Tripp deducts $30 million of business interest and reports taxable ordinary business income of $70 million. The disallowed deduction of $10 million of interest expense is carried forward and treated as interest paid in the succeeding tax year.

¶14,235

SECTION 1244 STOCK

Although debt can be more advantageous than equity, certain stock issuances receive special treatment which makes them favorable. Shareholders are permitted to deduct limited losses on the worthlessness or sale (including redemptions and liquidations) of Section 1244 stock as ordinary. Gains on the disposition of such stock are capital gains. Thus, the shareholders receive the best of both situations, ordinary loss treatment (up to a statutory limit) if the corporation fails and capital gain treatment if the corporation is successful.

The reason for this treatment is to place shareholders of small corporations on a more nearly equal basis with sole proprietors and partners and to encourage the flow of funds into small corporations. Certain restrictions apply to ensure that the provision benefits small corporations.

Eligible Shareholders

Only individuals and partnerships are eligible for ordinary loss treatment if they were original holders of the stock. The stock loses its Section 1244 status when it is transferred. If a partnership is an original holder, the subsequent loss is passed through to those partners who were partners when the stock was issued. Reg. §1.1244(a)-1(b)(2).

Loss Limitation

Ordinary loss treatment is limited to an annual $50,000 per shareholder and $100,000 on a joint return regardless of which spouse owns the stock. If the loss is greater than these limits ($50,000 or $100,000), the excess is treated as a capital loss. Section 1244 losses are treated as attributable to the taxpayer’s trade or business. As such, they have business status for net operating loss purposes. Thus, if the Section 1244 loss exceeds the shareholder’s taxable income, the excess is carried over under the net operating loss provisions.

EXAMPLE 14.50

Marge Summers, a single taxpayer, has a basis of $120,000 in Section 1244 stock when it becomes worthless. She incurs a $50,000 ordinary loss and a $70,000 capital loss. If she is married by year-end, even if the loss had been sustained months earlier, a $100,000 ordinary loss and a $20,000 capital loss would result on a joint return.

Corporate Requirements

Only a domestic small business corporation can issue Section 1244 stock. The stock can be common or preferred and voting or nonvoting. The corporation must qualify as a small business at the time the stock is issued. The total dollar amount of money and property received by the corporation for its stock, as a contribution to capital and as paid-in capital, cannot exceed $1,000,000 at the time the stock is issued. The property’s fair market value is not used in determining the $1,000,000 limit. Property received by the corporation is valued at its adjusted basis, reduced by any liabilities that were assumed by the corporation. Stock issued for services rendered does not qualify as Section 1244 stock.

The issuing corporation does not need to adopt a plan to issue Section 1244 stock. Determination of Section 1244 stock is made at the time of issuance. All stock issued qualifies as Section 1244 stock as long as the firm has not issued more than $1,000,000 of stock. Regulation 1.1244-(c)-2 provides special rules for determining which shares of stock are eligible for Section 1244 treatment if the firm has issued more than $1,000,000 of stock (however, this is beyond the scope of this text).

If the adjusted basis of the property transferred in return for Section 1244 stock exceeds its fair market value, the adjusted basis of such stock for the sole purpose of computing the Section 1244 loss is reduced by the amount of such excess. This treatment prevents the conversion of a capital loss on the property into an ordinary loss on the Section 1244 stock. Increases in basis through contributions to capital or otherwise are not counted for ordinary loss computation purposes. Code Sec. 1244(d)(1)(B).

EXAMPLE 14.51

Roy Ready incorporated a truck with a basis of $20,000 and a fair market value of $13,000. He subsequently contributed another $11,000 in the business before his stock became worthless. Since his basis in the stock was $31,000 ($20,000 + $11,000), his loss also is $31,000; only $13,000 is an ordinary loss under Code Sec. 1244. The remaining loss of $18,000, consisting of the paper loss at the time of incorporation plus capital contributions, is capital in nature.

PLANNING POINTER

In Example 14.51, the taxpayer could have maintained the $11,000 capital contributions as a Section 1244 deduction by purchasing stock in the corporation for $11,000 instead of contributing the $11,000 and adjusting the basis of the stockholdings. The purchase price of the stock would have been its adjusted basis for gain or loss purposes and for determining the Code Sec. 1244 loss.

The corporation must be an operating company at the time the loss is sustained. The corporation’s gross receipts from sources other than dividends, interest, royalties, rents, annuities, and sales or exchanges from stock or securities must exceed 50 percent of the corporation’s gross receipts for the five most recent tax years. The operating company requirement need not be satisfied if the total deductions allowed the corporation—other than the dividends-received deduction and the net operating loss deduction—exceeds the total gross income for the five-year period.

Reporting Requirements

Taxpayers must substantiate their claims of a Section 1244 loss. The taxpayer is required to maintain records sufficient to distinguish Section 1244 stock from any other stock the taxpayer may own in the corporation. The corporation also should maintain records showing all of the following:

1. The persons to whom stock was issued, the date of issuance to these persons, and a description of the amount and type of consideration received from each person.

2. The basis to the shareholder of any property received by the corporation and the fair market value of the property at the time it is received by the corporation.

3. The amount of money and the basis to the corporation of other property received for its stock as a contribution to capital and as paid-in capital.

4. Financial statements of the corporation, such as its income tax returns, that identify the sources of the gross receipts of the corporation for the period consisting of the five most recent tax years.

5. Information relating to any tax-free stock dividends made with respect to Section 1244 stock and any reorganization in which stock is transferred by the corporation in exchange for Section 1244 stock.

¶14,245

SECTION 1202 STOCK

Code Sec. 1244 aids small business capital formation by providing a benefit to shareholders who recognize a loss on their stock investment. Code Sec. 1202 aids capital formation by providing a benefit to shareholders who realize a gain. Within limits, Code Sec. 1202 enables noncorporate taxpayers to exclude up to 100 percent of the gain from the sale or exchange on qualified small business stock held for more than five years. The exclusion is 50 percent for stock issued before February 18, 2009. The exclusion is 75 percent for investors who acquired the stock after February 17, 2009 and before September 28, 2010. The exclusion was increased to 100 percent for stock acquired after September 27, 2010. The definition of small business stock is not the same as that used in Code Sec. 1244. Assuming all requirements are met, the stock effectively is identified as Code Sec. 1202 stock when issued.

Eligible Shareholders

Only individuals are eligible for the 50 (75/100) percent exclusion if they were the original holders of the stock and the stock was issued in exchange for money, property other than stock, or compensation for services rendered to the corporation. If the stock is issued in exchange for services, it is considered issued when included in the taxable income of the service provider. If a conduit entity was an original holder, the subsequent gain is passed through to those owners who were owners when the stock was issued. Conduits can be holders of Section 1202 stock. Partnerships, S corporations, regulated investment companies, and common trust funds qualify as conduits for purposes of Code Sec. 1202. The gain and share of the stock’s adjusted basis pass through proportionately to the owners (e.g., partners) of the conduit. Code Sec. 1202 applies only to stock originally issued after August 10, 1993, which is held for more than five years by the taxpayer. The stock generally loses its Section 1202 status when it is transferred unless the transfer is tax free and by gift, by death, from a partnership to a partner, or a stock-for-stock transfer.

Gain Limitation

Only gain from the sale or exchange of qualified small business stock is eligible for the 50 (75/100) percent exclusion. Exclusion treatment is subject to per-issuer cumulative limitations. The amount of eligible gain is limited to the greater of:

1. $10,000,000 reduced by the aggregate of eligible gain recognized from the sale of the corporation’s stock which has been taken into account by the taxpayer in prior years (a lifetime limitation), or

2. 10 times the aggregate adjusted basis of qualified small business stock issued by the corporation and disposed of by the taxpayer during the taxable year (an annual limitation). For this purpose only, the adjusted basis of the stock is not increased for additions to basis which took place after the date of original issuance.

In applying the lifetime or annual limitation, the relevant amount is the amount eligible for the Code Sec. 1202 exclusion rather than the amount actually excluded. Once a taxpayer’s cumulative eligible gain with respect to an issuer reaches the lifetime limitation, further gain from the sale of qualified small business stock of that issuer can be eligible for the Code Sec. 1202 exclusion subject to the annual limitation. In determining the taxpayer’s eligible gain, if the stock was acquired in exchange for property (other than money or stock), then for Code Sec. 1202 purposes only, the basis of the stock shall be no less than the property’s fair market value at the time of transfer. The basis adjustment for any subsequent contribution to capital also shall be no less than the property’s fair market value at the time of the transfer. This prevents taxpayers from converting gain on the contributed property to Code Sec. 1202 gain eligible for the 50, 75, or 100 percent exclusion. Assuming all requirements are met, the stock effectively is identified as Code Sec. 1202 stock when issued.

EXAMPLE 14.52

On January 10, 2014, Sara Shertzer acquired stock in Snave Co. for $300,000. Snave Co. is a qualified small business for Code Sec. 1202 purposes. On December 18, 2020, Sara sold the stock for $600,000. Sara’s realized gain is $300,000, and her recognized gain is $0. One-hundred percent of the $300,000 capital gain is excluded since it is within the limits of (1) $10,000,000 or (2) 10 × $300,000 = $3,000,000.

EXAMPLE 14.53

On February 20, 2014 Sam Ellsworth transferred property to Maxo Co. in return for 100 percent of its common stock. The corporation is a qualified small business for Code Sec. 1202 purposes. Sam’s adjusted basis in the property was $500,000, and it had a fair market value of $2,000,000. On February 25, 2020, Sam sold one-fourth of his shares for $800,000. Sam’s realized gain is $675,000 ($800,000 – ($500,000 × .25)). His recognized gain is $375,000 ($675,000 – $300,000 excludable gain). In this situation the fair market value of the property will be used to determine the excluded gain. One-fourth of $2,000,000 is $500,000, so the gain for Code Sec. 1202 purposes is $300,000 ($800,000 – $500,000). One-hundred percent of the $300,000 is the excluded gain. The $300,000 excluded gain is within the limits of (1) $10,000,000 or (2) 10 × ($2,000,000 × .25) = $5,000,000.

EXAMPLE 14.54

On March 15, 2019, Don Frescoln sold qualified small business stock in Duke Inc. For $10,000,000. His basis in the stock was $500,000. Don’s lifetime limit is $10,000,000; his annual limit is $5,000,000. His realized gain of $9,500,000 is less than the larger of the two limits and is all eligible for exclusion under Code Sec. 1202.

EXAMPLE 14.55

Assume the same facts as in Example 14.54. On April 1, 2020, Don sells an additional block of Duke Inc. Stock with a basis of $300,000 for $6,000,000. Don’s lifetime limit for 2020 is $500,000 ($10,000,000 - $9,500,000) and his annual limit is $3,000,000 (10 x $300,000). Of the realized gain of $5,700,000 ($6,000,000 - $300,000), $3,000,000 is eligible for exclusion under Code Sec. 1202.

The disposition of Code Sec. 1202 stock that was acquired on or before September 28, 2010 may result in a taxpayer being subject to alternative minimum tax. Code Sec. 57(a)(7) treats 7% of the gain that is excluded from gross income for regular tax purposes as gross income for alternative minimum tax purposes for stock acquired before September 28, 2010. Gain excluded on the disposition of Code Sec. 1202 stock acquired after September 27, 2010 is not an alternative minimum tax preference item.

Corporate Requirements

Only a domestic C corporation can issue Section 1202 stock. The stock can be common or preferred and voting or nonvoting. The corporation must qualify as a small business at the time the stock is issued. The corporation’s aggregate gross assets cannot exceed $50,000,000 anytime before the issuance of the stock and immediately after the issuance. Aggregate basis is equal to cash and the aggregate adjusted basis of property held. For this test only, the adjusted basis of contributed property is equal to its fair market value at the time of transfer. If aggregate gross assets subsequently exceed $50,000,000, the corporation no longer can issue Section 1202 stock; however, previously issued Section 1202 stock is not disqualified.

Active Business Requirements

The corporation must be an operating company which is actively engaged in a trade or business during substantially all of the time the taxpayer held its stock. A corporation meets this requirement if at least 80 percent of its assets are used in the active conduct of one or more qualified trades or businesses as defined in Code Sec. 1202(e)(3). Qualified trades and businesses do not include the following:

1. Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,

2. Any banking, insurance, financing, leasing, investing, or similar business

3. Any farming business

4. Any business involving the production or extraction of products

5. Any business involving the production or extraction of products

Code Sec. 1202(e)(7) places a limit of 10 percent of the total value of assets consisting of real property which is not used in the active conduct of a qualified trade or business. The ownership of, dealing in, or renting of real property is not be treated as the active conduct of a qualified trade or business for purposes of this test. If more than 10 percent of the total value of its assets consists of real estate not used in the active conduct of a qualified trade or business, then the corporation fails the active business test.

