2009 R-3 Lecture

RReegguullaattiioonn 33

Reg

ula

tion 3

1. C corporations, depreciation, and MACRS .......................................................................... 3

2. Small business corporations (S corporations)................................................................... 46

3. Appendix A: MACRS depreciation calculation.................................................................... 55

4. Appendix B: Form 4797................................................................................................ 57

5. Class questions ........................................................................................................... 59

R3-2

Becker CPA Review Regulation 3

© 2009 DeVry/Becker Educational Development Corp. All rights reserved. R3-3

C CORPORATIONS, DEPRECIATION, AND MACRS

I. FORMATION A. CORPORATION TAX CONSEQUENCES

1. General Rule: No Gain or Loss Recognized There is no gain or loss to the corporation issuing stock in exchange for property in the following transactions: a. Formation—issuance of common stock b. Reacquisition—purchase of treasury stock c. Resale—sale of treasury stock

2. Basis of Property (Corporation Receives) The general rule is that the basis of the property received from the transferor/shareholder is the greater of: a. Adjusted net book value (basis) of the transferor/shareholder (plus any gain

recognized by the transferor/shareholder) or b. Debt assumed by corporation (transferor may recognize gain to prevent a

negative basis).

PASS KEY Special Rule – Exception to General Rule

If the aggregate adjusted basis of property contributed to a corporation by each transferor/shareholder in a tax-free incorporation exceeds the aggregate fair market value of the property transferred, the corporation's basis in the property is limited to the aggregate fair market value of the property. (This prevents the transfer of property with "built-in losses" to the corporation.)

B. SHAREHOLDER TAX CONSEQUENCES 1. No Gain or Loss Recognized

The shareholder contributing property (not services) in exchange for corporation common stock has no gain or loss if the following two conditions have been met: a. 80% Control

Immediately after the transaction, those transferors/shareholders own at least 80% of the voting stock and at least 80% of the non-voting stock.

b. Boot Not Involved (Received) The following items represent taxable boot and will trigger gain recognition: (1) Cash withdrawn (boot received may generate gain to transferor) and (2) C.O.D. (cancellation of debt)—liabilities exceed net book value of assets

transferred into the corporation, which generates a gain (gain is recognized to the extent there is a boot received).

NBV Assets

< Liabilities >

Excess Liability = Boot

(3) Receipt of debt securities (e.g., bonds).

HIDE IT

CORPORATIONS

Formation Operations Taxation

Distributions Liquidation

CONTRIBUTIONS TO CAPITAL

Regulation 3 Becker CPA Review

R3-4 © 2009 DeVry/Becker Educational Development Corp. All rights reserved.

2. Basis of Common Stock (To Shareholder)

The basis of the common stock received from the corporation will be:

a. Cash—Amount Contributed

b. Property—Adjusted Basis (NBV)

(1) The adjusted basis of property is reduced by any debt (C.O.D.).

(2) Add: Taxable boot—debt exceeds asset adjusted basis—to bring stock basis to zero.

c. Services—Fair Market Value (Taxable)

Ordinary income (taxable)—the shareholder receiving common stock for services rendered must recognize the fair market value as ordinary income. [Note: A shareholder who contributes only services is not counted as part of the control group for purposes of the 80% control discussed in I.B.1.a.]

EXA

MPL

E

The ABC Company admits Tim as a 1/3 shareholder. Tim contributes a building worth $500,000 but having a basis of $100,000. There is a mortgage of $225,000 on the building, assumed by the corporation.

1980 COST : $100,000

TODAY FMV : $500,000 MORTGAGE : $225,000 BASIS $ "Rollover" Cost Basis < > Liabilities assumed by corporation $ "Net Basis" (If below zero, boot)

$ BOOT – TAXABLE TO SHAREHOLDER TIM

$ BASIS – OF SHAREHOLDER TIM’S COMMON STOCK

$ BASIS – CORPORATION HAS IN ASSET

PASS KEY

The general rule for taxable events and basis applies to corporations:

Transactions

Event Income Basis Taxable = FMV = FMV Nontaxable = N-O-N-E = NBV

Detailed Alternate Computation of Basis to Shareholder

Adjusted basis of transferred property Plus: FMV of services rendered Plus: Gain recognized by shareholder Minus: Cash received Minus: Liabilities assumed by the corporation Minus: FMV of non-money boot received = Basis of common stock



EXA

MPL

E

Duffy forms a corporation and contributes the following to the corporation:

Adjusted Fair Market Basis Value Equipment $ 40,000 $120,000 Building 20,000 40,000 Inventory 80,000 100,000 $140,000 $260,000 Duffy received 100 shares of stock with the following results: (i) Gain realized by Duffy Amount realized $260,000 Adjusted basis (140,000) Gain realized $120,000 (ii) Gain recognized by Duffy 0

(iii) Duffy's stock basis (see alternate computation) Old basis $140,000 Less: Boot 0 Add: Recognized gain 0 New basis of stock $140,000 (iv) Basis to corporation Transferor's basis $140,000 Add: Gain recognized 0 Basis of asset $140,000

EXA

MPL

E

Gearty forms a corporation and contributes property with a basis of $140,000 subject to a $60,000 mortgage as shown below:

Adjusted Fair Market Basis Value Assets with $60,000 mortgage $140,000 $260,000 Gearty received 100 shares of stock with the following results: (i) Gain realized by Gearty Amount realized $260,000 Adjusted basis (140,000) Gain realized $120,000 (ii) No gain recognized: no boot received/liabilities do not exceed basis. (iii) Gearty's stock basis (see alternate computation) Old basis $140,000 Less: Liability assumed

by corporation (60,000) Add: Recognized gain 0 New basis of stock $ 80,000 (iv) Basis to corporation Transferor's basis $140,000 Add: Gain recognized 0 Basis of asset $140,000



II. OPERATIONS

A. BOOK INCOME VS. TAXABLE INCOME (SCHEDULE M-1)

FINANCIAL TAX STATEMENT RETURN INCOME Income from continuing <EXPENSE> GROSS INCOME operations before NIBT taxes <TAX> NIAT Discontinued INCOME operations, <EXPENSE> net of tax NIBT – TAX = NIAT <DEDUCTIONS> Extraordinary gain INCOME A <loss>, net of tax <EXPENSE> NIBT – TAX = NIAT <CHARITY> Accounting adjustment B and changes, net of tax (to retained <DIV REC DED> earnings) NET INCOME TAXABLE INCOME

M-1RECONCILE

[Note: Schedule M-1 does not distinguish between temporary and permanent differences. Part II of the Schedule M-3 does, however. Please refer to the tax forms on the next several pages.]

B. CORPORATE TAXABLE ITEMS

Corporations are taxed in a manner similar to that of individual taxpayers. Many provisions are the same for both groups; however, some differences exist. Some of the principal differences are presented below.

1. Gross Income

The concept of gross income is very similar for both corporations and individuals.

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

(1) Interest income received in advance.

(2) Rental income received in advance. (Nonrefundable rent deposits and lease cancellation payments are rental income when received.)

(3) Royalty income received in advance.

Formation Operations

Taxation Distributions Liquidation

TAXABLE INCOME

















b. Some GAAP income items are not includible as taxable income, such as:

(1) Interest income from municipal or state obligations/bonds.

(2) Proceeds from life insurance on officers' lives ("key person" policy) where the corporation is the beneficiary.

2. Trade or Business Deductions (Ordinary and Necessary Expenses)

Those expenses that are attributable to the trade or business of the corporation are deductible. All of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a business are deductible. "Ordinary and necessary" means that the expenses are common (or accepted) in the particular business or profession and that they relate to producing the current year's income.

EXA

MPL

E

Reasonable salaries, office rentals, office supplies, and traveling expenses are all deductible when incurred for business purposes.

a. Domestic Production Deduction

(1) Overview

A business may deduct a specific percentage of their qualified production activities income. [Limitation: The deduction may not exceed 50% of the W-2 wages paid by the corporation for the year.]

(2) Percentage Deduction

The deduction percentage phases in over a period of years:

Tax Year Percentage Deduction

Effective Top Corporate Tax Rate

2004 2005-2006

2007, 2008, 2009 After 2009

0 3% 6% 9%

35.00% 33.95% 32.90% 31.85%

The deduction is a percentage of the lesser of:

(a) Qualified Production Activities Income (QPAI)

(b) Taxable Income (disregarding the QPAI deduction)

(3) Calculating QPAI

Domestic Production Gross Receipts < Cost of Goods Sold >

< Other directly allocable expenses or losses > < Proper share of other deductions > Qualified Production Activities Income



(4) Domestic Production Gross Receipts Defined

Domestic Production Gross Receipts generally are gross receipts derived in significant part within the United States from any disposition of qualified production property that is:

(a) Manufactured

(b) Produced

(c) Grown

(d) Extracted

(e) Constructed

(f) Engineering services

(g) Architectural services

b. Executive Compensation

A publicly held corporation may not deduct compensation expenses in excess of $1,000,000 paid to the CEO or the four other most highly compensated officers unless based upon qualifying commissions or a performance based plan of the company.

