Assignment 8 controllership

Corporations: Introduction and Operating Rules

L E A R N I N G O B J E C T I V E S : After completing Chapter 2, you should be able to:

LO.1 Summarize the tax treatment of various forms of conducting a business.

LO.2 Compare the taxation of individuals and corporations.

LO.3 List and apply the tax rules unique to corporations.

LO.4 Compute the corporate income tax.

LO.5 Explain the rules unique to computing the tax of related corporations.

LO.6 Describe and illustrate the reporting process for corporations.

LO.7 Evaluate corporations as an entity form for conducting a business.

C H A P T E R O U T L I N E

2-1 Tax Treatment of Various Business Forms, 2-2 2-1a Sole Proprietorships, 2-2 2-1b Partnerships, 2-2 2-1c Corporations, 2-3 2-1d Limited Liability Companies, 2-6

2-2 An Introduction to the Income Taxation of Corporations, 2-7 2-2a An Overview of Corporate versus Individual

Income Tax Treatment, 2-7 2-2b Specific Provisions Compared, 2-9 2-2c Accounting Periods and Methods, 2-9 2-2d Capital Gains and Losses, 2-10 2-2e Recapture of Depreciation, 2-11 2-2f Passive Losses, 2-12 2-2g Charitable Contributions, 2-13 2-2h Domestic Production Activities Deduction, 2-15 2-2i Net Operating Losses, 2-16 2-2j Deductions Available Only to Corporations, 2-16

2-3 Determining the Corporate Income Tax Liability, 2-21 2-3a Corporate Income Tax Rates, 2-21 2-3b Alternative Minimum Tax, 2-22 2-3c Tax Liability of Related Corporations, 2-22

2-4 Procedural Matters, 2-23 2-4a Filing Requirements for Corporations, 2-24 2-4b Estimated Tax Payments, 2-24 2-4c Schedule M–1—Reconciliation of Income (Loss) per

Books with Income per Return, 2-25 2-4d Schedule M–2—Analysis of Unappropriated Retained

Earnings per Books, 2-26 2-4e Schedule M–3—Net Income (Loss) Reconciliation for

Corporations with Total Assets of $10 Million or More, 2-27

2-4f Effect of Taxes on the Financial Statements, 2-29 2-4g Form 1120 Illustrated, 2-29 2-4h Consolidated Returns, 2-37

2-5 Tax Planning, 2-37 2-5a Corporate versus Noncorporate Forms of Business

Organization, 2-37 2-5b Operating the Corporation, 2-38

C H A P T E R

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THE BIG PICTURE

A HALF-BAKED IDEA?

Samantha Johnson owns Skylark Bakery. Currently, the bakery is operated as a sole proprietorship and gen-

erates an annual operating profit of $100,000. In addition, the bakery earns annual dividends of $5,000 from

investing excess working capital in the stock of publicly traded corporations. These stock investments typi-

cally are held for a minimum of three to four months before funds are required for the business. As a result

of income from other business ventures and investments, Samantha is in the 33 percent marginal tax rate

bracket irrespective of the bakery. In the past, Samantha has withdrawn $50,000 annually from the bakery,

which she regards as reasonable payment for her services.

Samantha has asked you about the tax consequences of conducting the business as a regular (C) corpo-

ration. Based on the given information, what would be the annual income tax savings (or cost) of operating

the bakery as a corporation? For purposes of this analysis, use the 2015 tax rates and ignore any employ-

ment tax or state tax considerations.

Read the chapter and formulate your response.

ª RYAN MCVAY/PHOTODISC/GETTY IMAGES

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F or Federal income tax purposes, the distinctions among forms of business organization are very important. The following discussion of the tax treatment of sole proprietorships, partnerships, and regular corporations highlights these dis-

tinctions. Limited liability companies, which generally are taxed as one of the three pre- ceding entity forms, are also discussed. Trusts and estates are covered in Chapter 20, and S corporations are discussed in Chapter 12.

2-1 TAX TREATMENT OF VARIOUS BUSINESS FORMS Business operations can be conducted in a number of different forms. Among the vari- ous possibilities are the following:

• Sole proprietorships.

• Partnerships.

• Trusts and estates.

• S corporations.

• Regular corporations.

• Limited liability companies.

2-1a Sole Proprietorships A sole proprietorship is not a taxable entity separate from the individual who owns the proprietorship. The owner of a sole proprietorship reports all business income and expenses of the proprietorship on Schedule C of Form 1040, with the net profit or loss from the proprietorship used by the taxpayer to report taxable income. The proprietor reports all of the net profit from the business, regardless of the amount actually with- drawn during the year.

Income and expenses of the proprietorship retain their character when reported by the proprietor. For example, ordinary income of the proprietorship is treated as ordinary income when reported by the proprietor, and capital gain is treated as capital gain.

2-1b Partnerships Partnerships are not subject to a Federal income tax. However, a partnership is required to file Form 1065, which reports the results of the partnership’s business activities. Most income and expense items are aggregated in computing the ordinary business income (loss) of the partnership on Form 1065. Any income and expense items that are not aggregated in computing the partnership’s ordinary business income (loss) are reported separately to the partners. Some examples of separately reported income items are interest income, dividend income, and long-term capital gain. Examples of separately reported expenses include charitable contributions and expenses related to investment income. Partnership reporting is discussed in detail in Chapter 10.

The partnership ordinary business income (loss) and the separately reported items are allocated to the partners according to the partnership’s profit and loss sharing agree- ment. Each partner receives a Schedule K–1 that reports the partner’s share of the part- nership ordinary business income (loss) and separately reported income and expense items. Each partner reports these items on his or her own tax return.

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The Big Picture

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Return to the facts of The Big Picture on p. 2-1. Samantha, the sole proprietor of Skylark Bakery, reports the $100,000 operating profit from the business on Schedule C of her individual tax return. Even though she withdrew only $50,000, Samantha reports all of the $100,000 operating profit from the business on Form 1040, where she computes taxable income for the year. She also reports divi- dend income of $5,000 on Schedule B of Form 1040.

LO.1

Summarize the tax treatment of various forms of conducting a business.

2-2 PART 2 Corporations

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2-1c Corporations Corporations are governed by Subchapter C or Subchapter S of the Internal Revenue Code. Those governed by Subchapter C are referred to as C corporations or regular corporations . Corporations governed by Subchapter S are referred to as S corporations .

S corporations, which generally do not pay Federal income tax, are similar to partner- ships in that ordinary business income (loss) flows through to the shareholders to be reported on their separate returns. Also like partnerships, S corporations do not aggre- gate all income and expense items in computing ordinary business income (loss). Cer- tain items flow through to the shareholders and retain their separate character when reported on the shareholders’ returns. The S corporation ordinary business income (loss) and the separately reported items are allocated to the shareholders according to their stock ownership interests. See Chapter 12 for detailed coverage of S corporations.

Unlike proprietorships, partnerships, and S corporations, C corporations are subject to an entity-level Federal income tax. This results in what is known as a double taxation effect. A C corporation reports its income and expenses on Form 1120. The corporation computes tax on the taxable income reported on the Form 1120 using the rate schedule applicable to corporations (see Exhibit 2.1 later in this section). When a corporation dis- tributes its income, the corporation’s shareholders report dividend income on their own tax returns. Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level. The effects of double taxation are illustrated in Examples 3 and 4.

Taxation of Dividends As noted earlier, the income of a C corporation is subject to double taxation, which stems, in part, from the fact that dividend distributions are not deductible by the cor- poration. Shareholders of closely held corporations frequently attempt to circumvent

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Jim and Bob are equal partners in Canary Enterprises, a calendar year partnership. During the year, Canary Enterprises had $500,000 gross income and $350,000 operating expenses. In addition, the partnership sold land that had been held for investment purposes for a long-term capital gain of $60,000. During the year, Jim withdrew $40,000 from the partnership, and Bob withdrew $45,000. The partnership’s Form 1065 reports ordinary business income of $150,000 ($500,000 income � $350,000 expensesÞ and long-term capital gain of $60,000 as a separately stated item. Jim and Bob each receive a Schedule K–1 reporting ordinary business income of $75,000 and separately stated long-term capital gain of $30,000. Each partner reports ordinary business income of $75,000 and long-term capital gain of $30,000 on his own return.

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Double Taxation Illustrated

Lavender Corporation has taxable income of $100,000 in 2015. It pays corporate tax of $22,250 (refer to Exhibit 2.1 on p. 2-4). This leaves $77,750, all of which is distributed as a dividend to Mike, a 43-year-old single individual and the corporation’s sole shareholder. Mike has no income sources other than Lavender Corporation. Mike has taxable income of $67,450 ($77,750 � $6,300 standard deduction � $4,000 personal exemption). He pays tax at the preferential rate applicable to qualified dividends received by individuals. His tax is $4,500 [($37,450 � 0%) þ ($30,000 � 15%)]. The combined tax on the corporation’s net profit is $26,750 ($22,250 paid by the corporation þ $4,500 paid by the shareholderÞ.

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Assume the same facts as in Example 3, except that the business is organized as a sole proprietor- ship. Mike reports the $100,000 profit from the business on his tax return. He has taxable income of $89,700 ($100,000 � $6,300 standard deduction – $4,000 personal exemption) and pays tax of $18,219. Therefore, operating the business as a sole proprietorship results in a tax savings of $8,531 in 2015 ($26,750 from Example 3 � $18,219).

CHAPTER 2 Corporations: Introduction and Operating Rules 2-3

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this disallowance by disguising a dividend distribution as some other purported trans- action. One of the more common ways of disguising dividend distributions is to pay excessive compensation to shareholder-employees of a closely held corporation. The IRS scrutinizes compensation and other economic transactions (e.g., loans, leases, and sales) between shareholders and closely held corporations to ensure that pay- ments are reasonable in amount. (See Chapter 5 for more discussion on constructive dividends.)

Double taxation also stems from the fact that dividend distributions are taxable to the shareholders. Historically, dividend income has been taxed at the same rates as ordinary income. However, to alleviate some of the double taxation effect, Congress reduced the tax rate applicable to dividend income of individuals for years after 2002. As a result of the American Taxpayer Relief Act of 2012, the current tax rate applicable to qualified dividend income (and long-term capital gains) is 15 percent or, for taxpayers in the 39.6 percent marginal tax bracket, 20 percent (0 percent for taxpayers in the 10 or 15 percent marginal tax bracket). A 3.8 percent Medicare surtax applies to net invest- ment income in excess of modified adjusted gross income of $200,000 ($250,000 if married filing jointly), thus increasing the double taxation of dividend income for high- income taxpayers.

Comparison of Corporations and Other Forms of Doing Business Chapter 13 presents a detailed comparison of sole proprietorships, partnerships, S corporations, and C corporations as forms of doing business. However, it is appropri- ate at this point to consider some of the tax and nontax factors that favor corporations over proprietorships.

Consideration of tax factors requires an examination of the corporate rate structure. The income tax rate schedule applicable to corporations is reproduced in Exhibit 2.1. As this schedule shows, the marginal rates for corporations range from 15 percent to 39 percent. In comparison, the marginal rates for individuals range from 10 percent to 39.6 percent. In many cases, the tax burden will be greater if a business is operated as a corporation (as in Example 3). However, the corporate form of doing business presents tax savings opportunities when the applicable corporate marginal rate is lower than the applicable individual marginal rate.

E X H I B I T 2.1 Corporate Income Tax Rates

Taxable Income Tax Is:

Over— But Not Over— Of the Amount Over—

$ 0 $ 50,000 15% $ 0

50,000 75,000 $ 7,500 þ 25% 50,000 75,000 100,000 13,750 þ 34% 75,000

100,000 335,000 22,250 þ 39% 100,000 335,000 10,000,000 113,900 þ 34% 335,000

10,000,000 15,000,000 3,400,000 þ 35% 10,000,000 15,000,000 18,333,333 5,150,000 þ 38% 15,000,000 18,333,333 — 35% 0

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Susanna, an individual taxpayer in the 39.6% marginal tax rate bracket, can generate $100,000 of additional taxable income in the current year. If the income is taxed to Susanna, the associated tax is $39,600 ($100,000 � 39:6%). If, however, Susanna is able to shift the income to a newly created corporation, the corporate tax is $22,250 (see Exhibit 2.1). Thus, by taking advantage of the lower corporate marginal tax rates, a tax savings of $17,350 ($39,600 � $22,250) is achieved.

2-4 PART 2 Corporations

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Any attempt to take advantage of the difference between the corporate and individ- ual marginal tax rates also must consider the double taxation effect. When the preferen- tial rate for dividend income is considered, however, tax savings opportunities still exist.

Examples 5 and 6 ignore other tax issues that also must be considered in selecting the proper form of doing business, but they illustrate the tax savings that can be achieved by taking advantage of rate differentials. In addition to the 3.8 percent Medi- care surtax (mentioned above), some of the other tax considerations that could affect the selection of a business form include the character of business income, the expecta- tion of business losses, employment taxes, and state taxes.

Unlike other forms of business, the tax attributes of income and expense items of a C corporation do not pass through the corporate entity to the shareholders. As a result, if the business is expected to generate tax-favored income (e.g., tax-exempt income or long-term capital gains), one of the other (non-C corporation) forms of business may be desirable.

Losses of a C corporation are treated differently than losses of a proprietorship, a partnership, or an S corporation. A loss incurred by a proprietorship may be deductible by the owner, because all income and expense items are reported by the proprietor. Partnership losses are passed through the partnership entity and may be deductible by the partners, and S corporation losses are passed through to the shareholders. C corpo- ration losses, however, have no effect on the taxable income of the shareholders. There- fore, one of the non-C corporation forms of business may be desirable if business losses are anticipated.

The net income of a proprietorship is subject to the self-employment tax, as are some partnership allocations of income to partners. In the alternative, wages paid to a share- holder-employee of a corporation (C or S) are subject to payroll taxes. The combined corporation-employee payroll tax burden should be compared with the self-employ- ment tax associated with the proprietorship and partnership forms of business. This analysis should include the benefit of the deduction available to a corporation for pay- roll taxes paid, as well as the deduction available to an individual for part of the self- employment taxes paid.

At the entity level, state corporate income taxes and/or franchise taxes are appli- cable for businesses formed as corporations. Although no entity-level Federal income tax is typically assessed on S corporations, limited liability companies (LLCs), or part- nerships, a few states impose a corporate income tax or franchise tax on such business forms. Consideration of state taxation when selecting a business form is particularly relevant for businesses that operate in more than one state. (See Chapter 16 for a dis- cussion of the taxation of multistate corporations.) At the owner level, the income of sole proprietorships, S corporations, and partnerships (including most LLCs) is sub- ject to state individual income taxation. Similarly, dividend income from corporate distributions is subject to state income taxation and without any rate preference for such income.

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Assume in Example 5 that the corporation distributes all of its after-tax earnings to Susanna as a dividend. The dividend results in income tax of $15,550 [($100,000 � $22,250) � 20%] to Susanna. Thus, even when the double taxation effect is considered, the combined tax burden of $37,800 ($22,250 paid by the corporation þ $15,550 paid by the shareholder) represents an income tax savings of $1,800 when compared to the $39,600 of tax that results when the $100,000 of income is subject to Susanna’s 39.6% marginal rate.

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Franco plans to start a business this year. He expects that the business will incur operating losses for the first three years and then become highly profitable. Franco decides to operate as an S cor- poration during the loss period, because the losses will flow through and be deductible on his per- sonal return. When the business becomes profitable, he intends to switch to C corporation status.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-5

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Nontax Considerations Nontax considerations will sometimes override tax considerations and lead to the con- clusion that a business should be operated as a corporation. The following are some of the more important nontax considerations:

• Sole proprietors and general partners in partnerships face the danger of unlimited liability. That is, creditors of the business may file claims not only against the assets of the business but also against the personal assets of proprietors or general partners. State corporate law protects shareholders from claims against their per- sonal assets for corporate debts.

• The corporate form of business can provide a vehicle for raising large amounts of capital through widespread stock ownership. Most major businesses in the United States are operated as corporations.

• Shares of stock in a corporation are freely transferable, whereas a partner’s sale of his or her partnership interest is subject to approval by the other partners.

• Shareholders may come and go, but a corporation can continue to exist. Death or withdrawal of a partner, on the other hand, may terminate the existing partnership and cause financial difficulties that result in dissolution of the entity. This continuity of life is a distinct advantage of the corporate form of doing business.

• Corporations have centralized management. All management responsibility is assigned to a board of directors, who appoint officers to carry out the corpora- tion’s business. Partnerships, by contrast, may have decentralized management, in which every partner has a right to participate in the organization’s business deci- sions. Limited partnerships , though, may have centralized management. Central- ized management is essential for the smooth operation of a widely held business.

2-1d Limited Liability Companies The limited liability company (LLC) has proliferated greatly in recent years, particularly since 1988 when the IRS first ruled that it would treat qualifying LLCs as partnerships for tax purposes. All 50 states and the District of Columbia have passed laws that allow LLCs, and thousands of companies have chosen LLC status. As with a corporation, oper- ating as an LLC allows its owners (“members”) to avoid unlimited liability exposure, which is a primary nontax consideration in choosing the form of business organization. The tax advantage of LLCs is that qualifying businesses may be treated as proprietor- ships or partnerships for tax purposes, thereby avoiding the problem of double taxation associated with regular corporations.

Some states allow an LLC to have centralized management, but not continuity of life or free transferability of interests. Other states allow LLCs to adopt any or all of the cor- porate characteristics of centralized management, continuity of life, and free transferabil- ity of interests. The comparison of business entities in Chapter 13 includes a discussion of LLCs.

G L O B A L T A X I S S U E S U.S. Corporate Tax Rate and Global Competitiveness

According to the Organization for Economic Cooperation and Development (OECD), the U.S. combined Federal and state corporate income tax rate of 39.1% is the highest among member states. The effective tax rate that most corporations pay in the United States is substantially less than the top statutory rate, however, as taxpayers reduce their exposure to the corporate tax through the use

of exclusions, deductions, credits, and deferral provisions. Still, the relatively high corporate tax rate puts the United States at a competitive disadvantage in attracting capital investment, and it encourages U.S. corporations to utilize foreign entities to shelter income from U.S. taxation.

Source: www.oecd.org/tax/tax-policy/tax-database.htm.

2-6 PART 2 Corporations

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Entity Classification Can an organization not qualifying as a corporation under state law still be treated as such for Federal income tax purposes? The tax law defines a corporation as including “associations, joint stock companies, and insurance companies.”1 Unfortunately, the Code contains no definition of what constitutes an association, and the issue became the subject of frequent litigation.

It was finally determined that an entity would be treated as a corporation if it had a majority of characteristics common to corporations. For this purpose, relevant character- istics are:

• Continuity of life.

• Centralized management.

• Limited liability.

• Free transferability of interests.

These criteria did not resolve all of the problems that continued to arise over corpo- rate classification. When a new type of business entity—the limited liability company— was developed, the IRS was deluged with inquiries regarding its tax status. As LLCs became increasingly popular with professional groups, all states enacted statutes allow- ing some form of this entity. Invariably, the statutes permitted the corporate characteris- tic of limited liability and, often, that of centralized management. Because continuity of life and free transferability of interests are absent, partnership classification was hoped for. This treatment avoided the double taxation inherent in the corporate form.

In 1996, the IRS eased the entity classification problem by issuing the check-the-box Regulations .2 The Regulations enable taxpayers to choose the tax status of a business entity without regard to its corporate (or noncorporate) characteristics. These rules sim- plified tax administration considerably and eliminated much of the litigation that arose with regard to the association (i.e., corporation) status.

