REG - Notes Chapter 3

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C Corps, Depreciation, and MACRS
Formation
Corporation tax consequences
• No gain/loss recognized upon formation
• Basis of property received by corporation is the greater of:
- Adjusted NBV of the transferor + any gain recognized by the transferor
- Debt assumed by the corporation
- Exception: if the NBV is less than the FMV of the asset, the corp uses the FMV as basis to avoid built
in losses

Shareholder tax consequences

• No gain/loss recognized when contributing property to a corp for stock if the following two have been met:
- Shareholder has 80% control, and
- Shareholder receives no boot (cash or cancellation of debt)

Basis of common stock to shareholder

• Cash – the amount shareholder contributed
• Property – Adjusted basis (NBV)
- The Adjusted basis of preoperty is reduced by any cancellation of debt
- Add: taxable boot – debt exceeds asset’s adjusted basis – to bring stock basis to zero
• Services rendered to corp at FMV

Operations
Book income vs. taxable income is reconciles on schedule M-1

Cash received in advance of accrual GAAP income is taxed such as:

• Interest income received in advance
• Rental income received in advance
• Royalty income received in advance
These create temporary differences

Some GAAP income items are not includible at taxable income, such as:
• Interest income from municipal or state bonds
• Proceeds from life insurance on key officers’ lives where the corporation is the beneficiary
These create permanent differences

Trade or business deductions (ordinary and necessary expenses)

Domestic production deduction – get a special deduction for keeping jobs in America and not outsourcing
- 2006 – 3% deduction
- ’07-‘09 – 6% deduction
- 2009+ – 9% deduction
The deduction is a percentage lesser of:
• Qualified Production Activities Income (QPAI), or
• Taxable income (disregarding the QPAI deduction)

Domestic Production Gross Receipts [gross receipts derived from production within the U.S]
(COGS)
(Other directly allocable expenses or losses)
(Proper share of other deductions)
= Qualified Production Activities Income (QPAI)

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Bonuses paid by an accrual taxpayer are deductible in the current tax year, provided they are paid within 2 ½
months after year end (so if 12/31 year end, then pay by 3/15)

Bad debts – specific charge-off method

• Accrual basis – must use direct write off methods
• Cash basis – not allowed a tax deduction

Business interest expense

• Interest incurred for business purposes are tax deductible
• Interest expense on loans for investments is deductible but limited to net investment income
• Prepaid interest expense – must allocate

Charitable contributions is allowed a maximum deduction of 10% of adjusted taxable income

Business losses or causualty losses related to business (its different than the individual/personal casualty loss)
• No $100 deductible
• No 10% of AGI reduction

Organizational expenditures and start up costs

• Corp can deduct up to $5,000 of organizational expenditures and $5,000 start up costs
• Any excess costs are amortized over 180 months
• GAAP rule - expense all
• Exam trick: carefully look at the month the business started. They’ll have the business start in July, so you
only get to 6 months on the excess amortization
• These cost do not include the cost of raising capital (flotation costs, commissions, underwriter fees)

Amortization, Depreciation, and Depletion

• Purchased goodwill
- Tax rule: amortize on straight-line basis over 15 years
- GAAP rule: not amortized, test for impairment

Life insurance premiums (expense)

• Premiums paid by Corp on key employees, and Corp is beneficiary, not tax deductible
• Employee names the beneficiary, it’s a employee benefit, and those premiums are tax deductible

Business gifts - $25 is deductible

Business meals and entertainment – 50% is tax deductible

Penalties and illegal activities are not deductible

Taxes
• State, local and federal payroll taxes relating to business are deductible when incurred
• Federal income taxes are not deductible
• Foreign income taxes may be used as a credit

Lobbying and political expenditures are not tax deductible

Capital gains and losses

• Capital losses can only be used to offset capital gains, so no deduction allowed
• Net capital losses can be
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- Carried back 3 years
- Carried forward 5 years
• Capital gains taxed as ordinary income, no special 15% rate

Net operating loss (same as individuals)

- Carried back 2 years
- Carried forward 20 years

General business credit

• Its generally net income less the greater of:
- 25% of regular tax liability above $25,000

R3-21 corporation taxation summary between temp and permanent differences

Dividends received deductions – you get to exclude a % of dividends based on ownership %

% Ownership Div Rec Deduction (DRD)
0 - 19% 70%
20 - 79% 80%
80 - 100% 100%
Requirements
• 1st corporation is taxed
• Owned for 45 days before or after
• Take smaller of:
- Div Rec Deduction % * dividends received, or
- Div Rec Deduction % * Taxable income before DRD

DRD does not apply to

• Personal service corps, personal holding companies, personally taxes S corps

Dividends from affiliated corps that file consolidated returns qualify for 100% deduction