Entertainment expenses for officers, directors, and 10%-or-greater owners may be deducted only to the extent that they are included in the individual's gross income.

c. Bonus Accruals (Non-Shareholder / Employees)

Bonuses paid by an accrual basis taxpayer are deductible in the tax year when all events have occurred that establish a liability with reasonable accuracy, and provided they are paid within 2½ months after year end.

d. Bad Debts—Specific Charge-Off Method

(1) Accrual Basis

Accrual method taxpayers must use the specific charge-off method (direct write-off method) for tax purposes. Thus, most taxpayers will write-off bad debts as they become worthless or partially worthless. (The allowance method is still required for financial accounting purposes, but is not allowed for calculating the tax deduction.)

(2) Cash Basis

A very important point for purposes of the CPA exam is to be aware of bad debts of cash-basis taxpayers. Because a cash-basis taxpayer has not included the amount in gross income, a bad debt is not deductible, except in the case of an uncollectible check that has been deposited and recorded as income.



e. Business Interest Expense

(1) General—Business Interest Expense

All interest paid or accrued during the taxable year on indebtedness incurred for business purposes is deductible.

(2) Interest Expense on Loans for Investment

Interest on loans for investment is limited to "net investment income (taxable)." This is the same limitation on deductibility as an individual's investment interest. (Interest on loans to purchase tax-free bonds is not deductible.)

(3) Prepaid Interest Expense

Prepaid interest expense must be allocated to the proper period to which it is related.

f. Charitable Contributions (10% of Adjusted Taxable Income Limitation)

Corporations making contributions to recognized charitable organizations are allowed a maximum deduction of 10% of their taxable income as defined below. Any disallowed charitable contribution may be carried forward for five years. Any accrual must be paid within 2 ½ months of the taxable year-end to be deductible.

Total taxable income is calculated before the deduction of:

(1) Any charitable contribution deduction;

(2) The dividends received deduction;

(3) Any net operating loss carryback;

(4) Any capital loss carryback; or

(5) U.S. production activities deduction.

g. Business Losses or Casualty Losses Related to Business

Generally, any loss sustained during the taxable year and not compensated for by insurance or otherwise is deductible. The loss may be treated as an ordinary loss or a capital loss, depending upon the type of asset involved in the casualty. Business casualty losses are treated slightly differently than for individuals.

PASS KEY

Business casualty differs from that of individual (personal) casualty in several ways. Two important differences concerning business casualty are:

• No $100 reduction • No 10% of AGI reduction

(1) Partially Destroyed

For property only partially destroyed, the loss is limited to the lesser of:

(a) The decline in value of the property, or

(b) The adjusted basis of the property immediately before the casualty.

CHARITABLE CONTRIBUTIONS



ORGANIZATIONAL EXPENDITURES

(2) Fully Destroyed (NBV)

For property fully destroyed (i.e., a total loss), the amount of the loss is the adjusted basis of the property.

EXA

MPL

E

1. Bad Luck, Inc., had a major casualty loss in 20X1. A warehouse building was seriously damaged by a storm. The fair market value of the building before the storm was $850,000; the fair market value after the storm was $400,000. The adjusted basis of the property was $600,000. Insurance reimbursements amounted to $300,000.

The amount of the casualty loss before insurance reimbursements is $450,000, which is the decline in value of the property and is less than the adjusted basis of the property. Subtracting the insurance reimbursement of $300,000, Bad Luck's deductible loss would be $150,000.

2. Assume the same facts above except the property was totally destroyed. The deductible casualty loss would be $300,000 ($600,000 – $300,000). Adjusted basis is used to determine the casualty loss irrespective of the decline in value.

h. Organizational Expenditures and Start-Up Costs

(1) Calculation

The corporation may elect to deduct up to $5,000 of organizational expenditures and $5,000 of start-up costs. Each $5,000 amount is reduced by the amount by which the organizational expenditures or start-up costs exceeds $50,000, respectively. Any excess organizational expenditures or start-up costs is amortized over 180 months (beginning with the month in which the active trade or business begins).

(2) Included Costs

Allowable organizational expenditures and start-up costs include fees paid for legal services in drafting the corporate charter, bylaws, minutes of organization meetings, fees paid for accounting services, and fees paid to the state of incorporation.

(3) Excluded Costs

The costs do not include costs of issuing and selling the stock, commissions, underwriter's fees, and costs incurred in the transfer of assets to a corporation.

PASS KEY

It is important for CPA candidates to remember the difference in the GAAP (financial statements) and the tax (income tax return) rule for organizational and start-up expenses.

Organizational and Start-Up Expenses

• Tax Rule – $5,000 expense maximum/180 months amortization of remainder • GAAP Rule – Expense



EXA

MPL

E

Kristi, a newly organized corporation, was formed on June 30, 20X5, and began doing business on July 1, 20X5. The corporation will have a December 31 year end Kristi Co. incurred the following expenses in organizing the business:

Legal fees for drafting corporate charter $15,000 Fees paid for accounting services 5,000 Fees paid to state of incorporation 3,000 Costs of selling shares of stock 10,000 $33,000

Amortization for the six months (July 1 to December 31, 20X5) will be $5,600, calculated as follows:

Legal fees for corporate charter $ 15,000 Accounting fees 5,000 Fees paid to state 3,000 Organization expenses $ 23,000

$23,000 < 5,000 > $5,000 $18,000 ÷ 180 mo. = $100 per mo. X 6 mo. = 600 $5,600

The cost of selling the shares may not be amortized; it is a reduction in the capital stock account.

i. Amortization, Depreciation, and Depletion

Goodwill, covenants not to compete, franchises, trademarks, and trade names (all acquired after August 10, 1993) must be amortized on a straight-line basis over a 15-year period beginning with the month such intangible was acquired. For depreciation and depletion, corporations use the same rules as individuals, covered later in this chapter.

PASS KEY

The CPA examination often tests the candidate's ability to distinguish the GAAP (financial statements) and tax (income tax returns) rules. The difference in the treatment of purchased goodwill (beginning in 2002) should be noted:

Purchased Goodwill

• Tax Rule – Amortized on a straight-line basis over 15 years. • GAAP Rule – Not amortized; test for impairment.

j. Life Insurance Premiums (Expense)

(1) Corporation Names Beneficiary (Key-Person)

Premiums paid by the corporation for life insurance policies on key employees are not deductible when the corporation is directly or indirectly the beneficiary.

(2) Insured Employee Names Beneficiary (Fringe Benefit)

If the premiums are paid on insurance policies where the beneficiary is named by the insured employee, such premiums are deductible as an employee benefit.

LIFE INSURANCE



k. Business Gifts

Business gifts are deductible up to a maximum deduction of $25 per recipient per year.

l. Business Meals and Entertainment

Business meals and entertainment expenses are 50% deductible to the corporation.

m. Penalties and Illegal Activities Not Deductible

Bribes, kickbacks, fines, penalties, and other payments that are illegal under federal law or under a generally enforced state law are not deductible. Similarly, the top two-thirds of a treble damage payment is not deductible if the taxpayer has been convicted of an antitrust violation.

n. Taxes

All state and local taxes and federal payroll taxes are deductible when incurred on property or income relating to business. Federal income taxes are not deductible. Foreign income taxes may be used as a credit.

o. Lobbying and Political Expenditures

Lobbying expenses incurred in attempting to influence state or federal legislation are not deductible. Direct-type lobbying expenses in connection with local governmental lobbying are deductible. Political contributions are not deductible.

p. Capital Gains and Losses

(1) Capital Losses Deduction Not Allowed

The $3,000 deduction for capital losses available to individuals is not allowed to corporations. Thus, a corporation can only use capital losses to offset capital gains.

(2) Capital Loss Carryover

Net capital losses are carried back three years and forward five years. They are carried over as short-term capital losses and are applied only against capital gains.

(3) Capital Gains Tax Calculation

Capital gains are taxed at the same rate as ordinary corporate income (i.e., no maximum 15% rate as with individual taxpayers).

q. Net Operating Losses

Corporations are entitled to the same net operating loss (NOL) as individuals. The carryback period is 2 years and the carryforward period is 20 years; however, the following additional points should be noted when calculating the corporate NOL:

(1) No charitable contribution deduction is allowed in calculating the NOL.

(2) The dividends received deduction is allowed to be deducted before calculating the NOL.

CAPITAL GAINS AND LOSSES



PASS KEY

The CPA examination often provides answers, which relate to capital loss rules, to questions concerning net operating losses. It is important to be able to distinguish all of these tax rules:

Offset Other Income Carryback Carryforward Net Operating Loss: N/A 2 20 Corporate Net Capital Loss: - 0 - 3 5 Individual Net Capital Loss: $3,000 maximum 0 Unlimited

r. General Business Credit

(1) Included Credits:

The general business credit consists of a combination of:

(a) Investment credit,

(b) Work opportunity credit,

(c) Alcohol fuels credit,

(d) Increased research credit,

(e) Low-income housing credit, and

(f) Other infrequent credits.

(2) Formula

It is generally net income tax less the greater of:

(a) 25% of regular tax liability above $25,000, or

(b) "Tentative minimum tax" for the year.

(c) "Net Income Tax" is regular tax plus alternative minimum tax less nonrefundable tax credits (other than the alternative minimum tax credit).

(3) Unused Credit Carryover

Unused credits can be carried back one year and forward twenty years.



PASS KEY Remember, deferred taxes are only established for temporary differences.