Under the check-the-box Regulations, an unincorporated entity with more than one owner is, by default, classified as a partnership. An unincorporated entity with only one owner is, by default, classified as a disregarded entity (or DRE). A DRE is treated as a sole proprietorship if it is owned by an individual taxpayer or as a branch or a division of a corporate owner. If the entity wants to use its default status, it simply files the appropriate tax return. If it wants to use a different status or change its status, it does so by “checking a box” on Form 8832. Thus, an LLC (single or multi-member) can choose to be taxed as a C corporation and, if it otherwise qualifies, even elect S corporation status.

The status election is not available to entities that are incorporated under state law or to entities that are required to be taxed as corporations under Federal law (e.g., certain pub- licly traded partnerships). LLCs are not treated as being incorporated under state law, so they default to either partnership or DRE status. Although an LLC does not typically pay Federal income taxes, LLCs are obligated to report and pay employment and excise taxes.

2-2 AN INTRODUCTION TO THE INCOME TAXATION OF CORPORATIONS

When examining how corporations are treated under the Federal income tax, a useful approach is to compare their treatment with that applicable to individual taxpayers. In addition, tax provisions that are unique to corporations must be addressed.

2-2a An Overview of Corporate versus Individual Income Tax Treatment The tax formula for computing the Federal income tax for a corporation is compared with that of an individual taxpayer in Exhibit 2.2, and the following discussion highlights similarities and differences between the two formulas.

1§ 7701(a)(3). 2Reg. §§ 301.7701–1 through �4, and �7.

LO.2

Compare the taxation of individuals and corporations.

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Similarities Gross income of a corporation is determined in much the same manner as it is for individ- uals. Thus, gross income includes compensation for services rendered, income derived from a business, gains from dealings in property, interest, rents, royalties, and divi- dends—to name only a few items. Both individuals and corporations are entitled to exclusions from gross income. However, corporate taxpayers are allowed fewer exclu- sions. Interest on municipal bonds and life insurance proceeds are two exclusions that are applicable to both individual and corporate taxpayers.

Gains and losses from property transactions are handled similarly. For example, whether a gain or loss is capital or ordinary depends upon the nature of the asset in the hands of the taxpayer making the taxable disposition. In defining what is not a capital asset, § 1221 makes no distinction between corporate and noncorporate taxpayers.

In the area of nontaxable exchanges, corporations are like individuals in that they do not recognize gain or loss on a like-kind exchange and may defer recognized gain on an involuntary conversion of property. The exclusion of gain from the sale of a personal residence does not apply to corporations. The disallowance of losses on sales of property to related parties (e.g., a corporation and a more-than-50-percent shareholder) and on wash sales of securities applies equally to individual and corpo- rate taxpayers.

The business deductions of corporations also parallel those available to indi- viduals. Deductions are allowed for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. Specific provision is made for the deducti- bility of interest, certain taxes, losses, bad debts, accelerated cost recovery, charitable contributions, net operating losses, research and experimental expenditures, and other less common deductions. There is no distinction between business and non- business interest or business and nonbusiness bad debts for corporations. Thus, these amounts are deductible in full as ordinary deductions by corporations. Like individuals, corporations are not allowed a deduction for interest paid or incurred on amounts borrowed to purchase or carry tax-exempt securities. The same holds true for expenses contrary to public policy and certain accrued expenses between related parties.

Some of the tax credits available to individuals, such as the foreign tax credit, can also be claimed by corporations. Not available to corporations are certain credits that are personal in nature, such as the child tax credit, the credit for elderly or disabled tax- payers, and the earned income credit.

E X H I B I T 2.2 Tax Formulas

Corporations Individuals

Income (broadly conceived) Income (broadly conceived)

(Exclusions) (Exclusions)

Gross income Gross income

(Deductions except for NOL and DRD)* (Deductions for AGI)**

Taxable income before NOL and DRD Adjusted gross income

(Net operating loss deduction) (Greater of itemized or standard deductions)

(Dividends received deduction) (Personal and dependency exemptions)

Taxable income Taxable income

Tax on taxable income Tax on taxable income

(Tax credits) (Tax credits)

Tax due (or refund) Tax due (or refund)

*NOL ¼ net operating loss; DRD ¼ dividends received deduction. **AGI ¼ adjusted gross income.

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Dissimilarities The income taxation of corporations and individuals also differs significantly. As noted earlier, different tax rates apply to corporations and to individuals. Corporate tax rates are discussed in more detail later in the chapter (see Examples 28 and 29).

All allowable corporate deductions are treated as business deductions. Thus, the determination of adjusted gross income (AGI), so essential for individual taxpayers, has no relevance to corporations. Taxable income is computed simply by subtracting from gross income all allowable deductions. Itemized deductions, the standard deduction, and the deduction for personal and dependency exemptions do not apply to corpora- tions. The $100 floor and 10 percent-of-AGI limitations on the deductible portion of per- sonal casualty and theft losses applicable to individuals do not apply to corporations.

2-2b Specific Provisions Compared A comparison of the income taxation of individuals and corporations appears in Concept Summary 2.1 on p. 2-20. In making this comparison, the following areas war- rant special discussion:

• Accounting periods and methods.

• Capital gains and losses.

• Recapture of depreciation.

• Passive losses.

• Charitable contributions.

• Domestic production activities deduction.

• Net operating losses.

• Special deductions available only to corporations.

2-2c Accounting Periods and Methods

Accounting Periods Corporations generally have the same choices of accounting periods as do individual taxpayers. Like an individual, a corporation may choose a calendar year or a fiscal year for reporting purposes. Corporations usually can have different tax years from those of their shareholders. Also, newly formed corporations (as new taxpayers) usually have a choice of any approved accounting period without having to obtain the consent of the IRS. Personal service corporations (PSCs) and S corporations, however, are subject to severe restrictions in the use of a fiscal year. The rules applicable to S corporations are discussed in Chapter 12.

A PSC has as its principal activity the performance of personal services, and such services are substantially performed by shareholder-employees. The performance of services must be in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.3 To limit the deferral of income possi- ble when a PSC has a tax year different from that of its calendar year shareholder- employees, a PSC must generally use a calendar year.4 However, a PSC can elect a fiscal year under either of the following conditions:

• A business purpose (e.g., natural business cycle) for the year can be demonstrated.

• The PSC year results in a deferral of not more than three months’ income. An elec- tion under § 444 is required, and the PSC will be subject to the deduction limitations of § 280H. Under the latter provision, a PSC’s deduction for shareholder-employee salaries will be limited if payment of those salaries is disproportionately postponed beyond December 31 (see Example 9).

3§ 448(d)(2)(A) and Reg. § 1.441–3(d)(1). 4§ 441(i). In some cases, a PSC was able to retain the same year as its fiscal year ending 1987. See § 444(b)(3).

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Accounting Methods As a general rule, the cash method of accounting is unavailable to corporations.5 However, several important exceptions apply in the case of the following types of corporations:

• S corporations.

• Corporations engaged in the trade or business of farming or timber.

• Qualified PSCs.

• Corporations with average annual gross receipts of $5 million or less for the most recent three-year period.

Regardless of these exceptions, most individuals and corporations that maintain inven- tory for sale to customers are required to use the accrual method of accounting for deter- mining sales and cost of goods sold. However, as a matter of administrative convenience, the IRS will permit many taxpayers to use the cash method for determining sales and cost of goods sold. This includes any entity with average annual gross receipts of not more than $1 million for the most recent three-year period, and some entities with average annual gross receipts of not more than $10 million for the same three-year period.6

A corporation that uses the accrual method of accounting must observe a special rule in dealing with cash basis related parties. If the corporation has an accrual outstanding at the end of any taxable year with respect to such a related party, it cannot claim a deduction until the recipient reports the amount as income.7 This rule is most often encountered when a corporation deals with an individual who owns (directly or indi- rectly) more than 50 percent of the corporation’s stock.

2-2d Capital Gains and Losses Capital gains and losses result from the taxable sales or exchanges of capital assets.8

Whether these gains and losses are long-term or short-term depends upon the holding period of the assets sold or exchanged. Each year, a taxpayer’s short-term gains and losses are combined, and long-term gains and losses are combined. The result is a net

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Beige Corporation, a PSC, has made an election under § 444 to use a fiscal year ending September 30. For its fiscal year ending September 30, 2015, Beige paid Burke, its sole shareholder, $120,000 in salary. Under § 280H, Burke must receive at least $30,000 [(3 months � 12 months) � $120,000] as salary during the period October 1 through December 31, 2015.

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The Big Picture

10

Return to the facts of The Big Picture on p. 2-1. Assume that Samantha incorporates her business as Skylark Bakery, Inc., a calendar year, accrual method C corporation. Samantha, a cash method tax- payer, owns 100% of the corporation’s stock at the end of 2015. On December 31, 2015, Skylark Bakery has accrued a $10,000 bonus to Samantha. Samantha receives the bonus in 2016 and reports it on her 2016 tax return. Skylark Bakery cannot claim a deduction for the $10,000 until 2016.

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Fiscal Year Exceptions

Valdez & Vance is a professional association of public accountants that receives over 40% of its gross receipts in March and April of each year from the preparation of tax returns. Under these cir- cumstances, the IRS might permit Valdez & Vance to use a May 1 to April 30 fiscal year because it reflects a natural business cycle (the end of the tax season).

5§ 448. 6Rev.Proc. 2001–10, 2001–1 C.B. 272, and Rev.Proc. 2002–28, 2002–1 C.B. 815.

7§ 267(a)(2). 8See Chapter 16 of South-Western Federal Taxation: Individual Income Taxes (2016 Edition) for a detailed discussion of capital gains and losses.

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short-term capital gain or loss and a net long-term capital gain or loss. If gains and losses result (e.g., net short-term capital gain and net long-term capital loss), such amounts are further netted against each other. If instead the results are all gains or all losses (e.g., net short-term capital loss and net long-term capital loss), no further combi- nation is necessary.

Capital Gains Individuals generally pay a preferential tax rate of 15 or 20 percent on net capital gains (i.e., excess of net long-term capital gain over net short-term capital loss).9 Corporations, however, receive no favorable tax rate on long-term capital gains, and such income is taxed at the normal corporate tax rates.

Capital Losses Net capital losses of corporate and individual taxpayers receive different income tax treatment. Generally, individual taxpayers can deduct up to $3,000 of such net losses against other income. Any remaining capital losses are carried forward to future years until absorbed by capital gains or by the $3,000 deduction. Loss carryovers retain their identity as either long term or short term.10

Unlike individuals, corporate taxpayers are not permitted to deduct any net capital losses against ordinary income. Capital losses, therefore, can be used only as an offset against capital gains. Corporations, however, carry back net capital losses to three pre- ceding years, applying them first to the earliest year in point of time. Carryforwards are allowed for a period of five years from the year of the loss. When carried back or for- ward, a long-term capital loss is treated as a short-term capital loss.11

2-2e Recapture of Depreciation In general, the recapture rules under §§ 1245 and 1250 are equally applicable to both individual and corporate taxpayers. However, corporations may have more depreciation recapture (ordinary income) on the disposition of § 1250 property than individuals. Under § 291, a corporation will have additional ordinary income equal to 20 percent of the excess of the amount of depreciation recapture that would arise if the property was § 1245 property over the amount of depreciation recapture com- puted under § 1250 (without regard to § 291). As a result, the § 1231 portion of the cor- poration’s gain on the disposition is correspondingly reduced by the additional recapture.

Under § 1250, recapture is limited to the excess of accelerated depreciation over straight-line depreciation. In general, only straight-line depreciation is allowed for real property placed in service after 1986; thus, there will usually be no depreciation

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11

Robin, an individual, incurs a net long-term capital loss of $7,500 for calendar year 2015. Assuming adequate taxable income, Robin may deduct $3,000 of this loss on his 2015 return. The remaining $4,500 ($7,500 � $3,000) of the loss is carried to 2016 and years thereafter until completely deducted. The $4,500 will be carried forward as a long-term capital loss.

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12

Assume the same facts as in Example 11, except that Robin is a corporation. None of the $7,500 long-term capital loss incurred in 2015 can be deducted in that year. Robin Corporation may, how- ever, carry back the loss to 2012, 2013, and 2014 (in this order) and offset it against any capital gains recognized in these years. If the carryback does not exhaust the loss, it may be carried for- ward to 2016, 2017, 2018, 2019, and 2020 (in this order). The long-term capital loss is treated as short term in any carryover year.

9A 0% rate applies to individual taxpayers in the 10% and 15% brackets. 10§§ 1211(b) and 1212(b).

11§§ 1211(a) and 1212(a).

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recapture on the disposition of § 1250 property (without regard to § 291). In contrast, all depreciation taken on § 1245 property is subject to recapture under that provision.

2-2f Passive Losses The passive loss rules apply to individual taxpayers and to closely held C corpora- tions and personal service corporations (PSCs).12 For S corporations and partner- ships, passive income or loss flows through to the owners, and the passive loss rules are applied at the owner level. The passive loss rules are applied to closely held C corporations and to PSCs to prevent taxpayers from incorporating to avoid the pas- sive loss limitation.

A corporation is closely held if, at any time during the last half of the taxable year, more than 50 percent of the value of the corporation’s outstanding stock is owned, directly or indirectly, by or for not more than five individuals. A corporation is classified as a PSC if it meets the following requirements:

• The principal activity of the corporation is the performance of personal services.

• The services are substantially performed by shareholder-employees.

• More than 10 percent of the stock (in value) is held by shareholder-employees. Any stock held by an employee on any one day causes the employee to be a shareholder-employee.

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Red Corporation purchases nonresidential real property on May 1, 2000, for $800,000. Straight-line depreciation is taken in the amount of $316,239 before the property is sold on October 8, 2015, for $1.2 million.

First, determine the recognized gain:

Sales price $1,200,000

Less: Adjusted basis—

Cost of property $ 800,000

Less: Cost recovery (316,239) (483,761)

Recognized gain $ 716,239

Second, determine the § 1245 recapture potential. This is the lesser of $716,239 (recognized gain) or $316,239 (cost recovery claimed).

Third, determine the normal § 1250 recapture amount:

Cost recovery taken $ 316,239

Less: Straight-line cost recovery (316,239)

§ 1250 ordinary income $ –0–

Fourth, because the taxpayer is a corporation, determine the additional § 291 amount:

§ 1245 recapture potential $ 316,239

Less: § 1250 recapture amount (–0–)

Excess § 1245 recapture potential $ 316,239

Apply § 291 percentage � 20% Additional ordinary income under § 291 $ 63,248

Red Corporation’s recognized gain of $716,239 is accounted for as follows:

Ordinary income under § 1250 $ –0–

Ordinary income under § 291 63,248

§ 1231 gain 652,991

Total recognized gain $ 716,239

12§ 469(a). For definitions, see § 469(j)(1) (closely held) and § 469(j)(2) (PSC).

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Similar to individual taxpayers, PSCs generally cannot deduct passive losses against either active income or portfolio income. The application of the passive loss rules is not as harsh for closely held C corporations. They may offset passive losses against net active income, but not against portfolio income.

2-2g Charitable Contributions Both corporate and individual taxpayers may deduct charitable contributions if the re- cipient is a qualified charitable organization. Generally, a deduction will be allowed only for the year in which the payment is made. However, an accrual basis corporation may claim the deduction in the year preceding payment if two requirements are met. First, the contribution must be authorized by the board of directors by the end of that year. Second, it must be paid on or before the fifteenth day of the third month of the next year.

Property Contributions Generally, a charitable contribution of property results in a deduction equal to the prop- erty’s fair market value at the date of the gift. As a result of this rule, a contribution of loss property (fair market value less than basis) should be avoided as the loss inherent in the property (i.e., the excess of basis over fair market value) would never be recog- nized. A sale of the property to recognize the loss, followed by a charitable contribution of the sale proceeds, would produce a more favorable tax result.

Fair market value also is the valuation amount for most charitable contributions of capital gain property. Capital gain property is property that, if sold, would result in long-term capital gain or § 1231 gain for the taxpayer.

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Brown, a closely held C corporation that is not a PSC, has $300,000 of passive losses from a rental activity, $200,000 of net active income, and $100,000 of portfolio income. The corporation may offset $200,000 of the $300,000 passive loss against the $200,000 net active income, but may not offset the remainder against the $100,000 of portfolio income. If Brown is a PSC, then none of the $300,000 of passive losses is deductible in the current year.

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15

On December 29, 2015, Blue Company, a calendar year, accrual basis taxpayer, authorizes a $5,000 donation to the Atlanta Symphony Association (a qualified charitable organization). The donation is made on March 11, 2016. If Blue Company is a partnership, the contribution can be deducted only in 2016.13 However, if Blue Company is a corporation and the December 29, 2015 authoriza- tion was made by its board of directors, Blue may claim the $5,000 donation as a deduction for calendar year 2015.

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16

Heron Corporation owns inventory with a basis of $10,000 and a fair market value of $8,000. A chari- table contribution of the inventory results in a deductible amount of $8,000, the inventory’s fair market value. However, a sale of the inventory, for a recognized loss of $2,000 ($8,000 amount realized – $10,000 basis), and donation of the sale proceeds, for a charitable deduction of $8,000, results in a total deductible amount of $10,000.

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17

During the current year, Mallard Corporation donates a parcel of land (a capital asset) to Oakland Community College. Mallard acquired the land five years ago for $60,000, and the fair market value on the date of the contribution is $100,000. The corporation’s charitable contribution deduction (subject to a percentage limitation discussed later) is measured by the asset’s fair market value of $100,000, even though the $40,000 appreciation on the land has never been included in income.

13Each calendar year partner will report an allocable portion of the charitable contribution deduction as of December 31, 2016 (the end of the partner- ship’s tax year). See Chapter 10.

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In two situations, a charitable contribution of capital gain property is measured by the basis of the property, rather than fair market value. If the corporation contributes tangible personal property and the charitable organization puts the property to an unre- lated use, the deduction is limited to the basis of the property. Unrelated use is defined as use that is not related to the purpose or function that qualifies the organization for exempt status.

The deduction for charitable contributions of capital gain property to certain private nonoperating foundations is also limited to the basis of the property.

As a general rule, the deduction for a contribution of ordinary income property is lim- ited to the basis of the property. Ordinary income property is appreciated property that, if sold, would not result in long-term capital gain for the taxpayer. Examples of ordinary income property include inventory and capital assets that have not been held more than 12 months. In addition, § 1231 property (depreciable property used in a trade or busi- ness) is treated as ordinary income property to the extent of any depreciation recap- tured under § 1245 or § 1250 (as adjusted under § 291). On certain contributions of inventory by corporations, however, the amount of the deduction is equal to the lesser of (1) the sum of the property’s basis plus 50 percent of the appreciation on the prop- erty or (2) twice the property’s basis. The following contributions of inventory qualify for this increased contribution amount.

• A contribution of property to a charitable organization for use that is related to the organization’s exempt function and such use is solely for the care of the ill, needy, or infants.

• A contribution of tangible personal research property constructed by the corpora- tion to a qualified educational or scientific organization that uses the property for research or experimentation or for research training. (The property must be con- tributed within two years from the date of its construction by the donor, and its original use must begin with the donee.)14

Limitations Imposed on Charitable Contribution Deductions Like individuals, corporations are subject to percentage limits on the charitable contribu- tion deduction.15 For any tax year, a corporate taxpayer’s contribution deduction is

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19

Assume the same facts as in the previous example, except that White Corporation donates the paint- ing to the American Cancer Society, which sells the painting and deposits the $200,000 proceeds in the organization’s general fund. White’s deduction is limited to the $90,000 basis because it contrib- uted tangible personal property that was put to an unrelated use by the charitable organization.

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Contributions of Tangible Personal Property

White Corporation donates a painting worth $200,000 to Western States Art Museum (a qualified organization), which exhibits the painting. White had acquired the painting in 2000 for $90,000. Because the museum put the painting to a related use, White is allowed to deduct $200,000, the fair market value of the painting.

