CH 17: Corporations: Introduction and Operating Rules

The personal holding company (PHC) tax (described in §§ 541-547) was enacted to discourage the sheltering of certain kinds of passive income in corporations owned by individuals with high marginal tax rates. Historically, the tax was aimed at "incorporated pocketbooks" that were frequently found in the entertainment and construction industries.

For example, a taxpayer could shelter income from securities in a corporation, which would pay no dividends, and allow the corporation's stock to increase in value. Like the accumulated earnings tax, the PHC tax employs a 20 percent rate and is designed to force a corporation to distribute earnings to shareholders.

A further negative consideration is that the tax rules for filing a consolidated return may not mesh with those applicable for financial accounting purposes.

For example, foreign corporations cannot be included in the consolidated tax return but should be considered when preparing financial statements. This variance in treatment may require explanatory reconciliation and will further add to the administrative burden.

Like individuals, corporations are subject to percentage limits on the charitable contribution deduction.26 For any tax year, a corporate taxpayer's contribution deduction is 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 carryback or capital loss carryback, and dividends received deduction.

The income taxation of corporations and individuals also differs significantly. Individuals are subject to a progressive tax rate structure; a flat tax rate applies to corporations.

Further, individuals are subject to an alternative minimum tax while the corporate AMT was repealed by the Tax Cuts and Jobs Act (TCJA) of 2017.

Property Contributions

Generally, a charitable contribution of property results in a deduction equal to the property's fair market value at the date of the gift. As a result, a contribution of loss property (fair market value less than basis) should be avoided. Instead, the loss property should be sold (allowing the loss to be recognized) and the proceeds contributed to the charity.

A Form 1120 must be filed on or before the fifteenth day of the fourth month following the close of a corporation's tax year.43 A regular corporation, other than a PSC, can use either a calendar year or a fiscal year to report its taxable income.

A Form 1120S must be filed on or before the fifteenth day of the third month following the close of an S corporation s tax year.

Members of an affiliated group need not file a consolidated return, and absent an election to consolidate, each corporation files its own Form 1120. If and when an election is made, all of the transactions for the group are combined and reported on one Form 1120.

A Form 1122 (Authorization and Consent of Subsidiary Corporation to Be Included in a Consolidated Income Tax Return) should be attached to the first consolidated Form 1120 for every subsidiary included in the group. Each subsequent consolidated Form 1120 must include a Form 851 (Affiliation Schedule) that provides pertinent information as to the members of the group.

A corporation is deemed to have made the election to amortize organizational expenditures for the taxable year in which it begins business.

A corporation can elect to forgo the election by capitalizing organizational expenditures on its first tax return.

Personal service corporation (PSC)

A corporation whose principal activity is the performance of personal services (e.g., health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and where such services are substantially performed by the employee-owners.

Dividends received deduction

A deduction allowed a shareholder that is a corporation for dividends received from a domestic corporation. The deduction usually is 50 percent of the dividends received, but it could be 65 or 100 percent depending upon the ownership percentage held by the recipient corporation. §§ 243-246.

Deferred Tax Expense

A deferred tax expense is the result of a deferred tax liability (a future tax liability related to transactions already reflected in the financial statements). Similarly, a deferred tax benefit is the result of a deferred tax asset (future tax savings related to transactions already reflected in the financial statements).

Reasonable needs of the business

A means of avoiding the penalty tax on an unreasonable accumulation of earnings. In determining the base for this tax (accumulated taxable income), § 535 allows a deduction for "such part of earnings and profits for the taxable year as are retained for the reasonable needs of the business." § 537.

Affiliated group

A parent-subsidiary group of corporations that is eligible to elect to file on a consolidated basis. Eighty percent ownership of the voting power and value of all of the corporations must be achieved every day of the tax year, and an identifiable parent corporation must exist (i.e., it must own at least 80 percent of another group member without applying attribution rules).

Personal holding company (PHC) tax

A penalty tax imposed on certain closely held corporations with excessive investment income. Assessed at a 20 percent tax rate on personal holding company income, reduced by dividends paid and other adjustments. § 541.