CORPORATE TAXATION SUMMARY

GAAP FINANCIAL STATEMENTS IRC

TAX RETURN

TEMP PERM NONE

GROSS INCOME: Gross Sales Income Income Installment Sales Income Income when received Rents and Royalties in Advance Income when earned Income when received State Tax Refund Income Income Dividends Equity Method Income is subsidiary's earnings Income is dividends received 100/80/70% Exclusion No exclusion Excluded forever

ITEMS NOT INCLUDIBLE IN "TAXABLE INCOME": State and Municipal Bond Interest Income Not taxable income Life Insurance Proceeds Income Not taxable income Gain / Loss on Treasury Stock Not reported Not reported

ORDINARY EXPENSES: Cost of Goods Sold Uniform capitalization rules Uniform capitalization rules Officers' Compensation (Top) Expense $1,000,000 limit Bad Debt Allowance (estimated) Direct write-off Estimated Liability for Contingency (e.g.,

warranty) Expense (accrue estimated) No deduction until paid

Interest Expense Business Loan Expense Deduct Tax-free Investment Expense Not deductible Taxable Investment Expense Deduct up to taxable income Contributions All expensed Limited to 10% of adjusted taxable

income

Loss on Abandonment / Casualty Expense Deduct Loss on Worthless Subsidiary Expense Deduct Depreciation MACRS vs. Straight Line Slow depreciation Fast depreciation Section 179 Depreciation Not allowed (must depreciate) 2008-2010 = $250,000 Different Basis of Asset Use GAAP basis Use tax basis Amortization Start Up Expenses Expense $5,000 max./15 yr. excess Franchise Amortize Amortize over 15 years Goodwill Impairment Test Amortize over 15 years Depletion Percentage vs. Straight Line (cost) Cost over years Percentage of sales Percentage in Excess of Cost Not allowed Percentage of sales Profit and Pension Expense Expense accrued No deduction until paid Accrued Expense (50% owner / family) Expense accrued No deduction until paid State Taxes (Paid) Expense Deduct Meals and Entertainment Expense Generally 50% deductible

GAAP EXPENSE ITEMS THAT ARE NOT TAX DEDUCTIONS: Life Insurance Expense (corporation) Expense Not deductible Penalties Expense Not deductible Lobbying/Political Expense Expense No deduction Federal Income Taxes Expense Not deductible

SPECIAL ITEMS: Net Capital Gain Income Income Net Capital Loss Report as loss Not deductible Carryback / Carryover (3 years back and

5 years forward) Not applicable Unused loss allowed as a STCL

Related Shareholder Report as a loss Not deductible Net operating loss Report as a loss Carryback 2 or carryover 20 Research and Development Expense Expense/Amortize/Capitalize



C. DIVIDENDS RECEIVED DEDUCTION

Domestic corporations are allowed a dividends received deduction. The purpose of this deduction is to prevent triple taxation of earnings. The amount of the dividends received deduction allowed is dependent upon the percentage of the investee corporation owned by the investor corporation. The percentage allowed may be either 70%, 80%, or 100%. The corporate shareholder must own the investee stock for more than 46 days during the 91-day period beginning on the date 45 days before the ex-dividend date of the stock to qualify for the dividends received deduction. Below are the percentage deductions based upon stock ownership:

Percentage Dividends ReceivedOwnership Deduction0% to < 20% 70%20% to < 80% 80%80% or more 100%

Little Corp.

BIG CORP.

Little Corp. Stock

Big Corp. Stock

Income

< Deductions >

__________________ Taxable Income

< Tax > Net Income (after tax)

Dividend

Income Dividend Income

< Deductions >

__________________ Taxable Income


Dividend

Income Dividend Income

< Deductions >

__________________ Taxable Income


DIVIDEND RECEIVED

DEDUCTION



GROSS INCOME (INCLUDES DIVIDEND INCOME) SPECIAL DEDUCTIONS (NOT INCLUDED) <DEDUCTIONS> • Charity deduction • Dividends received deduction A • Not gifts ($25 for business gifts) • Not political (none) <CHARITY> • Maximum allowed is 10% of A * • 5 year carryforward • Accrued amounts are deductible if paid within

2 1/2 months after year end B REQUIREMENTS 1) 1st corporation is taxed 2) Owned 45 days before or after DIVIDEND INCOME • 100% (Own 80%-100%) (consolidate) <DIVIDENDS RECEIVED DEDUCTION> • 80% (Own 20%-under 80%) (Large Investment) ** • 70% (Own under 20%) (Small Investment) ** • Limited to % of B

• Except: if taking the full % of dividend income, it creates or adds to corp. loss.

NET OPERATING LOSS: Carryback 2 years

TAXABLE INCOME OR LOSS Carryforward 20 years

* The chart indicates that the corporate charitable deduction is limited to 10% of "A." "A" is defined here as Gross Income minus Deductions, with the two "special deductions" not included. This is the same definition as that presented in item II.B.2.f (earlier in this chapter); the material is simply shown differently.

** The 70% and 80% deductions operate exactly the same except, of course, for the percentage differences.



1. Taxable Income Limitation

The dividends received deduction (DRD) equals the lesser of:

a. 70% (or 80%) dividends received, or

b. 70% (or 80%) of taxable income computed without regard to the DRD, any NOL deduction, or capital loss carryback.

2. Exception to Taxable Income Limitation

The taxable income limitation above does not apply if, after taking into account the full dividends received deduction, the result is a net operating loss (NOL). See example #3 below.

EXA

MPL

E

The Duffy Corporation owns 30% of the Fox Corporation (80% deduction applies). Below are alternative situations for the year. The dividends received deduction and taxable income would be calculated as follows:

Gross Income #1 #2 #3 Operations 250 250 250 Dividends Received 100 100 100 Total 350 350 350

Deductions Total, including charitable contributions (200) (260) (280)

TI before DRD 150 90 70 Tentative DRD (80% x $100) Percentage Limit (80% of TI) DRD <80> <72>* <80>** Taxable Income 70 18 (10)

80120

8072

8056

* Limited to lesser of 80% of dividends received ($100) or TI ($90) and no NOL created.

** When subtracting the full 80% DRD, an NOL is created, thus 80% of TI does not apply.

3. Entities for Which the DRD Does Not Apply

The dividends received deduction does not apply to:

a. Personal service corporations,

b. Personal holding companies, and

c. (Personally taxed) S corporations.

PASS KEY

An easy way to remember the entities not eligible for the dividends received deduction:

Don't take it "personally!"



4. 100% Dividends Received Deduction

a. Affiliated Corporations—100%

Dividends from affiliated corporations (80% or more common ownership) that file consolidated returns qualify for a 100% deduction.

b. Small Business Investment Corporations (SBICs)—100%

A 100% deduction is allowed for dividends received by a small business investment company. An SBIC makes equity and long-term credit available to small business concerns.

Schedule M-1 Reconciliation of Income (Loss) per Books to Taxable Income

1 Net Income ( or Loss ) Per Books $875,000 7 - Income Recorded on Books this year2 + Federal Income Tax [ per books ] $384,500 Not included on this return:3 + Excess Capital Losses over Gains $5,000 - Tax-exempt Interest $3,5004 + Income subject to Tax Not - Life Insurance Proceeds $100,000

Recorded on Books this year:+ Installment Sale Income $8,500+ Rents Received in Advance $15,000

5 + Expenses recorded on books this year 8 - Deductions on this return not chargednot on tax return: against book income this year:

+ Book Depreciation $14,000 - Tax Depreciation $28,000+ Contribution Carryover $0 - Contribution Carryover $0+ Meals & Entertainment [ 50%] $4,200 - Section 179 Deduction $20,000+ Allowance for Doubtful Accts. [ Incr] $15,000 - Direct Bad Debt Write Offs $8,650+ Warranty Accrual $8,500 - Actual Warranty Costs $7,500+ Different Basis of Assets $0 - Different Basis of Assets $0+ Expense of Organizational Costs $0 - Amortization of Organizational Cost $500+ Goodwill Impairment per books $5,000 - Goodwill Amortization per Return $9,200+ Pension Expense Accrued $12,000 - Pensions Paid $11,350+ Penalties $1,000

6 Add Lines 1 through 5 $1,347,700 9 Add Lines 7 and 8 $188,70010 Income ( Line 28 Page 1) L6- L9 $1,159,000

This is Taxable Income per page 1 of the tax return, before the dividends received deduction and the NOL carryforward deduction.



III. DEPRECIATION

Depreciation is an annual allowance given to a trade or business for exhaustion, wear and tear, and normal obsolescence. An asset's basis must be reduced by the depreciation allowed (or allowable) for a particular year, even if depreciation was not claimed by the taxpayer for that particular year.

A. MACRS: PROPERTY OTHER THAN REAL ESTATE

1. Types of Property

3-year 200% Class ADR (Asset Depreciation Range) midpoints of 4 years and less. Excludes automobiles and light trucks. Includes racehorses more than 2 years old and other horses more than 12 years old, and special tools.

5-year 200% Class ADR midpoints of more than 4 years and less than 10 years. Includes automobiles, light trucks, computers, typewriters, copiers, duplicating equipment.

7-year 200% Class ADR midpoints of 10 years and more, and less than 16 years. Includes office furniture and fixtures, equipment and property with no ADR midpoint not classified elsewhere. Includes railroad track.

10-year 200% Class ADR midpoints of 16 years and more, and less than 20 years.

15-year 150% Class ADR midpoint of 20 years and more, and less than 25 years including sewage treatment plants, telephone distribution plants, and comparable equipment used for the two-way exchange of voice and data communications.

20-year 150% Class ADR midpoint of 25 years and more, other than real property with an ADR midpoint of 27.5 years and more, including sewer pipes.