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Lark Corporation, a clothing retailer, donates children’s clothing to the Salvation Army to be used to attire homeless children. Lark’s basis in the clothes is $2,000, and the fair market value is $3,000. Lark’s deduction is $2,500 [$2,000 basis þ 50% ($3,000 � $2,000)]. If, instead, the fair market value is $7,000, Lark’s deduction is $4,000 (2 � $2,000 basis).

14These conditions are set forth in §§ 170(e)(3) and (4). 15The percentage limitations applicable to individuals and corporations are set forth in § 170(b).

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limited to 10 percent of taxable income. For this purpose, taxable income is computed without regard to the charitable contribution deduction, any net operating loss carry- back or capital loss carryback, dividends received deduction, and domestic production activities deduction. Any contributions in excess of the 10 percent limitation may be car- ried forward to the five succeeding tax years. Any carryforward must be added to subse- quent contributions and will be subject to the 10 percent limitation. In applying this limitation, the current year’s contributions must be deducted first, with carryover amounts from previous years deducted in order of time.16

2-2h Domestic Production Activities Deduction One important purpose of the American Jobs Creation Act of 2004 was to replace cer- tain tax provisions that our world trading partners regarded as allowing unfair advan- tage to U.S. exports. Among other changes, the Act created a deduction based on the income from manufacturing activities (designated as domestic production activities). The domestic production activities deduction (DPAD) is 9 percent of the lower of:

• Qualified production activities income, or

• Taxable income (computed without regard to the DPAD).17

For individuals, adjusted gross income is substituted for “taxable income.” The DPAD cannot exceed 50 percent of an employer’s W–2 wages related to qualified production activities income.

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Annual Limitation and Carryover Rules Illustrated

During 2015, Orange Corporation (a calendar year taxpayer) had the following income and expenses:

Income from operations $140,000

Expenses from operations 110,000

Dividends received 10,000

Charitable contributions made in May 2015 6,000

For purposes of the 10% limitation only, Orange Corporation’s taxable income is $40,000 ($140,000 � $110,000 þ $10,000). Consequently, the allowable charitable deduction for 2015 is $4,000 (10% � $40,000). The $2,000 unused portion of the contribution can be carried forward to 2016, 2017, 2018, 2019, and 2020 (in that order) until exhausted.

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22

Assume the same facts as in Example 21. In 2016, Orange Corporation has taxable income (for pur- poses of the 10% limitation) of $50,000 and makes a charitable contribution of $4,500. The maxi- mum deduction allowed for 2016 is $5,000 (10% � $50,000). The first $4,500 of the allowed deduction must be allocated to the contribution made in 2016, and the $500 balance is carried over from 2015. The remaining $1,500 of the 2015 contribution may be carried over to 2017, etc.

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23

Elk Corporation, a calendar year taxpayer, manufactures golf equipment. For the current year, Elk had taxable income of $360,000 (before considering the DPAD) and qualified production activities income of $380,000. Elk’s deduction is $32,400 [9% � $360,000 (the lesser of $380,000 or $360,000)]. Elk’s W–2 wages related to qualified production activities income were $70,000, so the W–2 wage limitation ($70,000 � 50% ¼ $35,000) does not apply.

16The carryover rules relating to all taxpayers are in § 170(d). 17§ 199.

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See Chapter 3 for a detailed discussion of the domestic production activities deduction.

2-2i Net Operating Losses Like the net operating loss (NOL) of an individual, the NOL of a corporation may be car- ried back 2 years and forward 20 to offset taxable income for those years. Similarly, cor- porations also may elect to forgo the carryback period and just carry forward an NOL. Unlike individual taxpayers, however, a corporation does not adjust its tax loss for the year for capital losses, because a corporation is not permitted a deduction for net capital losses. Nor does a corporation make adjustments for any nonbusiness deductions as individual taxpayers do. Further, a corporation is allowed to include the dividends received deduction (discussed below) in computing its NOL.18

2-2j Deductions Available Only to Corporations Certain deductions are specific to corporate taxpayers. Provisions applicable only to corporate taxpayers include the dividends received deduction and the organizational expenditures deduction.

Dividends Received Deduction The purpose of the dividends received deduction is to mitigate multiple taxation of cor- porate income. Without the deduction, income paid to a corporation in the form of a dividend would be taxed to the recipient corporation with no corresponding deduction to the distributing corporation. Later, when the recipient corporation paid the income to its shareholders, the income would again be subject to taxation with no corresponding deduction to the corporation. The dividends received deduction alleviates this inequity by causing only some or none of the dividend income to be taxable to the recipient corporation.

As the following table illustrates, the amount of the dividends received deduc- tion depends upon the percentage of ownership (voting power and value) the recipient corporate shareholder holds in a domestic corporation making the divi- dend distribution.19

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In 2015, Green Corporation has gross income (including dividends) of $200,000 and deductions of $300,000 excluding the dividends received deduction. Green Corporation had received $100,000 of dividends from Fox, Inc., in which Green holds a 5% stock interest. Green has an NOL computed as follows:

Gross income (including dividends) $200,000

Less:

Business deductions $300,000

Dividends received deduction (70% of $100,000) 70,000 (370,000)

Taxable income (or loss) ($170,000)

The NOL is carried back two years to 2013. (Green Corporation may forgo the carryback option and elect instead to carry forward the loss.) Assume that Green had taxable income of $40,000 in 2013. The carryover to 2014 is computed as follows:

Taxable income for 2013 $ 40,000

Less: NOL carryback (170,000)

Taxable income for 2013 after NOL carryback (carryover to 2014) ($130,000)

18The modifications required to arrive at the amount of NOL that can be car- ried back or forward are in § 172(d).

19§ 243(a). Dividends from foreign corporations generally do not qualify for a dividends received deduction. But see § 245.

LO.3

List and apply the tax rules unique to corporations.

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Percentage of Ownership by Corporate Shareholder Deduction Percentage

Less than 20% 70%

20% or more (but less than 80%) 80%

80% or more* 100%

* The payor corporation must be a member of an affiliated group with the recipient corporation.

The dividends received deduction cannot exceed the taxable income limitation. This limitation is equal to the corporation’s taxable income multiplied by the percentage that corresponds with the deduction percentage. Thus, if a corporate shareholder owns less than 20 percent of the stock in the distributing corporation, the dividends received deduction is limited to 70 percent of taxable income. For this purpose, taxable income is computed without regard to the NOL deduction, the domestic production activities deduction, the dividends received deduction, and any capital loss carryback. However, the taxable income limitation does not apply if the corporation has an NOL for the current taxable year.20

The following steps are useful in applying these rules.

1. Multiply the dividends received by the deduction percentage. 2. Multiply the taxable income by the deduction percentage. 3. The deduction is limited to the lesser of step 1 or step 2, unless deducting

the amount derived in step 1 results in an NOL. If so, the amount derived in step 1 is used. This is referred to as the NOL rule.

White Corporation is subject to the 70 percent of taxable income limitation (step 2). The NOL rule does not apply because subtracting $140,000 (step 1) from $180,000 (taxable income before the DRD) does not yield a negative figure. Blue Corporation does qualify for NOL rule treatment because subtracting $140,000 (step 1) from $120,000 (taxable

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Red, White, and Blue Corporations, three unrelated calendar year corporations, have the following information for the year:

Red Corporation

White Corporation

Blue Corporation

Gross income from operations $ 400,000 $ 320,000 $ 260,000

Expenses from operations (340,000) (340,000) (340,000)

Dividends received from domestic corporations (less than 20% ownership) 200,000 200,000 200,000

Taxable income before the dividends received deduction $ 260,000 $ 180,000 $ 120,000

In determining the dividends received deduction, use the three-step procedure described above:

Step 1 (70% � $200,000) $140,000 $140,000 $140,000 Step 2

70% � $260,000 (taxable income) $182,000 70% � $180,000 (taxable income) $126,000 70% � $120,000 (taxable income) $ 84,000

Step 3

Lesser of step 1 or step 2 $140,000 $126,000

Deduction results in an NOL (use Step 1) $140,000

20Further, the limitation does not apply in the case of the 100% deduction available to members of an affiliated group. § 246(b).

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income before the DRD) yields a negative figure. In summary, each corporation has a dividends received deduction for the year as follows: $140,000 for Red Corporation, $126,000 for White Corporation, and $140,000 for Blue Corporation.

No dividends received deduction is allowed unless the corporation has held the stock for more than 45 days.21 This restriction was enacted to close a tax loophole involving dividends on stock that is held only briefly. When stock is purchased shortly before a dividend record date and soon thereafter sold ex-dividend, a capital loss corre- sponding to the amount of the dividend often results (ignoring other market valuation changes). If the dividends received deduction was allowed in such cases, the capital loss resulting from the stock sale would exceed the taxable portion of the related dividend income.

Another loophole closing provision applies to the dividends received deduction when the underlying stock is debt financed. A corporation that finances the purchase of divi- dend-paying stock receives an interest expense deduction from such financing, but would report only a small amount of the related income if the dividends received deduction was allowed unabated. In general, the dividends received deduction is reduced with respect to any dividend-paying stock by the percentage of the investment in the stock that is acquired with “portfolio indebtedness.”22 For instance, if a stock purchase is financed 50 percent by debt, the dividends received deduction for dividends on such stock is reduced by 50 percent. However, the reduction in the dividends received deduction cannot exceed the amount of the interest deduction allocable to the dividend.

Organizational Expenditures Deduction Expenses incurred in connection with the organization of a corporation normally are chargeable to a capital account. That they benefit the corporation during its existence seems clear. But how can they be amortized when most corporations possess unlimited

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On October 1, 2015, Pink Corporation declares a $1 per share dividend for shareholders of record as of November 1, 2015, and payable on December 1, 2015. Black Corporation purchases 10,000 shares of Pink stock on October 29, 2015, for $25,000 and sells those 10,000 shares ex-dividend on November 5, 2015, for $15,000. (It is assumed that there is no fluctuation in the market price of the Pink stock other than the dividend element.) The sale results in a short-term capital loss of $10,000 ($15,000 amount realized � $25,000 basisÞ. On December 1, Black receives a $10,000 dividend from Pink. Without the holding period restriction, Black Corporation would recognize a $10,000 deduction (subject to the capital loss limitation) but only $3,000 of income [$10,000 divi- dend – $7,000 dividends received deduction ($10,000 � 70%)], or a $7,000 net loss. However, because Black did not hold the Pink stock for more than 45 days, no dividends received deduction is allowed.

E T H I C S & E Q U I T Y Pushing the Envelope on Year-End Planning

As of December 30, 2015, Lark Corporation (a calendar year taxpayer) has gross income from operations of $497,000, expenses from operations of $556,000, and divi- dends received from domestic corporations (less than 20 per- cent ownership) of $200,000. Currently, Lark does not expect

any more income or expenses to be realized by year-end. However, Lark’s tax department has suggested that the corpo- ration incur another $1,001 of deductible expenditures before year-end. What is the motivation behind the tax department’s recommendation, and is such year-end planning ethical?

21The stock must be held more than 45 days during the 91-day period begin- ning on the date that is 45 days before the ex-dividend date (or in the case of preferred stock, more than 90 days during the 181-day period beginning on the date that is 90 days before the ex-dividend date). § 246(c).

22Portfolio indebtedness is defined as “any indebtedness directly attributable to investment” in the stock. § 246A.

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life? The lack of a determinable and limited estimated useful life would therefore pre- clude any tax write-off. Section 248 was enacted to solve this problem.

Under § 248, a corporation may elect to amortize organizational expenditures over the 180-month period beginning with the month in which the corporation begins busi- ness.23 Organizational expenditures include the following:

• Legal services incident to organization (e.g., drafting the corporate charter, bylaws, minutes of organizational meetings, and terms of original stock certificates).

• Necessary accounting services.

• Expenses of temporary directors and of organizational meetings of directors or shareholders.

• Fees paid to the state of incorporation.

Expenditures that do not qualify as organizational expenditures include those connected with issuing or selling shares of stock or other securities (e.g., commis- sions, professional fees, and printing costs) or with transferring assets to a corpora- tion. These expenditures reduce the amount of capital raised and are not deductible at all.

The first $5,000 of organizational costs is immediately expensed, with any remaining amount of organizational costs amortized over a 180-month period. However, the $5,000 expensing amount is phased out on a dollar-for-dollar basis when these costs exceed $50,000. For example, a corporation with $52,000 of organizational costs would expense $3,000 [$5,000 � ($52,000 � $50,000)] of this amount and amortize the $49,000 balance ($52,000 � $3,000) over 180 months.

To qualify for the election, the expenditure must be incurred before the end of the taxable year in which the corporation begins business. In this regard, the corporation’s method of accounting is of no consequence. Thus, an expense incurred by a cash basis corporation in its first tax year qualifies even though the expense is not paid until a sub- sequent year.

A corporation is deemed to have made the election to amortize organizational expenditures for the taxable year in which it begins business. No separate statement or specific identification of the deducted amount as organizational expenditures is required. A corporation can elect to forgo the deemed election by clearly electing to capitalize organizational expenditures on a timely filed return for its first taxable year. In that case, the capitalized amount will be deductible by the corporation at such time as it ceases to do business and liquidates.

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Black Corporation, an accrual basis taxpayer, was formed and began operations on April 1, 2015. The following expenses were incurred during its first year of operations (April 1–December 31, 2015):

Expenses of temporary directors and of organizational meetings $15,500

Fee paid to the state of incorporation 2,000

Accounting services incident to organization 18,000

Legal services for drafting the corporate charter and bylaws 32,000

Expenses incident to the printing and sale of stock certificates 48,000

Black Corporation elects to amortize organizational costs under § 248. Because of the dollar cap (i.e., dollar-for-dollar reduction for amounts in excess of $50,000), none of the $5,000 expens- ing allowance is available. The monthly amortization is $375 [($15,500 þ $2,000 þ $18,000 þ $32,000) � 180 months], and $3,375 ($375 � 9 monthsÞ is deductible for tax year 2015. Note that the $48,000 of expenses incident to the printing and sale of stock certificates does not qualify for the election. These expenses cannot be deducted at all, but reduce the amount of the capital real- ized from the sale of stock.

23The month in which a corporation begins business may not be immedi- ately apparent. Ordinarily, a corporation begins business when it starts the

business operations for which it was organized. Reg. § 1.248–1(d). For a similar problem in the Subchapter S area, see Chapter 12.

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Organizational expenditures are distinguished from startup expenditures.24 Startup expenditures include various investigation expenses involved in entering a new busi- ness (e.g., travel, market surveys, financial audits, and legal fees) and operating expenses such as rent and payroll that are incurred by a corporation before it actually begins to produce any gross income. At the election of the taxpayer, such expenditures are deductible in the same manner as organizational expenditures. Thus, up to $5,000 can be immediately expensed (subject to the phaseout) and any remaining amounts amortized over a period of 180 months. The same rules that apply to the deemed election (and election to forgo the deemed election) for organizational expenditures also apply to startup expenditures.

Concept Summary 2.1 Income Taxation of Individuals and Corporations Compared

Individuals Corporations

Computation of gross income

§ 61. § 61.

Computation of taxable income

§§ 62, 63(b) through (h). § 63(a). Concept of AGI has no relevance.

Deductions Trade or business (§ 162); nonbusiness (§ 212); some personal and employee expenses (generally deductible as itemized deductions).

Trade or business (§ 162).

Charitable contributions Limited in any tax year to 50% of AGI; 30% for capital gain property unless election is made to reduce fair market value of gift.

Limited in any tax year to 10% of taxable income computed without regard to the charitable contribution deduction, NOL carryback, capital loss carryback, dividends received deduction, and domestic production activities deduction.

Excess charitable contributions carried over for five years.

Same as for individuals.

Amount of contribution is the fair market value of capital gain property; ordinary income property is limited to adjusted basis; capital gain property is treated as ordinary income property if certain tangible personalty is donated to a nonuse charity or a private nonoperating foundation is the donee.

Same as for individuals, but exceptions allowed for certain inventory and for research property where one-half of the appreciation is allowed as a deduction.

Time of deduction—year in which payment is made.

Time of deduction—year in which payment is made unless accrual basis taxpayer. Accrual basis corporation can take deduction in year preceding payment if contribution was authorized by board of directors by end of year and contribution is paid by fifteenth day of third month of following year.

Casualty losses $100 floor on personal casualty and theft losses; personal casualty losses deductible only to extent losses exceed 10% of AGI.

Deductible in full.

continued

24§ 195.

2-20 PART 2 Corporations

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2-3 DETERMINING THE CORPORATE INCOME TAX LIABILITY

2-3a Corporate Income Tax Rates Corporate income tax rates have fluctuated widely over the years, with the current rate structure reflecting a significant reduction that occurred in the Tax Reform Act of 1986. For example, the top statutory corporate income tax rate was reduced from 46 percent to 35 percent. Refer to Exhibit 2.1 for a schedule of current corporate income tax rates.

Individuals Corporations

Net operating loss Adjusted for several items, including nonbusiness deductions over nonbusiness income and personal exemptions.

Generally no adjustments.

Carryback period is 2 years, while carryforward period is 20 years.

Same as for individuals.

Dividends received deduction

None. 70%, 80%, or 100% of dividends received depending on percentage of ownership by corporate shareholder.

Net capital gains Taxed in full. Tax rate generally 15% or 20% on net capital gains.

Taxed in full.

Capital losses Only $3,000 of capital loss per year can offset ordinary income; unused loss is carried forward indefinitely to offset capital gains or ordinary income up to $3,000; short-term and long-term carryovers retain their character.

Can offset only capital gains; unused loss is carried back three years and forward five; carryovers and carrybacks are characterized as short-term losses.

Passive losses In general, passive losses cannot offset either active income or portfolio income.

Passive loss rules apply to closely held C corporations and personal service corporations.

For personal service corporations, passive losses cannot offset either active income or portfolio income.

For closely held C corporations, passive losses may offset active income but not portfolio income.

Domestic production activities deduction

Based on 9% of the lesser of qualified production activities income (QPAI) or modified AGI.

Based on 9% of the lesser of qualified production activities income (QPAI) or taxable income.

Tax rates Progressive with seven rates (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%).

Progressive with four rates (15%, 25%, 34%, and 35%). Two lowest brackets phased out between $100,000 and $335,000 of taxable income, and additional tax imposed between $15,000,000 and $18,333,333 of taxable income.

Alternative minimum tax Applied at a graduated rate schedule of 26% and 28%. Exemption allowed depending on filing status (e.g., $83,400 in 2015 for married filing jointly); phaseout begins when AMTI reaches a certain amount (e.g., $158,900 in 2015 for married filing jointly).

Applied at a 20% rate on AMTI less exemption; $40,000 exemption allowed but phaseout begins when AMTI reaches $150,000; adjustments and tax preference items are similar to those applicable to individuals but also include 75% adjusted current earnings. Small corporations (gross receipts of $5 million or less) are not subject to AMT.

Income Taxation of Individuals and Corporations Compared—(Continued)

LO.4

Compute the corporate income tax.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-21

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Unlike the individual income tax rate brackets, the corporate income tax rate brackets are not indexed for inflation.

For taxable income in excess of $100,000, the amount of the tax is increased by the lesser of (1) 5 percent of the excess or (2) $11,750. In effect, the additional tax means a 39 percent rate for every dollar of taxable income from $100,000 to $335,000.

Under § 11(b)(2), personal service corporations are taxed at a flat 35 percent rate on all taxable income. Thus, PSCs do not enjoy the tax savings of the 15 to 34 percent brackets applicable to other corporations.

2-3b Alternative Minimum Tax Corporations are subject to an alternative minimum tax (AMT) that is similar to the AMT applicable to individuals, both in objective and in application.25 The AMT for corporations, as for individuals, involves a broader tax base than does the regular tax. Like an individual, a corporation is required to apply a minimum tax rate to the expanded base and pay an AMT equal to the difference between the tentative AMT and the regular tax. Many of the adjustments and tax preference items necessary to arrive at alternative minimum taxable income (AMTI) are the same for individuals and corporations. The AMT rate and exemption amount for corporations are different from those applicable to individuals, however. Computation of the AMT for corporations is discussed in Chapter 3.