Accumulated earnings tax

A special 20 percent tax imposed on C corporations that accumulate (rather than distribute) their earnings beyond the reasonable needs of the business. The accumulated earnings tax and related interest are imposed on accumulated taxable income in addition to the corporate income tax. §§ 531-537.

In general, the $1 million maximum applies to compensation, commissions based on individual performance, and performance-based compensation tied to overall company performance. Before 2018, the $1 million limit excluded commissions and performance-based compensation.

Contracts in place on November 2, 2017, are grandfathered under pre-2018 law as long as there are no material changes to the contract. The limitation also does not apply to retirement plan contributions or employer-provided benefits that are excludible from gross income by the employee (e.g., health care benefits).

Schedule M-2 reconciles unappropriated retained earnings at the beginning of the year with unappropriated retained earnings at year-end. In general, this financial statement reconciliation is done by adding net income per books to the beginning balance of retained earnings and subtracting distributions made during the year. 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 (used by S corporations). These rules are intended to ease the compliance burden on small business.

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 three years, applying them first to the earliest year. Carryforwards then are allowed for a period of five years from the year of the loss. When carried back or forward, a long-term capital loss is treated as a short-term capital loss.

The taxation of dividend distributions to shareholders will reduce the tax savings that can be achieved through the shifting of income to a corporation and the arbitraging of tax rates. However, what if the double taxation of corporate earnings could be deferred or possibly avoided entirely?

Double taxation is deferred to the extent earnings are accumulated within the corporation instead of being distributed to shareholders. The present value of any tax liability on dividends is reduced the longer distributions are deferred. Also, a corporation's accumulation of earnings should cause its stock to appreciate in value. If a shareholder dies with such appreciated stock, all of the appreciation would avoid income taxation due to the step-up in basis under § 1014 (see Chapter 27).

Organizational expenditures

Expenditures related to the creation of a corporation or partnership. Common organizational expenditures include legal and accounting fees and state incorporation payments. Organizational expenditures exclude those incurred to obtain capital (underwriting fees) or assets (subject to cost recovery). Such expenditures incurred by the end of the entity's first year are eligible for a $5,000 limited expensing (subject to phaseout) and an amortization of the balance over 180 months. §§ 248 and 709(b).

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.

Failure to make the required estimated tax prepayments results in a nondeductible penalty being imposed on the corporation. The penalty is avoided, however, if any of various exceptions apply

Both corporate and individual taxpayers may deduct charitable contributions 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 due date of the corporation's tax return (i.e., the fifteenth day of the fourth month following the close of its taxable year).

Organizational expenditures are different from startup expenditures.35Startup expenditures include various investigation expenses involved in entering a new business (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. In general, startup expenditures must be capitalized.

However, at the election of the taxpayer, startup expenditures are deductible in the same manner as organizational expenditures. So 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 election) for organizational expenditures also apply to startup expenditures.

In general, entities that maintain inventory for sale to customers are required to use the accrual method of accounting for determining sales and cost of goods sold.

However, entities with average annual gross receipts of $26 million or less for the most recent three-year period can use the cash method to account for inventories.

Prior to the enactment of the TCJA of 2017, corporations were subject to an alternative minimum tax (AMT) that was structured similarly to the individual AMT.

However, the TCJA of 2017 repealed the corporate AMT for tax years beginning after 2017.

PSCs generally cannot deduct passive activity losses against either active income or portfolio income.

However, the application of the passive activity loss rules is not as harsh for closely held C corporations (that are not PSCs). They may offset passive activity losses against net active income, but not against portfolio income.

For this purpose, taxable income is computed without regard to the NOL 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.

The accumulated earnings tax (described in §§ 531-537) imposes a 20 percent tax on the current year's corporate earnings that have been accumulated without a reasonable business need. The burden of proving what constitutes a reasonable need is borne by the taxpayer.

In determining accumulated income, businesses are allowed a $250,000 ($150,000 for service corporations) minimum credit. As a result, most corporations can accumulate $250,000 in earnings over a series of years without fear of an accumulated earnings tax.

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 § 1250 depreciation recapture. In contrast, all depreciation taken on § 1245 property is subject to recapture.

A closely held corporation's deduction for shareholder-employee compensation is subject to the reasonableness standard of § 162(a)(1). A second limitation applies to publicly held corporations.