Assets held as part of the reasonably required working capital needs of a qualified trade or business of the corporation, or held for investment and reasonably expected to be used within two years to finance research and experimentation or increases in working capital needs, are treated as used in the active conduct of the qualified trade or business. Once a corporation has existed for at least two years, no more than 50% of its assets can qualify as used in a qualified trade or business under this rule.

Rollover of gain from qualified small business stock

Code Sec. 1045 enables a taxpayer other than a corporation to roll over tax-free gains on the sale of qualified small business stock held for more than six months if the proceeds from the sale are used to purchase other qualified small business stock within 60 days of the sale. The taxpayer’s basis in the newly acquired stock is reduced by the amount of capital gain not recognized. Also, the holding period of the stock sold is tacked on to the holding period of the newly acquired stock.

EXAMPLE 14.56

Justin Wells invests $300,000 in Shapot Corporation on September 1, 2018. Shapot Corporation qualifies as a small business corporation. On August 14, 2020, Justin sells his Shapot Corporation stock for $550,000. He then buys stock in Clerici Inc., also a small business corporation, for $525,000. Since Justin did not reinvest all $550,000, he must recognize a $25,000 gain.

Stock or Debt

Whether stock or debt is preferable depends on many considerations. Individual shareholders are entitled to the benefits of Code Secs. 1202 and 1244, which make stock advantageous to them. Corporate shareholders are not entitled to the benefits of Code Secs. 1244 and 1202, but they are entitled to the dividends-received deduction (discussed at ¶14,385), which also makes stock advantageous to them.

A major advantage of debt to the issuing corporation is that the corporation is entitled to a deduction for interest payments subject to the limitation of Code Sec. 163(j) discussed above. See ¶14,215. Dividend payments are not deductible. The recipient shareholder has gross income regardless of whether it is interest or dividends (except for corporate shareholders entitled to the dividends-received deduction), although dividends are taxed at a reduced rate for individual shareholders. A disadvantage of debt is that a loss upon its sale or worthlessness usually results in a nonbusiness bad debt (which is treated as a short-term capital loss by individuals) or a capital loss. Corporate shareholders might be able to claim a business bad debt deduction.

Thus, whether stock or debt is preferred depends in part on the type of shareholders, the marginal tax rates of the shareholders and the corporation, and the possibility of a Section 531 tax imposition (discussed in Chapter 18). Nontax factors also are important.

PLANNING POINTER

Toni Travels invested $50,000 cash in a wholly-owned corporation. Since she was aware of the advantages of debt in the capital structure, she received $25,000 in stock and $25,000 in debt. A few years later, the corporation became worthless. Only the $25,000 basis in the stock is eligible for ordinary loss treatment under Code Sec. 1244. The worthless debt is deductible only as a capital loss. Toni may have been better advised to have taken only stock in the original transfer to the corporation.

TAX BLUNDER

Sally Rogers owns 100 shares of Dino Co. She acquired the shares on December 20, 2015, for $100,000. Dino Co. qualifies as a small business corporation for Code Sec. 1202 purposes. Sally believed she would have a very large estimated tax payment due on January 15, 2020, so she sold the shares on January 2, 2020, for $250,000. Sally’s estimated tax payment was much less than she expected. Sally was uncertain of (and somewhat indifferent about) what to do with the proceeds from the sale of the Dino Co. shares, so she put the proceeds into a three-month certificate of deposit. The result of these events is that Sally must recognize the $150,000 fully in 2020. Sally did not hold the stock for more than five years, so the sale does not qualify for the 100 percent exclusion. Sally still could have deferred gain recognition by reinvesting in shares of a qualified small business corporation. Had she not been indifferent regarding her investment choice, she might have made a better decision.

Determination of Corporate Taxable Income

¶14,301

GENERAL RULES

There are many similarities between the rules used to determine taxable income for corporations and those used for individuals. Gross income is determined in the same manner for corporations and individuals. That is, Code Sec. 61, which defines gross income, applies to both types of taxpayers. Corporations also are entitled to exclusions from gross income. Thus, corporations can exclude interest income on municipal bonds. However, most of the statutory exclusions in Code Secs. 101 to 139 pertain to individuals only.

All corporate deductions are business deductions. Ordinary and necessary expenses incurred to carry on a trade or business are deductible. Code Sec. 162. These are similar to some of the for adjusted gross income deductions (for AGI) allowed to individuals. However, some of the for AGI deductions, such as self-employed health insurance and contributions to IRAs, apply only to individuals. Corporations do not have from adjusted gross income deductions (from AGI). They are not entitled to deductions for personal expenses. Also, they do not have itemized deductions or a standard deduction. However, there are some deductions that apply to corporations only, such as the dividends-received deduction under Code Sec. 243.

Because corporations do not have itemized deductions, the limitations and reductions used to compute deductions are different. For example, corporations do not reduce a casualty loss by $100 or a net casualty loss by 10 percent of adjusted gross income. Interest expense is not classified as personal interest under Code Sec. 163 if incurred by corporations and, therefore, is deductible, subject to the Code. Sec. 163(j) limitation.

Property transactions are taxed similarly. The determination of realized gain or loss and the classification of this gain or loss as capital, ordinary, or Code Sec. 1231 is similar. Both corporations and individuals are subject to depreciation recapture rules under Code Secs. 1245 and 1250. The deferral provisions for like-kind exchanges under Code Sec. 1031 and involuntary conversions under Code Sec. 1033 apply to corporations and individuals.

¶14,305

ACCOUNTING PERIODS

One of the elections a new corporation must make is its choice of an accounting period. In general, corporations have the same choices as do individuals. They may choose a calendar year or a fiscal year. However, a corporation has more flexibility in choosing its accounting period. It may choose any calendar or fiscal tax year regardless of the tax years of its owners.

Other entities do not have this freedom. For example, S corporations are required to adopt the calendar year unless they can establish a business purpose for a fiscal year. Deferral of income to shareholders is not a business purpose. Code Sec. 1378(b). Partnerships must have the same tax year as their partners who have a majority interest. If there is no majority interest, the partnership uses the tax year of all its principal partners. If there are no principal partners, the least aggregate deferral method must be used unless the partnership can establish a business purpose for using a fiscal year. Code Sec. 706(b).

Personal service corporations are corporations whose primary activity is the performance of personal services. These services are primarily performed by employee-owners. Personal-service corporations must use a calendar year for their tax year unless they can establish a business purpose for a fiscal year. Code Sec. 441(i).

¶14,311

ACCOUNTING METHODS

The corporation must select an accounting method in its initial tax year. Generally, the cash basis, accrual basis, or a hybrid basis which contains elements of the cash and accrual methods may be elected. Most corporations, however, must use the accrual method. However, this constraint does not apply to S corporations, qualified farming businesses, qualified personal service corporations, and corporations with average annual receipts of $26 million or less for the three prior tax years.

A corporation that meets the exception above (e.g., an S corporation) may use any of the three methods. However, corporations that maintain inventory for sale to customers are required to use the accrual method of accounting for determining sales and cost of goods sold unless they qualify for the exception available to businesses with average annual gross receipts of $26 million or less.

¶14,315

CAPITAL GAINS AND LOSSES

The process used to determine a corporation’s capital gains and losses is similar to that used by individuals. Gains and losses resulting from the taxable sale or exchange of capital assets must be reclassified as short-term or long-term. Next, the net short-term and the net long-term positions must be computed. If the short-term gains exceed the short-term losses, a net short-term gain results. If the short-term losses exceed the short-term gains, a net short-term loss results. Long-term gains and losses are netted in similar manner to determine the net long-term gain or loss.

The next step is to determine the corporation’s overall capital asset position. This is dependent upon the two net positions. If they are opposite (i.e., a net loss and a net gain), then they are combined. If they are similar (i.e., both net gains or net losses), then they are kept separate. Thus, there are six possible combinations:

1. Net long-term capital gain greater than net short-term capital loss. These are combined to produce a net capital gain.

2. Net long-term capital gain less than net short-term capital loss. These are combined to produce a net capital loss.

3. Net short-term capital gain greater than net long-term capital loss. These are combined to produce capital gain net income.

4. Net short-term capital gain less than net long-term capital loss. These are combined to produce a net capital loss.

5. Net long-term capital gain and net short-term capital gain. These are not combined. The net long-term capital gain is treated as a net capital gain, and the net short-term capital gain is treated as capital gain net income.

6. Net long-term capital loss and net short-term capital loss. These are not combined.

The taxation of corporate capital gains and losses depends on the net position (i.e., combinations one to six above).

Net Capital Gain

Corporations do not receive preferential treatment of net long-term capital gains. Net capital gains (combinations 1, 3, and 5, above) must be included in the corporation’s gross income and are taxed at the same rate as ordinary income, a flat 21 percent.

EXAMPLE 14.57

Hands Corporation has gross receipts from sales of $230,000, deductible expenses of $75,000, and a net capital gain of $48,000. Hands’ gross income is $278,000 ($230,000 + $48,000). Its taxable income is $203,000 ($278,000 – $75,000). Its tax liability will be computed on the $203,000; the $48,000 net capital gain does not receive preferential treatment.

Net Capital Losses

Unlike individuals, corporations may not take a deduction for net capital losses in the year in which they occur. The net capital loss can never be used to reduce ordinary income. Corporate taxpayers may claim capital losses only against capital gains.

Net capital losses (combinations 2, 4, and 6, above) of a corporation are carried back to the three preceding tax years to offset net capital gains claimed in those years. If some net capital loss remains, it is carried forward for a period of five tax years. The carryovers must be taken back to the third, second, and first preceding tax years in that order, and any remaining losses carried forward to the five succeeding tax years in order. Unused losses at the end of the five-year carryforward period are lost forever. Also, all net capital losses carried back or forward become short-term capital losses regardless of their original status.

EXAMPLE 14.58

Civic Corporation incurred a net long-term capital loss of $15,000 in 2020. It also had gross receipts from sales of $120,000 and deductible expenses of $70,000 in 2020. Civic’s gross income is $120,000, and its taxable income is $50,000 ($120,000 – $70,000). The $15,000 net capital loss does not affect taxable income in 2020. Civic Corporation carries the loss back to 2017, 2018, and 2019, in that order, to offset any net capital gains of those years. If the loss is not exhausted, the remainder is carried, in order, forward to 2021, 2022, 2023, 2024, and 2025. The $15,000 is treated as a short-term capital loss in any of the carryback or carryforward years.

 

EXAMPLE 14.59

Assume the same facts as in Example 14.58, except that Civic Corporation had a net short-term capital gain of $7,000 in 2017, a net short-term capital gain of $2,000 and a net long-term capital gain of $3,000 in 2018, and no capital gains or losses in 2019. The $15,000 net capital loss incurred in 2020 first is carried back to 2017 and offsets the $7,000 net short-term capital gain. Civic will receive a refund of taxes paid on that gain. The remaining $8,000 loss ($15,000 – $7,000) is carried to 2018 where it offsets the $2,000 net short-term capital gain and then the $3,000 net long-term capital gain. Civic will receive a refund of taxes paid on both gains. The remaining loss of $3,000 ($8,000 – ($2,000 + $3,000)) is carried to 2019. Since there were no net capital gains in that year, the $3,000 loss will be carried to 2021.

¶14,325

DEPRECIATION RECAPTURE

Corporations generally compute the ordinary income recapture on Section 1245 and Section 1250 assets in the same manner as individuals. Section 1245 assets are generally subject to ordinary income recapture to the extent of the full depreciation taken on the asset. Section 1250 assets acquired before 1981 are generally subject to ordinary income recapture to the extent of the cumulative excess of the depreciation taken over the amount allowed using straight-line depreciation. Nonresidential real property placed in service in years 1981 through 1986 is subject to depreciation recapture to the extent of the full depreciation taken if an accelerated depreciation method was used. Residential real estate continues to use the pre-1981 recapture rules. Post-1986 acquisitions of buildings are depreciated on a straight-line basis.

However, corporations have special recapture rules under Code Sec. 291. Application of these rules may result in a greater amount of ordinary income than the Section 1250 recapture rules for other business organizations. Code Sec. 291 requires that 20 percent of the excess of any amount that would be treated as ordinary income under Code Sec. 1245 over the amount treated as ordinary income under Code Sec. 1250 is additional depreciation recapture, and thus, ordinary income. Similar rules apply to amortization of pollution control facilities and intangible drilling costs incurred by corporate taxpayers. The computation of Section 291 gain is shown below.

Amount that would have been ordinary income if Section 1245 property	$XXX
Less: Amount of ordinary income under Section 1250	(XX)
Excess of Section 1245 gain over Section 1250 gain	$XXX
Section 291 applicable percentage	× 20%
Section 291 gain (ordinary income)	$XXX

If the gain recognized on the transaction exceeds the ordinary income recognized under Code Sec. 1245, 1250, or 291, then such excess is a Section 1231 gain. The effect of Section 291 is to reduce the amount of capital gain available to offset capital losses.