2-3c Tax Liability of Related Corporations Members of a controlled group of corporations ( related corporations ) are subject to spe- cial rules for computing the income tax, the accumulated earnings credit, and the AMT

E X A M P L E

The Big Picture

28

Return to the facts of The Big Picture on p. 2-1. Assume that Samantha incorporates her business as Skylark Bakery, Inc., a calendar year C corporation. The corporation pays Samantha a salary of $50,000 for the current year. For 2015, Skylark Bakery has taxable income of $51,500 [$100,000 oper- ating profit þ $5,000 dividends � $50,000 salary expense � $3,500 dividends received deduction ($5,000 � 70%)]. Its income tax liability is $7,875, determined as follows:

Tax on $50,000 at 15% $7,500

Tax on $1,500 at 25% 375

Tax liability $7,875

E X A M P L E

29

Silver Corporation, a calendar year taxpayer, has taxable income of $335,000 for the current year. Its income tax liability is $113,900, determined as follows:

Tax on $100,000 $ 22,250

Tax on $235,000 � 39% 91,650 Tax liability $113,900

Note that the tax liability of $113,900 is 34% of $335,000. Thus, due to the 39% rate (34% normal rate þ 5% additional tax on taxable income between $100,000 and $335,000), the benefit of the lower rates on the first $75,000 of taxable income completely phases out at $335,000. The tax rate drops back to 34% on taxable income between $335,000 and $10 million.

25Small corporations are not subject to the alternative minimum tax. See § 55.

LO.5

Explain the rules unique to computing the tax of related corporations.

2-22 PART 2 Corporations

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exemption.26 If these restrictions did not exist, the shareholders of a corporation could gain significant tax advantages by splitting a single corporation into multiple corpora- tions. The next two examples illustrate the potential income tax advantage of multiple corporations.

A comparison of Examples 30 and 31 reveals that the income tax savings that could be achieved by using multiple corporations result from having more of the total taxable income taxed at lower marginal rates. To close this loophole, the law limits a controlled group’s taxable income in the tax brackets below 35 percent to the amount the corpora- tions in the group would have if they were one corporation. Thus, in Example 31, under the controlled corporation rules, only $12,500 (one-fourth of the first $50,000 of taxable income) for each of the four related corporations would be taxed at the 15 percent rate. The 25 percent rate would apply to the next $6,250 (one-fourth of the next $25,000) of taxable income of each corporation. This equal allocation of the $50,000 and $25,000 amounts is required unless all members of the controlled group consent to an apportionment plan providing for an unequal allocation. Controlled groups include parent-subsidiary groups, brother-sister groups, combined groups, and certain insurance companies.

Similar limitations apply to controlled groups with respect to the $250,000 accumu- lated earnings credit and the $40,000 AMT exemption amount. Both the accumulated earnings tax and the AMT are discussed in Chapter 3. Controlled groups are discussed in detail in Chapter 8.

2-4 PROCEDURAL MATTERS This section covers various aspects of the corporate income tax return, including filing requirements, estimated tax payments, and special disclosure schedules on the return.

E X A M P L E

30

Tax Savings from Multiple Corporations

Gray Corporation annually yields taxable income of $300,000. The corporate tax on $300,000 is $100,250, computed as follows:

Tax on $100,000 $ 22,250

Tax on $200,000 � 39% 78,000 Tax liability $100,250

E X A M P L E

31

Assume that Gray Corporation in the previous example is divided equally into four corporations. Each corporation would have taxable income of $75,000, and the tax for each (absent the special provisions for related corporations) would be computed as follows:

Tax on $50,000 $ 7,500

Tax on $25,000 � 25% 6,250 Tax liability $13,750

The total liability for the four corporations would be $55,000 ($13,750 � 4). The savings would be $45,250 ($100,250 � $55,000).

26§ 1561(a).

LO.6

Describe and illustrate the reporting process for corporations.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-23

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2-4a Filing Requirements for Corporations A corporation must file a Federal income tax return whether or not it has taxable income. A corporation that was not in existence throughout an entire annual account- ing period is required to file a return for the portion of the year during which it was in existence. In addition, a corporation must file a return even though it has ceased to do business if it has valuable claims for which it will bring suit. A corporation is relieved of filing income tax returns only when it ceases to do business and retains no assets.27

The corporate return is filed on Form 1120. Corporations electing under Subchapter S (see Chapter 12) file on Form 1120S. Forms 1120 and 1120S are reproduced in Appendix B. Corporations with assets of $10 million or more generally are required to file returns electronically.28

The return must be filed on or before the fifteenth day of the third month follow- ing the close of a corporation’s tax year. As noted previously, a regular corporation, other than a PSC, can use either a calendar year or a fiscal year to report its taxable income. The tax year of the shareholders has no effect on the corporation’s tax year.

Corporations can receive an automatic extension of six months for filing the corpo- rate return by filing Form 7004 by the due date for the return. However, the IRS may ter- minate the extension by mailing a 10-day notice to the corporation. A Form 7004 must be accompanied by the corporation’s estimated tax liability.29

2-4b Estimated Tax Payments A corporation must make payments of estimated tax unless its tax liability can reasonably be expected to be less than $500. The required annual payment (which includes any esti- mated AMT liability) is the lesser of (1) 100 percent of the corporation’s tax for the current year or (2) 100 percent of the tax for the preceding year (if that was a 12-month tax year and the return filed showed a tax liability). Estimated payments can be made in four installments due on or before the fifteenth day of the fourth month, the sixth month, the ninth month, and the twelfth month of the corporate taxable year.30 The full amount of the unpaid tax is due on the due date of the return. For a calendar year corporation, the payment dates are as follows:

April 15 June 15 September 15 December 15

A corporation failing to pay its required estimated tax payments will be subjected to a nondeductible penalty on the amount by which the installments are less than the tax due. However, the underpayment penalty will not be imposed if the estimated pay- ments are timely and are equal to the tax liability of the corporation for the prior year or equal to the tax due computed on an annualized basis. If the annualized method is used for one installment and the corporation does not use this method for a subsequent installment, any shortfall from using the annualized method for a prior payment(s) must be made up in the subsequent installment payment. The penalty is imposed on each installment; that is, a corporation must pay one-fourth of its required annual payment by the due date of each installment.

27§ 6012(a)(2) and Reg. § 1.6012–2(a). 28Reg. §§ 1.6012–2(a)(3) (Form 1120), 1.6012–2(h) (Form 1120S), and

301.6011–5 (electronic filing).

29Reg. § 1.6081–3. 30§ 6655. If the due date falls on a Saturday, Sunday, or legal holiday, the

due date is the next business day.

2-24 PART 2 Corporations

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A large corporation cannot base its installment payments on its previous year’s tax liability except for its first installment payment. A corporation is considered large if it had taxable income of $1 million or more in any of its three preceding years.

2-4c Schedule M–1—Reconciliation of Income (Loss) per Books with Income per Return Schedule M–1 of Form 1120 is used to reconcile net income as computed for financial accounting purposes with taxable income reported on the corporation’s income tax return (commonly referred to as book-tax differences). Schedule M–1 is required of cor- porations with less than $10 million of total assets.

The starting point on Schedule M–1 is net income (loss) per books. Additions and sub- tractions are entered for items that affect financial accounting net income and taxable income differently. The following items are entered as additions (see lines 2 through 5 of Schedule M–1):

• Federal income tax per books (deducted in computing net income per books but not deductible in computing taxable income).

• The excess of capital losses over capital gains (deducted for financial accounting purposes but not deductible by corporations for income tax purposes).

• Income that is reported in the current year for tax purposes but is not reported in computing net income per books (e.g., prepaid income).

• Various expenses that are deducted in computing net income per books but are not allowed in computing taxable income (e.g., charitable contributions in excess of the 10 percent ceiling applicable to corporations).

The following subtractions are entered on lines 7 and 8 of Schedule M–1:

• Income reported for financial accounting purposes but not included in taxable income (e.g., tax-exempt interest).

• Deductions taken on the tax return but not expensed in computing net income per books (e.g., domestic production activities deduction).

The result is taxable income (before the NOL deduction and the dividends received deduction).

E X A M P L E

32

Condor Corporation, a calendar year C corporation, has taxable income of $1.5 million and $2 million for 2014 and 2015, respectively. The required 2015 estimated tax installment payments for Condor, a “large corporation,” are computed as follows:

Payment Amount

April 15, 2015 $127,500*

June 15, 2015 212,500**

September 15, 2015 170,000

December 15, 2015 170,000

Total $680,000

* Based on preceding year’s tax, for first installment only: [$1.5 million taxable income � 34% (see Exhibit 2.1)] ¼ $510,000 � 4 ¼ $127,500.

** Based on current year’s tax, for remaining installments: [$2 million taxable income � 34% (see Exhibit 2.1)] ¼ $680,000 � 4 ¼ $170,000. Second installment must include shortfall from first installment: [$170,000 þ ($170,000 � $127,500)] ¼ $212,500.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-25

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2-4d Schedule M–2—Analysis of Unappropriated Retained Earnings per Books Schedule M–2 reconciles unappropriated retained earnings at the beginning of the year with unappropriated retained earnings at year-end. Beginning balance plus net income per books, as entered on line 1 of Schedule M–1, less dividend distributions during the year equals ending retained earnings. Other sources of increases or decreases in retained earnings are also listed on Schedule M–2.

Corporations with less than $250,000 of gross receipts and less than $250,000 in assets do not have to complete Schedule L (balance sheet) and Schedules M–1 and M–2 of Form 1120. Similar rules apply to Form 1120S. These rules are intended to ease the compliance burden on small business.

E X A M P L E

33

During the current year, Tern Corporation had the following transactions:

Net income per books (after tax) $92,400

Taxable income 50,000

Federal income tax per books (15% � $50,000) 7,500 Interest income from tax-exempt bonds 5,000

Interest paid on loan, the proceeds of which were used to purchase the tax-exempt bonds 500

Life insurance proceeds received as a result of the death of a key employee 50,000

Premiums paid on key employee life insurance policy 2,600

Excess of capital losses over capital gains 2,000

For book and tax purposes, Tern Corporation determines depreciation under the straight-line method. Tern’s Schedule M–1 for the current year is as follows:

Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return Note: The corporation may be required to file Schedule M-3 (see instructions).

1 Net income (loss) per books . . . . . .

2 Federal income tax per books . . . . .

3 Excess of capital losses over capital gains .

4 Income subject to tax not recorded on books this year (itemize):

5 Expenses recorded on books this year not deducted on this return (itemize):

a Depreciation . . . . $

b Charitable contributions . $

c Travel and entertainment . $

6 Add lines 1 through 5 . . . . . . . .

7 Income recorded on books this year not included on this return (itemize):

Tax-exempt interest $

8 Deductions on this return not charged against book income this year (itemize):

a Depreciation . . $

b Charitable contributions $

9 Add lines 7 and 8 . . . . . . 10 Income (page 1, line 28)—line 6 less line 9

92,400 7,500 2,000

3,100 105,000

55,000

55,000 50,000

5,000

Prem.–life ins. $2,600; Int.– state bonds $500

Life insurance proceeds $50,000

E X A M P L E

34

Assume the same facts as in Example 33. Tern Corporation’s beginning balance in unappropriated retained earnings is $125,000. During the year, Tern distributed a cash dividend of $30,000 to its shareholders. Based on these further assumptions, Tern’s Schedule M–2 for the current year is as follows:

Schedule M-2 Analysis of Unappropriated Retained Earnings per Books (Line 25, Schedule L) 1 Balance at beginning of year . . . . .

2 Net income (loss) per books . . . . . .

3 Other increases (itemize):

4 Add lines 1, 2, and 3 . . . . . . . .

5 Distributions: a Cash . . . .

b Stock . . . .

c Property . . .

6 Other decreases (itemize):

7 Add lines 5 and 6 . . . . . . 8 Balance at end of year (line 4 less line 7)

Form 1120

125,000 92,400

217,400

30,000

30,000 187,400

2-26 PART 2 Corporations

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2-4e Schedule M–3—Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More Corporate taxpayers with total assets of $10 million or more are required to report much greater detail relative to differences between income (loss) reported for financial pur- poses and income (loss) reported for tax purposes. This expanded reconciliation of book and taxable income (loss) is reported on Schedule M–3 . Corporations that are not required to file Schedule M–3 may do so voluntarily. Any corporation that files Schedule M–3 is not allowed to file Schedule M–1. Corporations (and partnerships) with $10 million to $50 million of total assets may elect to file Schedule M–1 in lieu of Schedule M–3, Parts II and III. Electing entities must still file Schedule M–3, Part I (lines 1–12). Entities with less than $10 million of assets that voluntarily file Schedule M–3 also may elect the reduced Schedule M–3 filing requirements. Schedule M–3 is repro- duced in Appendix B of this text.

Schedule M–3 is a response, at least in part, to financial reporting scandals such as Enron and WorldCom. One objective of Schedule M–3 is to create greater trans- parency between corporate financial statements and tax returns. Another objective is to identify corporations that engage in aggressive tax practices by requiring that transactions that create book/tax differences be disclosed on corporate tax returns. The increase in transparency and disclosure comes at a cost, however, as the IRS esti- mates that, on average, almost 89 hours are needed to comply with the requirements of Schedule M–3.

Total assets for purposes of the $10 million test and the income and expense amounts required by Schedule M–3 are determined from the taxpayer’s financial reports. If the taxpayer files Form 10–K with the Securities and Exchange Commission (SEC), that statement is used. If no 10–K is filed, information from another financial source is used, in the following order: certified financial statements, prepared income statements, or the taxpayer’s books and records.

Part I—Financial Information and Net Income (Loss) Reconciliation Part I requires the following financial information about the corporation:

• The source of the financial net income (loss) amount used in the reconciliation— SEC Form 10–K, audited financial statements, prepared financial statements, or the corporation’s books and records.

• Any restatements of the corporation’s income statement for the filing period, as well as any restatements for the past five filing periods.

• Any required adjustments to the net income (loss) amount referred to above (see Part I, lines 5 through 10).

The adjusted net income (loss) amount must be reconciled with the amount of taxable income reported on the corporation’s Form 1120.

Because of Schedule M–3’s complexity, the coverage in this chapter will be limited to some of the more important concepts underlying the schedule. A series of examples adapted from the instructions for Schedule M–3 will be used to illustrate these concepts.

E X A M P L E

35

Southwest Sportsman’s Corporation (SSC) sells hunting and fishing equipment to sportsmen. SSC has several stores in Texas, New Mexico, and Arizona. It also has a subsidiary in Mexico, which is organized as a Mexican corporation. SSC, which does not file a Form 10–K with the SEC, reports income from its Mexican subsidiary on its audited financial statements, which show net income of $45 million in 2015. The Mexican corporation, which is not consolidated by SSC for tax purposes and is therefore not an includible corporation, had net income of $7 million. SSC must enter $7 million on Part I, line 5a of Schedule M–3, resulting in net income per income statement of includible corporations of $38 million.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-27

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A situation similar to that described in Example 35 could result in additional entries in Part I of Schedule M–3. For example, if SSC engaged in transactions with its nonincludible Mexican subsidiary, an entry would be required on line 8 (adjustment to eliminations of transactions between includible corporations and nonincludible entities).

Part II—Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations with Taxable Income per Return Part II reconciles income and loss items of includible corporations, while Part III reconciles expenses and deductions. As indicated in Example 35, corporations included in a financial reporting group may differ from corporations in a tax reporting group. Corporations may also be partners in a partnership, which is a flow-through entity. The following example illustrates the adjustments that are required in this situation.

Part III—Reconciliation of Expense/Deduction Items Part III lists 36 reconciling items relating to expenses and deductions. For these items, taxpayers must reconcile differences between income statement amounts (column a) and tax return amounts (column d), then classify these differences as temporary (col- umn b) or permanent (column c) differences. The totals of the reconciling items from Part III are transferred to Part II, line 27, and are included with other items required to reconcile financial statement net income (loss) to tax return net income (loss).

E X A M P L E

36

Southwest Sportsman’s Corporation also owns an interest in a U.S. partnership, Southwest Hunting Lodges (SHL). On its audited financial statements, SSC reported net income of $10 million as its distributive share from SHL. SSC’s Schedule K–1 from SHL reports the following amounts:

Ordinary income $5,000,000

Long-term capital gain 7,000,000

Charitable contributions 4,000,000

Section 179 expense 100,000

To adjust for the flow-through items from the partnership, SSC must report these items on Schedule M–3, Part II, line 9 [Income (loss) from U.S. partnerships]. The corporation reports $10 million (book income) on line 9, column (a). SSC reports income per tax return of $7.9 million ($5,000,000 þ $7,000,000 � $4,000,000 � $100,000) in column (d) of line 9 and a permanent dif- ference of $2.1 million in column (c).

E X A M P L E

37

Book-Tax Differences Reconciled

Southwest Sportsman’s Corporation acquired intellectual property in 2015 and deducted amortiza- tion of $20,000 on its financial statements, which were prepared according to GAAP. For Federal income tax purposes, SSC deducted $30,000. The corporation must report the amortization on line 28, Part III as follows: $20,000 book amortization in column (a), $10,000 temporary difference in column (b), and $30,000 tax return amortization in column (d).

E X A M P L E

38

In January 2015, Southwest Sportsman’s Corporation established an allowance for uncollectible accounts (bad debt reserve) of $35,000 on its books and increased the allowance by $65,000 dur- ing the year. As a result of a client’s bankruptcy, SSC decreased the allowance by $25,000 in November 2015. The corporation deducted the $100,000 of increases to the allowance on its 2015 income statement but was not allowed to deduct that amount on its tax return. On its 2015 tax return, the corporation was allowed to deduct the $25,000 actual loss sustained because of its client’s bankruptcy. These amounts must be reported on line 32, Part III as follows: $100,000 book bad debt expense in column (a), $75,000 temporary difference in column (b), and $25,000 tax return bad debt expense in column (d).

2-28 PART 2 Corporations

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Example 37 illustrates the Schedule M–3 reporting when book expenses are less than tax return deductions. Example 38 illustrates reporting procedures when book expenses are greater than tax return deductions. Both examples illustrate the report- ing of temporary differences. The amounts from both examples are included in the totals derived in Part III and are carried to Part II, line 27. The reconciliation of book income and taxable income occurs in lines 26 through 30. The reconciled amount on Part II, line 30, column (a) must be equal to the net income per income statement of includible corporations on Part I, line 11. The reconciled amount on Part II, line 30, column (d) must be equal to the taxable income reported on Form 1120.

2-4f Effect of Taxes on the Financial Statements Because differences exist between taxable income and net income per books, what effect do these differences have on an entity’s financial statements? How are income tax accruals arrived at and reported for accounting purposes? What other types of dis- closures regarding present and potential tax liabilities are required to satisfy account- ing standards? These and other questions are answered and discussed at length in Chapter 14.

For 2014 tax returns, a corporation with total assets of $10 million or more must file Schedule UTP (Uncertain Tax Position Statement) with its Form 1120. In general, a corporation is required to report tax positions taken on a current or prior year’s Fed- eral income tax return and for which the corporation recorded a reserve for Federal income tax in its audited financial statements (or for which no reserve was recorded because of an expectation to litigate). Financial reporting of tax positions is discussed in Chapter 14.

2-4g Form 1120 Illustrated To provide an example on the use of the corporate income tax return, a Form 1120, which follows, has been completed for Swift Corporation. Due to the $10 million test, Swift Corporation does not require the use of Schedule M–3.

Swift Corporation was formed on January 10, 1985, by James Brown and Martha Swift to sell men’s clothing. Pertinent information regarding Swift is summarized as follows:

• The business address is 6210 Norman Street, Buffalo, TX 75831.

• The employer identification number is 11-1111111; the principal business activity code is 448110.