In general, § l62(m) limits the deductible amount of a publicly held corporation's compensation to any covered employee to $1 million annually. Covered employees are the principal executive officer, the principal financial officer, and the three other most highly compensated officers.

Business deductions are allowed for both corporations and individuals. Business deductions include interest (subject to the limitations discussed in text Section 17-10, certain taxes, losses (including casualty and theft losses), bad debts, cost recovery, charitable contributions, net operating losses, research and experimental expenditures, and some other less common deductions.

In the corporate form, there is no distinction between business and nonbusiness bad debts. Like individuals, corporations are not allowed an interest expense deduction if tax-exempt securities are purchased with borrowed funds. The same holds true for entertainment expenses, expenses contrary to public policy, certain accrued expenses between related parties, and lobbying expenses.

The purpose of the dividends received deduction is to mitigate multiple taxation of corporate income. Without the deduction, dividend income paid to a corporation would be taxed to the recipient corporation, with no corresponding deduction to the distributing corporation.

Later, when the recipient corporation distributed 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.

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 and dependent tax credits, the credit for elderly or disabled taxpayers, and the earned income credit.

Flow-Through Entities In the case of a partnership or an S corporation, the business interest deduction limitation applies at the entity level. The general carryforward rule for disallowed business interest does not apply to partnerships (or S corporations):

rather, a partner (or S corporation shareholder) can deduct the disallowed interest under a special carryforward rule. A partner's (or S corporation shareholder's) adjusted taxable income is determined without regard to the partner's (or shareholder's) distributive share of the partnership's (or S corporation's) items of income, gain, deduction, or loss.

As a general rule, the deduction for a contribution of ordinary income property also is limited to the basis of the property. Ordinary income property is appreciated property that, if sold, would not result in long-term capital gain (inventory and stock held for 12 months or less are common examples).

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 property or (2) twice the property's basis.

The following inventory contributions qualify for this increased contribution amount:

•A contribution of property to a charitable organization whose exempt purpose includes the care of the ill, the needy, or infants. •A contribution of tangible personal research property constructed by the corporation to a qualified educational or scientific organization that uses the property for research or experimentation or for research training.

Consolidated returns also have a number of potential disadvantages.

•An election is binding on subsequent years and can be avoided only if the makeup of the affiliated group changes or the IRS consents to the revocation of consolidated return status. •Recognition of losses from certain intercompany transactions is deferred. •The requirement that all group members use the parent's tax year could create short tax years for the subsidiaries. This could cause a bunching of income and use up a full year for carryover purposes. •Additional administrative compliance costs may be incurred as the consolidated tax return provisions are extensive and complex.

The consolidated return rules allow the group to make use of the losses of one (or more) of its members. Because this possibility could lead to major tax avoidance (e.g., a profitable corporation acquires a loss corporation to take advantage of its loss carryovers), multiple safeguards have been enacted by Congress to preclude (or curtail) such potential abuse.

One such safeguard protects against the use of losses and deductions that arose in a separate return year. A further safeguard limits the use of losses and deductions when ownership changes within the affiliated group have taken place.

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 (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 37 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), and then classify these differences as temporary (column 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).

Unlike individual taxpayers, however, a corporation:

•Does not adjust its tax loss for the year for any capital losses (since a corporation cannot deduct net capital losses), •Does not make adjustments for any nonbusiness deductions (as individual taxpayers do), and •Is allowed to include the dividends received deduction (discussed below) in computing its NOL.

The starting point on Schedule M-1 is net income (or loss) per books. Additions and subtractions 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 expense 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).

A PSC is a corporation:

•Formed to provide "personal services" (services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting): •Where the services are substantially performed by shareholder-employees; and •Where more than 10 percent of the stock (in value) is held by shareholder-employees. To limit deferral of income possibilities, PSCs must generally adopt a calendar year.

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 purposes and income (loss) reported for tax purposes. This expanded reconciliation of book and taxable income (loss) is reported on Schedule M-3.47 Schedule M-3 is reproduced in Appendix B.

Schedule M-3 is a response, at least in part, to a variety of financial reporting scandals. One objective of Schedule M-3 is to create greater transparency 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.