EXAMPLE 14.60

Computer Services Corporation acquired an office building for $1,170,000. The building was depreciated under the straight-line method. The building was sold nine years later for $960,000. Depreciation taken on the building up to the time of sale was $270,000 ($30,000 per year for nine years). The adjusted basis at the time of sale was $900,000 ($1,170,000 – $270,000). Computer Services Corporation has a $60,000 gain on the sale (amount realized of $960,000 less adjusted basis of $900,000). Since straight-line depreciation was used, there is no depreciation recapture under Code Sec. 1245 or 1250. However, ordinary income of $12,000 recognized under Code Sec. 291 is computed as follows:

Ordinary income if Section 1245 gain	$60,000
Less: Ordinary income under Section 1250	0
Excess Section 1245 gain	$60,000
Section 291 percentage	× 20%
Section 291 gain (ordinary income)	$12,000

The remaining $48,000 gain ($60,000 – $12,000) is Section 1231 gain.

¶14,335

NET OPERATING LOSS

A net operating loss (NOL) arises when a corporation’s business deductions exceed its gross income. NOLs arising in tax years beginning after December 31, 2017 may be carried forward indefinitely and offset up to 80 percent of taxable income in the carry over year. Tax law before the passage of the Tax Cuts and Jobs Act of 2017 provided for a two-year carryback and 20-year carryforward of NOLs with no taxable income limitation for regular tax computation purposes. Thus, NOLs arising in tax years beginning on or before December 31, 2017 are not subject to the 80 percent limitation. However, the elimination of the NOL carryback and the indefinite carryover period applies to losses arising in tax years ending after December 31, 2017. Accordingly, the NOLs of fiscal year taxpayers arising in tax years that begin before December 31, 2017 and end after December 31, 2017 would not be subject to the 80 percent limitation but could not be carried back and could be carried forward indefinitely.

Corporations may want to consider the interaction of the 80 percent limitation and bonus depreciation when making asset acquisitions if such purchases would create or increase an NOL subject to the 80 percent limitation.

Although the Tax Cuts and Jobs Act of 2017 eliminated the carryback provisions for NOLs arising in tax years beginning after December 31, 2017, it permits a new two-year carryback for certain farming losses and retains pre-Act law for insurance companies.

Unlike individuals, corporations are not required to make adjustments to the NOL for capital gains and losses or nonbusiness expenses, since they are not allowed deductions for these items in the computation of taxable income. Also, corporations are permitted the full dividends-received deduction (see ¶14,385) in computing their NOLs. Similar to individuals, NOL deductions for each year are considered separately. Thus, NOL carryovers from other years are omitted in computing the NOL for the present year.

EXAMPLE 14.61

In 2020, Mighty Corporation has $200,000 of gross income from operations and operating deductions of $300,000. The corporation also received $50,000 in dividends from a 30-percent owned domestic corporation. The corporation has a net operating loss for the year of $82,500, computed as follows:

Gross Income
Operations	$200,000
Dividends	50,000
Total Gross Income		$250,000
Deductions
Operations	$300,000
Dividends-received deduction ($50,000 × 65%)	32,500
Total Deductions		332,500
Net Operating Loss		$82,500

Mighty Corporation may carry the $82,500 NOL forward.

EXAMPLE 14.62

Assume the same facts as in Example 14.61. In addition, Mighty Corporation has taxable income of $40,000 in 2021. Mighty may use the NOL from 2020 to offset $32,000 ($40,000 x 80%) of 2021 taxable income, resulting in 2021 taxable income of $8,000. Mighty will carry forward the remaining NOL of $50,500 ($82,500 - $32,000) to 2022.

 

EXAMPLE 14.63

NIFCO began operations in 2017 and incurred a net operating loss of $20,000 for its first tax year that ended on December 31, 2017. In 2018, NIFCO incurred a net operating loss of $12,000, and in 2019, NIFCO incurred a net operating loss of $3,000. In 2020, NIFCO broke even and had neither gain nor loss. Assume that in 2021, NIFCO has $15,000 of taxable income before the NOL deduction. NIFCO’s NOL deduction in 2021 is $15,000. NIFCO can offset 100% of its 2021 income with the loss that is carried over from 2017. The 2017 NOL is $5,000 after offsetting 2021 income. In 2022, NIFCO has taxable income of $14,000 before the NOL deduction. Its NOL deduction in 2022 will be limited to $12,200 and is comprised of $5,000 from 2017 and $7,200 (.80 x ($14,000 - $5,000)) from 2018. There will be $1,800 income for 2021 ($14,000 - $12,200). NIFCO will carry forward the $4,800 remaining loss from 2018 and the $3,000 loss from 2019 to 2022.

¶14,345

CHARITABLE CONTRIBUTIONS

The deductibility of charitable contributions is dependent upon (1) what type of property is donated, (2) when the property is donated, and (3) to whom the property is donated, as well as the corporation’s adjusted taxable income. In order to receive a deduction, the property must be donated to a qualified charitable organization. Code Sec. 170(c). A deduction is allowed only in the year of transfer or payment (i.e., when the contribution occurs). However, an accrual-basis corporation may claim a deduction in the year preceding payment if its board of directors authorized a charitable contribution during the year and payment of the contribution is made by the 15th day of the third month of the next tax year. Code Sec. 170(a).

EXAMPLE 14.64

The board of directors of Willis Corporation authorized a $3,000 cash donation to a qualified charitable organization on December 13, 2020. The payment was not made until February 25, 2021. Willis Corporation is a calendar-year corporation. If the corporation is on the accrual method of accounting, the charitable deduction will be allowed for 2020. Under the cash method, the deduction would not be allowed until 2021, the year paid.

The amount deductible is dependent upon the type of property contributed and the corporation’s adjusted taxable income. Property type determines the initial dollar measure of the contribution. The overall deduction for contributions by a corporation is generally limited to 10 percent of adjusted taxable income (as described below).

Ten Percent Limitation

The maximum amount deductible by a corporation for charitable contributions is 10 percent of its adjusted taxable income. Thus, the deduction is limited to the lesser of 10 percent of adjusted taxable income or the sum of the initial measures of all property donated during the tax year. Adjusted taxable income is equal to taxable income without regard to the charitable contribution deduction, the dividends-received deduction, and any capital loss carryback. Code Sec. 170(b)(2). If the charitable contributions for the tax year exceed the 10 percent limitation, the excess can be carried forward for five years. Carryovers are used on a first-in, first-out basis after first deducting the current year’s contributions. Code Sec. 170(b) and (d).

EXAMPLE 14.65

Block Inc. reports the following items:

Gross income from sales	$310,000
Deductible expenses	220,000
Domestic dividends received (10 percent owned)	15,000
Net operating loss carryover	10,000
Charitable contributions	11,000

Taxable income is computed as follows:

Gross income from sales		$310,000
Domestic dividends		15,000
Gross income		$325,000
Deductible expenses	$220,000
Net operating loss carryover	10,000
Charitable contributions	9,500
Dividends-received deduction	7,500	247,000
Taxable income		$78,000

For charitable contribution purposes, adjusted taxable income equals $95,000; i.e., taxable income before the charitable contribution deduction and the dividends-received deduction ($325,000 – ($220,000 + $10,000)). (No adjustment is made for the NOL carryover.) Thus, the charitable contribution deduction is limited to $9,500 ($95,000 × 10 percent). The remaining $1,500 ($11,000 – $9,500) is carried forward to the following tax year.

For dividends-received deduction purposes, adjusted taxable income equals $95,500; i.e., taxable income before the dividends-received deduction and the NOL deduction ($325,000 – ($220,000 + $9,500). Thus, the dividends-received deduction is equal to 50% times the lesser of $15,000 or $95,500.

PLANNING POINTER

A number of corporations have set up their own private foundations so as to make contributions of up to 10 percent in good years.

Initial Measure of Contribution

The initial dollar measure of the contribution depends upon the property contributed to the charity. The initial measure of cash contributions is the amount of cash contributed. The initial measure of property contributions is their fair market value. However, under certain conditions fair market value is not allowed. Additionally, in order to receive a deduction for noncash contributions, the corporation must meet the qualified appraisal and documentation rules of Code Sec. 170(f)(11). These rules require special substantiation of deductions for contributions of more than $500, $5,000 and $500,000 (the requirements are greater as the amount increases).

Long-Term Capital Gain Property

If the corporation contributes property whose sale would have resulted in a long-term capital gain, the initial measure of the contribution is its fair market value (i.e., the appreciation also is deductible). However, if the property is tangible personal property not related to the charity’s tax-exempt purpose (e.g., donating a painting to a hospital), the appreciated property is donated to certain private nonoperating foundations (as defined in Code Sec. 509(a)), or the property is any patent, copyright, trademark, trade name, trade secret, know-how, software (with some exceptions), or similar property, or applications or registrations of such property then the initial measure is fair market value minus the amount of long-term capital gain that would have been recognized if the property had been sold. Code Sec. 170(e)(1).

EXAMPLE 14.66

Blake Corporation donates a painting that it bought several years ago for $30,000 to Orleans City Museum. At the time of the contribution the painting had a fair market value of $75,000. The initial measure of the contribution is $75,000.

EXAMPLE 14.67

Assume the same facts as in Example 14.65, except that Blake Corporation donates the painting to Orleans City Hospital. The initial measure of the contribution is $30,000 ($75,000 fair market value less the $45,000 long-term capital gain that would have been recognized if Blake Corporation had sold the painting).

Section 1231 property would be considered as long-term capital gain property unless it has depreciation recapture potential under Code Secs. 1245, 1250, and 291. To the extent of the recapture potential it is considered ordinary income property.

Corporations also are permitted an additional deduction equal to a percentage of the qualified donee income received or accrued by a charity on the corporation’s contribution of any patent, copyright, trademark, trade name, trade secret, know-how, software (with some exceptions), or similar property, or applications or registrations of such property. The amount of any additional charitable contribution deduction is based on a sliding scale and equals 100 percent in the first and second years following the date of the contribution, 90 percent in the third year and reduced by 10 percent each year such that it is 10 percent in the eleventh and twelfth years following the date of the contribution. This additional charitable deduction is allowed only to the extent that that aggregate of the amounts that are calculated with these percentages exceed the amount of the deduction claimed on the contribution of the patent or other qualified intellectual property. Code Sec. 170(m)(4).

EXAMPLE 14.68

On March 10, 2020, Hines Company contributed a patent to a qualified charity. The patent’s fair market value was $1,000,000 and its adjusted basis was $100,000. Hines Company obtained all the required documentation to substantiate the deduction. The charity did not receive any income from the patent in 2020, but in 2021, it received $150,000. Hines Company is entitled to a $100,000 charitable contribution deduction in 2020. In 2021, it is entitled to a $50,000 charitable contribution deduction computed as follows: 100% x $150,000 = $150,000 but the aggregate amount under the percentages only exceeds the claimed amount of the deduction ($100,000) by $50,000, thus the qualified donee income deduction is limited to $50,000.

Ordinary Income Property

Ordinary income property is property that, if sold, would produce ordinary income to the seller. Examples of such property are inventories, short-term capital assets, and property subject to recapture under Code Sec. 1245, 1250, or 291. The initial measure of these contributions is equal to the fair market value reduced by any ordinary income that would have been recognized if the property had been sold. Usually this is equal to the lesser of the property’s fair market value or adjusted basis. If the property is tangible personal property not related to the charity’s tax-exempt function, then the initial measure of the contribution is fair market value minus the gain that would have been recognized if the property were sold.

EXAMPLE 14.69

Best Co. donated inventory to a public charity. At the time of donation, the inventory had a basis of $10,000 and a fair market value of $12,000. The initial measure of the contribution is $10,000 ($12,000 – $2,000).

EXAMPLE 14.70

Assume the same facts as in Example 14.69, except that the inventory’s fair market value is $8,000. In this case, the initial measure of the contribution is $8,000.

EXAMPLE 14.71

Sandy Corporation donated an automobile to a public charity. The charity will use the automobile in its operations. The automobile was acquired for $10,000. At the time of donation the automobile had a fair market value of $12,000 and an adjusted basis of $4,000. The initial measure of the contribution is $6,000 ($12,000 – $6,000 ordinary income recognized if property sold).

EXAMPLE 14.72

Assume the same facts as in Example 14.71, except that the automobile will not be used by the charity. In this case, the initial measure of the contribution is $4,000 ($12,000 – $8,000 gain recognized if property sold).

Inventory

Corporations contributing qualified inventory property to public charities can deduct the adjusted basis of the property plus one-half of the appreciation, not to exceed twice the amount of the adjusted basis. Code Sec. 170(e)(3) and (4). Qualified inventory must have use related to the function or purpose of the charitable organization. The inventory must be used for the care of the ill, the needy, or infants. The charitable organization cannot receive any money, property, or services for the transfer or the use of the qualified inventory.