• James Brown and Martha Swift each own one-half of the outstanding common stock; no other class of stock is authorized. James Brown is president of the company, and Martha Swift is secretary-treasurer. Both are full-time employees of the corporation, and each receives a salary of $70,000. James’s Social Security number is 123-45-6789; Martha’s Social Security number is 987-65-4321.

• The corporation uses the accrual method of accounting and reports on a calendar basis. The specific chargeoff method is used in handling bad debt losses, and inventories are determined using the lower of cost or market method. For book and tax purposes, the straight-line method of depreciation is used.

• During 2014, the corporation distributed a cash dividend of $35,000. Selected portions of Swift’s profit and loss statement reflect the following debits and credits:

CHAPTER 2 Corporations: Introduction and Operating Rules 2-29

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Account Debit Credit

Gross sales $1,045,000

Sales returns and allowances $ 50,000

Purchases 506,000

Dividends received from stock investments in less-than-20%-owned U.S. corporations 60,000

Interest income

State bonds $ 4,000

Certificates of deposit 6,000 10,000

Premiums on term life insurance policies on the lives of James Brown and Martha Swift; Swift Corporation is the designated beneficiary 8,000

Salaries—officers 140,000

Salaries—clerical and sales 100,000

Taxes (state, local, and payroll) 35,000

Repairs 20,000

Interest expense

Loan to purchase state bonds $ 2,000

Other business loans 10,000 12,000

Advertising 8,000

Rental expense 24,000

Depreciation 16,000

Other deductions 21,000

A comparative balance sheet for Swift Corporation reveals the following information:

Assets January 1, 2014 December 31, 2014

Cash $ 240,000 $ 163,850

Trade notes and accounts receivable 104,200 142,300

Inventories 200,000 256,000

Certificates of deposit 150,000 150,000

State bonds 100,000 100,000

Prepaid Federal tax — 1,700

Stock investment 300,000 400,000

Buildings and other depreciable assets 120,000 120,000

Accumulated depreciation (44,400) (60,400)

Land 10,000 10,000

Other assets 1,800 1,000

Total assets $1,181,600 $1,284,450

Liabilities and Equity January 1, 2014 December 31, 2014

Accounts payable $ 150,000 $ 125,000

Other current liabilities 40,150 36,300

Mortgages 105,000 100,000

Capital stock 250,000 250,000

Retained earnings 636,450 773,150

Total liabilities and equity $1,181,600 $1,284,450

Net income per books (before any income tax accrual) is $231,000. During 2014, Swift Corporation made estimated tax payments to the IRS of $61,000. Swift Corporation’s Form 1120 for 2014 is reproduced on the following pages.

2-30 PART 2 Corporations

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Form1120 Department of the Treasury Internal Revenue Service

U.S. Corporation Income Tax Return For calendar year 2014 or tax year beginning , 2014, ending , 20

Information about Form 1120 and its separate instructions is at www.irs.gov/form1120.

OMB No. 1545-0123

2014

TYPE OR PRINT

Name

Number, street, and room or suite no. If a P.O. box, see instructions.

City or town, state, or province, country and ZIP or foreign postal code

A Check if: 1a Consolidated return

(attach Form 851) .

b Life/nonlife consoli- dated return . . .

2 Personal holding co. (attach Sch. PH) . .

3 Personal service corp. (see instructions) . .

4 Schedule M-3 attached

B Employer identification number

C Date incorporated

D Total assets (see instructions)

$

E Check if: (1) Initial return (2) Final return (3) Name change (4) Address change

In c

o m

e

1a Gross receipts or sales . . . . . . . . . . . . . . . . . 1a

b Returns and allowances . . . . . . . . . . . . . . . . . 1b

c Balance. Subtract line 1b from line 1a . . . . . . . . . . . . . . . . . . . . . 1c

2 Cost of goods sold (attach Form 1125-A) . . . . . . . . . . . . . . . . . . . . 2

3 Gross profit. Subtract line 2 from line 1c . . . . . . . . . . . . . . . . . . . . 3

4 Dividends (Schedule C, line 19) . . . . . . . . . . . . . . . . . . . . . . 4

5 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

6 Gross rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

7 Gross royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

8 Capital gain net income (attach Schedule D (Form 1120)) . . . . . . . . . . . . . . . 8

9 Net gain or (loss) from Form 4797, Part II, line 17 (attach Form 4797) . . . . . . . . . . . 9

10 Other income (see instructions—attach statement) . . . . . . . . . . . . . . . . . 10

11 Total income. Add lines 3 through 10 . . . . . . . . . . . . . . . . . . . . . 11

D e

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n s .) 12 Compensation of officers (see instructions—attach Form 1125-E) . . . . . . . . . . . . 12

13 Salaries and wages (less employment credits) . . . . . . . . . . . . . . . . . . 13

14 Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . 14

15 Bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

16 Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

17 Taxes and licenses . . . . . . . . . . . . . . . . . . . . . . . . . . 17

18 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

19 Charitable contributions . . . . . . . . . . . . . . . . . . . . . . . . . 19

20 Depreciation from Form 4562 not claimed on Form 1125-A or elsewhere on return (attach Form 4562) . . 20

21 Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

22 Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

23 Pension, profit-sharing, etc., plans . . . . . . . . . . . . . . . . . . . . . 23

24 Employee benefit programs . . . . . . . . . . . . . . . . . . . . . . . 24

25 Domestic production activities deduction (attach Form 8903) . . . . . . . . . . . . . . 25

26 Other deductions (attach statement) . . . . . . . . . . . . . . . . . . . . . 26

27 Total deductions. Add lines 12 through 26 . . . . . . . . . . . . . . . . . . . 27

28 Taxable income before net operating loss deduction and special deductions. Subtract line 27 from line 11. 28

29a Net operating loss deduction (see instructions) . . . . . . . . . . 29a

b Special deductions (Schedule C, line 20) . . . . . . . . . . . . 29b

c Add lines 29a and 29b . . . . . . . . . . . . . . . . . . . . . . . . . 29c

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30 Taxable income. Subtract line 29c from line 28 (see instructions) . . . . . . . . . . . . 30

31 Total tax (Schedule J, Part I, line 11) . . . . . . . . . . . . . . . . . . . . . 31

32 Total payments and refundable credits (Schedule J, Part II, line 21) . . . . . . . . . . . . 32

33 Estimated tax penalty (see instructions). Check if Form 2220 is attached . . . . . . . . 33

34 Amount owed. If line 32 is smaller than the total of lines 31 and 33, enter amount owed . . . . . 34 35 Overpayment. If line 32 is larger than the total of lines 31 and 33, enter amount overpaid . . . . . 35 36 Enter amount from line 35 you want: Credited to 2015 estimated tax Refunded 36

Sign Here

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct,

and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Signature of officer Date Title

May the IRS discuss this return

with the preparer shown below

(see instructions)? Yes No

Paid Preparer Use Only

Print/Type preparer’s name Preparer's signature Date Check if self-employed

PTIN

Firm’s name Firm's EIN

Firm's address Phone no.

For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11450Q Form 1120 (2014)

Swift Corporation

Buffalo, TX 75831

6210 Norman Street

11–1111111

1-10-85

1,284,450 00

00 00

00 00 00

00 00 00

00

00

450,000

00995,000

545,000

60,000 6,000

611,000 140,000 100,000 20,000

24,000 35,000 10,000

0050,000

61,000 00

1,045,000 00

00

00 00

00

00

16,000

8,000

21,000 374,000

00

00

237,000

42,000

00195,000 00

00 00

59,300

1,700 1,700

000,24 00

CHAPTER 2 Corporations: Introduction and Operating Rules 2-31

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Form 1120 (2014) Page 2 Schedule C Dividends and Special Deductions (see instructions) (a) Dividends

received (b) %

(c) Special deductions (a) × (b)

1 Dividends from less-than-20%-owned domestic corporations (other than debt-financed stock) . . . . . . . . . . . . . . . . . . . . . . . .

2 Dividends from 20%-or-more-owned domestic corporations (other than debt-financed stock) . . . . . . . . . . . . . . . . . . . . . . . .

3 Dividends on debt-financed stock of domestic and foreign corporations . . . . .

4 Dividends on certain preferred stock of less-than-20%-owned public utilities . . .

5 Dividends on certain preferred stock of 20%-or-more-owned public utilities . . . .

6 Dividends from less-than-20%-owned foreign corporations and certain FSCs . . .

7 Dividends from 20%-or-more-owned foreign corporations and certain FSCs . . .

8 Dividends from wholly owned foreign subsidiaries . . . . . . . . . . .

9 Total. Add lines 1 through 8. See instructions for limitation . . . . . . . .

10 Dividends from domestic corporations received by a small business investment company operating under the Small Business Investment Act of 1958 . . . . .

11 Dividends from affiliated group members . . . . . . . . . . . . . .

12 Dividends from certain FSCs . . . . . . . . . . . . . . . . .

13 Dividends from foreign corporations not included on lines 3, 6, 7, 8, 11, or 12 . . .

14 Income from controlled foreign corporations under subpart F (attach Form(s) 5471) .

15 Foreign dividend gross-up . . . . . . . . . . . . . . . . . .

16 IC-DISC and former DISC dividends not included on lines 1, 2, or 3 . . . . . .

17 Other dividends . . . . . . . . . . . . . . . . . . . . .

18 Deduction for dividends paid on certain preferred stock of public utilities . . . .

19 Total dividends. Add lines 1 through 17. Enter here and on page 1, line 4 . . .

20 Total special deductions. Add lines 9, 10, 11, 12, and 18. Enter here and on page 1, line 29b . . . . . . . Form 1120 (2014)

70

80 see

instructions

42

48

70

80

100

100

100

100

42,000

42,000

42,000

60,000

60,000

2-32 PART 2 Corporations

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Form 1120 (2014) Page 3 Schedule J Tax Computation and Payment (see instructions)

Part I–Tax Computation 1 Check if the corporation is a member of a controlled group (attach Schedule O (Form 1120)) . . . .

2 Income tax. Check if a qualified personal service corporation (see instructions) . . . . . . . . 2

3 Alternative minimum tax (attach Form 4626) . . . . . . . . . . . . . . . . . . . . 3

4 Add lines 2 and 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

5 a Foreign tax credit (attach Form 1118) . . . . . . . . . . . . . . 5a

b Credit from Form 8834 (see instructions) . . . . . . . . . . . . . 5b

c General business credit (attach Form 3800) . . . . . . . . . . . . 5c

d Credit for prior year minimum tax (attach Form 8827) . . . . . . . . . 5d

e Bond credits from Form 8912 . . . . . . . . . . . . . . . . 5e

6 Total credits. Add lines 5a through 5e . . . . . . . . . . . . . . . . . . . . . 6

7 Subtract line 6 from line 4 . . . . . . . . . . . . . . . . . . . . . . . . . 7

8 Personal holding company tax (attach Schedule PH (Form 1120)) . . . . . . . . . . . . . . 8

9 a Recapture of investment credit (attach Form 4255) . . . . . . . . . . 9a

b Recapture of low-income housing credit (attach Form 8611) . . . . . . . 9b

c Interest due under the look-back method—completed long-term contracts (attach Form 8697) . . . . . . . . . . . . . . . . . . . . . . 9c

d Interest due under the look-back method—income forecast method (attach Form 8866) . . . . . . . . . . . . . . . . . . . . . . . 9d

e Alternative tax on qualifying shipping activities (attach Form 8902) . . . . . 9e

f Other (see instructions—attach statement) . . . . . . . . . . . . 9f

10 Total. Add lines 9a through 9f . . . . . . . . . . . . . . . . . . . . . . . . 10

11 Total tax. Add lines 7, 8, and 10. Enter here and on page 1, line 31 . . . . . . . . . . . . . 11 Part II–Payments and Refundable Credits

12 2013 overpayment credited to 2014 . . . . . . . . . . . . . . . . . . . . . . 12

13 2014 estimated tax payments . . . . . . . . . . . . . . . . . . . . . . . . 13

14 2014 refund applied for on Form 4466 . . . . . . . . . . . . . . . . . . . . . . 14 ( )

15 Combine lines 12, 13, and 14 . . . . . . . . . . . . . . . . . . . . . . . . 15

16 Tax deposited with Form 7004 . . . . . . . . . . . . . . . . . . . . . . . . 16

17 Withholding (see instructions) . . . . . . . . . . . . . . . . . . . . . . . . 17

18 Total payments. Add lines 15, 16, and 17 . . . . . . . . . . . . . . . . . . . . . 18

19 Refundable credits from:

a Form 2439 . . . . . . . . . . . . . . . . . . . . . . 19a

b Form 4136 . . . . . . . . . . . . . . . . . . . . . . 19b

c Form 8827, line 8c . . . . . . . . . . . . . . . . . . . 19c

d Other (attach statement—see instructions). . . . . . . . . . . . . 19d

20 Total credits. Add lines 19a through 19d . . . . . . . . . . . . . . . . . . . . . 20

21 Total payments and credits. Add lines 18 and 20. Enter here and on page 1, line 32 . . . . . . . . 21 Schedule K Other Information (see instructions)

1 Check accounting method: a Cash b Accrual c Other (specify) Yes No 2 See the instructions and enter the:

a Business activity code no.

b Business activity

c Product or service

3 Is the corporation a subsidiary in an affiliated group or a parent-subsidiary controlled group? . . . . . . . . . . If “Yes,” enter name and EIN of the parent corporation

4 At the end of the tax year:

a Did any foreign or domestic corporation, partnership (including any entity treated as a partnership), trust, or tax-exempt organization own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of the

corporation’s stock entitled to vote? If "Yes," complete Part I of Schedule G (Form 1120) (attach Schedule G) . . . . . .

b Did any individual or estate own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of the corporation’s stock entitled to vote? If "Yes," complete Part II of Schedule G (Form 1120) (attach Schedule G) .

Form 1120 (2014)

59,300 00

61,000 00

61,000 00

61,000 00

61,000 00

59,300 00

59,300 00

59,300 00

Retail sales 448110

X

Men’s clothing X

X

X

CHAPTER 2 Corporations: Introduction and Operating Rules 2-33

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Form 1120 (2014) Page 4 Schedule K Other Information continued (see instructions)

Yes No

5 At the end of the tax year, did the corporation:

a Own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote of any foreign or domestic corporation not included on Form 851, Affiliations Schedule? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (iv) below.

(i) Name of Corporation (ii) Employer

Identification Number (if any)

(iii) Country of Incorporation

(iv) Percentage Owned in Voting

Stock

b Own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust? For rules of constructive ownership, see instructions.

If “Yes,” complete (i) through (iv) below.

(i) Name of Entity (ii) Employer

Identification Number (if any)

(iii) Country of Organization

(iv) Maximum Percentage Owned in Profit, Loss, or Capital

6 During this tax year, did the corporation pay dividends (other than stock dividends and distributions in exchange for stock) in excess of the corporation’s current and accumulated earnings and profits? (See sections 301 and 316.) . . . . . . .

If "Yes," file Form 5452, Corporate Report of Nondividend Distributions.

If this is a consolidated return, answer here for the parent corporation and on Form 851 for each subsidiary.

7 At any time during the tax year, did one foreign person own, directly or indirectly, at least 25% of (a) the total voting power of all classes of the corporation’s stock entitled to vote or (b) the total value of all classes of the corporation’s stock? . . . .

For rules of attribution, see section 318. If “Yes,” enter:

(i) Percentage owned and (ii) Owner’s country

(c) The corporation may have to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Enter the number of Forms 5472 attached

8 Check this box if the corporation issued publicly offered debt instruments with original issue discount . . . . . .

If checked, the corporation may have to file Form 8281, Information Return for Publicly Offered Original Issue Discount Instruments. 9 Enter the amount of tax-exempt interest received or accrued during the tax year $

10 Enter the number of shareholders at the end of the tax year (if 100 or fewer)

11 If the corporation has an NOL for the tax year and is electing to forego the carryback period, check here . . . . .

If the corporation is filing a consolidated return, the statement required by Regulations section 1.1502-21(b)(3) must be attached

or the election will not be valid.

12 Enter the available NOL carryover from prior tax years (do not reduce it by any deduction on line 29a.) $

13 Are the corporation’s total receipts (page 1, line 1a, plus lines 4 through 10) for the tax year and its total assets at the end of the tax year less than $250,000? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

If “Yes,” the corporation is not required to complete Schedules L, M-1, and M-2. Instead, enter the total amount of cash distributions

and the book value of property distributions (other than cash) made during the tax year $

14 Is the corporation required to file Schedule UTP (Form 1120), Uncertain Tax Position Statement (see instructions)? . . . .

If “Yes,” complete and attach Schedule UTP.

15a Did the corporation make any payments in 2014 that would require it to file Form(s) 1099? . . . . . . . . . . .

b If “Yes,” did or will the corporation file required Forms 1099? . . . . . . . . . . . . . . . . . . . .

16 During this tax year, did the corporation have an 80% or more change in ownership, including a change due to redemption of its own stock? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17 During or subsequent to this tax year, but before the filing of this return, did the corporation dispose of more than 65% (by value) of its assets in a taxable, non-taxable, or tax deferred transaction? . . . . . . . . . . . . . . . . . .

18 Did the corporation receive assets in a section 351 transfer in which any of the transferred assets had a fair market basis or fair market value of more than $1 million? . . . . . . . . . . . . . . . . . . . . . . . . . . .

Form 1120 (2014)

4,000 2

X

X

X

X

X

X

X

X

X

X X

2-34 PART 2 Corporations

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Form 1120 (2014) Page 5 Schedule L Balance Sheets per Books Beginning of tax year End of tax year

( ) ( )

( ) ( )

( ) ( )

( ) ( )

( ) ( )

Assets (a) (b) (c) (d)

1 Cash . . . . . . . . . . . .

2a Trade notes and accounts receivable . . .

b Less allowance for bad debts . . . . .

3 Inventories . . . . . . . . . . .

4 U.S. government obligations . . . . .

5 Tax-exempt securities (see instructions) . .

6 Other current assets (attach statement) . .

7 Loans to shareholders . . . . . . .

8 Mortgage and real estate loans . . . . .

9 Other investments (attach statement) . . .

10a Buildings and other depreciable assets . .

b Less accumulated depreciation . . . . .

11a Depletable assets . . . . . . . . .

b Less accumulated depletion . . . . . .

12 Land (net of any amortization) . . . . .

13a Intangible assets (amortizable only) . . .

b Less accumulated amortization . . . . .

14 Other assets (attach statement) . . . . . 15 Total assets . . . . . . . . . .

Liabilities and Shareholders’ Equity 16 Accounts payable . . . . . . . . .

17 Mortgages, notes, bonds payable in less than 1 year

18 Other current liabilities (attach statement) . .

19 Loans from shareholders . . . . . . .

20 Mortgages, notes, bonds payable in 1 year or more

21 Other liabilities (attach statement) . . . .

22 Capital stock: a Preferred stock . . . .

b Common stock . . . .

23 Additional paid-in capital . . . . . . .

24 Retained earnings—Appropriated (attach statement)

25 Retained earnings—Unappropriated . . .

26 Adjustments to shareholders’ equity (attach statement)

27 Less cost of treasury stock . . . . . . 28 Total liabilities and shareholders’ equity . .

Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return Note: The corporation may be required to file Schedule M-3 (see instructions).

1 Net income (loss) per books . . . . . .

2 Federal income tax per books . . . . .

3 Excess of capital losses over capital gains .

4 Income subject to tax not recorded on books this year (itemize):

5 Expenses recorded on books this year not deducted on this return (itemize):

a Depreciation . . . . $

b Charitable contributions . $

c Travel and entertainment . $

6 Add lines 1 through 5 . . . . . . . .

7 Income recorded on books this year not included on this return (itemize):

Tax-exempt interest $

8 Deductions on this return not charged against book income this year (itemize):

a Depreciation . . $

b Charitable contributions $

9 Add lines 7 and 8 . . . . . . 10 Income (page 1, line 28)—line 6 less line 9

Schedule M-2 Analysis of Unappropriated Retained Earnings per Books (Line 25, Schedule L) 1 Balance at beginning of year . . . . .