As for individuals, the net operating loss (NOL) of a corporation generally may be carried forward indefinitely to offset taxable income for those future years.

The NOL deduction for any carryover year is limited to 80 percent of taxable income (determined without regard to the NOL deduction) for both individuals and corporations.

Any business interest deduction disallowed by reason of the limitation is treated as business interest paid or accrued in the succeeding tax year. The carryforward period is unlimited.

The business interest deduction limitation does not apply to certain small businesses. In general, the small business exception applies to taxpayers with average gross receipts for the prior three-year period of $26 million or less.

A corporation must file a Federal income tax return whether it has taxable income or not. If a corporation began (or ceased) operations during a year, a short-period return (less than 12 months) must be filed for that year.

The corporate income tax return is Form 1120. Corporations electing under Subchapter S (see Chapter 22) use 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.

In the area of nontaxable exchanges, both corporations and individuals do not recognize gain or loss on a like-kind exchange and may defer realized gain on an involuntary conversion.

The disallowance of losses on property sales to related parties (e.g., a corporation and a more-than-50% shareholder) and on wash sales of securities apply to both individual and corporate taxpayers. The exclusion of gain from the sale of a personal residence does not apply to corporations.

Expenses that do not qualify as organizational expenditures include those connected with issuing or selling shares of stock or other securities (e.g., commissions, professional fees, and printing costs) or with transferring assets to a corporation. These expenses must be capitalized.

The first $5,000 of organizational costs is immediately expensed, with any remaining 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.

As noted previously, the deferral of certain intercompany sales can be advantageous (if gains are involved) or disadvantageous (if losses are involved).

The realized gain or loss from the intercompany sale is not recognized but is deferred. The deferred gain or loss may be recognized in a later year when the property ultimately is sold to outsiders.

Capital gains and losses result from the taxable sales or exchanges of capital assets.8 These gains and losses are classified as long term or short term depending on the holding period. 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 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), these 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 combination is necessary.

The election to file a consolidated return is available only to an affiliated group.38 An affiliated group exists when one corporation owns at least 80 percent of the voting power and stock value of another corporation.

The stock ownership test must be met on every day of the tax year. Multiple tiers and chains of corporations are allowed as long as the group has an identifiable parent corporation (i.e., at least 80 percent of one corporation must be owned by another).

If a useful life cannot be determined, no deduction is allowed. 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 business.

The §§ 1245 and 1250 depreciation recapture rules apply to both individual and corporate taxpayers (see Chapter 14). However, corporations may have more depreciation recapture (ordinary income) on the disposition of § 1250 property than do individuals because of § 291 recapture.

Under § 291, a corporation has additional ordinary income equal to 20 percent of the excess of (1) the amount of depreciation recapture that would be required if § 1245 applied to the disposition (i.e., § 1245 recapture potential) over (2) the amount of depreciation recapture computed under § 1250 (without regard to § 291). As a result, the § 1231 portion of the corporation's gain on the disposition is reduced by the additional recapture.

A limitation on the deduction for business interest applies to all taxpayers.12 Business interest is interest paid or accrued on trade or business debt. Although the limitation applies to any business, the rules are most likely to affect large corporations and flow-through entities due to a small business exception.

Under § l63(j), the deduction for business interest for any year is limited to the sum of: 1.The taxpayer's business interest income for the year. 2.30 percent of the taxpayer's adjusted taxable income for the year, and 3.The taxpayer's floor plan financing interest for the year.

Floor Plan Financing Interest

Virtually all auto dealers acquire their inventory via debt (known as "floor plan" financing), with the debt being secured by the inventory. Interest on this debt ("floor plan financing interest") is deductible without limitation.

No dividends received deduction is allowed unless the corporation has held the stock for more than 45 days.33 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 corresponding 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.

To qualify for the election, the expenditures must be incurred before the end of the tax year in which the corporation begins business. The corporation's method of accounting is of no consequence;

an expense incurred by a cash basis corporation in its first tax year qualifies even though it is not paid until a subsequent year. However, this rule could prove to be an unfortunate trap for corporations formed late in the first taxable year. Consider the following example.