Depreciation
MACRS depreciation rules for machinery and equipment
• Salvage value is ignored
• Half year convention – applies to personal property places in service or disposed of during a taxable year is
treated as being placed or disposed at the midpoint of the year
• Mid-Quarter convention – if more than 40% of depreciable property is placed in service in the last quarter
of the year, the mid quarter convention must be used

MACRS: real estate (buildings)

• Salvage value ignored
• Subtract land cost
• Residential rental property (apartments, rental homes) – 27.5 year straight line
• Non-residential real property (office building, warehouses) – 39 year straight line
• Mid month convention – straight line depreciation is computed based on the number of months the property
was in service. ½ month is taken in the month the property was placed in service. ½ month is taken for the
month in which the property was disposed.

Expense deduction in leiu of depreciation (section 179)

Each tax year, a tax payer may deduct a fixed amount of depreciation (machinery and property).
• The limit for 2006 is $108,000 on new or used property that is acquired during the year
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• The max amount is reduced dollar for dollar by the amount of property palce in service during the year that
exceeds $430,000 in 2006
• The deduction is not permitted when a net loss exists or if it would create a net loss
• SUV’s: limit the cost of sport utility vehicle (SUV) that may be expensed under section 179 to $25,000

Depletion
• GAAP is cost depletion calculation (R3 – 28)
• % Depletion (non GAAP)
- The deduction is limited to 50% of taxable income
- Allowable percentages range from 5%-22% depending on the mineral being extracted

Amortization
• Intangibles such as goodwill, licences, franchises, and trademarks are amortized SL over 15 years
• Business start up costs and organization costs – 5,000 is expensed and excess is amortized SL over 180
months (explained earlier)

Summary of Section 1231, 1245, and 1250 assets

Section 1231 – depreciable personal and real property used in taxpayers trade or business and held over 1 year
• Special capital gain treatment on net gains from sales, exchanges of certain non-capital assets
• All 1231 losses are treated as ordinary income

Section 1245 (machinery and equipment, gains only) – personal business property assets used in trade or
business for over a year (autos)
• Upon a sale of a 1245 asset all accumulated depreciation is recaptured as ordinary income
• Any remaining gain is a capital gain under section 1231

Section 1250 (buildings, gains only) – real business property used in trade or business for over 1 year
(warehouse)
• Recaptures deprecation in excess of straight line

Taxation of a C Corporation
Filing requirements – 15th day of the third month after tax year end, so 12/31 yr end, file by 3/15
Estimated payments of corporate tax
• Large corporations – must pay 100% of tax as shown on the current year tax return
• Not large corporations (less than a $1 million in taxable income in the past 3 years)
- 100% of tax as shown on the current year tax return
- 100% of tax as shown on the previous years tax return

An affiliated group of corporations may elect to be taxed a single unit, thereby eliminating intercompany
gains/losses
• An affiliated group means that a common parent owns:
- 80% or more of the voting power of all outstanding stock, and
- 80% or more of the value of all outstanding stock of each corporation

Alternative minimum tax

Adjustments – add or subtract items to income – LIE
• Long term contracts – difference between completed contract and percentage of completion
• Installment sale dealer – difference between full accrual and installment sales
• Excess Depreciation over 40 yr-SL for real property, 150% DDB for personal property using normal life

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Preferences – add items to increase income – PPP

• Percentage depletion – excess percentage depletion over the adjusted basis of the property
• Private activity (tax exempt interest income)
• Pre ’87 ACRS excess depreciation over SL

Adjusted Current Earnings – increase or decrease – MIND

• Muni interest income (tax exempt interest income)
• Increase CSV life insurance
• Non S/L depreciation (excess over SL)
• Div Rec deduction – when you have under 20% ownership

Exemption Formula – the exemption amount is $40,000 less 25% of AMTI in excess of $150,000. As a result,
the exemption is completely phaseout for AMTI over $310,000
40,000 – [(Minimum taxable income – $150,000) * 25%] = Exemption allowed

The tax rate on the AMTI is a flat 20%

Foreign tax credit is allowed

Minimum tax credit (MTC)

• AMT can be used as a credit against future regular tax
• Can be carried forward forever

The accumulated earnings tax is imposed on regular C corps whose accumulated (retained) earnings are in
excess of $250,000 is improperly retained
• 15% additional tax if found guilty

Personal holding company tax – corps set up by rich people to channel their investment income to corporate tax
rates (15-25%) instead of paying their higher individual rate

Personal holding company – corps more than 50% owned by 5 or less individuals and having 60% of adjusted
gross income consisting of:
• Net rent
• Interest that is taxable (non taxable is excluded)
• Royalties (not mineral, oil, gas or copyright royalties)
• Dividends from an unrelated domestic corp
Personal holding companies are taxed an additional 15% on net income not distributed