2 Net income (loss) per books . . . . . .

3 Other increases (itemize):

4 Add lines 1, 2, and 3 . . . . . . . .

5 Distributions: a Cash . . . .

b Stock . . . .

c Property . . .

6 Other decreases (itemize):

7 Add lines 5 and 6 . . . . . . 8 Balance at end of year (line 4 less line 7)

Form 1120 (2014)

104,200

120,000 44,400

250,000

171,700 59,300

10,000 241,000

636,450 171,700

808,150

104,200

240,000

200,000

75,600

10,000

1,800 1,181,600

150,000

40,150

105,000

250,000

636,450

1,181,600

300,000

100,000 150,000

142,300

120,000 60,400

250,000 250,000

163,850

142,300 256,000

151,700

59,600

10,000

1,000 1,284,450

125,000

36,300

100,000

773,150

1,284,450

400,000

100,000

4,000

4,000 237,000

35,000

35,000

773,150

4,000

Prem.– life ins. $8,000; Int.– state bonds $2,000

CHAPTER 2 Corporations: Introduction and Operating Rules 2-35

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Form 1125-A (Rev. December 2012)

Department of the Treasury Internal Revenue Service

Cost of Goods Sold ▶ Attach to Form 1120, 1120-C, 1120-F, 1120S, 1065, or 1065-B.

▶ Information about Form 1125-A and its instructions is at www.irs.gov/form1125a.

OMB No. 1545-2225

Name Employer identification number

1 Inventory at beginning of year . . . . . . . . . . . . . . . . . . . . . 1

2 Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

3 Cost of labor . . . . . . . . . . . . . . . . . . . . . . . . . . 3

4 Additional section 263A costs (attach schedule) . . . . . . . . . . . . . . . . 4

5 Other costs (attach schedule) . . . . . . . . . . . . . . . . . . . . . 5

6 Total. Add lines 1 through 5 . . . . . . . . . . . . . . . . . . . . . . 6

7 Inventory at end of year . . . . . . . . . . . . . . . . . . . . . . . 7

8 Cost of goods sold. Subtract line 7 from line 6. Enter here and on Form 1120, page 1, line 2 or the appropriate line of your tax return (see instructions) . . . . . . . . . . . . . . . 8

9a Check all methods used for valuing closing inventory:

(i) Cost

(ii) Lower of cost or market

(iii) Other (Specify method used and attach explanation.) ▶

b Check if there was a writedown of subnormal goods . . . . . . . . . . . . . . . . . . . . . . ▶

c Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970) . . . . . . ▶

d If the LIFO inventory method was used for this tax year, enter amount of closing inventory computed under LIFO . . . . . . . . . . . . . . . . . . . . . . . . . . . 9d

e If property is produced or acquired for resale, do the rules of section 263A apply to the entity (see instructions)? . . Yes No

f Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yes No

Section references are to the Internal Revenue Code unless otherwise noted.

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, 1065, or 1065-B, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of merchandise is an income-producing factor. See Regulations section 1.471-1. If inventories are required, you generally must use an accrual method of accounting for sales and purchases of inventory items.

Exception for certain taxpayers. If you are a qualifying taxpayer or a qualifying small business taxpayer (defined below), you can adopt or change your accounting method to account for inventoriable items in the same manner as materials and supplies that are not incidental.

Under this accounting method, inventory costs for raw materials purchased for use in producing finished goods and merchandise purchased for resale are deductible in the year the finished goods or merchandise are sold (but not before the year you paid for the raw materials or merchandise, if you are also using the cash method).

If you account for inventoriable items in the same manner as materials and supplies that are not incidental, you can currently deduct expenditures for direct labor and all indirect costs that would otherwise be included in inventory costs. See the instructions for lines 2 and 7.

For additional guidance on this method of accounting, see Pub. 538, Accounting Periods and Methods. For guidance on adopting or changing to this method of accounting, see Form 3115, Application for Change in Accounting Method, and its instructions.

Qualifying taxpayer. A qualifying taxpayer is a taxpayer that, (a) for each prior tax year ending after December 16, 1998, has average annual gross receipts of $1 million or less for the 3 prior tax years and (b) its business is not a tax shelter (as defined in section 448(d)(3)). See Rev. Proc. 2001-10, 2001-2 I.R.B. 272.

Qualifying small business taxpayer. A qualifying small business taxpayer is a taxpayer that, (a) for each prior tax year

ending on or after December 31, 2000, has average annual gross receipts of $10 million or less for the 3 prior tax years, (b) whose principal business activity is not an ineligible activity, and (c) whose business is not a tax shelter (as defined in section 448 (d)(3)). See Rev. Proc. 2002-28, 2002-18 I.R.B. 815.

Uniform capitalization rules. The uniform capitalization rules of section 263A generally require you to capitalize, or include in inventory, certain costs incurred in connection with the following.

• The production of real property and tangible personal property held in inventory or held for sale in the ordinary course of business.

• Real property or personal property (tangible and intangible) acquired for resale.

• The production of real property and tangible personal property by a corporation for use in its trade or business or in an activity engaged in for profit.

See the discussion on section 263A uniform capitalization rules in the instructions for your tax return before completing Form 1125-A. Also see Regulations sections 1.263A-1 through 1.263A-3. See Regulations section 1.263A-4 for rules for property produced in a farming business.

For Paperwork Reduction Act Notice, see instructions. Cat. No. 55988R Form 1125-A (Rev. 12-2012)

Swift Corporation 11-1111111

200,000 506,000

706,000 256,000

450,000

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Although most of the entries on Form 1120 for Swift Corporation are self-explanatory, the following comments may be helpful:

• To arrive at the cost of goods sold amount (line 2 on page 1), Form 1125–A must be completed.

• Reporting of dividends requires the completion of Schedule C (page 2). Gross dividends are shown on line 4 (page 1), and the dividends received deduction appears on line 29b (page 1). Separating the dividend from the deduction facili- tates the application of the taxable income limitation (which did not apply in Swift’s case).

• Income tax liability is $59,300, computed as follows:

Tax on $100,000 $22,250

Tax on $95,000 at 39% 37,050

$59,300

• The result is transferred to line 2 of Schedule J and ultimately is listed on line 31 (page 1). Because the estimated tax payment of $61,000 is more than the tax liabil- ity of $59,300, Swift will receive a tax refund of $1,700.

• Schedule K, line 4b, requires a Schedule G to be completed, but the schedule is not shown in the illustrated example.

• In completing Schedule M–1 (page 5), the net income per books (line 1) is net of the Federal income tax ($231,000 � $59,300). The left side of Schedule M–1 (lines 2–5) represents positive adjustments to net income per books. After the negative adjustments are made (line 9), the result is taxable income before NOLs and special deductions (line 28, page 1).

• In completing Schedule M–2 (page 5), the beginning retained earnings figure of $636,450 is added to the net income per books as entered on Schedule M–1 (line 1). The dividends distributed in the amount of $35,000 are entered on line 5 and subtracted to arrive at the ending balance in unappropriated retained earnings of $773,150.

• Because this example lacks certain details, supporting schedules that would be attached to Form 1120 have not been included. For example, a Form 4562 would be included to verify the depreciation deduction (line 20, page 1), and other deductions (line 26, page 1) would be supported by a schedule.

2-4h Consolidated Returns Corporations that are members of a parent-subsidiary affiliated group may be able to file a consolidated income tax return for a taxable year. Consolidated returns are discussed in Chapter 8.

2-5 TAX PLANNING

2-5a Corporate versus Noncorporate Forms of Business Organization The decision to use the corporate form in conducting a trade or business must be weighed carefully. Besides the nontax considerations of the corporate form (limited liability, continuity of life, free transferability of interests, and centralized management), tax ramifications will play an important role in any such decision. Close attention should be paid to the following:

1. Operating as a regular corporate entity (C corporation) results in the imposition of the corporate income tax. Corporate taxable income will be taxed twice—once as earned by the corporation and again when distributed to the shareholders.

LO.7

Evaluate corporations as an entity form for conducting a business.

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Because dividends are not deductible, a closely held corporation may have a strong incentive to structure corporate distributions in a deductible form. Before legislation in 2003 lowered the rate on qualified dividends to 15 percent, share- holders had a tax incentive to bail out profits in the form of salaries, interest, or rent.31 With the current 15 or 20 percent rate on qualified dividends, shareholders may save taxes by having the corporation pay dividends rather than salaries, rent, or interest, which could be taxed at an individual marginal rate as high as 39.6 per- cent. The decision should be made only after comparing the tax cost of the two alternatives. The 3.8 percent Medicare surtax on net investment income (including dividend and net capital gain income) must be considered in this analysis.

2. The differences in Federal tax brackets between an individual and a corporation may not be substantial. Furthermore, several state and local governments impose higher taxes on corporations than on individuals. In these jurisdictions, the com- bined Federal, state, and local tax rates on the two types of taxpayers are practi- cally identical. Consequently, the tax ramifications of incorporating can be determined only on a case-by-case basis.

3. Corporate-source income loses its identity as it passes through the corporation to the shareholders. Thus, items that normally receive preferential tax treatment (e.g., interest on municipal bonds) are not taxed as such to the shareholders.

4. As noted in Chapter 5, it may be difficult for shareholders to recover some or all of their investment in the corporation without an ordinary income result. Most corporate distributions are treated as dividends to the extent of the corporation’s earnings and profits. However, the preferential rate on qualified dividends reduces the impact of such a result.

5. Corporate losses cannot be passed through to the shareholders.32

6. The liquidation of a corporation will normally generate tax consequences to both the corporation and its shareholders (see Chapter 6).

7. The corporate form provides shareholders with the opportunity to be treated as employees for tax purposes if the shareholders render services to the corporation. Such status makes a number of attractive tax-sheltered fringe benefits available. They include, but are not limited to, group term life insurance and excludible meals and lodging. One of the most attractive benefits of incorporation is the abil- ity of the business to provide accident and health insurance to its employees, including shareholder-employees. Such benefits are not included in the employ- ee’s gross income. Similar rules apply to other medical costs paid by the employer. These benefits are not available to partners, sole proprietors, and more-than-2 percent shareholder-employees of S corporations.

2-5b Operating the Corporation Tax planning to reduce corporate income taxes should occur before the end of the tax year. Effective planning can cause income to be shifted to the next tax year and can pro- duce large deductions by incurring expenses before year-end. Particular attention should be focused on the following.

Charitable Contributions Recall that accrual basis corporations may claim a deduction for charitable contributions in the year preceding payment. The contribution must be authorized by the board of directors by the end of the tax year and paid on or before the fifteenth day of the third month of the following year. It might be useful to authorize a contribution even though it may not ultimately be made. A deduction cannot be thrown back to the previous year (even if paid within the two and one-half months) if it has not been authorized.

31Such procedures lead to a multitude of problems, one of which, the reclas- sification of debt as equity, is discussed in Chapter 4. The problems of unreasonable salaries and rents are covered in Chapter 5 in the discussion of constructive dividends.

32Points 1, 2, and 5 could be resolved through a Subchapter S election (see Chapter 12), assuming that the corporation qualifies for such an election. In part, the same can be said for point 3.

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The enhanced deduction amount for contributions of qualified inventory can pro- duce significant tax savings. Gifts of inventory should be designed to take advantage of this provision whenever feasible. Effort should be taken to properly document the type of inventory donated and each recipient charitable organization, as the statutory provi- sions that allow for an enhanced deduction have very specific requirements for qualifi- cation. Further, a corporation’s cost of goods sold must be reduced to reflect any charitable contribution of inventory.

The five-year carryover period for excess charitable contributions, coupled with the requirement that a current year’s contribution be applied against the 10 percent-of- taxable-income limitation before the utilization of any carryover amount, may require some tax planning. Under these rules, a charitable contribution in the current year could preclude any deduction for an amount in its fifth year of the carryover period. For a corporation with an annual gift-giving plan, this dilemma may require the defer- ral of a current year’s contribution to obtain a deduction for the expiring carryover amount.

Timing of Capital Gains and Losses A corporation should consider offsetting gains on the sale of capital assets by selling some of the depreciated securities in the corporate portfolio. In addition, any already realized capital losses should be carefully monitored. Recall that corporate taxpayers are not permitted to claim any net capital losses as deductions against ordinary income. Capital losses can be used only as an offset against capital gains. Further, net capital losses can only be carried back three years and forward five. Gains from the sales of capital assets should be timed to offset any capital losses. The expiration of the carryover period for any net capital losses should be watched carefully so that sales of appreciated capital assets occur before that date.

Net Operating Losses In some situations, electing to forgo an NOL carryback and utilizing the carryforward option may generate greater tax savings.

When deciding whether to forgo the carryback option, several factors should be considered. First, the time value of the tax refund that is lost by not using the carry- back procedure should be calculated. Second, the election to forgo an NOL carry- back is irrevocable. Thus, one cannot later choose to change if the predicted high profits do not materialize. Third, consider the future increases (or decreases) in cor- porate income tax rates that can reasonably be anticipated. This last consideration is the most difficult to work with. The current political environment appears receptive to tax reform legislation that would result in a decrease in the corporate income tax rates.

Dividends Received Deduction In those cases where the taxable income limitation is applicable to a corporation’s divi- dends received deduction, consideration should be given to the proper timing of income and deductions so as to bring the NOL rule into play. The NOL rule, the excep- tion to the taxable income limitation, can result in a significant increase in the amount of a corporation’s dividends received deduction.

E X A M P L E

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Ruby Corporation incurred a $50,000 NOL in 2015. Ruby, which was in the 15% bracket in 2013 and 2014, has developed a new product that management predicts will push the corporation into the 34% bracket in 2016. If Ruby carries the NOL back, the tax savings will be $7,500 ($50,000 � 15%). However, if Ruby elects to carry the NOL forward, assuming that management’s prediction is accurate, the tax savings will be $17,000 ($50,000 � 34%).

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The other two limitations applicable to the dividends received deduction can be avoided with some basic planning tenets. First, the holding period requirement is satis- fied by holding stock for at least 46 days. Second, the debt-financed stock restriction is avoided if indebtedness is not directly attributable to an investment in stock.33 Clearly, indebtedness incurred specifically to acquire stock should be avoided. However, the use of stock as security for a loan should also be avoided, as the debt-financed restric- tion can apply in such cases.

Organizational Expenditures To qualify for the 180-month amortization procedure of § 248, only organizational expenditures incurred in the first taxable year of the corporation can be considered. This rule could prove to be an unfortunate trap for corporations formed late in the year.

The solution to the problem posed by Example 41 is for Thrush Corporation to adopt a fiscal year that ends on or beyond January 31. All organizational expenditures will then have been incurred before the close of the first taxable year.

Shareholder-Employee Payment of Corporate Expenses In a closely held corporate setting, shareholder-employees often pay corporate expenses (e.g., travel and entertainment) for which they are not reimbursed by the corporation. The IRS often disallows the deduction of these expenses by the shareholder-employee because the payments are voluntary on his or her part. If the deduction is more beneficial at the shareholder-employee level, a corporate policy against reimbursement of such expenses should be established. Proper planning in this regard would be to decide before the beginning of each tax year where the deduction would do the most good. Corporate policy on reimbursement of such expenses could be modified on a year-to-year basis depending upon the circumstances.

In deciding whether corporate expenses should be kept at the corporate level or shifted to the shareholder-employee, the treatment of unreimbursed employee expenses must be considered. First, because employee expenses are itemized deductions, they will be of no benefit to the taxpayer who chooses the standard deduction option. Second, these expenses will be subject to the 2 percent-of-AGI floor. No such limitation will be imposed if the corporation claims the expenses.

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Pearl Corporation, a calendar year C corporation, has the following information for the year:

Gross income from operations $ 200,000

Expenses from operations (225,000)

Dividends received from domestic corporations (less than 20% ownership) 100,000

Taxable income before dividends received deduction $ 75,000

Pearl’s dividends received deduction is $52,500 [70% � $75,000 (taxable income limitation)]. If, how- ever, Pearl incurs additional expenses of $5,001 (or defers $5,001 of income), then the NOL rule applies and Pearl’s dividends received deduction is $70,000 [70% � $100,000 (dividends received)].

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Thrush Corporation is formed in December 2015. Qualified organizational expenditures are incurred as follows: $62,000 in December 2015 and $30,000 in January 2016. If Thrush uses the cal- endar year for tax purposes, only $62,000 of the organizational expenditures can be written off over a period of 180 months.

33See, for example, OBH, Inc. v. U.S., 2005–2 USTC {50,627, 96 AFTR 2d 2005–6801, 397 F.Supp.2d 1148 (D.Ct.Neb., 2005) where the court applied narrow interpretation of “directly attributable” requirement.

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REFOCUS ON THE BIG PICTUREREFOCUS ON THE BIG PICTURE

COOKED TO PERFECTION

Conducting Skylark Bakery as a corporation would save Samantha $9,375 in income taxes annually, computed as follows:

Bakery Operated as Sole Proprietorship

Operating profit of $100,000:

Tax on $100,000 @ 33% $33,000

Dividends of $5,000:

Tax on $5,000 @ 15% 750

Withdrawals of $50,000:

No tax –0–

Total income tax when operated as sole proprietorship $33,750

Bakery Operated as Regular Corporation

Corporate taxable income of $51,500* (see below):

Tax on $50,000 @ 15% $ 7,500

Tax on $1,500 @ 25% 375

Total corporate income tax $ 7,875

Samantha’s salary of $50,000:

Tax on $50,000 @ 33% 16,500

Total income tax when operated as C corporation $24,375

* Computation of corporate taxable income:

Operating profit $100,000 Dividends 5,000 Less: Salary to Samantha (50,000)

Dividends received deduction (70%) (3,500) Taxable income $ 51,500

The example illustrates the tax savings available when a high-income individual tax- payer takes advantage of the lower marginal tax rates of C (regular) corporations. However, other issues, such as employment tax considerations and the taxation of dividend distributions (income and Medicare surtax), also should be considered. Fur- ther, other potential entity options, such as the LLC and S corporation, also should be evaluated.

What If? What if the bakery in the first year it becomes a corporation generates a $10,000 short-term capital loss (STCL) on the disposition of some of its stock investments? Regular corporations can only deduct capital losses against capital gains; thus, the $10,000 STCL would not be deductible currently by the corporation and, instead, would be carried forward for up to five years. If the bakery is operated as a sole pro- prietorship, Samantha would report the capital loss on her individual return. She could use the $10,000 STCL to offset any capital gains she may have and deduct up to $3,000 of the loss against ordinary income. ª

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Key Terms

C corporations, 2-3

Check-the-box Regulations, 2-7

Disregarded entity, 2-7

Dividends received deduction, 2-16

Domestic production activities deduction (DPAD), 2-15

Limited liability company (LLC), 2-6

Limited partnerships, 2-6

Organizational expenditures, 2-19

Passive loss, 2-12

Personal service corporations (PSCs), 2-9

Regular corporations, 2-3

Related corporations, 2-22

S corporations, 2-3

Schedule M–1, 2-25

Schedule M–3, 2-27

Discussion Questions

1. LO.1 Jennifer and Jamie are starting a business and have asked you for advice about whether they should form a partnership, a corporation, or some other type of

entity. Prepare a list of questions you would ask in helping them decide which type of entity they should choose. Explain your reasons for asking each of the questions.

2. LO.1 Barbara owns 40% of the stock of Cassowary Corporation (a C corporation) and 40% of the stock of Emu Corporation (an S corporation). In the current

year, each corporation has operating income of $120,000 and tax-exempt interest income of $8,000. Neither corporation pays any dividends during the year. Discuss how this information will be reported by the corporations and Barbara for the year.