2. MACRS (1987 and Beyond) Depreciation Rules

MACRS stands for Modified Accelerated Cost Recovery System. For 3-, 5-, 7-, and 10-year MACRS property (other than real property) placed in service after January 1, 1987, MACRS is computed using the 200% declining balance method. For 20-year property, MACRS is computed using the 150% declining balance method.

3. Salvage Value (Ignored)

Salvage value is ignored under this method.

4. Half-Year Convention

In general, a half-year convention applies to personal property, under which such property placed in service or disposed of during a taxable year is treated as having been placed in service or disposed of at the midpoint of the year.

5. 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.

6. Bonus Depreciation

For 2008, bonus depreciation of 50% on new MACRS property (with a 20-year or less recovery period) is allowed. The remaining cost is depreciated over the applicable life. Bonus depreciation is also allowed for AMT purposes. A taxpayer may elect out of the bonus depreciation.

MODIFIED ACCELERATED

COST RECOVERY

SYSTEM



B. MACRS: REAL ESTATE (SALVAGE VALUE IGNORED/SUBTRACT LAND COST)

1. Residential Rental Property (27.5-year Straight-Line)

Examples of residential rental property include apartments and duplex rental homes.

2. Non-Residential Real Property (39-year Straight-Line)

Examples of nonresidential real property (real property that is not residential rental property and that does not have an ADR midpoint of more than 27.5 years) include office buildings and warehouses.

3. Mid-Month Convention

Straight-line depreciation is computed based upon the number of months the property was in service. One half month is taken in the month the property is placed in service. One half month is taken for the month in which the property is disposed of.

C. EXPENSE DEDUCTION IN LIEU OF DEPRECIATION (§179)

Each tax year, a taxpayer may deduct a fixed amount of depreciable (machinery and equipment) property. The limit for 2008-2010 is $250,000 of new or used property that is acquired during the year.

1. The maximum amount is reduced dollar for dollar by the amount of property placed in service during the taxable year that exceeds $800,000.

2. The deduction is not permitted when a net loss exists or if it would create a net loss.

3. SUVs: Section 179 limits the cost of a sport utility vehicle (SUV) that may be expensed under §179 to $25,000. This does not eliminate the exemption from the luxury auto depreciation limits for SUVs or other vehicles with a gross vehicle weight rating in excess of 6,000 pounds. For this purpose, an SUV is defined as a four-wheeled vehicle with a gross vehicle weight of more than 6,000 pounds, but less than 14,000 pounds.

Because this definition would include heavy pickup trucks, vans, and small buses in addition to SUVs, the term "sport utility vehicle" is further defined to exclude any of the following vehicles:

a. A vehicle designed to have a seating capacity of more than nine persons behind the driver's seat.

b. A vehicle equipped with a cargo area of at least six feet that is an open area and is not readily accessible directly from the passenger compartment.

D. STRAIGHT-LINE IN LIEU OF ACCELERATED DEPRECIATION ELECTION

A taxpayer may choose to depreciate property on a straight-line basis. If a taxpayer chooses straight-line, he may choose the regular recovery period or a longer alternative depreciation system (ADS) recovery period.

PASS KEY It is important for CPA Examination candidates to remember the following concepts:

Machinery and Equipment Real Estate

• Half-year convention • Mid-month convention

• Mid-quarter convention

The CPA Examination infrequently tests a candidate's ability to actually compute the correct amount of tax depreciation; however, Appendix A provides additional explanatory information regarding a MACRS depreciation calculation.



IV. DEPLETION

Depletion is allowed on exhaustible natural resources, such as timber, minerals, oil, and gas. The two methods of depletion are (i) cost depletion and (ii) percentage depletion.

A. COST DEPLETION (GAAP)

Under cost depletion, the remaining basis of the property is divided by the remaining number of recoverable units (tons of ore, barrels of oil) to arrive at the unit depletion rate. The deduction for depletion is the depletion unit rate multiplied by the number of units sold for the year.

EXA

MPL

E

Oil property having an estimated 1,000,000 barrels cost $1,000,000. In 2005, 50,000 barrels were sold. The depletion deduction for 2005 is $50,000 calculated as follows:

$1,000,0001,000,000 barrels = $1 per barrel

$1 per barrel x 50,000 = $50,000

B. PERCENTAGE DEPLETION (NON-GAAP)

Under this method, the deduction is limited to 50% of taxable income (excluding depletion) from the well or mine. The allowable percentages range from 5% to 22% depending upon the mineral or substance being extracted. Percentage depletion may be taken even after costs have been completely recovered and there is no basis.

For oil and gas properties only, the overall limitation of 50% of taxable income from the property is increased to 100%.

V. AMORTIZATION

A. INTANGIBLES

Intangibles such as goodwill, licenses, franchises, and trademarks may be amortized using straight-line basis over a period of 15 years, starting with the month of acquisition. [Note the difference. For GAAP purposes, intangible assets with indefinite lives are subject only to an impairment test, and intangible assets with finite lives are amortized over those lives and also subject to an impairment test.]

B. OTHERS

Certain items can be expensed and/or amortized on a straight-line basis over a period of years, regardless of their useful life. These include:

1. Business start-up expenses or organization costs. Each is permitted to first take off $5,000 to be expensed, and the remainder is amortized over 180 months. (The $5,000 is reduced as total cost exceeds $50,000 for each item);

2. Research expenses (existing trades or businesses may amortize research expenses over a 60-month period); and

3. Pollution-control facilities

DEPLETION

AMORTIZATION



VI. SUMMARY OF SECTION 1231, 1245, AND 1250 ASSETS A. SECTION 1231

Section 1231 assets are comprised principally of depreciable personal and real property used in the taxpayer's trade or business and held for over twelve months. Trade or business property and capital assets (held over twelve months) that have been involuntarily converted (e.g., fire, etc.) are also included in this section. 1. Capital Gain Treatment

Section 1231 provides a special benefit by allowing capital gain treatment (tax rates of 5% or 15%) on net Section 1231 gains from sales, exchanges, or involuntary conversions of certain "non-capital" assets, subject to Section 1245 and Section 1250 provisions because certain gains for Section 1231 assets fall under Sections 1245 or 1250.

2. Ordinary Loss Treatment All losses of Section 1231 net assets are Section 1231 losses, and they are treated as ordinary. (There are no Section 1245 or Section 1250 losses.) The advantages of an ordinary loss over a capital loss are that: a. A capital loss cannot be deducted in excess of capital gains (except for the

$3,000 per year allowance for individual taxpayers), and b. A Section 1231 net loss is deducted immediately in full without consideration of

capital gains. B. SECTION 1245 (MACHINERY AND EQUIPMENT): GAINS ONLY

1. Personal Business Property Section 1245 assets are personal properties used in a trade or business for over twelve months (e.g., autos).

2. Recapture All Accumulated Depreciation Upon the sale of a Section 1245 asset (depreciable personal property):

a. The lesser of gain recognized or all accumulated depreciation is recaptured as ordinary income under Section 1245, and

b. Any remaining gain is capital gain under Section 1231.

C. SECTION 1250 (BUILDINGS): GAINS ONLY 1. Real Business Property

Section 1250 assets are real properties used in a trade or business over twelve months (e.g., a warehouse).

2. Recapture Difference Between Straight-Line and Depreciation Taken Section 1250 rules differ slightly from Section 1245 in that Section 1250 recaptures only that portion of depreciation taken on real property that is in excess of straight line. (Note: This only applies to assets placed into service under the old accelerated methods of depreciation for real property. The current law requires real property to be depreciated under the straight-line method.)

3. Straight-Line Depreciation Taken The amount of straight-line depreciation taken results in the overall gain being taxed at 25% (this is called "unrecaptured Section 1250 gains").

4. Excess Gain is Section 1231 Gain (Capital Gain Treatment) Any gain in excess of original cost less straight-line depreciation would be allowed capital gain treatment under Section 1231.

DEPRECIATION RECAPTURE



If the result is a LOSS, then treat it as a Section 1231 (ordinary)

loss.

If the result is a GAIN, then treat it as a Section 1231 (capital) gain.

Sale or exchange of depreciable property, or land, used in trade or business and held for more than one

year*

GAIN LOSS

If personal property, Section 1245 determines the character

of the gain.

If real property, Section 1250 determines the

character of the gain.

Gain = ordinary income to the

extent of all accumulated depreciation

Accelerated depreciation in excess of straight line depreciation is "recaptured" as ordinary income, and the remaining depreciation is taxed at a 25% maximum

rate.

The remaining gain is treated under Section 1231.

The losses are to be netted with Section 1231 gains.

COMPARE

Flowchart of Gain or Loss from Section 1231 and 1245 Assets

* This illustrates the general rules. Special rules are applicable to casualty and theft, involuntary conversion situations, and low-income housing.

PASS KEY The CPA Examination infrequently tests on the depreciation recapture rules. However, when tested, the personal property (machinery and equipment) rules are typically the area. A simple rule of thumb for personal property recapture is:

• Loss = Treat as ordinary loss (no limitation) • Ordinary income = Gain to extent of accumulated depreciation • Section 1231 (capital) gain = Gain for sale price in excess of original cost



EXA

MPL

E

Example of Application of 1231, 1245, and 1250

Facts: During 20X5 Roberts Printing, Inc. sold the following assets during the year:

Description Selling Price Cost Accum. Deprec.