EXAMPLE 14.73

Block Inc. donated inventory to a charity. The fair market value of the inventory was $15,000 and its adjusted basis was $4,000. The initial measure of the contribution is $4,000 ($15,000 fair market value minus $11,000 ordinary income recognized if it had been sold).

EXAMPLE 14.74

Assume the same facts as Example 14.73, except that the property donated was qualified inventory to be used for the ill, the needy, or infants. In this case, the initial measure of the contribution is $8,000 ($4,000 + one-half of the appreciation (1/2 of $11,000) = $9,500, but this is limited to twice the adjusted basis (2 × $4,000)).

If the inventory contributed is “apparently wholesome” food, the fair market value is the amount for which the quantity of property contributed would have been sold by the donor at the time of the contribution. The fair market value of food that cannot or will not be sold solely by reason of the taxpayer's internal standards, lack of market, or similar circumstances is determined without regard to the internal standards, lack of market, or other circumstances. The same valuation rules apply if the taxpayer produces the food exclusively for purposes of transferring it to a public charity; the fact that the item was produced for transfer is disregarded.

Contributions of food inventory is subject to a limitation of 15 percent of adjusted taxable income. Also, the general 10 percent limitation applicable to other contributions is reduced by the amount of these contributions.

EXAMPLE 14.75

HRB Inc. has adjusted taxable income of $300,000 and contributes bread to a homeless shelter during the year. It also contributes $6,000 cash to a school in the neighborhood where its bakery is located. The bread would otherwise have been sold for $40,000 and has a basis of $30,000. The initial measure of the contribution of bread is $35,000 ($30,000 + one-half of the appreciation (1/2 of $10,000)). Since this amount is less than 15 percent of adjusted taxable income, it is fully deductible. However, HBR's general 10 percent of adjusted taxable income limit on its charitable deduction is reduced to zero, so that HBR may not deduct its $6,000 contribution of cash to the school.

TAX BLUNDER

X Company made a contribution of ordinary income property to a qualified charity. The adjusted basis of the property was $70,000, and its fair market value was $30,000. X Company received a charitable deduction of $30,000 (its fair market value, reduced by any gain recognized had it been sold). X Company should not have given this property to the charity. It never will recognize the $40,000 loss on the property. X Company would have been better off to have sold the property, recognize the $40,000 loss, and then make a $30,000 cash contribution to the charity. Under this scenario, X Company still would have had a $30,000 charitable contribution, and it also would have had a $40,000 recognized ordinary loss.

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RELATED TAXPAYERS—LOSSES AND EXPENSES

A special rule applicable to related taxpayers may cause (1) the disallowance of deductions for losses on sales or exchange, directly or indirectly, of property between related taxpayers, and (2) the deferral of deductions for accrued business and interest expenses of the taxpayer which remain unpaid at the end of the taxpayer’s tax year and which are payable to a related cash-basis taxpayer. Code Sec. 267. Related taxpayers are viewed as consisting of a single economic unit. Thus, related parties are unable to artificially recognize losses and create deductions for tax purposes where no losses or deductions have been sustained within the economic unit.

In addition to certain family members, related persons include: (1) a corporation and an individual with direct and/or indirect ownership of more than 50 percent, (2) two corporations if the same persons own more than 50 percent in value of the outstanding stock in each corporation, and (3) a fiduciary of a trust and a corporation if the trust or grantor owns more than 50 percent of the stock. The constructive ownership rules apply in determining ownership. Code Sec. 267(b).

The loss disallowance rules apply to any sale at a loss even if no tax avoidance motive exists and the selling price is at fair market value. The disallowance of any loss is permanent for the seller. The buyer’s initial basis in the property is the purchase price (fair market value). However, the buyer is permitted to reduce any gain recognized on a subsequent sale by the amount of the previously disallowed loss.

EXAMPLE 14.76

A corporation sells an asset to Barry Winslow, its sole shareholder, at its fair market value of $10,000. The corporation has an adjusted basis in the asset of $12,000. The corporation will not be allowed a deduction for its $2,000 loss incurred on the sale. Barry sells the asset several years later for $15,000. Barry has a realized gain of $5,000 ($15,000 – $10,000); however, his recognized gain is $3,000 ($5,000 realized gain – $2,000 loss previously unrecognized by the corporation).

Expenses commonly deferred under the related taxpayer rule are interest and compensation payable by an accrual-basis corporation to its cash-basis shareholders. Persons who are related are required to use the same accounting method with respect to transactions between themselves in order to prevent a deduction without the corresponding inclusion in income. The accrual-basis taxpayer is allowed the deduction for expenses incurred to cash-basis taxpayers when the payment is made.

EXAMPLE 14.77

Nation Corporation, using the accrual method of accounting, incurs a $2,000 salary expense due to its cashbasis sole shareholder at the end of 2020. The amount is paid on January 15, 2021. The corporation will not be allowed a deduction for the salary expense until 2021, when the salary is paid.

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ORGANIZATIONAL EXPENDITURES

Expenditures related to the organization process are incurred when a corporation is formed. Some of these expenditures benefit the corporation over its entire corporate life and are capitalized as organizational expenditures. Organizational expenditures are an intangible asset which have an indefinite life.

Generally, assets with indefinite lives may not be amortized for federal income tax purposes. However, the corporation may elect to expense organizational expenses in the year it begins business. The deduction is limited to the lesser of: (1) the actual organizational expenses or (2) $5,000. The $5,000 is reduced dollar-for-dollar by the amount that total organizational expenses exceed $50,000 (thus, at $55,000 there would be no deduction). The remaining organizational expenses may be amortized in a 180-month period beginning with the month the corporation begins business. Code Sec. 248(a). Only those expenditures incurred before the end of the tax year in which the corporation begins business are eligible for amortization. The corporation is deemed to have made an election for the taxable year in which it begins business. It can forego the election by capitalizing the organizational expenses on the tax return for its first taxable year. Organizational expenses that are capitalized are deductible upon corporate dissolution. If the election is made and the business is dissolved prior to the end of amortization period, then the remaining organizational expenditures are deductible in the year of dissolution.

Organizational expenditures are any expenditures which are (1) incident to the creation of the corporation, (2) chargeable to a capital account, and (3) of a character that if expended incident to the creation of a corporation having a limited life would be amortizable over such life. Typical organizational expenditures include legal and accounting fees, incorporation fees, and organizational meetings expenses. Note that expenses in connection with underwriting securities (e.g., commissions, printing costs, etc.) are not eligible. Expenses of transferring assets to the corporation also are not organizational expenditures. Reg. §1.248-1(a) and (b).

EXAMPLE 14.78

Petit Corporation begins business on August 1, 2020, and adopts the calendar year. Petit incurs the following expenses in 2020:

Expenses of organization meetings	$6,000
Fee paid for incorporation	3,200
Legal services in setting up corporation	3,000
Expenses of printing and sale of stock certificates	2,500
Accounting fees for monthly statements	2,000

Petit uses the cash method of accounting and paid all expenses in February 2021. Petit’s total organizational costs are $12,200 ($6,000 + $3,200 + $3,000). The expenses of printing and sale of stock certificates and the accounting fees do not qualify as organizational expenditures. If Petit does not elect out of the deemed election then its first year deduction equals $5,200 ($5,000 + $200 ($7,200/180 = $40/month x 5 months = $200)).

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START-UP EXPENDITURES

Start-up expenditures are different from organizational expenditures. Start-up expenditures are business expenses paid or incurred in connection with investigating the creation or acquisition of an active trade or business, creating an active trade or business, or conducting an activity engaged in for profit and for the production of income before the time in which the active trade or business begins. Code Sec. 195(c). Start-up expenditures must be capitalized. However, the corporation may elect to expense start-up expenses in the year it begins business. The deduction is limited to the lesser of: (1) the actual start-up expenses or (2) $5,000. The $5,000 is reduced dollar-for-dollar by the amount that total start-up expenses exceed $50,000 (thus, at $55,000 there would be no deduction). The remaining start-up expenses may be amortized over a 180-month period beginning with the month the corporation begins business. Code Sec. 195(b). If the business is disposed of prior to the end of the amortization period, then any remaining start-up expenditures are deductible in the year of disposition. Code Sec. 195(b).

The election to amortize start-up expenditures must be made by the due date of the return, including extensions, for the first tax year in which the trade or business begins. Reg. §1.195-1. The expenditures must be such that if incurred in connection with the operation of an existing active trade or business would be deductible in the tax year paid or incurred. Code Sec. 195(c)(1)(B). Examples of start-up expenditures are market surveys, fees incurred for consultants, travel costs, legal fees, and advertising expenses. Where the taxpayer incurs investigation expenses for expanding a present trade or business, a deduction is allowed whether the decision is made to acquire or not acquire the business. The expenditures are not for the investigation of a “new” business.

¶14,385

DIVIDENDS-RECEIVED DEDUCTION

Corporation income is subject to double taxation, once at the corporate level and again at the shareholder level at the time of distribution of after-tax earnings. Triple taxation may occur if a corporation receives dividends out of after-tax earnings of another corporation. Without a special provision, the corporation earning the income would be subject to taxation and the income would be taxed a second time when paid as dividends to a recipient corporation. The income would be taxed a third time when the recipient corporation pays dividends to its shareholders. To provide some relief, a dividends-received deduction is allowed. Code Sec. 243.

The dividends qualifying for the dividends-received deduction are those dividends paid by domestic corporations subject to the corporate income tax. Only dividends paid out of a corporation’s earnings and profits qualify for the dividends-received deduction. Distributions received from S corporations are not eligible for the dividends-received deduction. The S corporation is exempt from the corporate income tax and distributions are not income to the recipients; thus, there is no need for the dividends-received deduction.

The deduction allowed is a percentage of the dividend received. This percentage is based upon the percentage of ownership by the corporate shareholder. Corporations owning less than 20 percent of the distributing corporation may deduct 50 percent of the dividend received. If the corporate shareholder owns 20 percent or more but less than 80 percent of the distributing corporation, then the corporate shareholder is entitled to deduct 65 percent of the dividend received. Finally, if the corporate shareholder owns 80 percent or more of the distributing corporation and both corporations are members of an affiliated group, then a 100 percent deduction is permitted.

The firm’s dividends-received deduction is equal to the relevant percent (50% or 65%, depending on ownership) times the lesser of: (1) dividends received from taxable, unaffiliated domestic corporations or (2) the firm’s taxable income, as adjusted (described below). Taxable income, as adjusted, is not used if the firm has a current net operating loss or if the full dividends-received deduction (the relevant percent times the amount of dividends received) creates a net operating loss. In these situations, the firm takes the full dividends-received deduction (based on the amount of the dividend and not constrained by taxable income, as adjusted).

The limitations on the aggregate amount of dividends-received deductions are first determined for dividends received from 20 percent or more owned corporations and then separately determined for dividends received from under 20 percent owned corporations after taxable income is reduced by dividends received from 20 percent or more owned corporations.

EXAMPLE 14.79

Dade Corporation has the following income and expenses:

Gross income from operations	$200,000
Expenses from operations	(150,000)
Dividends received from a 15%-owned domestic corporations	100,000
Taxable income before the dividends-received deduction	$150,000
The dividends-received deduction is $50,000 ($100,000 × 50%).

Taxable income, as adjusted, equals the corporation’s taxable income computed without regard to:

1. The dividends-received deduction

2. Any net operating loss carryforward deduction

3. Any capital loss carryback

 

EXAMPLE 14.80

Assume the same facts as in Example 14.79, except that the gross income is only $140,000 instead of $200,000. Taxable income before the dividends-received deduction is $90,000. Instead of a $50,000 deduction, the dividends-received deduction is limited to $45,000 (50% × $90,000).

 

EXAMPLE 14.81

Assume the same facts as in Example 14.79, except that the gross income from operations is $90,000. Taxable income before the dividends-received deduction is $40,000 ($90,000 + $100,000 – $150,000). If the corporation received the full dividends-received deduction of $50,000 (50% × $100,000), then it would have an NOL of $10,000 ($40,000 – $50,000); thus, it is permitted the full deduction and is not limited to a $20,000 deduction (50% × $40,000).

In summary, the full dividends-received deduction is available if the corporation has an NOL or would have an NOL if it received the full deduction. Also, if taxable income, as adjusted, is greater than the dividend received, a full deduction is available. The full dividends-received deduction is not available if taxable income is less than the dividend received but large enough such that a full dividend-received deduction does not make it negative. In this case, the deduction is limited to a percentage of taxable income, as adjusted.

EXAMPLE 14.82

Continuing Example 14.79, as long as the gross income from operations is $100,000 or more but less than $150,000, there will be taxable income not including the dividends-received deduction of $50,000 or more. The net loss from operations will be $50,000 or less. The dividends-received deduction will be limited to 50 percent of taxable income before the dividends-received deduction.