3. LO.1, 7 Art, an executive with Azure Corporation, plans to start a part-time busi- ness selling products on the Internet. He will devote about 15 hours each

week to running the business. Art’s salary from Azure places him in the 35% tax bracket. He projects substantial losses from the new business in each of the first three years and expects sizable profits thereafter. Art plans to leave the profits in the business for several years, sell the business, and retire. Would you advise Art to incorporate the business or operate it as a sole proprietorship? Why?

4. LO.1, 2 Janice is the sole owner of Catbird Company. In the current year, Catbird had operating income of $100,000, a long-term capital gain of $15,000, and

a charitable contribution of $5,000. Janice withdrew $70,000 of profit from Catbird. How should Janice report this information on her individual tax return if Catbird Company is:

a. An LLC?

b. An S Corporation?

c. A C corporation?

5. LO.1, 2 Joel is the sole shareholder of Manatee Corporation, a C corporation. Because Manatee’s sales have increased significantly over the last several

years, Joel has determined that the corporation needs a new distribution warehouse. Joel has asked your advice as to whether (1) Manatee should purchase the ware- house or (2) he should purchase the warehouse and lease it to Manatee. What relevant tax issues will you discuss with Joel?

6. LO.1 Can a sole proprietor form as a single-member limited liability company (LLC)? If so, how would such an LLC be taxed?

7. LO.1 In the current year, Juanita and Joseph form a two-member LLC and do not file Form 8832 (Entity Classification Election). As a result, the LLC will be treated as

a partnership for Federal tax purposes. Assess the validity of this statement.

8. LO.2 Ann is the sole shareholder of Salmon Corporation, a newly formed C corpo- ration. Fran is the sole shareholder of Scarlet Corporation, a newly formed

C corporation that is a personal service corporation. Both Ann and Fran plan to have their corporations elect a March 31 fiscal year-end. Will the IRS treat both corpora- tions alike with respect to the fiscal year election? Why or why not?

Decision Making

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9. LO.2 Which of the following C corporations will be allowed to use the cash method of accounting for 2015? Explain your answers.

a. Jade Corporation, which had gross receipts of $5.3 million in 2012, $4.1 million in 2013, and $5 million in 2014.

b. Lime Corporation, a personal service corporation, which had gross receipts of $5.8 million in 2012, $5.2 million in 2013, and $4.4 million in 2014.

10. LO.2 Lupe, a cash basis taxpayer, owns 55% of the stock of Jasper Corporation, a cal- endar year accrual basis C corporation. On December 31, 2015, Jasper accrues

a performance bonus of $100,000 to Lupe that it pays to him on January 15, 2016. In which year can Jasper deduct the bonus? In which year must Lupe include the bonus in gross income?

11. LO.2 In the current year, Jeanette, an individual in the 25% marginal tax bracket, recognized a $20,000 long-term capital gain. Also in the current year, Parrot

Corporation, a C corporation in the 25% marginal tax bracket, recognized a $20,000 long-term capital gain. Neither taxpayer had any other property transactions in the year. What tax rates are applicable to these capital gains?

12. LO.2 John (a sole proprietor) and Eagle Corporation (a C corporation) each recog- nize a long-term capital gain of $10,000 and a short-term capital loss of

$18,000 on the sale of capital assets. Neither taxpayer had any other property trans- actions during the year. Describe the tax consequences of these gains and losses for John and for Eagle.

13. LO.2 A taxpayer sells a warehouse for a recognized gain. Depreciation had been properly claimed on the property, based on the straight-line method over a

39-year recovery period. Will the same amount of depreciation recapture result whether the taxpayer is an individual or a C corporation? Explain.

14. LO.2 Osprey Corporation, a closely held corporation, has $100,000 of net active income, $25,000 of portfolio income, and a $120,000 loss from a passive activity.

a. How much of the passive loss can Osprey deduct in the current year if it is a PSC?

b. If it is not a PSC?

15. LO.2 On December 24, 2015, the directors of Partridge Corporation, an accrual basis calendar year taxpayer, authorized a cash contribution of $10,000 to the

American Cancer Association. The payment is made on April 14, 2016. Can Partridge deduct the charitable contribution in 2015? Explain.

16. LO.2, 7 The board of directors of Orange Corporation, a calendar year taxpayer, is holding its year-end meeting on December 30, 2015. One topic on the

board’s agenda is the approval of a $25,000 gift to a qualified charitable organiza- tion. Orange has a $20,000 charitable contribution carryover to 2015 from a prior year. Identify the tax issues the board should consider regarding the proposed contribution.

17. LO.2 In general, how is the domestic production activities deduction (DPAD) computed?

18. LO.2, 3, 7 Gold Corporation, a calendar year C corporation, was formed in 2009 and has been profitable until the current year. In 2015, Gold incurs a

net operating loss. Identify the issues that Gold Corporation should consider regard- ing its NOL carryback and carryover options.

19. LO.1, 3 Marmot Corporation pays a dividend of $100,000 in the current year. Otter Corporation, which is in the 25% marginal bracket, owns 15% of Marmot’s

stock. Gerald, an individual taxpayer in the 25% marginal bracket, also owns 15% of Marmot’s stock. Compare and contrast the treatment of the dividend by Otter Corpo- ration and Gerald.

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20. LO.3 Mustard Corporation (a C corporation) owns 15% of the stock of Burgundy Corporation (a C corporation), which pays an annual dividend to its sharehold-

ers. Mustard is considering the purchase of additional shares of Burgundy stock. Would this stock purchase affect the amount of dividends received deduction that Mustard can claim? Explain.

21. LO.3 Determine whether the following expenditures by Cuckoo Corporation are organizational expenditures, startup expenditures, or neither.

a. Legal expenses incurred for drafting the corporate charter and bylaws.

b. Accounting fees incurred in organization.

c. Expenses of temporary board of directors’ organizational meetings.

d. Employee salaries incurred during the training period before opening for business.

e. Brokerage fees incurred in initial stock sales.

22. LO.5 Omar is the sole shareholder of Plum Corporation, which has annual taxable income of approximately $200,000. Omar formed a new solely owned corpo-

ration, Ivory Corporation, and had Plum Corporation transfer one-half of its assets to Ivory Corporation. Because this results in each of the two corporations having approximately $100,000 of taxable income each year, Omar believes it will reduce overall corporate income taxes. Will Omar’s plan work? Discuss.

23. LO.6 When are C corporations required to make estimated tax payments? How are these payments calculated?

24. LO.6 Schedule M–1 of Form 1120 is used to reconcile financial net income with taxable income reported on the corporation’s income tax return as follows:

net income per books þ additions � subtractions ¼ taxable income. Classify the fol- lowing items as additions or subtractions in the Schedule M–1 reconciliation.

a. Life insurance proceeds received upon death of covered executive.

b. Tax depreciation in excess of book depreciation.

c. Federal income tax per books.

d. Capital loss in excess of capital gain.

e. Charitable contributions in excess of taxable income limitation.

f. Premiums paid on life insurance policies covering executives (corporation is beneficiary).

g. Domestic production activities deduction.

25. LO.6 In the current year, Woodpecker, Inc., a C corporation with $8.5 million in assets, deducted amortization of $40,000 on its financial statements and

$55,000 on its Federal tax return. Is Woodpecker required to file Schedule M–3? If a Schedule M–3 is filed by Woodpecker, how is the difference in amortization amounts treated on that schedule?

Computational Exercises

26. LO.2 Goose Corporation, a C corporation, incurs a net capital loss of $12,000 for 2015. It also has ordinary income of $10,000 in 2015. Goose had net capital

gains of $2,500 in 2011 and $5,000 in 2014.

a. Determine the amount, if any, of the net capital loss of $12,000 that is deduct- ible in 2015.

b. Determine the amount, if any, of the net capital loss of $12,000 that is carried forward to 2016.

27. LO.2 Aqua Corporation purchases nonresidential real property on May 9, 2012, for $1 million. Straight-line cost recovery is taken in the amount of $89,765 before

the property is sold on November 30, 2015, for $1.5 million.

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a. Compute the amount of Aqua’s recognized gain on the sale of the realty.

b. Determine the amount of the recognized gain that is treated as § 1231 gain and the amount that is treated as § 1250 recapture (ordinary income).

28. LO.2 Hummingbird Corporation, a closely held C corporation that is not a PSC, has $40,000 of net active income, $15,000 of portfolio income, and a $45,000 loss

from a passive activity. Compute Hummingbird’s taxable income for the year.

29. LO.2 Compute the charitable contribution deduction (ignoring the percentage limi- tation) for each of the following C corporations.

a. Amber Corporation donated inventory of clothing (basis of $24,000, fair market value of $30,000) to a qualified charitable organization that operates homeless shelters.

b. Brass Corporation donated stock held as an investment to Western College (a qualified organization). Brass acquired the stock three years ago for $18,000, and the fair market value on the date of the contribution is $32,000. Western College plans on selling the stock.

c. Ruby Corporation donates a sculpture worth $130,000 to a local museum (a qualified organization), which exhibits the sculpture. Ruby acquired the sculp- ture four years ago for $55,000.

30. LO.3 Crane and Loon Corporations, two unrelated C corporations, have the follow- ing transactions for 2015:

Crane Loon

Gross income from operations $180,000 $300,000

Expenses from operations 255,000 310,000

Dividends received from domestic corporations (15% ownership) 100,000 230,000

a. Compute the dividends received deduction for Crane Corporation.

b. Compute the dividends received deduction for Loon Corporation.

31. LO.3 Cherry Corporation, a calendar year C corporation, is formed and begins busi- ness on April 1, 2015. In connection with its formation, Cherry incurs organi-

zational expenditures of $54,000. Determine Cherry Corporation’s deduction for organizational expenditures for 2015.

32. LO.4 Compute the income tax liability for each of the following unrelated C corpo- rations.

a. Darter Corporation has taxable income of $68,000.

b. Owl Corporation has taxable income of $10,800,000.

c. Toucan Corporation, a personal service corporation, has taxable income of $170,000.

Problems

33. LO.1, 2 In the current year, Riflebird Company had operating income of $220,000, operating expenses of $175,000, and a long-term capital loss of $10,000.

How do Riflebird Company and Roger, the sole owner of Riflebird, report this infor- mation on their respective Federal income tax returns for the current year under the following assumptions?

a. Riflebird Company is a proprietorship (Roger did not make any withdrawals from the business).

b. Riflebird Company is a C corporation (no dividends were paid during the year).

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34. LO.1, 2 Ellie and Linda are equal owners in Otter Enterprises, a calendar year busi- ness. During the current year, Otter Enterprises has $320,000 of gross income

and $210,000 of operating expenses. In addition, Otter has a long-term capital gain of $15,000 and makes distributions to Ellie and Linda of $25,000 each. Discuss the impact of this information on the taxable income of Otter, Ellie, and Linda if Otter is:

a. A partnership.

b. An S corporation.

c. A C corporation.

35. LO.1, 2 In the current year, Azure Company has $350,000 of net operating income before deducting any compensation or other payment to its sole owner,

Sasha. In addition, Azure has interest on municipal bonds of $25,000. Sasha has sig- nificant income from other sources and is in the 39.6% marginal tax bracket. Based on this information, determine the income tax consequences to Azure Company and to Sasha during the year for each of the following independent situations.

a. Azure is a C corporation and pays no dividends or salary to Sasha.

b. Azure is a C corporation and distributes $75,000 of dividends to Sasha.

c. Azure is a C corporation and pays $75,000 of salary to Sasha.

d. Azure is a sole proprietorship, and Sasha withdraws $0.

e. Azure is a sole proprietorship, and Sasha withdraws $75,000.

36. LO.1, 2 Torsten owns 100% of Taupe Corporation, which had net operating income of $420,000 and long-term capital gain of $30,000 in 2015. Torsten

has sufficient income from other sources to be in the 39.6% marginal tax bracket without regard to the results of Taupe Corporation. The corporation makes no distri- butions to Torsten during the year. Ignoring the 3.8% Medicare surtax on net invest- ment income, explain the tax treatment if Taupe Corporation is:

a. An S corporation.

b. A C corporation.

37. LO.1 Purple Company has $200,000 in net income for 2015 before deducting any compensation or other payment to its sole owner, Kirsten. Kirsten is single

and has no dependents. She claims the $6,300 standard deduction, and her personal exemption is $4,000 for 2015. Purple Company is Kirsten’s only source of income. Ignoring any employment tax considerations, compute Kirsten’s after-tax income if:

a. Purple Company is a proprietorship and Kirsten withdraws $50,000 from the business during the year.

b. Purple Company is a C corporation and the corporation pays out all of its after- tax income as a dividend to Kirsten.

c. Purple Company is a C corporation and the corporation pays Kirsten a salary of $138,750.

38. LO.2 In the current year, Wilson Enterprises, a calendar year taxpayer, suffers a casualty loss of $90,000. How much of the casualty loss will be deductible by

Wilson under the following circumstances?

a. Wilson is an individual proprietor and has AGI of $225,000. The casualty loss was a personal loss, and the insurance recovered was $50,000.

b. Wilson is a corporation, and the insurance recovered was $50,000.

39. LO.1, 4, 7 Benton Company (BC) has one owner, who is in the 33% Federal income tax bracket. BC’s gross income is $395,000, and its ordinary

trade or business deductions are $245,000. Compute the Federal income tax liability on BC’s income for the current year under the following assumptions:

a. BC is operated as a proprietorship, and the owner withdraws $100,000 for per- sonal use.

b. BC is operated as a corporation, pays out $100,000 as salary, and pays no divi- dends to its shareholder.

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c. BC is operated as a corporation and pays out no salary or dividends to its shareholder.

d. BC is operated as a corporation, pays out $100,000 as salary, and pays out the remainder of its earnings as dividends.

e. Assume that Robert Benton of 1121 Monroe Street, Ironton, OH 45638 is the owner of BC, which was operated as a proprietorship. Robert is thinking about incorporating the business for next year and asks your advice. He expects about the same amounts of income and expenses and plans to take $100,000 per year out of the company whether he incorporates or not. Write a letter to Robert [based on your analysis in (a) and (b)] containing your recommendations.

40. LO.2, 4 Juan, an attorney, is the sole shareholder of Carmine Corporation, a C cor- poration and professional association. The corporation paid Juan a salary

of $336,000 during its fiscal year ending September 30, 2015.

a. How much salary must Carmine pay Juan during the period October 1 through December 31, 2015, to permit the corporation to continue to use its fiscal year without negative tax effects?

b. Carmine Corporation had taxable income of $95,000 for the year ending September 30, 2015. Compute the corporation’s income tax liability for the year.

41. LO.2 Broadbill Corporation, a calendar year C corporation, has two unrelated cash method shareholders: Marcia owns 51% of the stock, and Zack owns the

remaining 49%. Each shareholder is employed by the corporation at an annual sal- ary of $240,000. During 2015, Broadbill paid each shareholder-employee $220,000 of his or her annual salary, with the remaining $20,000 paid in January 2016. How much of the 2015 salaries for Marcia and Zack is deductible by Broadbill in 2015 if the corporation is:

a. A cash method taxpayer?

b. An accrual method taxpayer?

42. LO.1, 2, 4 Jonathan owns 100% of Lemon Company. In the current year, Lemon recognizes a long-term capital gain of $70,000 and no other income (or

loss). Jonathan is in the 33% tax bracket and has no recognized capital gains (or losses) before considering his ownership interest in Lemon Company. What is the income tax result from the $70,000 if Lemon is:

a. An LLC? (No election has been filed under the check-the-box Regulations.)

b. A C corporation?

43. LO.2, 4 In the current year, Tanager Corporation (a C corporation) had operating income of $480,000 and operating expenses of $390,000. In addition,

Tanager had a long-term capital gain of $55,000 and a short-term capital loss of $40,000.

a. Compute Tanager’s taxable income and tax for the year.

b. Assume, instead, that Tanager’s long-term capital gain was $15,000 (not $55,000). Compute Tanager’s taxable income and tax for the year.

44. LO.2 Virginia owns 100% of Goshawk Company. In the current year, Goshawk Company sells a capital asset (held for three years) at a loss of $40,000. In

addition, Goshawk has a short-term capital gain of $18,000 and net operating income of $90,000 during the year. Virginia has no recognized capital gain (or loss) before considering her ownership in Goshawk. How much of the capital loss may be deducted for the year and how much is carried back or forward if Goshawk is:

a. A proprietorship?

b. A C corporation?

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45. LO.2 During 2015, Gorilla Corporation has net short-term capital gains of $15,000, net long-term capital losses of $105,000, and taxable income from other

sources of $460,000. Prior years’ transactions included the following:

2011 net short-term capital gains $40,000

2012 net long-term capital gains 18,000

2013 net short-term capital gains 25,000

2014 net long-term capital gains 20,000

a. How are the capital gains and losses treated on Gorilla’s 2015 tax return?

b. Determine the amount of the 2015 capital loss that is carried back to each of the previous years.

c. Compute the amount of capital loss carryforward, if any, and indicate the years to which the loss may be carried.

d. If Gorilla is a sole proprietorship, rather than a corporation, how would the owner report these transactions on her 2015 tax return?

46. LO.2 Heron Company purchases commercial realty on November 13, 1997, for $650,000. Straight-line depreciation of $287,492 is claimed before the prop-

erty is sold on February 23, 2015, for $850,000. What are the tax consequences of the sale of realty if Heron is:

a. A C corporation?

b. A sole proprietorship?

47. LO.2 In the current year, Plum, Inc., a closely held C corporation, has $410,000 of net active income, $20,000 of portfolio income, and a $75,000 passive activity loss.

What is Plum’s taxable income for the current year under the following circumstances?

a. Plum is a personal service corporation.

b. Plum is not a personal service corporation.

48. LO.2 Aquamarine Corporation, a calendar year C corporation, makes the following donations to qualified charitable organizations during the current year:

Adjusted Basis Fair Market Value

Painting held four years as an investment, to a church, which sold it immediately $15,000 $25,000

Apple stock held two years as an investment, to United Way, which sold it immediately 40,000 90,000

Canned groceries held one month as inventory, to Catholic Meals for the Poor 10,000 17,000

Determine the amount of Aquamarine Corporation’s charitable deduction for the current year. (Ignore the taxable income limitation.)

49. LO.2, 7 Joseph Thompson is president and sole shareholder of Jay Corporation. In December 2015, Joe asks your advice regarding a charitable contribution

he plans to have the corporation make to the University of Maine, a qualified public charity. Joe is considering the following alternatives as charitable contributions in December 2015:

Fair Market Value

(1) Cash donation $200,000

(2) Unimproved land held for six years ($110,000 basis) 200,000

(3) Maize Corporation stock held for eight months ($140,000 basis) 200,000

(4) Brown Corporation stock held for nine years ($360,000 basis) 200,000

Joe has asked you to help him decide which of these potential contributions will be most advantageous taxwise. Jay’s taxable income is $3.5 million before considering the contribution. Rank the four alternatives and write a letter to Joe communicating your advice. The corporation’s address is 1442 Main Street, Freeport, ME 04032.

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For the latest in changes to tax legislation, visit www.cengagebrain.com.

50. LO.2, 7 In 2015, Gray Corporation, a calendar year C corporation, has a $75,000 charitable contribution carryover from a gift made in 2010. Gray is contem-

plating a gift of land to a qualified charity in either 2015 or 2016. Gray purchased the land as an investment five years ago for $100,000 (current fair market value is $250,000). Before considering any charitable deduction, Gray projects taxable income of $1 million for 2015 and $1.2 million for 2016. Should Gray make the gift of the land to charity in 2015 or in 2016? Provide support for your answer.