Recognized Gain/Loss

Printing Press $4,000 $6,800 $3,200 $400 gain Photocopier $2,600 $2,500 $500 $600 gain Delivery Van $500 $15,000 $13,000 $1,500 loss

Step 1: Calculate Gain or Loss Gain or loss is calculated by the following formula: Cost – accumulated depreciation = adjusted basis Compare the selling price to the adjusted bases = gain or loss Step 2: Calculate Depreciation Recapture

Both the printing press and photocopier are Sec. 1245 personal property sold at a gain; thus, for each asset, the lesser of gain recognized or all accumulated depreciation must be recaptured as ordinary income:

Ordinary Income (Depreciation Recapture) Printing Press $400 Photocopier $500* *Only $500 of the $600 gain is ordinary income because the ordinary income recapture is the lesser of the accumulated depreciation ($500) or gain recognized ($600). Step 3: Remaining Gain or Loss

Any remaining gain after calculating the ordinary income recapture is first netted with any Sec. 1231 losses: Sec. 1231 Gain Sec. 1231 Loss Photocopier $100 Delivery Van $1,500

The net result is a loss of $1,400, which is treated as a Sec. 1231 loss and deducted as an ordinary loss.





VII. TAXATION OF A C CORPORATION

A. FILING REQUIREMENTS

A C corporation is required to file a U.S. Corporation Income Tax Return, Form 1120, by the 15th day of the third month after the close of its tax year. (For a December 31 corporation, the return is due by March 15.)

1. Legal Holiday or Weekend

When the due date falls on a legal holiday or weekend, the tax return is due on the next business day.

2. Extension (Form 7004)

An extension of six months is available by filing Form 7004.

3. Accrual Basis vs. Cash Basis

While the cash basis of accounting is used for tax purposes by most individuals, qualified personal service corporations (which are treated as individuals for purposes of these rules), and taxpayers whose average annual gross receipts do not exceed $1,000,000, the accrual basis method of accounting for tax purposes is required for the following:

a. The accounting for purchases and sales of inventory (and inventories must be maintained),

b. Tax shelters,

c. Certain farming corporations (other farming or tree-raising businesses may generally use the cash basis), and

d. C corporations, trusts with unrelated trade or business income, and partnerships having a C corporation as a partner provided the business has greater than $5 million of average annual gross receipts for the three-year period ending with the tax year.

B. ESTIMATED PAYMENTS OF CORPORATE TAX

Corporations are required to pay estimated taxes on the fifteenth day of the fourth, sixth, ninth, and twelfth months of their tax year. One-fourth of the estimated tax is due with each payment. Unequal quarterly payments may be made using the annualized income method. An underpayment penalty will be assessed if these payments are not made and the amount owed on the return is $500 or more.

1. Corporations Other Than Large Corporations

Corporations not classified as large corporations are required to pay the lesser of:

a. 100% of the tax shown on the return for the current year, or

b. 100% of the tax shown on the return for the preceding year

Note: This alternative cannot be used if the corporation owed no tax for the preceding year or the preceding tax year was less than 12 months.

2. Large Corporations

A large corporation (a corporation whose taxable income was $1 million or more in any of its three preceding tax years):

a. Must pay 100% of the tax as shown on the current year return.

b. May not use the second payment alternative above (item 1.b).

ESTIMATED TAXES



Regular Tax Minimum Tax Accumulated Earnings Tax

or Personal Holding

Companies Tax

CONSOLIDATED RETURNS

C. GRADUATED TAX RATES AND TAXABLE INCOME

The taxable income of a corporation is arrived at by taking gross income (basically the same items that would be included in an individual's gross income) and deducting the same business expenses that an individual would deduct. A corporation, however, receives no exemptions. A corporation's taxable income is subject to the following graduated tax schedule:

Taxable Income 2008 Rates Of the amount over $ 1 – $ 50,000 15% $ 0 $ 50,001 – $ 75,000 $ 7,500 + 25% $ 50,000 $ 75,001 – $ 100,000 $ 13,750 + 34% $ 75,000 $ 100,001 – $ 335,000 $ 22,250 + 39% $ 100,000 $ 335,001 – $10,000,000 $ 113,900 + 34% $ 335,000 $ 10,000,001 – $15,000,000 $ 3,400,000 + 35% $10,000,000 $ 15,000,001 – $18,333,333 $ 5,150,000 + 38% $15,000,000 $ 18,333,333 over 35% $ 0

The rate brackets above 35% result from a phaseout of lower brackets such that corporations with taxable income above $18,333,333 will have all income tax at a flat 35%.

D. CONSOLIDATED TAX RETURNS

An affiliated group of corporations may elect to be taxed as a single unit, thereby eliminating intercompany gains and losses.

1. Requirements

To be entitled to file a consolidated return, all the corporations in the group (i) must have been members of an affiliated group at some time during the tax year and (ii) each member of the group must file a consent. Note that the act of filing a consolidated return by all the affiliated corporations will satisfy the consent requirement.

2. Affiliated Group Defined

An affiliated group means that a common parent owns:

a. 80% or more of the voting power of all outstanding stock and

b. 80% or more of the value of all outstanding stock of each corporation.

Note: Filing a consolidated return is a privilege afforded to affiliated groups of corporations (Code Sections 1501 and 1504(b)), and it can only be filed if all of the affiliated corporations consent to such a filing. An affiliated group has ownership through a common parent. As discussed above, the common parent must directly own at least 80% of the voting power of at least one of the affiliated (includible) corporations and at least 80% of the value of the stock of that corporation, and the other corporations not controlled by the parent must be controlled under the 80% ownership test by an includible corporation. Not all corporations are allowed the privilege of filing a consolidated return. Examples of those that are denied the privilege include S corporations, foreign corporations, most real estate investment trusts (REITs), some insurance companies, and most exempt organizations.

3. Brother-Sister Corporations

Corporations where an individual (not a corporation) owns 80% or more of the stock of two or more corporations, may not file consolidated returns.




or Personal Holding

Companies Tax

ALTERNATIVE MINIMUM TAX

Consolidated Return NOT Brother/Sister

C/S

B S

C/SC/S

P

S

C/SSub

4. Advantages of Filing Consolidated Return

Among the advantages of filing a consolidated return are:

a. Capital losses of one corporation offset capital gains of another corporation;

b. Operating losses of one corporation offset the operating profits of another corporation;

c. Dividends received are 100% eliminated in consolidation since they are intercompany dividends; and

d. A corporation's NOL carryover may be applied against the income of the consolidated group.

5. Disadvantages of Filing Consolidated Return

The disadvantages of filing a consolidated return include:

a. Mandatory compliance with complex regulations;

b. In the initial consolidated tax return year, a double counting of inventory can occur if group members had intercompany transactions;

c. Tax credits may be limited by operating losses of other members; and

d. The election to file consolidated returns is binding for future years and may only be terminated by disbanding the group or seeking permission of the Internal Revenue Service.

E. CORPORATE ALTERNATIVE MINIMUM TAX

Corporations are subject to a minimum tax (AMT) of 20% on alternative minimum taxable income (AMTI), less an exemption amount. The objective of the corporate AMT, like that of the individual AMT, is to ensure that every

corporation with substantial economic income pays at least some minimum amount of tax despite the use of exclusions, deductions, and credits.



PASS KEY

The CPA examination has focused the majority of their questions concerning corporate minimum tax on the following four areas:

• Distinguishing "adjustments", "preferences", and "ACE" • The exemption formula • Credits – available to reduce the minimum tax • The minimum tax credit carryforward – to reduce future regular tax

REGULAR TAXABLE INCOME • Long term contracts Add or minus • Installment sale dealer ADJUSTMENT • Excess depreciation (post 1986) items to income

• Percentage depletion • Private activity – issued post '86 Addback Tax exempt interest income PREFERENCES • Pre '87 ACRS excess depr items to increase income

• Muni interest income Tax exempt interest income Adjusted • Increase CSV life insurance Current • Non S/L depreciation Earnings (after 1989; excess over alt depr sys life) Increase/Decrease • Dividends received deduction (neg. adj limited to past positive) (under 20% ownership)

<A.M.T. NOL DEDUCTION>

MINIMUM TAXABLE INCOME <A.M.T. EXEMPTION>

$40,000 less 25% of MTI over $150,000

A.M.T. x 20%

GROSS ALTERNATIVE MINIMUM TAX <FOREIGN TAX CREDIT>

TENTATIVE MINIMUM TAX <REGULAR TAX LIABILITY>

ALTERNATIVE MINIMUM TAX

If a corporation's tentative minimum tax exceeds the regular tax, the excess amount is the alternative minimum tax, which is payable in addition to the regular tax.



1. Calculation

a. Regular Taxable Income

Alternative minimum taxable income begins with regular taxable income or (loss) before NOL, which is then modified by adjustments, tax preference items, and the adjusted current earnings (ACE) adjustment.

b. Adjustment

(1) Long-Term Contracts

An adjustment is calculated for the difference between completed contract revenue and percentage of completion revenue.

(2) Installment Sales—Dealer

An adjustment is calculated for the difference between full accrual revenue and installment sales revenue.

(3) Excess of depreciation of tangible property placed in service after 1986 over:

(a) Straight-line for real property using a 40-year life, or

(b) 150% declining balance (with a switch to straight-line) for personal property using the applicable class life.

c. Preferences

(1) Percentage Depletion

A preference exists for the excess of percentage depletion over the adjusted basis of the property.