Adjusted Taxable Income

"Adjusted taxable income"15 is taxable income computed without regard to any: 1.Nonbusiness income, gain, deduction, or loss: 2.Business interest or business interest income: 3.Net operating loss (NOL) deduction: 4.Deduction for qualified business income (§ 199A); and 5.Deduction allowable for depreciation, amortization, or depletion. The Treasury Department and the IRS are authorized to provide other adjustments to the computation of adjusted taxable income.17 The 30 percent of adjusted taxable income amount cannot be less than zero.

Business Interest Income

"Business interest income" is the amount of interest income includible in gross income for the year that is related to a trade or business. Congress believes that a corporation typically will have neither investment interest income nor investment interest expense: instead, all interest income and interest expense of a corporation is assumed to be part of the corporation's trade or business.

A corporation must make estimated tax payments unless its tax liability can reasonably be expected to be less than $500. The required annual payment 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, the return filed showed a tax liability, and the corporation involved is not a large corporation).

Current Tax Expense Determining current tax expense begins with estimating the current tax liabilities to be reflected on the corporation's tax returns. This includes three steps.

1.Identifying (and adjusting pretax book income for) all permanent and temporary book-tax differences. 2.Identifying (and adjusting pretax book income for) any tax carryovers that may impact current taxable income (e.g., capital losses, charitable contributions, NOLs). 3.Identifying (and adjusting the current tax liability for) any tax credits that may be available but have no impact on either book or taxable income.

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.Limit the deduction 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 sometimes is referred to as the NOL rule.

Gross income of a corporation is determined in much the same manner as it is for individuals. As a result, gross income includes compensation for services rendered, business income, gains from selling property, interest, rents, royalties, and dividends.

Although both individuals and corporations are entitled to exclusions from gross income, fewer exclusions are available to corporate taxpayers. Interest on municipal bonds and life insurance proceeds are exclusions that apply to both individual and corporate taxpayers.

The privilege of filing a consolidated return is based on the concept that an affiliated group of corporations constitutes a single taxable entity despite the existence of technically separate businesses (e.g., a parent and its subsidiary).

By filing a consolidated return, the corporation can eliminate intercompany profits and losses on the principle that its tax liability should be based on transactions with outsiders rather than on intragroup affairs.

Some of the key differences between income taxation of individuals and corporations include:

Accounting periods and methods. •Capital gains and losses. •Recapture of depreciation. •Business interest expense limitation. •Passive activity losses. •Charitable contributions. •Executive compensation. •Net operating losses. •Special deductions available only to corporations.

Any contributions in excess of the 10 percent limitation may be carried forward to the five succeeding tax years.

Any carryforward is combined with contributions in those years and then subject to the 10 percent limitation. The current year's contributions are always deducted first, with carryover amounts from previous years deducted in order of time.

Passive activity loss

Any loss from (1) activities in which the taxpayer does not materially participate or (2) rental activities (subject to certain exceptions). Net passive activity losses cannot be used to offset income from nonpassive activity sources. Rather, they are suspended until the taxpayer either generates net passive activity income (and a deduction of such losses is allowed) or disposes of the underlying property (at which time the loss deductions are allowed in full). One relief provision allows landlords who actively participate in the rental activities to deduct up to $25,000 of passive activity losses annually. However, a phaseout of the $25,000 amount commences when the landlord's AGI exceeds $100,000. Another relief provision applies for material participation in a real estate trade or business.

Trade or Business The term trade or business does not include performing services as an employee.

As a result, an individual cannot include W-2 wages in adjusted taxable income for purposes of computing the interest deduction limitation. The term also does not include certain real property trades or businesses and certain farming businesses.

The dividends received deduction cannot exceed the taxable income limitation. This limitation is equal to the corporation's taxable income multiplied by the same percentage used to compute the deduction.

As a result, if a corporate shareholder owns less than 20 percent of the stock in the distributing corporation, the dividends received deduction is limited to 50 percent of taxable income.

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.

Over the past several decades, there has been little difference between the top individual and corporate marginal tax rates. For instance, prior to the TCJA of 2017, there was less than a 5 percent difference between those rates (39.6 percent individual rate versus 35 percent corporate rate). This nominal differential in top rates limited the tax savings opportunities that could be achieved by individuals shifting income to a corporation.