51. LO.2, 7 Dan Simms is the president and sole shareholder of Simms Corporation, 1121 Madison Street, Seattle, WA 98121. Dan plans for the corporation to

make a charitable contribution to the University of Washington, a qualified public char- ity. He will have the corporation donate Jaybird Corporation stock, held for five years, with a basis of $11,000 and a fair market value of $25,000. Dan projects a $310,000 net profit for Simms Corporation in 2015 and a $100,000 net profit in 2016. Dan calls you on December 11, 2015, and asks whether he should make the contribution in 2015 or 2016. Write a letter advising Dan about the timing of the contribution.

52. LO.2 White Corporation, a calendar year C corporation, manufactures plumbing fixtures. For the current year, White has taxable income [before the domestic

production activities deduction (DPAD)] of $900,000, qualified production activities income (QPAI) of $1.2 million, and W–2 wages attributable to QPAI of $200,000.

a. How much is White Corporation’s DPAD?

b. Assume instead that W–2 wages attributable to QPAI are $150,000. How much is White’s DPAD?

53. LO.2, 3 During the current year, Swallow Corporation, a calendar year C corpora- tion, has the following transactions:

Income from operations $660,000

Expenses from operations 720,000

Dividends received from Brown Corporation 240,000

a. Swallow Corporation owns 12% of Brown Corporation’s stock. How much is Swallow’s taxable income or NOL for the year?

b. Assume instead that Swallow Corporation owns 26% of Brown Corporation’s stock. How much is Swallow’s taxable income or NOL for the year?

54. LO.3 In each of the following independent situations, determine the dividends received deduction. Assume that none of the corporate shareholders owns

20% or more of the stock in the corporations paying the dividends.

Almond Corporation Blond Corporation Cherry Corporation

Income from operations $ 700,000 $ 800,000 $ 900,000

Expenses from operation (600,000) (850,000) (910,000)

Qualifying dividends 100,000 100,000 100,000

55. LO.3 Gull Corporation, a cash method, calendar year C corporation, was formed and began business on November 1, 2015. Gull incurred the following

expenses during its first year of operations (November 1, 2015–December 31, 2015):

Expenses of temporary directors and organizational meetings $21,000

Fee paid to state of incorporation 3,000

Expenses for printing and sale of stock certificates 11,000

Legal services for drafting the corporate charter and bylaws (not paid until January 2016) 19,000

a. Assuming that Gull Corporation elects under § 248 to expense and amortize organizational expenditures, what amount may be deducted in 2015?

b. Assume the same facts as above, except that the amount paid for the legal services was $28,000 (instead of $19,000). What amount may be deducted as organizational expenditures in 2015?

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56. LO.3 Egret Corporation, a calendar year C corporation, was formed on March 6, 2015, and opened for business on July 1, 2015. After its formation but prior to

opening for business, Egret incurred the following expenditures:

Accounting $ 7,000

Advertising 14,500

Employee payroll 11,000

Rent 8,000

Utilities 1,000

What is the maximum amount of these expenditures that Egret can deduct in 2015?

57. LO.4 In each of the following independent situations, determine the corporation’s income tax liability. Assume that all corporations use a calendar year for tax

purposes and that the tax year involved is 2015.

Taxable Income

Purple Corporation $ 65,000

Azul Corporation 290,000

Pink Corporation 12,350,000

Turquoise Corporation 19,000,000

Teal Corporation (a personal service corporation) 130,000

58. LO.5 Red Corporation and White Corporation, both calendar year C corporations, are members of a controlled group of corporations. For the current year, Red

has taxable income of $130,000, and White has taxable income of $200,000. Assum- ing that the controlled group does not make an election regarding the apportion- ment of the marginal tax brackets, what is the income tax liability for each of the corporations?

59. LO.6 Grouse Corporation, a calendar year C corporation, had taxable income of $1.4 million, $1.2 million, and $700,000 for 2012, 2013, and 2014, respec-

tively. Grouse has taxable income of $1.6 million for 2015. What are Grouse Corpo- ration’s minimum required estimated tax payments for 2015?

60. LO.6 Emerald Corporation, a calendar year and accrual method taxpayer, provides the following information and asks you to prepare Schedule M–1 for 2015:

Net income per books (after-tax) $257,950

Federal income tax per books 41,750

Tax-exempt interest income 15,000

Life insurance proceeds received as a result of death of corporate president 150,000

Interest on loan to purchase tax-exempt bonds 1,500

Excess of capital loss over capital gains 6,000

Premiums paid on life insurance policy on life of Emerald’s president 7,800

61. LO.6 The following information for 2015 relates to Sparrow Corporation, a calendar year, accrual method taxpayer.

Net income per books (after-tax) $174,100

Federal income tax per books 86,600

Tax-exempt interest income 4,500

MACRS depreciation in excess of straight-line depreciation used for financial purposes 7,200

Excess of capital loss over capital gains 9,400

Nondeductible meals and entertainment 5,500

Interest on loan to purchase tax-exempt bonds 1,100

Based on the above information, use Schedule M–1 of Form 1120, which is available on the IRS website, to determine Sparrow’s taxable income for 2015.

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62. LO.6 Dove Corporation, a calendar year C corporation, had the following informa- tion for 2015:

Net income per books (after-tax) $386,250

Taxable income 120,000

Federal income tax per books 30,050

Cash dividend distributions 150,000

Unappropriated retained earnings, as of January 1, 2015 796,010

Based on the above information, use Schedule M–2 of Form 1120 (see Example 34 in the text) to determine Dove’s unappropriated retained earnings balance as of December 31, 2015.

63. LO.6 In the current year, Pelican, Inc., incurs $10,000 of meals and entertain- ment expenses that it deducts in computing net income per the corpora-

tion’s financial statements. All of the meals and entertainment expenditures are subject to the 50% cutback rule applicable to such expenditures. How is this infor- mation reported on Schedule M–3?

64. LO.6 In the current year, Pelican, Inc., incurs $50,000 of nondeductible fines and penalties. Its depreciation expense is $245,000 for financial statement purposes

and $310,000 for tax purposes. How is this information reported on Schedule M–3?

65. LO.6 In January 2015, Pelican, Inc., established an allowance for uncollectible accounts (bad debt reserve) of $70,000 on its books and increased the allow-

ance by $120,000 during the year. As a result of a client’s bankruptcy, Pelican, Inc., decreased the allowance by $60,000 in November 2015. Pelican, Inc., deducted the $190,000 of increases to the allowance on its 2015 income statement but was not allowed to deduct that amount on its tax return. On its 2015 tax return, the corpora- tion was allowed to deduct the $60,000 actual loss sustained because of its client’s bankruptcy. On its financial statements, Pelican, Inc., treated the $190,000 increase in the bad debt reserve as an expense that gave rise to a temporary difference. On its 2015 tax return, Pelican, Inc., took a $60,000 deduction for bad debt expense. How is this information reported on Schedule M–3?

66. LO.2, 3, 7 In January of the current year, Don and Steve each invested $100,000 cash to form a corporation to conduct business as a retail golf equip-

ment store. On January 5, they paid Bill, an attorney, to draft the corporate charter, file the necessary forms with the state, and write the bylaws. They leased a store building and began to acquire inventory, furniture, display equipment, and office equipment in February. They hired a sales staff and clerical personnel in March and conducted training sessions during the month. They had a successful opening on April 1, and sales increased steadily throughout the summer. The weather turned cold in October, and all local golf courses closed by October 15, which resulted in a drastic decline in sales. Don and Steve expect business to be very good during the Christmas season and then to taper off significantly from January 1 through the end of February. The corporation accrued bonuses to Don and Steve on December 31, payable on April 15 of the following year. The corporation made timely estimated tax payments throughout the year. The corporation hired a bookkeeper in February, but he does not know much about taxation. Don and Steve have retained you as a tax consultant and have asked you to identify the tax issues they should consider.

Tax Return Problems

1. On November 1, 2005, Janet Morton and Kim Wong formed Pet Kingdom, Inc., to sell pets and pet supplies. Pertinent information regarding Pet Kingdom is summarized as follows:

• Pet Kingdom’s business address is 1010 Northwest Parkway, Dallas, TX 75225; its tele- phone number is (214) 555-2211; and its e-mail address is [email protected].

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• The employer identification number is 11-1111111, and the principal business activity code is 453910.

• Janet and Kim each own 50% of the common stock; Janet is president and Kim is vice president of the company. No other class of stock is authorized.

• Both Janet and Kim are full-time employees of Pet Kingdom. Janet’s Social Secu- rity number is 123-45-6789, and Kim’s Social Security number is 987-65-4321.

• Pet Kingdom is an accrual method, calendar year taxpayer. Inventories are deter- mined using FIFO and the lower of cost or market method. Pet Kingdom uses the straight-line method of depreciation for book purposes and accelerated deprecia- tion (MACRS) for tax purposes.

• During 2014, the corporation distributed cash dividends of $250,000.

Pet Kingdom’s financial statements for 2014 are shown below.

Income Statement

Income

Gross sales $ 5,750,000

Sales returns and allowances (200,000)

Net sales $ 5,550,000

Cost of goods sold (2,300,000)

Gross profit $ 3,250,000

Dividends received from stock investments in less-than-20%- owned U.S. corporations 43,750

Interest income:

State bonds $ 15,000

Certificates of deposit 20,000 35,000

Total income $ 3,328,750

Expenses

Salaries—officers

Janet Morton $262,500

Kim Wong 262,500 $525,000

Salaries—clerical and sales 725,000

Taxes (state, local, and payroll) 238,000

Repairs and maintenance 140,000

Interest expense:

Loan to purchase state bonds $ 9,000

Other business loans 207,000 216,000

Advertising 58,000

Rental expense 109,000

Depreciation* 106,000

Charitable contributions 38,000

Employee benefit programs 60,000

Premiums on term life insurance policies on lives of Janet Morton and Kim Wong; Pet Kingdom is the designated beneficiary 40,000

Total expenses (2,255,000)

Net income before taxes $ 1,073,750

Federal income tax (356,023)

Net income per books $ 717,727

* Depreciation for tax purposes is $136,000. You are not provided enough detailed data to complete a Form 4562 (depreciation). If you solve this problem using H&R BLOCK Tax Software, enter the amount of depreciation on line 20 of Form 1120.

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Balance Sheet

Assets January 1, 2014 December 31, 2014

Cash $ 1,200,000 $ 1,037,750

Trade notes and accounts receivable 2,062,500 2,147,000

Inventories 2,750,000 3,030,000

Stock investment 1,125,000 1,125,000

State bonds 375,000 375,000

Certificates of deposit 400,000 400,000

Prepaid Federal tax –0– 3,977

Buildings and other depreciable assets 5,455,000 5,455,000

Accumulated depreciation (606,000) (712,000)

Land 812,500 812,500

Other assets 140,000 128,500

Total assets $13,714,000 $13,802,727

Liabilities and Equity January 1, 2014 December 31, 2014

Accounts payable $ 2,284,000 $ 1,975,000

Other current liabilities 175,000 155,000

Mortgages 4,625,000 4,575,000

Capital stock 2,500,000 2,500,000

Retained earnings 4,130,000 4,597,727

Total liabilities and equity $13,714,000 $13,802,727

During 2014, Pet Kingdom made estimated tax payments of $90,000 each quarter to the IRS. Prepare a Form 1120 for Pet Kingdom for tax year 2014. Suggested software: H&R BLOCK Tax Software.

2. On February 12, 2002, Nancy Trout and Delores Lake formed Kingfisher Corpora- tion to sell fishing tackle. Pertinent information regarding Kingfisher is summarized as follows:

• Kingfisher’s business address is 1717 Main Street, Ely, MN 55731; its telephone number is (218) 555-2211; and its e-mail address is [email protected].

• The employer identification number is 11-1111111, and the principal business activity code is 451110.

• Nancy owns 50% of the common stock and is president of the company, and Delores owns 50% of the common stock and is vice president of the company. No other class of stock is authorized.

• Both Nancy and Delores are full-time employees of Kingfisher. Nancy’s Social Secu- rity number is 123-45-6789, and Delores’s Social Security number is 987-65-4321.

• Kingfisher is an accrual method, calendar year taxpayer. Inventories are deter- mined using FIFO and the lower of cost or market method. Kingfisher uses the straight-line method of deprecation for book purposes and accelerated deprecia- tion (MACRS) for tax purposes.

• During 2014, the corporation distributed cash dividends of $80,000.

Kingfisher’s financial statements for 2014 are shown on the next page.

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Income Statement

Income

Gross sales $2,408,000

Sales returns and allowances (80,000)

Net sales $2,328,000

Cost of goods sold (920,000)

Gross profit $1,408,000

Dividends received from stock investments in less-than-20%-owned U.S. corporations 12,000

Interest income

State bonds $ 14,000

Certificates of deposit 10,000 24,000

Total income $1,444,000

Expenses

Salaries—officers

Nancy Trout $160,000

Delores Lake 160,000 $320,000

Salaries—clerical and sales 290,000

Taxes (state, local, and payroll) 85,000

Repairs and maintenance 56,000

Interest expense:

Business loans $ 12,000

Loan to purchase state bonds 8,000 20,000

Advertising 6,000

Rental expense 68,000

Depreciation* 40,000

Charitable contributions 15,000

Employee benefit programs 24,000

Premiums on term life insurance policies on lives of Nancy Trout and Delores Lake; Kingfisher is the designated beneficiary 16,000

Total expenses (940,000)

Net income before taxes $ 504,000

Federal income tax (171,904)

Net income per books $ 332,096

* You are not provided enough detailed information to complete a Form 4562 (depreciation). If you solve this problem using H&R BLOCK Tax Software, enter the amount of deprecation on line 20 of Form 1120.

Balance Sheet

Assets January 1, 2014 December 31, 2014

Cash $ 380,000 $ 335,524

Trade notes and accounts receivable 308,400 480,280

Inventories 900,000 1,012,000

State bonds 160,000 160,000

Federal income tax refund –0– 3,096

Certificates of deposit 140,000 140,000

Stock investments 300,000 300,000

Building and other depreciable assets 240,000 240,000

Accumulated depreciation (88,800) (128,800)

Land 20,000 20,000

Other assets 3,600 2,000

Total assets $2,363,200 $2,564,100

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Liabilities and Equity January 1, 2014 December 31, 2014

Accounts payable $ 300,000 $ 299,104

Other current liabilities 80,300 40,000

Mortgages 210,000 200,000

Capital stock 500,000 500,000

Retained earnings 1,272,900 1,524,996

Total liabilities and equity $2,363,200 $2,564,100

During 2014, Kingfisher made estimated tax payments of $43,750 each quarter to the IRS. Prepare a Form 1120 for Kingfisher for tax year 2014. Suggested software: H&R BLOCK Tax Software.

Research Problems

Student Edition

Note: Solutions to Research Problems can be prepared by using the Checkpoint�

Student Edition online research product, which is available to accompany this text. It is also possible to prepare solutions to the Research Problems by using tax research materials found in a standard tax library.

Research Problem 1. A personal service corporation (PSC) generally is limited to the calendar year for reporting purposes. One exception to this rule is when the PSC can demonstrate a business purpose for a fiscal year-end. Discuss the business purpose exception, including examples of when the standard is and is not satisfied. Support your research with proper citations of tax authority.

Partial list of research aids: § 441(i). Reg. § 1.441–3.

Research Problem 2. A new client, John Dobson, recently formed John’s Premium Steakhouse, Inc., to operate a new restaurant. The restaurant will be a first-time busi- ness venture for John, who recently retired after 30 years of military service. John transferred cash to the corporation in exchange for 100% of its stock, and the corpo- ration is considering leasing a building and restaurant equipment. John has asked you for guidance on the tax treatment of various expenses (e.g., licensing, training, advertising) he expects the corporation to incur during the restaurant’s pre-opening period. Research the tax treatment of startup expenditures, including the point at which a business begins for purposes of determining what expenses are included. Prepare a memo for the client files describing the results of your research.

Partial list of research aids: § 195. Reg. § 1.195–1.

Research Problem 3. Tern Corporation, a calendar year C corporation, is solely owned by Jessica Ramirez. Tern’s only business since its incorporation in 2012 has been land surveying services. In Tern’s state of incorporation, land surveying can be performed only by a licensed surveyor. Jessica, Tern’s only employee, is a licensed surveyor but is not a licensed engineer. Upon audit of Tern’s 2012 and 2013 tax returns, the IRS assessed tax deficiencies stemming from its conclusion that the cor- poration was a personal service corporation subject to the flat tax rate of 35%. Jessica believes that the IRS’s determination is incorrect, and she has asked you for advice on how to proceed. Evaluate the IRS’s position regarding the treatment of Tern Cor- poration as a personal service corporation, and prepare a memo for the client files describing the results of your research.

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Research Problem 4. A client has asked you for guidance on selecting the best type of entity for her new business. Using the Internet as your sole research source, pre- pare an outline detailing the advantages and disadvantages of the entity forms avail- able to a sole owner. Include both tax and nontax issues in your analysis.

Research Problem 5. A significant percentage of U.S. corporations are closely held corporations, with the stock of such corporations often owned predominately or exclusively by family members. Using the Internet as your sole research source, pre- pare an outline describing the tax implications and planning opportunities unique to family-owned, closely held corporations.

Research Problem 6. Download Schedule M–3 and the accompanying instructions from the IRS website. The instructions provide several examples of adjustments that are reported on Schedule M–3. Select three of these examples, and make the required entries to the appropriate parts and lines of Schedule M–3.

Research Problem 7. On November 21, 2013, Max Baucus, chairman of the Senate Finance Committee, released a proposal to change several provisions related to the taxation of business income including, but not limited to, that earned by corpora- tions. The proposal deals primarily with cost recovery and tax accounting methods. Many of the proposed changes are similar to ones contained in House Ways and Means Committee Chairman Dave Camp’s small business tax reform discussion draft released earlier in the year. Locate the staff discussion draft of Chairman Baucus’s proposal and prepare a PowerPoint presentation of no more than five slides high- lighting the major reforms contained in the proposal.

Roger CPA Review Questions

1. What is the filing deadline for a C Corporation?

a. March 15

b. April 15

c. The 15th day of the 3rd month after year end

d. The 15th day of the 4th month after year end

2. Keckye Co. is a calendar year C Corporation. When is Keckye’s tax return due?

a. March 15

b. April 15

c. June 15

d. October 15

3. Keckye Co. is a C Corporation with a fiscal year-end of September 30. When is Keckye’s tax return due?

a. March 15

b. April 15

c. December 15

d. January 15

4. Identify which of the following cannot function as a pass-through entity for tax pur- poses.

a. Sole proprietorship

b. Limited Liability Company

c. Partnership

d. S-Corporation

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Internet Activity

Use the tax resources of the Internet to address the following questions. Do not restrict your search to the Web, but include a review of newsgroups and general reference materials, practitioner sites and resources, primary sources of the tax law, chat rooms and discussion groups, and other opportunities.

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5. The following chart shows ownership percentages of Devon Corp. in X, Y and Z Corporations, and dividends received by Devon from these corporations in 20X14.

Devon’s Ownership % Dividend Received

X Corp. 15% $100,000

Y Corp. 20% 120,000

Z Corp. 30% 200,000

Devon is a calendar-year corporation and received no other dividends in 20X14. What amount of dividend income must be included by Devon on its 20X14 corpo- rate tax return?

a. $126,000

b. $114,000

c. $94,000

d. $106,000

6. Crimson Corp. was organized as a calendar-year corporation in January 20X14, incurring $51,000 in qualified organizational expenses, and began business in March 20X14. What is the maximum amount Crimson may deduct for organizational expenditures on its 20X14 corporate tax return?

a. $4,000

b. $6,611

c. $6,350

d. $7,133

7. When preparing Schedule M-1 of Form 1120, which of the following must be added to net income per books in order to compute taxable income?

a. 100% of meals and entertainment expense

b. Municipal bond interest

c. Excess of tax vs. book depreciation

d. Accrued bad debt expense

For the latest in changes to tax legislation, visit www.cengagebrain.com.

CHAPTER 2 Corporations: Introduction and Operating Rules 2-57

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