(2) Private Activity Bonds

A preference exists for tax-exempt interest from private activity bonds issued after August 7, 1986.

(3) Pre-1987 ACRS Depreciation

A preference exists for the excess of ACRS accelerated depreciation over straight-line on pre-1987 property.

d. Adjusted Current Earnings (ACE)

The adjusted current earnings (ACE) adjustment equals 75% of the difference (positive or negative) between ACE and AMTI before this adjustment and the alternative tax NOL deduction.

(1) Municipal bond interest

(2) Increase life insurance cash surrender value

(3) Non-straight-line depreciation after 1989 vs. ADS

(4) Dividends received deduction (less than 20% ownership/70% deduction)

M I N D

P

P

P

L

E

I




or Personal Holding

Companies Tax

e. Exemption Amount

The exemption amount is $40,000 less 25% of AMTI in excess of $150,000. As a result, the exemption amount is completely eliminated at AMTI in excess of $310,000.

EXA

MPL

E

Assume minimum income is $210,000.

Exemption 40,000 Minimum Taxable Income 210,000 Allowable <$150,000> Excess 60,000 x 25% Disallowed < 15,000> Exemption—Allowed 25,000

f. Tax Rate

The tax rate on the alternative minimum taxable income is a flat 20%.

g. Credits

The foreign tax credit is the only credit (for corporate alternative minimum tax) that the CPA exam requires a candidate to know for purposes of corporate minimum tax.

h. Minimum Tax Credit (MTC)

(1) Credit Against Future Regular Tax

The AMT system is actually an alternative tax system and, in a true sense, just an acceleration of the payment of a corporation's income taxes. For this reason, a corporation that pays AMT in one year may use this AMT as a credit in future years against the corporation's regular income tax liability.

(2) Carryforward

The MTC may be carried forward indefinitely but may not be carried back.

F. ACCUMULATED EARNINGS TAX

1. The accumulated earnings tax is imposed on regular C corporations whose accumulated (retained) earnings are in excess of $250,000 if improperly retained instead of being distributed as dividends to (high tax bracket) shareholders.

a. Regular corporations are entitled to $250,000 of (lifetime) accumulated earnings.

b. Personal service corporations are entitled to only $150,000 of (lifetime) accumulated earnings.

c. The accumulated earnings tax is not imposed on personal holding companies (PHCs), tax-exempt corporations, or passive foreign investment corporations.

ACCUMULATED EARNINGS

TAX




or Personal Holding

Companies Tax

2. The additional tax rate for accumulated earnings is a flat 15%.

3. To avoid unreasonable accumulation of earnings, there should be:

a. A specific, definite, and feasible plan for the use of accumulation (reasonable needs), or

b. A need to redeem the corporate stock included in a deceased stockholder's gross estate.

4. Just because the stock is widely held does not exempt it from the accumulated earnings tax. The accumulated earnings tax is not self-assessed by the corporation; it is IRS-assessed as a result of an IRS audit of the corporation.

5. A dividend paid by the due date of the tax return or hypothetical "consent" dividends may reduce or eliminate the tax.

6. Calculation:

BEFORE: Dividends rec deduct TAXABLE INCOME net operating loss charity deduction cap. loss carryover <ALL CHARITY>

<ALL CAPITAL LOSSES>

<TAXES>

During tax year <DIVIDENDS PAID> within 2½ months Accumulated consent dividends Taxable Income LIFETIME CREDIT 250,000 (Reg. corp.) BUSINESS NEED OR 150,000 (Service corp.) BEG. E&P <CORP. NEEDS>

<BEG. EXCESS> BEG. EXCESS

<REMAINING CREDIT> REMAINING CREDIT

CURRENT ACCM TAXABLE INC.

X 15%

ACCUMULATED EARNINGS TAX

G. PERSONAL HOLDING COMPANY TAX

Personal holding companies (PHCs) are really corporations set up by high tax bracket taxpayers to channel their investment income into a corporation and shelter that income by the low normal tax (15%–25%) of the corporation, instead of paying their higher individual tax rates on that income.

PERSONAL HOLDING COMPANY




DistributionsLiquidation

1. Definition of Personal Holding Company

The tax law criteria define personal holding companies as corporations more than 50%-owned by 5 or fewer individuals (either directly or indirectly at any time during the last half of the tax year) and having 60% of adjusted ordinary gross income consisting of:

a. Net rent (if less than 50% of ordinary gross income);

b. Interest that is taxable (nontaxable is excluded);

c. Royalties (but not mineral, oil, gas, or copyright royalties); or

d. Dividends from an unrelated domestic corporation.

2. Additional Tax Assessed

Corporations deemed to be personal holding companies are taxed an additional 15% on personal holding company net income not distributed.

a. Taxable income must be reduced by federal income taxes and net long-term capital gain (net of tax) to determine the undistributed personal holding company income prior to the dividend paid deduction.

b. There is no penalty if net income is distributed (i.e., in the form of actual dividends or consent dividends).

c. PHCs are not subject to the accumulated earnings tax.

3. Self-Assessed Tax

The tax is self-assessed by filing a separate Schedule 1120 PH along with Form 1120.

H. PERSONAL SERVICE CORPORATIONS DENIED GRADUATED RATES

A personal service corporate (PSC) is a corporation primarily involved in the performance of one of the following fields: accounting, law, consulting, engineering, architecture, health, and actuarial science. PSCs are denied the right to use the graduated corporate rates. Rather, they are taxed at a flat 35%.

VIII. CORPORATE DISTRIBUTIONS

Distributions from corporations to shareholders are taxable to such shareholders if the distributions are classified as dividends.

A. DIVIDENDS DEFINED

A dividend is defined by the Internal Revenue Code as a distribution of property by a corporation out of its earnings and profits (E&P):

1. Current E&P (By Y/E) = taxable dividend

2. Accumulated E&P (Dist. Date) = taxable dividend

3. Return of Capital (No E&P) = tax free and reduces basis of common stock

4. Capital Gain Distribution (No E&P/No Basis) = taxable income as a capital gain

[Note: The general rule is that current and accumulated E&P are not netted. Dividends come from current E&P and then from accumulated E&P. If both are positive there are no issues; distributions are dividends to the extent of the total of current and accumulated E&P. If current E&P is positive and accumulated E&P is negative, distributions are dividends to the extent of current E&P only. If current and accumulated E&P are negative, distributions are not dividends at all. However, if current E&P is negative and accumulated E&P is positive, the two amounts are netted, and distributions are dividends if the net is positive.]

N I R D

DISTRIBUTION BY CORPORATIONS

EARNINGS AND

PROFITS



[Note regarding preferred vs. common shareholders: A dividend to a preferred shareholder is based on that shareholder's fixed percentage at purchase. Preferred shareholders are not common equity owners of a corporation, and they only get paid based on their preferred percentage; therefore, any dividend payments to a preferred shareholder are considered dividend income to the shareholder. Preferred shareholders are paid in full before common shareholders receive dividends. Common shareholders are residual owners of a corporation and share in the earnings and profits of the corporation as well as the net assets.]

B. SOURCE OF DISTRIBUTIONS

1. Order of Distribution Allocation

Distributions are deemed to come from current E&P first and then from accumulated E&P. Any distribution in excess of both current and accumulated E&P is treated as a nontaxable return of capital that reduces the shareholder's basis in the stock.

EXA

MPL

ES

At December 31, 20X4, the Julie Corporation had $20,000 of accumulated E&P. For the taxable year 20X4, Julie had current E&P (before distributions) of $25,000.

(1) If Julie makes distributions in 20X5 of $25,000 or less, the distribution would be a dividend out of current E&P.

(2) If the distribution is greater than $25,000, but less than or equal to $45,000, the distribution would be a dividend as follows: $25,000 out of current E&P and up to $20,000 out of accumulated E&P.

(3) If the distribution is greater than $45,000, the distribution would be a dividend of $45,000, and the excess over $45,000 is a nontaxable return of capital.

2. Matching Cash Dividends to Source

It is sometimes necessary to allocate cash dividends paid during the year to earnings and profits in order to determine the taxable income for each payment. When dividends are in excess of earnings and profits, the following allocation applies:

a. Current Earnings and Profits

Current earnings and profits are allocated on a pro rata basis to each distribution.

b. Accumulated Earnings and Profits

Accumulated earnings and profits are applied in chronological order, beginning with the earliest distribution.

EXA

MPL

E In 20X5, Linda Corp. had current earnings and profits of $15,000. It paid four cash dividends during the year of $7,500 each for a total of $30,000. Half of each dividend ($3,750) will be treated as having been made from current earnings and profits taxable to the shareholder to that extent.

C. CONSTRUCTIVE DIVIDENDS

Some transactions, while not in the form of dividends, are treated as such when the payments are not in proportion to stock ownership. Examples include:

1. Excessive salaries paid to shareholder employees,

2. Excessive rents and royalties,

3. "Loans" to shareholders where there is no intent to repay, and

4. Sale of assets below fair market value.



D. STOCK DIVIDENDS

1. Definition

A stock dividend is a distribution by a corporation of its own stock to its shareholders.

2. Generally Not Taxable

Stock dividends are generally not taxable unless the shareholder has a choice of receiving cash or other property.

3. Determination of Value

The value of the taxable stock dividend is the fair market value on the distribution date.

4. Allocation of Basis

The basis of a nontaxable stock dividend, where old and new shares are identical, is determined by dividing the basis of the old stock by the number of old and new shares.