However, this landscape changed dramatically with the enactment of the corporate 21 percent flat tax rate. Consequently, a high-income individual now can achieve up to a 16 percent reduction in tax rate by shifting income to a corporation (37 percent individual rate versus 21 percent corporate rate). As a result, high-income individuals might consider the corporate entity form as a means to reduce their tax burdens.

In two situations, a charitable contribution of capital gain property is measured by the basis of the property rather than fair market value. First, if the taxpayer contributes tangible personal property and the charitable organization puts the property to an unrelated use, the deduction is limited to the basis of the property.

If the use is related to the charity's exempt purpose, the contribution deduction will be based on the property's fair market value. Second, the deduction for charitable contributions of capital gain property to certain private foundations is also limited to the basis of the property.

Accrual basis taxpayers generally must recognize gross income no later than the tax year in which the income is included as income for financial statement purposes.

In addition, accrual taxpayers can elect to defer income inclusion of advance payments for goods and services to the end of the tax year following the tax year of receipt.

Gains and losses from property transactions are handled similarly. For example, whether a gain or loss is capital or ordinary depends on the nature of the asset in the hands of the taxpayer.

In defining what is not a capital asset, § 1221 makes no distinction between corporate and noncorporate taxpayers.

Income Taxation of Individuals and Corporations Compared INDIVIDUALS: Computation of Gross Income: Sec 61 Computation of Taxable Income: Sec 62 and 63(b) thru (g) Deductions: Trade or business (§ 162); nonbusiness (§ 212); deduction for qualified business income (§ 199A); reimbursed employee business expenses; some personal expenses (generally deductible as itemized deductions). Charitable Contributions: Limited in any tax year to 50% of AGI (60% of AGI for cash contributions); generally limited to 30% of AGI for capital gain property. Excess charitable contributions carried over for five years. Amount of deduction 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 tangible personalty is donated to a nonuse charity or the donation is to certain private foundations. Time of deduction is the year in which payment is made. Casualty Losses: Personal casualty losses limited to losses attributable to a Federally declared disaster; $100 floor on losses; total personal casualty losses deductible only to extent losses exceed 10% of AGI. Net Operating Loss: Adjusted for several items, including nonbusiness deductions over nonbusiness income. Indefinite carryforward; carryforward deduction limited to 80% of taxable income. Dividends received deduction: None Net Capital Gains: Taxed in full. Tax rate is 0%, 15%, or 20% on net capital gains. 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- and long-term carryovers retain their character. Passive Activity Losses: In general, passive activity losses cannot offset either active income or portfolio income. Tax Rates: Progressive with seven rates (10%, 12%, 22%, 24%, 32%, 35%, and 37%). Alternative Minimum Tax: Applied at a graduated rate schedule of 26% and 28%. Exemption allowed depending on filing status (e.g., $113,400 for married filing jointly in 2020); phaseout begins when AMTI reaches a certain amount (e.g., $1,036,800 in 2020 for married filing jointly).

Income Taxation of Individuals and Corporations Compared INDIVIDUALS: Computation of Gross Income: Sec 61 Computation of Taxable Income: § 63(a). Concept of AGI has no relevance. Deductions: Trade or business (§ 162). Charitable Contributions: Limited in any tax year to 10% of taxable income computed without regard to the charitable contribution deduction, net operating loss carryback, capital loss carryback, and dividends received deduction. Same as for individuals. Same as for individuals, but exceptions allowed for certain inventory and for research property where one-half of the appreciation also is allowed as a deduction. Time of deduction is the 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 fourth month of following year. Casualty Losses: Deductible in full. Net Operating Loss: Generally no adjustments. Same as for individuals. Dividends received deduction: 50%, 65%, or 100% of dividends received depending on percentage of ownership by corporate shareholder. Net Capital Gains: Taxed in full. No preferential tax rate. Capital Losses: Can offset only capital gains; unused loss is carried backthree years and forward five; carryovers and carrybacks are characterized as short-term losses. Passive Activity Losses: Passive activity loss rules apply to closely held C corporations and personal service corporations.For personal service corporations, passive activity losses cannot offset either active income or portfolio income.For closely held C corporations, passive activity losses may offset active income but not portfolio income. Tax Rates: Flat rate of 21%. Alternative Minimum Tax: None.