Gross income from operations	$100,000
Expenses from operations	(150,000)
Dividends received	100,000
Taxable income before dividends-received deduction	$50,000
Dividends-received deduction ($50,000 × 50%)	25,000
Taxable income	$25,000

Since the full dividends-received deduction ($50,000) would make taxable income zero (not negative), the deduction is limited to $25,000 (50% × $50,000).

PLANNING POINTER

If there is any doubt prior to year-end whether the full dividends-received deduction is available, steps should be taken to defer income and accelerate deductions to ensure a net operating loss after the full deduction. Typical strategies include deferred payment sales, delaying shipping, stepping up acquisitions of cost recovery property, sales and leaseback at a loss, the use of escrow accounts, the payment of bonuses, stepping up repairs and maintenance, etc.

EXAMPLE 14.83

Continuing with Example 14.82, if gross income from operations decreased by $1 or operating expenses increased by $1, the corporation would be allowed the full dividends-received deduction of $50,000.

Gross income from operations	$100,000
Expenses from operations	(150,001)
Dividends received	100,000
Taxable income before dividends-received deduction	$49,999
Dividends-received deduction	50,000
Taxable income	($1)

Stock must have been held for more than 45 days to be eligible for the dividends-received deduction. The stock also must be held without being protected by an offsetting short sale or option. Code Sec. 246(b) and (c). This restriction prevents corporations from purchasing dividend-paying stock shortly before the declaration of dividends and selling the stock immediately after receiving the right to the dividend. For example, without this requirement a corporation would pay tax of only $105 on $1,000 of dividend income ($1,000 × 50% dividend inclusion rate × 21% corporate tax rate) while generating a tax savings of $210 ($1,000 loss × 21%) if the stock were to decline by the amount of the dividend payment.

Debt-Financed Portfolio Stock

A restriction applies to the dividends-received deduction when a corporation has issued debt to finance its purchase of the stock. This reduction is equal to the ratio of the amount of portfolio indebtedness to the adjusted basis of the portfolio stock. Portfolio indebtedness means any debt directly attributable to the taxpayer corporation’s investment in portfolio stock. Without such a restriction, a corporation may be able to fully deduct interest paid to finance its investment in dividend-paying stock and be taxed on only 35 or 50 percent (100 percent minus dividends-received deduction) of the related dividend income.

EXAMPLE 14.84

A corporation purchases 25 percent of the stock in another corporation for $300,000, of which $120,000 or 40 percent is borrowed. The corporation receives dividends of $24,000 from the investment. The allowable dividends-received deduction is limited to $9,360 ($24,000 × 65% × (100% – 40%)).

Extraordinary Dividends

The basis of stock held by a corporation must be reduced by the nontaxed portion of any extraordinary dividend received by the corporation with respect to stock. Code Sec. 1059. Stock basis is not reduced if the stock was held for more than two years before the earliest date that the dividend is declared, agreed to, or announced. The nontaxed portion of a cash distribution is the amount that is offset by the dividends-received deduction. The nontaxed portion of a property distribution is the fair market value of the property reduced by any liabilities assumed by the shareholder that is offset by the dividends-received deduction.

Generally, a dividend is deemed extraordinary when it exceeds 10 percent of a corporate taxpayer’s adjusted basis in a share of stock. The 10 percent becomes 5 percent in the case of preferred stock for purposes of determining whether the dividend is extraordinary. In determining whether the dividend is extraordinary, an alternative permits the taxpayer to substitute the fair market value of the share of stock on the day before the ex-dividend date for its adjusted basis. This is intended to mitigate the effect of basis reduction where a shareholder can demonstrate that the stock has appreciated significantly since the shareholder’s original investment.

The nontaxed portion of dividends on certain “disqualified” preferred stock issued after July 10, 1989, is treated as an extraordinary dividend (and therefore would be subject to basis reduction). The preferred stock is considered to be disqualified if (1) the preferred stock at the time it is issued has a dividend rate that declines, or can reasonably be expected to decline, in the future; (2) the issue price of the preferred stock exceeds its liquidation rights or its stated redemption price; or (3) the preferred stock is structured so as to avoid other provisions of Code Sec. 1059 and to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the disposition of the stock. Code Sec. 1059(f).

The reduction in basis is treated as occurring at the beginning of the ex-dividend date.

EXAMPLE 14.85

Matter Corporation purchases 100 shares of Fact Corporation stock for $3,000, or $30 per share, on February 2, 2019. On November 3, 2020, Matter Corporation receives a dividend of $4 per share. Matter deducts 50 percent of the $400 in dividends, or $200, on its tax return for the year. The dividend is considered to be extraordinary because it exceeds 10 percent of Matter’s adjusted basis in the shares. Matter will reduce its basis by $200 (the nontaxed portion of the distribution) for purposes of determining gain or loss. If Matter can show that the fair market value of the stock is at least $40 on the day before the ex-dividend date, the dividend would not be extraordinary because it would not exceed 10 percent of the fair market value. Thus, Matter would not have to reduce the basis of its stock.

Any basis adjustment may not reduce the corporation’s basis in the stock below zero. However, nontaxed portions of extraordinary dividends that otherwise would reduce basis below zero in the absence of this limitation are treated as gain from a sale or exchange of the stock in the year in which the extraordinary dividend is received.

An extraordinary dividend basis reduction will not apply if the stock was held by the taxpayer for the entire period the distributing corporation and any predecessor has been in existence. Also, dividends qualifying for the 100 percent dividend deduction are not subject to the extraordinary dividend rule.

Dividends Received from Affiliated Corporations

Where dividends are received from an affiliated corporation and the corporation group is not filing a consolidated return, a 100 percent dividends-received deduction may be elected by the group. An affiliated group exists where a corporation owns 80 percent or more of the outstanding voting stock and 80 percent or more of the value of all outstanding stock of another corporation.

The election to deduct the entire dividend is made by the parent corporation for its tax year. Each member of the group must consent to the election. Members of the affiliated group must share one corporate tax rate schedule, one accumulated earnings credit, and one alternative minimum tax exemption.

EXAMPLE 14.86

Parent Corporation owns 90 percent of the stock in Subsidiary Corporation. Subsidiary Corporation pays a $54,000 dividend to Parent Corporation. Parent Corporation can elect to deduct the full 100 percent of the dividend ($54,000) in the computation of taxable income. Subsidiary Corporation must consent to the election because it must also agree on the sharing of the corporate tax rate schedule, accumulated earnings credit, and the alternative minimum tax exemption.

Dividends Received from Foreign Corporations

The deduction with respect to dividends received from certain foreign corporations is beyond the scope of this discussion. Code Sec. 245.

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EXECUTIVE COMPENSATION

In general, a corporation and its executives attempt to design a compensation package that maximizes the executives’ after-tax cash flows at the least cost and cash outflow to the corporation. Thus, the compensation package usually includes a combination of cash payments (salary and bonus), fringe benefits (nontaxable and taxable), and deferred compensation. However, in developing the package, the corporation is constrained in that the compensation package must be reasonable in amount Reg. §1.162-7(a). The Internal Revenue Service can use the substance over form doctrine to find that some of the compensation is unreasonable and in substance is a dividend (not deductible by the corporation) and not compensation.

Code Section 162(m) also limits the deductibility of executive compensation of publicly-traded corporations. The otherwise allowable deduction for compensation with respect to a covered employee of a publicly held corporation is limited to no more than $1 million per year. A publicly held corporation means any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934. This definition includes all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs). The definition also includes certain additional corporations that are not publicly traded, such as large private C or S corporations.

Section 162(m) defines a covered employee as (1) the chief executive officer (CEO), (2) the principal financial officer (CFO), and (3) the three most highly compensated officers, other than the CEO or CFO. In addition, if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual remains a covered employee for all future years. Thus, an individual remains a covered employee with respect to compensation otherwise deductible for subsequent years, including for years during which the individual is no longer employed by the corporation and years after the individual has died. For example, compensation paid to another individual, such as compensation paid to a beneficiary after the employee’s death, or to a former spouse pursuant to a domestic relations order, is subject to the deduction limitation.

Prior to the Tax Cuts and Jobs Act of 2017, the $1 million deduction limitation did not apply to compensation that was based on a performance-based compensation plan. A transition rule grandfathers the deduction for performance-based compensation paid pursuant to a plan that was part of a written binding contract with the covered employee in effect on November 2, 2017. Any contract that was entered into on or before November 2, 2017 and that is renewed after such date is treated as a new contract and would be subject to the limitation upon the renewal.

Determination of Corporate Income Tax Liability

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COMPUTATION OF TAX LIABILITY

After determining its taxable income, a corporation then must compute its income tax liability. This is a multiple-step process. The corporation first computes its regular tax liability. This amount is reduced by any tax credits to which it is entitled, such as the foreign tax credit (Code Sec. 27) and the general business credit (Code Sec. 38). Any recapture of previously claimed tax credits is added to the resultant amount to produce the corporation’s income tax liability.

¶14,405

CORPORATE REGULAR INCOME TAX RATES

The federal tax rate for corporations and associations taxed as corporations is 21 percent (Code Sec. 11(b)).

EXAMPLE 14.87

Alpha Corporation has taxable income of $85,000. The tax incurred would be $17,850 ($85,000 × 21%)

The corporate tax rate is low enough to encourage incorporation for businesses that intend to retain their earnings. There is double taxation only if dividends are paid. A tax of 21 percent may be viewed as a reasonable price to pay for the indefinite deferral of the second tax at the shareholder level. For tax years beginning after December 31, 2017, personal service corporations are also taxed at a flat tax rate of 21 percent. A personal service corporation is one in which substantially all of the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. Substantially all of the stock (95 percent) must be held by employees, retired employees, or their estates. With a top 37% rate for individuals, the rate structure may encourage the incorporation of personal service businesses, especially those not eligible for the qualified business income deduction of Code Sec. 199A.

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CONTROLLED GROUPS OF CORPORATIONS

Code Sec. 1561 was enacted to limit the benefits that taxpayers might receive by using multiple corporations. Multiple corporations that are members of a controlled group must share certain tax benefits as if they were one corporation. These benefits include the Section 179 election to expense certain depreciable property, and the $250,000 accumulated earnings credit.

Parent-subsidiary corporations, brother-sister corporations, combined groups, and certain insurance companies are controlled groups. Code Sec. 1563(a). Affiliated groups and controlled groups are not synonymous. An affiliated group always involves a parent-subsidiary relationship. Thus, parent-subsidiary corporations are both controlled groups and affiliated groups. However, two corporations owned by the same individual (brother-sister corporations) are a controlled group but not an affiliated group.

Parent-Subsidiary Corporations

A parent-subsidiary controlled group consists of one or more chains of corporations connected through stock ownership with a common parent corporation. Code Sec. 1563(a)(1). The parent corporation must own at least 80 percent of the total voting power of all classes of voting stock or at least 80 percent of the total value of shares of all classes of stock of at least one corporation (the subsidiary). Once this initial parent-subsidiary relationship is established, then another corporation can be included in the group if the parent corporation, the subsidiary corporation, or any other corporation in the group individually owns or collectively own at least 80 percent of the total voting power of all of its classes of voting stock or at least 80 percent of the total value of shares of all of its classes of stock.

EXAMPLE 14.88

Alpha and Beta are members of a parent-subsidiary controlled group. Alpha is the parent.

 

EXAMPLE 14.89

Alpha, Beta, and Chi are members of a parent-subsidiary controlled group. Alpha is the parent.

EXAMPLE 14.90

Alpha, Beta, Chi, and Delta are members of a controlled parent-subsidiary. Alpha is the parent.

The controlled parent-subsidiary group is subject to the restrictions of tax benefits mentioned earlier. However, a benefit of this controlled group is that it may elect to file a consolidated return.

Brother-Sister Corporations

In general, a brother-sister controlled group consists of two or more corporations owned by five or fewer individuals, estates, or trusts who (1) own at least 80 percent of the combined voting power of all voting stock or at least 80 percent of the total value of shares of all classes of stock of each corporation and (2) own more than 50 percent of total combined voting power of all voting stock or more than 50 percent of the total value of all classes of stock of each corporation. In calculating the 50 percent test, ownership of each person is included only to the extent that such ownership is identical with respect to each corporation. Thus, only the smallest percentage owned in any of the corporations is counted. Stock owned by family members or certain entities may be attributed to a taxpayer under the attribution rules. Code Sec. 1563(d)(2).

For purposes of Code Sec. 1561 regarding the accumulated earnings credit, only the 50 percent test is used. Thus, a group could be a brother-sister controlled group for Code Sec. 1561 purposes but not be a brother-sister controlled group for all other purposes. Brother-sister controlled groups also may not file a consolidated tax return.