Corporate distributions
Dividends defined – earnings and profits (E&P)
• Current E&P (by year end) = taxable dividend
• Accumulated E&P (dist. date) = taxable dividend
• Return of Capital (No E&P) = tax free and reduced basis of common stock
• Capital Gain Distribution (No E&P/No Basis) = taxable income as capital gain

Matching cash dividends to source

• Current earnings and profit – allocated on a pro rata basis to each distribution
• Accumulated earnings and profits – applied in chronological order, beginning with the earliest distribution

Stock dividends – not taxable

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Corp paying dividend
• The payment of the dividend does not create a taxable event
• Property dividends recognizes a gain as if the property had been sold (FMV – adjusted basis)

Stock redemption/buyback
• Proportional buyback – taxable dividend income (to shareholder – ordinary income)
• Disproportional (only shares from certain stockholders were bought back) – sale by shareholder is subject
to capital g/l to shareholder

Corporate liquidation – corp and shareholder recognize g/l (double taxation). Two types of corporate
liquidations
• Corp sells assets and distributes cash to shareholders
- The corp recognizes a g/l on the sale of the assets, and
- Shareholders recognize a g/l to the extent the cash exceeds adjusted basis
• Corp distributes assets to shareholders
- Corp recognizes g/l as if it sold the assets for the FMV (FMV-basis = g/l)
- Shareholder recognizes g/l to extent FMV of assets received exceed the adjusted basis in the stock

Re-organizations are a tax free event

• Because it results in the continuation of a business in a modified form. In order to meet the “continuity
requirement” the acquiring corporation must continue the business of the old entity or use a significant portion
of the old corporations assets

Worthless stock – Section 1244 stock (small business stock)

• An original stockholder can be treated as having an ordinary loss (fully tax deductible), instead of a capital
loss
• Up to S $50,000 (MFJ $100,000)
• Any loss in excess of this amount would be a capital loss, which would offset capital gains and then a
maximum $3,000 per year would be deductible

Small Business stock

• A non corporate shareholder, who holds qualified small business stock for more than 5 years, may exclude
50% of the gain on the sale or exchange of the stock

Small Business Corps – S Corps

Eligible S Corp Shareholders
• Must be an individual, estate or certain type of trust (no corps or P/S not allowed)
• May not be a non-resident alien
• Limit of 100 shareholders
• Only one class of stock allowed. Differences among common stock voting rights are allowed. (no preferred)

If you elect to be an S corp by March 15, then it takes effect for the whole year

S corps must adopt a calendar year, unless there is valid business purpose

Pass-through entity, no tax at the corporate level

Exception: Taxed at corporate level if both conditions exist:
- A C corp elects S corp status, and
- FMV of the corporate assets exceeds the adj basis of on the election date
Pass through income/losses to shareholder K-1

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• Like P/S, S corps report both separately and non-separately stated items of income and/or loss
• Allocations to shareholders are made on a per share, per day basis
• Losses are limited to a shareholders adj basis in S corp stock + direct shareholder loans to the corp
- in a P/S, liabilities increase basis

Computing shareholder basis in S corp stock

Initial basis
+ Income & additional investment into the stock
- Distribution & losses
= Ending basis

An S corp shareholder is permitted to deduct (on their personal income tax return their pro rate share of the S
corp loss based on the following limitation:
Loss limitation = Basis + direct shareholder loans – distributions

Taxability of distributions to shareholders

S Corp with no C Corp E&P
Distribution Treatment Tax Result
To extent of basis in stock return of capital not taxable, reduce basis in stock
In excess of basis of stock capital gain distribution taxed as ST ot LT capital gain

S Corp with C Corp E&P

Distribution
To extent of AAA
To extent of C corp E&P
To extent of basis in stock
In excess of basis of stock
Treatment Tax Result
S-corp profits (already taxed) not taxable, reduce basis in stock
old C corp div taxed as div, no basis reduction
return of capital not taxable, reduce basis in stock
capital gain distribution taxed as ST ot LT capital gain

AAA = Accumulated Adjustments Account = the cumulative amount of S corp income or loss (like R/E)

Terminating the S selection

• Holders of the majority of the corporations stock consent to a voluntary revocation
• The corporation fails to meet any or all of the eligibility requirements (lets a foreigner be a shareholder)
• More than 25% of the corp’s gross receipts come from passive investments for 3 consecutive years and the
corporation had C corp earnings and profits at the end of each year

Once an S corp election is terminated or revoked, a new election cannot be made for 5 years unless the IRS
agrees otherwise.