Capital Gains

Individuals pay the required tax using a preferential rate of 0, 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; this income is taxed at the normal corporate tax rate.

Corporations: -Income (Broadly) Defined (Exclusions) -Gross Income (Deductions except for NOL and DRD) -Taxable Income before NOL and DRD (Net operating loss deduction) (Dividends received deduction) -Taxable Income -Tax on taxable income (Tax credits) Tax Due (or refund)

Individuals: Income (Broadly defined) (Exclusions) -Gross Income (Deductions for AGI) -Adjusted Gross Income (Greater of itemized or standard deductions) (Deduction for qualified business income) -Taxable Income -Tax on taxable income (Tax Credits) Tax Due (or refund)

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 net capital losses against other income. Any remaining capital losses are carried forward to future years until absorbed by capital gains or by the $3,000 annual deduction. Loss carryovers retain their identity as either long term or short term.

Corporations generally have the same choices of accounting periods as do individual taxpayers. A corporation may choose a calendar year or a fiscal year for reporting purposes, but corporations normally can have different tax years from those of their shareholders.

Newly formed corporations (as new taxpayers) usually can choose an accounting period (IRS consent is not needed). Personal service corporations (PSCs) and S corporations, however, are restricted in the use of fiscal years.

Beyond the minimum credit, earnings can be accumulated for reasonable needs of the business , such as expansion of the business, replacement of plant and equipment, working capital needs, product liability losses, debt retirement, self-insurance, and loans to suppliers and customers.

Reasonable needs do not include loans to shareholders, investments in unrelated properties or businesses, and unrealistic hazards and contingencies. Finally, the accumulated earnings tax can be further reduced or eliminated by distributing dividends.

Schedule M-1 of Form 1120 is used to reconcile net income as computed for financial accounting purposes [i.e., using generally accepted accounting principles (GAAP)] with taxable income reported on the corporation's income tax return (commonly referred to as book-tax differences).

Schedule M-1 is required of corporations with less than $10 million of total assets.

A corporation that needs more time to prepare and file its tax return can receive an automatic six-month extension of its tax return due date if it files Form 7004 (and pays the related tax liability) by the due date of its return.

The IRS may terminate an extension by mailing a 10-day notice to the corporation.

All allowable corporate deductions are treated as business deductions. As a result, the determination of adjusted gross income (AGI), so essential for individual taxpayers, has no relevance to corporations.

Taxable income is computed simply by subtracting all allowable deductions from gross income. Itemized deductions (and the related limitations), the standard deduction, and the deduction for qualified business income do not apply to corporations. In addition, individuals are subject to a limitation on "excess business losses" (which does not apply to corporations).

Accounting for income taxes under GAAP is governed by Accounting Standards Codification (ASC) 740. Consistent with most financial accounting principles, ASC 740 emphasizes the balance sheet, taking a balance sheet approach to the accounting for income taxes. Specifically, it requires that the balance sheet reflect both a current liability related to all income taxes (Federal, state and local, and foreign) reflected on its tax returns for the year as well as a deferred tax liability or deferred tax asset for the future tax effects of items included in its current and prior financial statements but not in taxable income (i.e., temporary book-tax differences).

That is, ASC 740 adopts a comprehensive inter-period allocation approach to income taxes, requiring that all income taxes that relate to the income reported in the current financial statements be reported in those same financial statements regardless of when they might be legally due under the tax law. The sum of the liabilities reflected on the current tax returns represents a corporation's current tax expense while the future tax effects related to its temporary book-tax differences lead to the recognition of either a deferred tax expense or deferred tax benefit.

The passive activity loss rules apply to individual taxpayers, closely held C corporations, and personal service corporations.

These rules prevent taxpayers from incorporating to avoid the passive activity loss limitations (refer to Chapter 11). 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 five or fewer individuals.

Corporate income tax rates have fluctuated over the years. The top corporate income tax rate was reduced from 46 percent to 34 percent in 1986, and then raised to a top rate of 35 percent a few years later (see Exhibit 17.3).