EXA

MPL

E In 20X4, Linda purchased 100 shares of Conduf stock for $18,000 ($180 per share). In 20X5, the corporation declared a 50% stock dividend and Linda received 50 new shares. After the stock dividend, the basis of each new share is $120 ($18,000 ÷ 150 shares).

E. SHAREHOLDER TAXABLE AMOUNT

The taxable amount of a dividend from a corporation's earnings and profits depends upon the type of entity the shareholder is:

1. Individual Shareholder

a. Cash dividends—amount received

b. Property dividends—FMV of property received

2. Corporate Shareholders (remember dividends received deduction)

a. Cash dividends—amount received

b. Property dividends—FMV of property received

F. CORPORATION PAYING DIVIDEND—TAXABLE AMOUNT

1. General Rule

The general rule is the payment of a dividend does not create a taxable event. A dividend is a reduction of earnings and profits (retained earnings).

2. Property Dividends

If a corporation distributes appreciated property, the tax results are as follows:

a. The corporation recognizes gain as if the property had been sold (i.e., FMV less adjusted basis). The gain increases current E&P.

FMV Property

< Net Book Value >

Corp. Gain E&P





b. The recipient shareholder includes the FMV of property in income as a dividend (to the extent of E&P).

PASS KEY When the CPA examination has tested on the taxation of corporations paying property dividends, an unusual chain of events needs to be understood. The following illustrates these consequences: 1. Corporation has no E&P (dividend would not be taxable income) 4. Corporate gain increase/creates corporate E&P 2. Corporation distributes appreciated property as a dividend 5. Dividend to shareholder is now taxable income (to extent of E&P) 3. Corporation has a recognized gain (on property dividend)

c. When depreciable property is distributed, the corporation cannot recognize a loss.

G. STOCK REDEMPTION Stock redemptions occur when a corporation buys back stock from its stockholders. If the stock redemption qualifies for sale or exchange treatment, gain or loss is recognized by the shareholder. If not, the redemption is treated as a dividend to the extent of the corporation's E&P. The corporation can recognize gain (but not loss) on any appreciated property distributed as though it had sold the property for its FMV. 1. Proportional—taxable dividend income (to shareholder-ordinary income). Generally,

the corporation either redeems or cancels the stock pro-rata for all shareholders. 2. Disproportional (substantially disproportionate)—sale by shareholder subject to taxable

capital gain/loss to shareholder. Disproportional means that there has been a meaningful reduction in the shareholder's ownership interest. The percentage ownership after the redemption must be less than 50% and must be less than 80% of the percentage ownership before the redemption. Percentage ownership includes what is owned by certain family members (only spouse, children, grandchildren, and parents). Regardless of family ownership, a complete 100% termination of shareholder's interest is considered disproportional.

3. Partial liquidation of corporation (stock held by a non-corporate shareholder)—treated as an exchange of stock, not as a dividend.

4. Complete buy-out of shareholder—shareholder's entire interest is redeemed, and the transaction is treated as an exchange of stock.

5. Redemption not essentially equivalent to a dividend—treated as an exchange of stock. 6. Redemption to pay estate taxes—or expenses—treated as an exchange when the

corporation redeems stock that has been included in the decedent's gross estate (subject to dollar and time limitations).

IX. CORPORATE LIQUIDATION

If a corporation is liquidated, the transaction is subject to double taxation (that is, the corporation and the shareholder must generally recognize gain or loss). Corporation liquidations take two general forms and are discussed below. A. CORPORATION SELLS ASSETS AND DISTRIBUTES CASH TO SHAREHOLDERS

The result of this transaction is: 1. Corporation recognizes gain or loss (as normal) on the sale of the assets, and

SALE PRICE <BASIS>

TAXABLE GAIN/LOSS

CORPORATE LIQUIDATION



2. Shareholders recognize gain or loss to extent cash exceeds adjusted basis of stock.

PROCEEDS <STOCK BASIS>

TAXABLE GAIN/LOSS

B. CORPORATION DISTRIBUTES ASSETS TO SHAREHOLDERS

The result of this transaction is:

1. Corporation recognizes gain or loss as if it sold the assets for the FMV, and

FMV <BASIS>

TAXABLE GAIN/LOSS

2. Shareholders recognize gain or loss to extent FMV of assets received exceeds the adjusted basis of stock.

FMV <STOCK BASIS>

TAXABLE GAIN/LOSS

C. TAX-FREE REORGANIZATIONS

1. Reorganization Defined

Reorganization includes the following:

a. Mergers or consolidations (Type A);

b. The acquisition by one corporation of another corporation's stock, stock for stock (Type B);

c. The acquisition by one corporation of another corporation's assets, stock for assets (Type C);

d. Dividing of the corporation into separate operating corporations (Type D);

e. Recapitalizations (Type E); and

f. Mere change in identity, form, or place of organization (Type F).

2. Parent/Subsidiary Liquidation

No gain or loss is recognized by either the parent corporation or the subsidiary corporation when the parent, who owns at least 80%, liquidates its subsidiary. Parent assumes the basis of the subsidiary's assets as well as any unused NOL or capital loss or charitable contribution carryovers.

REORGANIZATION



3. Nontaxable Event

a. Corporation – Nontaxable

(1) The reorganization is a nontaxable transaction.

(2) All tax attributes remain.

b. Shareholder – Nontaxable

(1) The reorganization is a nontaxable transaction.

(2) The shareholder continues to retain his/her original basis.

(3) The shareholder recognizes gain to the extent he/she receives boot (cash) in the reorganization.

PASS KEY

The general rule for taxable events and basis applies to reorganizations:

Taxpayer Event Income Basis Tax Attributes

Corporation Nontaxable N-O-N-E NBV No Change

Shareholder Nontaxable N-O-N-E NBV No Change

4. Continuity of Business

A reorganization is treated as a nontaxable transaction 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 entities) or use a significant portion of the old corporation's assets.

5. Control Requirement

In addition to the continuity requirement, there is a control test. Control is defined as at least 80% of the total voting power of all classes of stock and at least 80% of all other classes of stock. This is the same requirement as that of a tax-free incorporation discussed above.

6. Tax Status of Reorganizations

Reorganizations are nontaxable (except to the extent of boot received) because the shareholders have not liquidated their investment but have continued operations in a modified form.

PASS KEY To distinguish the liquidation and reorganization rules, review the following:

● Liquidation Completely ceases Taxable Taxable ● Reorganization Continues Nontaxable Nontaxable

Business Activity

Corporation Consequence

Shareholder Consequence



D. WORTHLESS STOCK—SECTION 1244 STOCK (SMALL BUSINESS STOCK)

When a corporation's stock is sold or becomes worthless, an original stockholder can be treated as having an ordinary loss (fully tax deductible), instead of a capital loss, up to $50,000 ($100,000 if married filing jointly). 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.

1. Maximum Ordinary Loss Deduction

a. Married—$100,000

b. Single—$50,000

2. Qualifications

a. Cash or property paid to the corporation in exchange for its first $1,000,000 of capital stock.

b. The stock must have been issued to an individual stockholder (or a partnership) for money or other property but not stock or securities or services rendered.

E. SMALL BUSINESS STOCK: 50% EXCLUSION OF GAIN

A noncorporate 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.

1. Maximum Exclusion and Limited to 50% of the Greater of:

a. 10 times the taxpayer's basis in the stock (or)

b. $10 million dollars (shareholder by shareholder basis)

2. Qualified Corporation and Must Have the Following:

a. Stock issued after August 10, 1993

b. Acquired at the original issuance

c. C corporation only (not an S corporation)

d. Have less than $50 million of capital as of date of stock issuance

e. 80% (or more) of the value of the corporation's assets must be used in the active conduct of one or more qualified trades or businesses

3. Includible portion of the gain is taxed at 28% rate.



SMALL BUSINESS CORPORATIONS (S CORPORATIONS)

Small closely held corporations may elect to be treated in a manner similar to partnerships. In effect, all the earnings or losses of the corporation are passed through to the shareholders.

This results in no corporate-level tax; however, the individuals are taxed on their share of the corporate earnings regardless of whether the corporation actually distributes the earnings to them.

I. ELIGIBILITY

To qualify as a small business corporation, the following requirements must be met:

A. QUALIFIED CORPORATION

The corporation must be a domestic corporation. An S corporation may own any interest in a C corporation (even 100%), but the S corporation may not file a consolidated tax return with the C corporation. An S corporation may also create a qualified S subsidiary in which it owns 100% of the stock; the two S corporations would file as one entity for tax purposes.

B. ELIGIBLE SHAREHOLDERS

1. Eligible shareholders must be an individual, estate, or certain types of trusts.

2. An individual shareholder may not be a nonresident alien.

3. Qualified retirement plans, trusts, and 501(c)(3) charitable organizations may be shareholders.

4. Neither corporations nor partnerships are eligible shareholders.

5. Grantor and voting trusts are permissible shareholders.

C. SHAREHOLDER LIMIT

There may not be more than 100 shareholders. Family members may elect to be treated as one shareholder. Family members include common ancestors, lineal descendants of common ancestors, and their current or former spouses.

D. ONE CLASS OF STOCK

There may not be more than one class of stock outstanding. However, differences in common stock voting rights are allowed. Preferred stock is not permitted.