EXAMPLE 14.91

Alpha, Beta, and Chi Corporations each have only one class of stock outstanding. The ownership of this stock is as follows:

Shareholders	Corporations	Identical Ownership
	Alpha	Beta	Chi
Jones	25%	20%	55%	20%
Smith	25%	30%	35%	25%
Nelson	50%	50%	10%	10%
	100%	100%	100%	55%

Alpha, Beta, and Chi are members of a controlled brother-sister group because both ownership tests are met. Five or fewer individuals own at least 80 percent of each corporation (they own 100 percent of each) and they have greater than a 50 percent common ownership (55 percent identical ownership).

 

EXAMPLE 14.92

Same as Example 14.91, except for the following ownership:

Shareholders	Corporations	Identical Ownership
	Alpha	Beta	Chi
Jones	5%	30%	45%	5%
Smith	65%	10%	35%	10%
Nelson	30%	60%	20%	20%
	100%	100%	100%	35%

Alpha, Beta, and Chi are not members of a controlled brother-sister group. Although the 80 percent test is met, the identical ownership test of greater than 50 percent is not met. (In determining identical ownership, include the minimum ownership in each row.) Both tests must be met in order to have a brother-sister controlled group.

In determining ownership for the 80 percent test, only individuals who own stock in each and every corporation of the controlled group are counted. Reg. §1.1563-1(a)(3).

EXAMPLE 14.93

Alpha and Beta each have one class of stock outstanding. Ownership is as follows:

Shareholders	Corporations	Identical Ownership
	Alpha	Beta
Boggs	55%	100%	55%
Lyle	45%	0%	0%
	100%	100%	55%

At first glance it appears that both the 80 percent and greater than 50 percent tests are met. However, since Lyle does not own stock in Beta Corporation, his ownership is not counted in calculating the 80 percent test. Thus, the 80 percent test is not met and there is not a brother-sister controlled group. (See Vogel Fertilizer Co., 1982-1 USTC ¶9134, 455 U.S. 16, 102 S.Ct. 821 (1982).)

EXAMPLE 14.94

Alpha, Beta and Chi Corporations each have only one class of stock outstanding. The ownership of the stock is as follows:

	Corporations	Identical Ownership
Shareholders	Alpha	Beta	Chi
Jones	20%	15%	15%	15%
Smith	20%	20%	20%	20%
Nelson	20%	35%	18%	18%
Delta Corporation	40%	30%	47%	N/A
	100%	100%	100%	53%

Although the 80 percent test is not met, the 50 percent test is met. Thus, Alpha, Beta and Chi are a brother-sister controlled group for Code Sec. 1561 purposes and must share the Section 179 expenses and the accumulated earnings credit.

Combined Groups

A combined group consists of three or more corporations of which each is a member of a parent-subsidiary controlled group or a brother-sister controlled group and one of the corporations is a common parent in the parent-subsidiary controlled group and also is a member of the brother-sister controlled group. Code Sec. 1563(a)(3).

EXAMPLE 14.95

Delta, Gamma, and Sigma Corporations each have only one class of stock outstanding. The ownership of their stock is as follows:

Shareholders	Delta	Corporations Gamma	Sigma
Jones	60%	40%	—
Hill	40%	60%	—
Gamma Corp.	—	—	80%
	100%	100%	80%

Delta and Gamma are members of a brother-sister controlled group. Gamma and Sigma are members of a parent-subsidiary group. Since Gamma also is a member of the brother-sister group, Delta, Gamma, and Sigma are members of a combined group.

Allocations of Income, Deductions, and Credit

In addition to restrictions placed on controlled groups by Code Sec. 1561, Code Sec. 482 has the potential to effect further constraints. Members of controlled groups may attempt to minimize tax liability by shifting income, deductions, or credits in an advantageous fashion. Code Sec. 482 gives the IRS the power to rearrange the distribution, thereby reducing the controlled group’s ability to manipulate tax liabilities. Specifically, the IRS has the right to reallocate gross income, deductions, and credits between two or more corporations owned or controlled by the same interests if such reallocation is necessary to prevent the evasion of taxes or to clearly reflect income.

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CONSOLIDATED RETURNS

For tax planning purposes, a parent-subsidiary controlled group has three alternatives: (1) file separate returns, (2) file a consolidated return, or (3) file separate returns with a Code Sec. 243 election of a 100 percent dividends-received deduction. The parent-subsidiary group may make an irrevocable election to file a consolidated tax return. Code Sec. 1501. Each member must consent and each subsidiary must conform its tax year and accounting methods to those of the parent. Consolidated returns must continue to be filed until the IRS grants permission to stop or the group no longer qualifies. For example, if the parent’s stock ownership in the subsidiary falls below 80 percent, then the group no longer qualifies to file a consolidated return.

Certain corporations are precluded from being included in a consolidated return. Tax-exempt corporations, life and mutual insurance companies, foreign corporations, U.S. possessions corporations, regulated investment companies and real estate investment trusts, and foreign sales corporations are not eligible to be included in a consolidated return. Code Sec. 1504(b).

There are certain advantages in filing consolidated returns. Income from one member is offset by losses generated by other members. Also, capital losses of a member corporation that otherwise would not be deductible can be used to offset other members’ capital gains. Additionally, income from intercompany transactions is not included in the determination of consolidated income. Finally, the group does not have any allocation problems under Code Sec. 482.

There are certain disadvantages in filing a consolidated return. The election is irrevocable and is binding on all subsequent years unless the group is terminated or the IRS grants the group permission to discontinue filing consolidated returns. Also, losses on intercompany transactions are not deductible. Additionally, the recordkeeping needed to file a consolidated return can be significant and, therefore, more costly than if separate returns are filed.

Although the filing of a consolidated tax return has certain advantages, there are several limitations that affect the members’ ability to offset income by using the losses or deductions of other members. A loss corporation’s net operating loss carryover may be applied against the consolidated income of the group on consolidated returns. However, tax losses of other group members cannot offset the income of another member corporation to the extent that said income is paid out as dividends on certain nonvoting, nonconvertible preferred stock issued after November 17, 1989. Code Sec. 1503(f). Also, if the loss year was a separate return limitation year (SRLY), then the loss may be carried over only against income of the loss corporation. An SRLY is any year in which a member of the group filed a separate tax return. A separate return year is not an SRLY if the corporation was a member of the affiliated group for each day of that year. Under certain conditions, a loss corporation can acquire a profitable subsidiary and apply its loss carryover against the profits of that corporation.

An additional limitation is the inability to offset a built-in deduction of a subsidiary against consolidated income. Built-in deductions can arise if the subsidiary had an SRLY. Any built-in deductions are deducted only against income of the subsidiary that sustained the deductions. The built-in deduction rules do not apply if the group acquired the assets more than 10 years prior to the tax year or the total adjusted basis of all assets (other than cash, marketable securities, and goodwill) of the acquired subsidiary did not exceed the fair market value of all such assets by more than 15 percent. Reg. §1.1502-15.

EXAMPLE 14.96

Maryland Corporation purchases all of the stock of Baltimore Corporation at the end of the year. Baltimore Corporation owns an asset with a basis of $50,000 and a fair market value of $30,000. The asset is sold in the following year for $22,000 and a consolidated return is filed. Of the $28,000 loss, $20,000 is treated as a built-in loss and can be deducted only against the separate income of Baltimore Corporation.

EXAMPLE 14.97

Assume the asset from Example 14.96 is depreciable property. Depreciation deductions attributable to the $20,000 difference between basis and fair market value are treated as built-in deductions and limited to deductions against the separate income of Baltimore.

The rules and regulations pertaining to consolidated income tax returns are very complex. Several treatises, each consisting of several volumes, exist on the subject.

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CORPORATE TAX RETURNS

All corporations, with certain exceptions, are required to file a corporate tax return each year. A return must be filed even if the corporation has no taxable income. Code Sec. 6012(a)(2). A corporation that is in existence for only a portion of a tax year is required to file a tax return covering that partial tax year.

A corporation also is required to make estimated tax payments throughout the year unless its estimated tax for the year is less than $500. The corporation must make these payments by the 15th day of the 4th, 6th, 9th, and 12th month of its tax year. Code Sec. 6655(c). Corporations on a calendar year must make the payments by April 15, June 15, September 15, and December 15. In the aggregate these payments must be equal to the lesser of 100 percent of the corporation’s actual tax liability or 100 percent of the tax liability for the preceding tax year. The 100 percent test applies only if the preceding tax year was for 12 months and the corporation filed a tax return showing a tax liability. Code Sec. 6655(d). Large corporations (with taxable income of $1,000,000 or more in any one of the three preceding tax years) may use the preceding year’s tax liability to estimate the first quarterly payment only; subsequent quarterly payment must be based on this year’s expected taxable income. With few exceptions, the corporation will be assessed a nondeductible penalty if it does not make the required payments.

A corporation is required to file Form 1120 by the 15th day of the fourth month following the end of its tax year. Thus, a calendar-year corporation is required to file its return by April 15. However, corporations with a fiscal year ending June 30 must file Form 1120 by September 15. A corporation may receive an automatic extension of six months from the original due date if it files for an extension by the due date of the return. Code Sec. 6081. Form 1120 and related schedules (e.g., Schedule M-1, M-2 and M-3) are available at  www.irs.gov  (the IRS’s website).

Form 1120 generally reports taxable income according to various tax rules. The corporation is required to report, on Schedule L, its beginning and ending balance sheets. The balance sheets are taken from the corporation’s basic financial accounting records.

Also included in Form 1120 are Schedule M-1 (Reconciliation of Income (Loss) per Books With Income per Return) and Schedule M-2 (Analysis of Unappropriated Retained Earnings per Books). Schedule M-3 (Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More) is required of large and midsize firms in lieu of Schedule M-1. The net income on the financial books of a corporation may differ from the taxable income on its return. This is caused by differences in accounting methods between financial and taxable income. For example, accelerated depreciation may be used for taxable income computations while straight-line depreciation may be used for financial accounting purposes. Schedule M-1 is used to reconcile these differences.

The reconciling elements of Schedule M-1 fall into four categories:

1. Expenses taken on the books but not taken on the tax return (e.g., federal income taxes)

2. Expenses not taken on the books but taken on the tax return (e.g., charitable contribution carryovers from earlier tax years)

3. Income reported on the books but not reported on the tax return (e.g., tax-exempt municipal bond interest)

4. Income not reported on the books but reported on the tax return (e.g., prepayments recognized as income because of the claim of right doctrine)

These differences are either permanent differences or temporary differences. Permanent differences are income, deduction, gain, or loss items which affect either taxable income or book income, but not both. An example of a permanent difference would be nontaxable municipal bond interest that is included in book income but excluded from taxable income determination. Temporary differences are income, deduction, gain, or loss items that affect both taxable income and book income, but not in the same tax year. Temporary differences affect (create, increase or decrease) a deferred tax asset or liability for book purposes. A temporary difference exists where accelerated depreciation is taken for tax purposes but straight-line depreciation is used for book purposes. Temporary differences reverse themselves over the life of the business.

Schedule M-1 has two columns. In the left column, entries are made for book income, federal income tax, excess of capital losses over capital gains, income items in the return not included in the books (e.g., prepaid rent) and expenses deducted on the books but not on the return (e.g., gifts costing over $25). In the right hand column, entries are made for income reported on the books and not included in the return (e.g., tax-exempt interest) and expenses deducted on the return but not on the books (e.g., excess of accelerated depreciation used for tax purposes over straight-line used for book purposes). The difference between the right hand column and the left hand column should equal the corporation’s taxable income before the net operating loss deduction and special deductions.

EXAMPLE 14.98

Harris Corporation had the following results from operations during 2020:

Net income per books, after taxes	$77,000
Taxable income	75,000
Federal income taxes	13,750
Tax-exempt interest on municipal bonds	3,000
Net capital loss (capital losses in excess of capital gains)	1,250
Premiums paid on life insurance for key employees	1,000
Life insurance proceeds received because of death of key employee	10,000
MACRS depreciation in excess of straight-line depreciation used for book purposes	5,000

Harris Corporation’s Schedule M-1 is as follows:

Schedule M-2, which serves as a bridge of the two balance sheets, also has two columns. The left column is for opening retained earnings, book income for the year, and any increases in retained earnings. The right hand column is for distributions and other items that decrease retained earnings. For example, an adjustment to decrease revenues in a previous period would affect the right hand column. The difference between these two columns is the ending retained earnings. This figure should equal the corporation’s unappropriated retained earnings at the end of the tax year entered in the Schedule L balance sheet on Form 1120.

The reconciliation of retained earnings serves to disclose unusual transactions which have a bearing on the corporation or its shareholders. Where the reconciliation of retained earnings shows distributions to the corporate shareholders, the IRS should establish that the shareholders have reported the relevant income.