This rate was the highest of all the developed countries in the world prior to the enactment of the TCJA of 2017. The TCJA of 2017 reduced the corporate tax rate to a flat rate of 21 percent for tax years beginning after 2017 (including for PSCs).

A corporation using 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 a related party, it cannot claim a deduction until the related party reports the amount as income.

This rule is most often encountered when an accrual method corporation deals with a cash method individual who owns (directly or indirectly) more than 50 percent of the corporation's stock. However, in the case of a personal service corporation, any shareholder-employee is treated as a related party for purposes of this limitation.

Both U.S. financial accounting and tax rules use the term consolidation, butthere is only a slight resemblance in the content of those rules. Here are some of the key similarities and differences between the bookand tax treatment of conglomerates.

•GAAP consolidations for the most part are mandatory when specified ownership levels are met. Federal income tax consolidation is an election by the affiliates to join the parent's tax return. •GAAP consolidations can include entities such as partnerships and non-U.S. entities. Federal income tax rules generally limit the consolidated return only to U.S. C corporations. •Ownership levels required for a U.S. subsidiary to consolidate with a parent differ between the book and tax rules. For example, not only does GAAP set a lower maximum for consolidation (50 percent versus 80 percent) but consolidation may not be elective (see above). Furthermore, the categorization and treatment of minority interests may vary. •Tax rules treat a merger or an acquisition of a target corporation by a parent as a nontaxable transaction, assuming that the requirements of a § 368 reorganization are met (see Chapter 20). Under GAAP, the transaction usually is reported as a purchase of the target's identifiable assets and liabilities. •After a takeover occurs, book cost amounts are "stepped up" or"down"to fair market value and any excess purchase price is deemed to be goodwill. For Federal income tax purposes, if reorganization treatment is available, the target's basis in its assets carries over to the parent's accounts. •Goodwill is treated differently under book and tax rules. Financial accounting goodwill cannot be amortized, but impairments to its value are reported as operating losses. Book income results if that impairment of the goodwill is reversed, for example, because the value of the goodwill has increased. For Federal income tax purposes, purchased goodwill is amortized over 15 years.

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., tax depreciation in excess of financial accounting depreciation). The result is taxable income (before the NOL deduction and the dividends received deduction). Concept Summary 17.3 provides a conceptual diagram of Schedule M-1.

Organizational expenditures include the following:

•Legal services related 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.

Advantages and Disadvantages of Filing Consolidated Returns The advantages of a consolidated return are summarized below.

•Losses of one group member can be used to shelter the income of other members. See Example 29. •Taxation of intercompany dividends may be eliminated. •Deductions may be optimized due to percentage limitations being modified as a result of the consolidation process. See Example 29. •Recognition of income from certain intercompany transactions can be deferred. See Example 31. Consolidation also eliminates any intercompany pricing problems among related corporations that might arise under § 482.

In any single year, the IRS cannot impose both the PHC tax and the accumulated earnings tax. Generally, a company is considered a PHC and may be subject to the tax if:

•More than 50 percent of the value of the outstanding stock is owned by five or fewer individuals at any time during the last half of the year, and •A substantial portion (60 percent or more) of the corporation's income is comprised of passive types of income including dividends, interest, rents, royalties, or certain personal service income. Similar to the accumulated earnings tax, the PHC tax can be further reduced or eliminated by distributing dividends.

As a general rule, the cash method of accounting is unavailable to corporations.4 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 $26 million or less for the most recent three-year period.

Computing Consolidated Taxable Income Several categories of transactions do not enter into the determination of taxable income.

•Some intercompany transactions are disregarded. Examples would be dividends paid by one group member to another. See also the situation presented in Example 27. •Gains and losses from certain intercompany sales are not recognized until the sold asset leaves the affiliated group (e.g., disposition of the property to an outside party). See Examples 31 and 32.

Generally, a deferred tax asset is produced when:

•The recognition of revenue is accelerated for tax purposes relative to book (e.g., the recognition of unearned revenues for tax earlier than book), or •The deductibility of an expense reported in the financial statements is deferred for tax purposes (e.g., an expense reported in the financial statements has not yet met the economic performance test for tax).

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 previously (see Part I, lines 5 through 10).