EXAMPLE 14.99

Assume the same facts in Example 14.98 and the following additional facts. Harris Corporation’s beginning balance of unappropriated retained earnings is $160,000. During the year it distributed a cash dividend of $25,000 to its shareholders.

Harris Corporation’s Schedule M-2 is as follows:

Large and midsize corporations (those with total assets of $10 million or more) must file Schedule M-3 (Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More) in lieu of Schedule M-1. Schedule M-3 requires more information than Schedule M-1. Its purpose is to make the differences between financial accounting net income (book income) and taxable income more transparent. It requires separate reconciliations of book income and taxable income and of book and tax expense/deduction items. It also requires that firms distinguish between permanent and timing differences.

Schedule M-3 provides the IRS information that will help identify firms that have engaged in aggressive transactions and therefore improve the audit process of corporations. However, completion of Schedule M-3 is quite complex, so coverage in this book is limited to basic examples of adjustments. (It would be helpful if you download Schedule M-3 from the IRS website and refer to it as you read the remainder of this section.)

Part I of Schedule M-3 requests financial information, e.g., the source of the financial information (audited financial statements, SEC Form 10-K, etc.), any restatements of the firm’s income statement items for the year and previous five years, and any required adjustments to the firm’s net income (loss) due to restatements. Additionally, corporations must indicate the accounting standard used for book purposes. Many corporations use U.S. GAAP; however, the convergence efforts between U.S. accounting standards setters (FASB and SEC) and the International Accounting Standards Board have led to greater use of International Financial Reporting Standards (IFRS). Eventually U.S. corporations may be required to use IFRS and some currently may voluntarily use IFRS. Since U.S. GAAP and IFRS do not fully align, the IRS needs to know which accounting method is used for book purposes so it can better follow book-to-tax adjustments.

In Part I, corporations must convert worldwide consolidated book net income (loss) to adjusted net income (loss) for includible corporations only. Some corporations included in the corporation’s worldwide consolidated book income might not be included in its consolidated group for tax purposes. Adjustments must be made to eliminate any nonincludible entities’ incomes (losses). The adjusted net income (loss) must then be reconciled to the firm’s taxable income reported on Form 1120. Examples 14.100 through 14.102 are based on the examples in the instructions to Schedule M-3.

EXAMPLE 14.100

Mump Inc. is a Detroit-based corporation with stores in the Detroit metropolitan area. It has assets of $500 million. Last year, it bought 100% of Can Co., a Canadian firm based in Windsor, Canada. Mump Inc. issues consolidated statements for financial accounting purposes; however, Can Co. is not part of its tax consolidated group. This year, Mump Inc. reported $80 million of consolidated net income on its audited financial statements. Can Co.’s net loss of $10 million was included in the $80 million. Since Can Co. is not an includible corporation for tax purposes, Mump Inc. makes a $10 million positive adjustment to the $80 million.

Part II requires the reconciliation of net income (loss) items of includible corporations. It contains 25 income/loss items whereby the firm must reconcile book income (loss) to taxable income (loss) by identifying each difference as a temporary or permanent difference. Items included are unearned/deferred revenue, capital loss limitation and carryforward used, and hedging transactions. Column a contains book income (loss) amounts, column b contains temporary differences, column c contains permanent differences, and column d contains income (loss) per tax return.

EXAMPLE 14.101

In 2020, Wing Company’s book income was $20 million and it had assets of $300 million. It earned $20,000 interest income on Ohio municipal bonds, which was included in its book income and received $70,000 in prepaid income from customers, which it recorded as unearned revenue for book purposes. It also reported $100,000 in book income from its distributive share of income in Slow Co. (a partnership). The Schedule K-1 Wing Company received from Slow Co. reported the following: $50,000 ordinary income; $70,000 long-term capital gain; $40,000 charitable contribution; and $2,000 Code Section 179 expense. Wing Company treats the difference between book income and taxable income from its investment in Slow Co. as a permanent difference.

Wing Company must make the following adjustments on Part II of Schedule M-3:

Line	Column a	Column b	Column c	Column d
9	$100,000		($22,000)	$78,000
13	$20,000		($20,000)	$-0-
20	$-0-	$70,000		$70,000

Part III requires the reconciliation of expense claimed for book income to the deduction claimed for tax purposes of includible corporations. It contains 37 items where the firm again must identify the temporary and permanent differences. Items included are: bad debt expense, depreciation, depletion, and fines and penalties. Column a contains book income (loss) amounts, column b contains temporary differences, column c contains permanent differences, and column d contains income (loss) per tax return. Lines 1 and 2 of Part III require a corporation to indicate its current income tax expense (taxes paid/payable this year based on the corporation’s taxable income) and deferred income tax expense (which is the net change in deferred tax liability due to temporary differences between book income and taxable income).

EXAMPLE 14.102

Continuing with the Example 14.101 included in Wing Company’s assets are goodwill from previous acquisitions and intellectual property. The goodwill is not deductible for tax purposes but is deductible for book purposes if subject to impairment. In 2020, $120,000 was impaired. The intellectual property is amortizable for both book and tax purposes; book amortization expense was $25,000 and was $40,000 for tax purposes.

Wing Company must make the following adjustments on Part III of Schedule M-3:

Line	Column a	Column b	Column c	Column d
26	$120,000		($120,000)	$-0-
28	$25,000	$15,000		$40,000

Corporations with at least $10,000,000 but less than $50,000,000 in total assets at the end of the tax year may file Schedule M-1 in place of Schedule M-3, Parts II and III. The objectives of the IRS policy are to reduce corporate filing burden and simplify corporate reporting.

As noted earlier, Schedule M-3 is designed to help the IRS better audit corporations. The IRS also developed Schedule UTP (uncertain tax positions statement), which also is designed to increase the IRS’s audit effectiveness and efficiency. Corporations with assets of at least $10 million that issued audited financial statements and have one or more tax positions must file form UTP. (A tax position taken on a tax return is one that would result in an adjustment on that tax return if the position is not sustained.) The new form in part evolved from what firms must report for financial accounting purposes; thus, it is discussed further at the end of the next section.

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INCOME TAXES AND FINANCIAL ACCOUNTING

Book Income (Loss) and Taxable Income (Loss) Differences

The Financial Accounting Standards Board (FASB) also is concerned about the effects of permanent and temporary differences between book income and taxable income, and the effect these have on financial statement transparency and usefulness. Accounting Standards Codification (ASC) 740 (Income Taxes, ASC Topic 740) provides how firms should determine and account for current income tax expense and deferred income taxes arising from temporary differences. In general, it does not address permanent differences. Deferred income taxes can produce either an asset or a liability.

A firm’s income tax provision is its tax expense for financial accounting purposes. It has two components (is the sum of these components): current tax expense (or benefit) and deferred tax expense (or benefit). Current tax expense is the amount of taxes paid or payable (or refundable) based on the corporation’s taxable income and existing tax law. Deferred tax expense (or benefit) represents the net change during the year in the corporation’s deferred tax liabilities and assets. Deferred tax assets are due to deductible temporary differences and carryforwards. If, based on available evidence, it appears more likely than not that some or all of the deferred tax asset will not be realized then it must be reduced by a valuation allowance. Deferred tax liabilities are due to taxable temporary differences.

A deferred tax asset is recognized when taxable income is greater than book income, and can occur for a variety of reasons: revenues or gains are recognized for tax purposes earlier than for book purposes, expenses or losses are deductible earlier for book purposes than for tax purposes, the book basis of an asset is less than its tax basis, etc. The firm records the deferred tax asset only if it is more likely than not (greater than 50% likelihood) to materialize. A deferred tax liability is recognized when taxable income is less than book income and generally occurs when the opposite timing relationship exists between book and tax recognition; e.g., revenue or gains are recognized for book purposes earlier than for tax purposes, expenses or losses are deductible later for book purposes than for tax purposes, the book basis of an asset is greater than its tax basis.

Once recorded, deferred tax assets and deferred tax liabilities appear on the balance sheet and must be classified as current or noncurrent. If the deferral is due to a related asset or liability then its classification is based on this specific asset or liability; for example, a deferred tax asset or tax liability due to depreciation is noncurrent since property, plant and equipment is a noncurrent asset. If the deferral is not due to a specific asset or liability then it is classified based upon its expected reversal date (current if this period and noncurrent if some future period).

Deferred tax assets and deferred tax liabilities are unusual in that they do not fit the normal scheme where assets are beneficial and liabilities are not. The deferred tax asset is due to book income being less than taxable income, which means that the firm paid more in taxes than it recorded as an income tax expense for book purposes. Effectively, the firm has “prepaid” some expected future taxes, and this prepayment acts as a non-interest bearing receivable from the U.S. government. However, when (if ever) the prepayment will occur is not known with certainty. Similarly, deferred tax liability arises because the firm’s taxable income is less than its book income, which means that the firm paid less in taxes than it recorded as an income tax expense for book purposes. The firm has some future tax liability it expects to (might) incur when the timing differences reverse. In the interim, it has full use of the cash it would have used to pay the taxes and the actual liability may never occur.

EXAMPLE 14.103

Tomco’s pretax book income and taxable income differ because of one item, prepaid income received from its customers. Its income before the prepaid income was $900,000 in 2020 and $1,200,000 in 2021. Assume that corporate tax rates are a constant 25% (combined federal plus state). Tomco received $100,000 in prepaid income in 2020 and it earned the $100,000 in 2021. For book purposes Tomco recognizes the $100,000 income in 2021 but for tax purposes it recognizes the $100,000 income in 2020. Its current and deferred tax position is as follows:

	2020	2021
	Book	Tax	Book	Tax
Income before prepaid income	$900,000	$900,000	$1,200,000	$1,200,000
Prepaid income	-0-	100,000	100,000	-0-
Income after prepaid income	$900,000	$1,000,000	$1,300,000	$1,200,000
Tax rate	x 25%	x 25%	x 25%	x 25%
Income tax expense	$225,000	$250,000	$325,000	$300,000
Current tax expense (payable)		$250,000		$300,000
Deferred tax expense 2020:	$25,000 [($900,000 − $1,000,000) x 25%] increase in deferred tax asset
Deferred tax expense 2021:	$25,000 [($1,300,000 − $1,200,000) x 25%] decrease in deferred tax asset

In this example the temporary difference reverses in one year. In 2020 income tax expense was less than current tax expense, and the difference of $25,000 is a deferred tax asset. In 2021 when the temporary difference reverses, income tax expense is $25,000 more than current tax expense and the deferred tax asset is reduced. The journal entries follow:

2020:
Income tax expense	$225,000
Deferred tax asset	25,000
Income taxes payable		$250,000
2021:
Income tax expense	$325,000
Deferred tax asset		25,000
Income taxes payable		$300,000

 

EXAMPLE 14.104

Smith Company’s pretax book income and taxable income differ because of one item, depreciation expense. Its income before depreciation expense was $900,000 in 2020 and $1,200,000 in 2021. Assume that corporate tax rates are a constant 25%. Book depreciation expense in 2020 and 2021 was $100,000 per year. Tax depreciation expense was $150,000 in 2020 and $50,000 in 2021. Its current and deferred tax position is as follows:

	2020	2021
	Book	Tax	Book	Tax
Income before depreciation expense	$900,000	$900,000	$1,200,000	$1,200,000
Depreciation expense	100,000	150,000	100,000	50,000
Income after depreciation expense	$800,000	$750,000	$1,100,000	$1,150,000
Tax rate	x 25%	x 25%	x 25%	x 25%
Income tax expense	$200,000	$187,500	$275,000	$287,500
Current tax expense (payable)		$187,500		$287,500
Deferred tax expense 2020:	$12,500 [($800,000 − $750,000) x 25%] increase in deferred tax liability
Deferred tax expense 2021:	$12,500 [($1,100,000 − $1,150,000) x 25%] decrease in deferred tax liability

In this example the temporary difference reversed in one year. In 2020 income tax expense was greater than current tax expense, and the difference of $12,500 is a deferred tax liability. In 2021 when the temporary difference reverses, income tax expense is $12,500 less than current tax expense and the deferred tax liability is reduced. The journal entries follow:

2020:
Income tax expense	$200,000
Income taxes payable		$187,500
Deferred tax liability		12,500
2021:
Income tax expense	$275,000
Deferred tax liability	12,500
Income taxes payable		$287,500

Theoretically, deferred tax assets represent future tax benefits that will reduce future income taxes payable. However, if events indicate that some of the future tax benefit will more likely than not be realized then the firm must use a valuation allowance account (a contra-asset) to revalue the net deferred tax asset. According to ASC 740, both positive and negative evidence must be evaluated in determining whether a valuation adjustment is needed. Past and current information about the firm’s current financial position and results of operations should be used. Expectations about future reversals of existing taxable temporary differences, future taxable income, expected future tax rates, and tax planning strategies that might/would be implemented also should be evaluated. If the weight of all evidence indicates that a valuation allowance is needed then the firm is required to do so.

EXAMPLE 14.105

Sueco’s NOL carryover for 2020 is $500,000. Assuming a 25% tax rate, the expected future tax benefit is $125,000 ($500,000 x 25%), which would result in a deferred tax asset of $125,000. However, evidence suggests that Sueco will only be able to use $400,000 of the NOL, which gives rise to a $25,000 ($100,000 x 25%) allowance adjustment. The journal entry follows:

Deferred tax asset	$125,000
Deferred tax asset valuation allowance		$25,000
Income tax expense		100,000

EXAMPLE 14.106

Kimco’s taxable income in 2020 was $30,000,000. Its book income was $28,000,000. There is a $2,000,000 temporary difference (item is currently deductible for book purposes but not for tax purposes). In 2021, after careful analysis of all relevant factors, Kimco determines that it is more likely than not that $300,000 of the items underlying the deferred tax asset will never be realized. Tax rates are a constant 25%. Kimco makes the following journal entries in 2020 and 2021:

2020:
Income tax expense	$7,000,000
Deferred tax asset	500,000
Income taxes payable		$7,500,000
2021:
Income tax expense	$75,000
Deferred tax asset valuation allowance		$75,000

Kimco’s net deferred tax asset at the end of 2021 is $425,000 ($500,000 - $75,000). Each year Kimco will evaluate all relevant factors to determine if adjustments are needed to increase or decrease the valuation allowance account.

Again, the intent behind these financial accounting requirements is to provide additional information and transparency about a firm’s financial position, cash flows and results of operations to financial statement users.

Uncertain Tax Positions

ASC 740 provides acceptable accounting methods for firms’ uncertain tax provisions. It also requires additional disclosure about the unrecognized tax benefits associated with these positions.

Per ASC 740, a tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of deferred tax assets. The tax position contains, but is not limited to, a decision not to file a tax return; shift of income between jurisdictions; characterization of income or decision to exclude reporting taxable income in a tax return; a decision to classify a transaction, entity or other position in a tax return as tax exempt; or an entity’s status (e.g., pass-through, tax-exempt).

An uncertain tax position must be recognized if it has a more-likely-than-not chance (greater than 50%) of being sustained if contested by the IRS. Being sustained sets a high threshold because it presumes an audit will occur, the IRS has full knowledge of the transactions and events, and all administrative and judicial appeals will occur. It also requires significant judgment and substantial documentation.

If the position does not meet the more-likely-than-not threshold then the firm cannot recognize the tax benefit until it does meet the threshold, the firm settles the position with the IRS or through litigation, or the statute of limitations on the transaction expires. If the position does meet the more-likely-than-not threshold then the firm must measure the amount of benefit recognized for financial accounting purposes. The measure equals the largest amount of benefit that has a greater than 50% chance of being realized upon settlement. The measurement process is quite complex and beyond the scope of this text.

Since the firm in all likelihood takes the tax position in determining its taxable income, its income tax expense for book purposes will be greater than its income taxes payable. Since this difference is due to the uncertain position, the firm must recognize a liability for the unrecognized tax benefit because theoretically at some point the IRS might challenge the position, deny it (or some part of it) and the firm would owe additional taxes.

EXAMPLE 14.107

Vlade Company has two uncertain tax positions. Position A provides a $300,000 tax benefit and position B provides a $500,000 tax benefit. Position B does not meet the more-likely-than not threshold, so for financial accounting purposes it cannot be recognized this year. Position A does meet the threshold, so Vlade Company must measure the benefit before recording it for financial accounting purposes. Based on probability analysis, it determines that $160,000 has a greater than 50% chance of being realized upon settlement with the IRS, so for financial accounting purposes it will record a benefit of $160,000.

 

EXAMPLE 14.108

In 2020, Sunny Company’s tax rate is 25%. Its pretax book income and taxable income are $30,000,000 before considering an uncertain tax position that produces a $2,000,000 deduction for federal income tax purposes. Since the position fails the greater than 50% chance of being realized requirement, Sunny Company cannot record it for book purposes; thus, book income will be $2,000,000 greater than taxable income. So, it makes the following journal entry:

Income tax expense	$7,500,000
Income taxes payable		$7,000,000
Liability for unrecognized tax benefits		500,000

EXAMPLE 14.109

Continuing with example 14.108, the IRS challenged Sunny Company’s position in 2022 and ultimately allowed a $900,000 deduction. Sunny Company makes the following journal entry:

Liability for uncertain income tax benefits	$500,000
Income taxes payable		$275,000
Income tax expense		225,000

Schedule UTP (Uncertain Tax Position Statement)

The financial accounting treatment of uncertain tax positions hopefully improves firm transparency and financial statement quality. However, it also provides the IRS with additional information to investigate aggressive firm behavior. In an effort to obtain more transparency and information, the IRS issued Schedule UTP. The IRS spends about 25% of its time auditing large corporations by searching for issues. Schedule UTP enables the IRS to prioritize its selection of taxpayers and issues that pose the greatest compliance risk, reduce the time needed to identify issues and complete audits, ensure that the taxpayer and IRS spend more time discussing the law, and, overall, improve audit effectiveness and efficiency.

Schedule UTP requires firms with assets of $10 million or more to report each U.S. federal income tax position taken on its federal income tax return if (1) the corporation has taken a tax position on its U.S. tax return for the current tax year or a prior tax year and (2) either the corporation or a related party has recorded a reserve with respect to that tax position in audited financial statements, or the corporation or related party did not record a reserve for that tax position because the corporation expects to litigate the position. A reserve is considered recorded for federal income tax purposes when a reserve for federal income tax with respect to a tax position is recorded in the audited financial statements of the corporation or related party. These positions must be reported regardless of the accounting standards used (U.S. GAAP, IFRS or country-specific standards). Additionally, under certain conditions, a tax position for which a reserve was not recorded for financial accounting purposes still must be reported on Schedule UTP. A tax position for which a reserve was not recorded in the audited financial statements, of which the probability of settling with the IRS is less than 50% and for which the corporation intends to litigate the tax position and believes it is more likely then not to prevail in the litigation must be reported on Schedule UTP. Schedule UTP is attached to the firm’s Form 1120. (It would be helpful if you download Schedule UTP from the IRS website and refer to it as you read the remainder of this section.)

A tax position taken on a tax return is a tax position that would result in an adjustment to a line item on that return if the position is not sustained. If multiple tax positions affect a single line item then each tax position must be reported separately. The corporation is required to report a concise description of each uncertain tax position. Schedule UTP specifically indicates that the financial accounting treatment of the tax position should be used as a guide. So, if for financial accounting purposes no reserve was required for a tax position taken on the tax return because the amount was immaterial or the tax position was sufficiently certain so that no reserve was required then the corporation does not have to report the tax position on Schedule UTP.

Schedule UTP requires significant disclosure. Part I and Part II addresses the current and prior tax years, respectively. Per the instructions to Schedule UTP, each uncertain tax position (UTP) must be disclosed along with: the primary Code Section relating to the UTP; whether the UTP creates a temporary or permanent difference; and the employer identification number (EIN) of the pass-through entity to which the UTP relates (if it is related to a pass-through entity). Additionally, the corporation must determine if the UTP is a major tax position (not including expected-to-litigate positions) based on its relative size to the sum of all UTPs taken on the tax return. If the size of the UTP divided by the sum of the sizes of all UTPs taken on the tax return is at least ten percent then it is a major tax position. If it is a major position then this must be indicated on Schedule UTP. Since multinational corporations sometimes use transfer prices to shift income, each UTP also must be identified as either a transfer pricing position (T) or other UTP (G). Finally, the corporation must rank each UTP based on its size, whereby the largest UTP is ranked 1.

Part III of Schedule UTP requires the corporation to give a concise description (no more than a few sentences) of each UTP listed in Part I or Part II. The description must include all relevant facts affecting the tax treatment of the UTP and information that can be expected to apprise the IRS of the identity of the UTP and the nature of the issue. Neither the hazards of the UTP nor an analysis of support for or against the UTP should be included.

SUMMARY

· Taxpayers have a choice of selecting a sole proprietorship, partnership, or corporation as the form to do business.

· Partnerships and sole proprietors may select to be taxed as a corporation for federal tax purposes by using the “check-the-box” system.

· The transfer of property solely for stock of a corporation that is at least 80 percent controlled by the transferor group is tax free.

· Realized gains are recognized on said transfers to the extent of boot received.

· Boot includes property other than stock (although nonqualified preferred stock is boot) as well as liabilities in excess of basis.

· Property basis carries over to the stock and to the corporation.

· Debt is favored over equity because interest is deductible by the corporation and dividends are not deductible.

· High debt-equity ratios are subject to IRS investigation and could lead to debt being classified as equity.

· If debt is reclassified as equity, the interest deduction is lost and interest and principal payments may be classified as dividends.

· Corporations with $1,000,000 or less in equity capital that issue stock for property generally qualify for Code Sec. 1244.

· Losses (except for built-in losses) on the sale of Code Sec. 1244 stock are ordinary up to $50,000 ($100,000 on a joint return), but gains are capital gains.

· Code Sec. 1202 also enables noncorporate taxpayers to exclude 100 percent (75 percent for stock acquired after 2/17/09 and before 9/28/10; 50 percent for stock acquired after 8/10/93 and before 2/18/09) of any gain from the sale or exchange of qualified small business stock held for more than five years which was originally issued.

· Taxpayers may rollover the gain from sale of Code Sec. 1202 stock if they invest the proceeds in a qualified small business corporation within 60 days of sale.

· The corporate tax rate is 21 percent.

· Special features of corporate taxation include: (a) organization expenses are amortized over 180 months; (b) dividends received from U.S. corporations are subject to a dividends-received deduction of 50, 65, or 100 percent; (c) charitable deductions of up to 10 percent of taxable income (as adjusted) are allowed; and (d) capital losses in excess of capital gains must be carried back three years and then forward five years.

· Multiple corporations that are members of a controlled group (brother-sister, parent-subsidiary, or combined group) must share certain tax benefits as if they were one corporation (e.g., accumulated earnings credit, Code Sec. 179 election to expense).

· Parent-subsidiary controlled groups may file a consolidated return.

· The corporate annual tax return is due by the 15th day of the fourth month following the close of the tax year, except for those with a June 30 year end.

· Form 1120 is used and requires the computation of taxable income, the reporting of balance (analyzing sheets), and the completion of Schedules M-1 or M-3 (reconciling book income to taxable income) and M-2 (analyzing unappropriated retained earnings per books).

· Some corporations also must file Schedule UTP, which provides the IRS with information about the corporation’s uncertain tax positions.

· Schedule UTP evolved from the financial accounting treatment of timing differences and uncertain tax positions as stipulated in ASC 740. ASC 740 provides guidance regarding the financial accounting treatment and disclosure of timing differences, the valuation of deferred tax benefits, and the treatment of uncertain tax positions. Its purpose is to make financial statements more transparent and useful.

PROBLEMS

Question # 52. Bob, Sam, and Tom formed IU Inc. in 2020. Bob contributed equipment (Code Sec. 1231 property) he acquired in 2017 for $190,000. On the date of transfer, the equipment’s adjusted basis and fair market value were $100,000 and $150,000, respectively. Bob received 150 shares of IU Inc. Sam transferred land (capital asset) which he acquired in 2014. The land’s adjusted basis and fair market value on the date of transfer were $50,000 and $250,000, respectively. Sam received 250 shares of IU Inc. Tom contributed inventory with an adjusted basis of $35,000 and a fair market value of $50,000 in return for 50 shares of IU Inc.

a. What are the tax consequences to Bob?

b. What are the tax consequences to Sam?

c. What are the tax consequences to Tom?

Question # 65 Bill decided to incorporate his printing business and to give his manager, Charlie, a share in the business. Bill's sole proprietorship transferred the following to Tom Co.:

	Basis	Value
Accounts payable	$0	$7,000
Accounts receivable	0	8,000
Printing press	6,000	10,000
Truck	24,000	20,000
Cash	2,000	2,000

Bill received 70 shares of the stock, worth $29,000. Charlie invested $2,000 in cash and received the remaining 30 shares of the stock. What are the tax consequences to Bill, Charlie, and Tom Co.?

Question # 79. Jacobs Inc. is renovating its corporate headquarters and its new décor does not allow it to showcase art that hung on the walls before the renovation. Jacobs has decided to donate its art collection to local organizations. In the current year it gives a Remington to the Denver Museum of Art and a Renoir to Porter Hospital. The hospital intends to sell the Renoir and use the proceeds to purchase equipment. Jacob’s Inc. had purchased the Remington for $600,000 about 15 years ago and the Renoir for $2,000,000 at about the same time. At the time of the gift, the Remington was appraised for $5,000,000 and the Renoir for $25,000,000. What is the amount Jacobs can deduct for its gifts, assuming it has sufficient income?