II. ELECTING S CORPORATION STATUS

A. WHEN ELECTION TAKES EFFECT

All shareholders (voting and nonvoting) must consent to a valid election. If the election is made at any time during the entire preceding year or on or before the fifteenth day of the third month of the election year, the election would be effective on the first day of the tax year (e.g., January 1 for a calendar year corporation).

B. NEW SHAREHOLDERS

After the election is made, the consent of a new shareholder is not required. The S corporation status continues unless a shareholder(s) who owns more than 50% of the stock affirmatively acts to terminate the election.

S CORPORATIONS



III. EFFECT OF S CORPORATION ELECTION ON CORPORATION

A. S CORPORATION TAX YEAR

S corporations file Form 1120S and must adopt the calendar year, unless a valid business purpose for a different taxable year (fiscal year) is established. The return is due by the 15th day of the third month (March 15) after the close of the tax year.

B. NO TAX ON CORPORATION

Generally, there is no tax at the corporation level; all earnings are passed through to shareholders. There are certain exceptions (see item C, below).

C. CERTAIN CORPORATION-LEVEL TAXES

There are three principal taxes imposed upon S corporations.

1. LIFO Recapture Tax

C corporations that elect S status must include in taxable income for the last C corporation year the excess of inventory computed under FIFO over LIFO (cumulative basis). The resulting tax on the C corporation may be paid in four equal installments, the first of which is due with the final C corporation return. The remaining installments are paid by the S corporation.

2. Built-In Gains Tax

a. Overview

A distribution or sale of an S corporation's assets may result in a tax on any "built-in gain" at the corporate-level. An unrealized "built-in gain" results when the following two conditions occur:

(i) A C corporation elects S corporation status, and

(ii) The fair market value of the corporate assets exceeds the adjusted basis of corporate assets on the election date.

The net unrealized built-in gain is the excess of the fair market value of corporate assets over adjusted basis of corporate assets at the beginning of the year of which S corporation status is elected. The amount of "built-in gain" recognized in any one year is limited to the net unrealized "built-in gain" less any "built-in gain" previously recognized.

b. Exemptions from Recognition of Gain

An S corporation is exempt from a tax on "built-in gains" under any of the following circumstances:

(1) The S corporation was never a C corporation.

(2) The sale or transfer does not occur within 10 years of the first day of the first year that the S election is made.

(3) The S corporation can demonstrate that the appreciation occurred after the S election.

(4) The S corporation can demonstrate that the distributed asset was acquired after the S election.

(5) The net unrealized built-in gain has been completely recognized in prior tax years.

BUILT-IN GAINS



c. Calculation of Tax

The tax is calculated by multiplying 35% (the highest corporate tax rate) by the lesser of the following:

(1) Recognized built-in gain for the current year, or

(2) The taxable income of the S corporation if it were a C corporation.

3. Tax on Passive Investment Income

An S corporation is subject to an income tax imposed at the highest corporate rate (35%) on the lesser of net income or excess passive investment income if the following two tests are met:

a. The S corporation has accumulated C corporation earnings and profits (i.e., accumulated earnings attributable to prior periods in which the corporation was a C corporation), and

b. Passive investment income (e.g., royalties, dividends, interest, rents, and annuities but not gains on sales of securities) exceeds 25% of gross receipts.

IV. EFFECT OF S CORPORATION ELECTION ON SHAREHOLDERS

A. PASS-THROUGH OF INCOME AND/OR LOSSES (TO SHAREHOLDER / K-1)

Net income (or loss) is passed-through to shareholders as follows:

1. Like partnerships, S corporations report both separately and non-separately stated items of income and/or loss. Separately stated income items include dividends, interest, capital gains and losses, Section 1231 gains and losses, etc. Separately stated deductions include charitable contributions, Section 179 expenses, etc.

2. Allocations to shareholders are made on a per-share, per-day basis.

3. Losses are limited to a shareholder's adjusted basis in S corporation stock plus direct shareholder loans to the corporation. Shareholder guarantees do not increase basis. Any losses disallowed may be carried forward indefinitely and will be deductible as the shareholder's basis is increased.

4. The following S corporation items flow through to the shareholder in a manner similar to a partnership (see Schedule K-1, p. 50, for complete list):

a. Ordinary income (not subject to FICA)

b. Rental income/loss

c. Portfolio income (including interest, dividends, royalties, and all capital gains (losses)).

d. Tax-exempt interest

e. Percentage depletion

f. Foreign income tax

g. Section 1231 gains and losses

h. Charitable contributions

i. Expense deduction for recovery property (Section 179)

SHAREHOLDER TAXATION



5. Fringe Benefits

a. Deductible Fringe Benefits

Fringe benefits are deductible for non-shareholder employees and those employee shareholders owning 2% or less of the S corporation.

b. Non-Deductible Fringe Benefits

The cost of fringe benefits for shareholders owning over 2% is not deductible to the S corporation, unless the corporation includes the benefits in the employee/shareholder's W-2 income.

EXA

MPL

E

The Duffy Corporation, an S corporation, is owned equally by three shareholders, Rick, Tim, and Peter. The corporation is on a calendar year basis. On February 1, 20X5, Peter sold his 1/3 interest in Duffy Corporation to George. For the year ended December 31, 20X5, the corporation had non-separately stated ordinary income of $120,000. For 20X5, the income of the corporation should be allocated as follows:

Rick ($120,000 x 1/3) $ 40,000 Tim ($120,000 x 1/3) 40,000 Peter (31/365 x $40,000) 3,397 George (334/365 x $40,000) 36,603 Total $120,000

PASS KEY

Similar to a partnership, shareholders in an S corporation must include on their personal income tax return their distributive share of each separate "pass-thru" item.

Shareholders are taxed on these items, regardless of whether or not the items have been distributed (withdrawn) to them during the year.

6. Accumulated Adjustments Account ("AAA")

The tax effects of distributions paid to shareholders of an S corporation that has accumulated earnings and profits since inception (or since the most recent electing of S status) are computed by using the accumulated adjustments account (AAA). The AAA is zero at the inception of the S corporation.

a. Increases to the AAA

The AAA is essentially increased by separately and non-separately stated income and gains (except tax-exempt income and certain life insurance proceeds).

b. Decreases to the AAA

The AAA is essentially decreased by corporate distributions (distributions may not reduce the AAA below zero), separately and non-separately stated expense items and losses (except for certain non-deductible items that do not affect the capital account), and non-deductible expenses (except life insurance premiums on a contract that is owned by the corporation and that identifies the corporation as beneficiary) that relate to income other than tax-exempt income.







B. COMPUTING SHAREHOLDER BASIS IN S CORPORATION STOCK

The rules for determining a shareholder's basis in S corporation stock are generally the same as for partnerships, as follows:

Initial Basis

+ Income items (separately and non-separately stated items) + Additional shareholder investments in corporation stock

– Distribution to shareholders – Loss or expense items

Ending Basis

PASS KEY

An S corporation shareholder is permitted to deduct (on their personal income tax return) their pro rata share of the S corporation loss subject to the following limitation:

Loss limitation = Basis + Direct shareholder loans – Distributions

C. TAXABILITY OF DISTRIBUTIONS TO SHAREHOLDERS

Because S corporations are only subject to a single level of tax, distributions from an S corporation are generally not subject to taxation for shareholders. However, the rules for determining the taxability of distributions are presented below.

S Corporation with No C Corporation E&P Distribution Tax result Treatment 1st To extent of basis in stock Not subject to tax, reduces basis

in stock Return of capital

2nd In excess of basis of stock Taxed as long-term capital gain (if stock held for > year)

Capital gain distribution

EXA

MPL

E Always Corporation, a calendar year S corporation since its formation in 1990, has two equal shareholders, A and W. During 20X5, A received distributions from Always Corporation of $22,000. At December 31, 20X5 after all adjustments to basis had been made, except for distributions, A's basis in his Always stock was $18,000. For 20X5, A will treat $18,000 as a nontaxable return of capital (reduction of basis of stock) and a $4,000 long-term capital gain.

B A

S

E

DISTRIBUTIONS



ACCUMULATED ADJUSTMENT

ACCOUNT

S Corporation with C Corporation E&P

Distribution Tax result Treatment

1st To extent of AAA Not subject to tax, reduces basis in stock

S-Corp (already taxed) profits

2nd To extent of C corporation E&P

Taxed as a dividend, does not reduce basis in stock

Old C-Corp taxable dividend

3rd To extent of basis in stock Not subject to tax, reduces basis in stock

Return of capital

4th In excess of basis in stock Taxed as long-term capital gain Capital gain distribution

As previously presented, "AAA" stands for Accumulated Adjustments Account, which essentially means the cumulative amount of S corporation income or loss (separately and non-separately stated items, excluding tax-exempt income) since the corporation most recently elected S status, less all cumulative distributions. Distributions may not reduce AAA below zero; however, AAA may be negative from S corporation losses.

The New Elect Corporation, was a C corporation until it elected S status on January 1, 1992. New Elect had accumulated E&P of $20,000 at December 31, 1991. For the period 1992–2006, New Elect had ordinary income of $100,000 and had made shareholder distributions of $60,000. Thus, New Elect's AAA balance at December 31, 2006 was $40,000. In 2007, New Elect had ordinary income of $40,000 and made distributions to shareholders of $110,000. The tax result of these 2007 items are as follows:

(1) To extent of AAA ($40,000 + $40,000 = $80,000) Tax-free

(2) To extent of C corporation E&P ($20,000) Dividend

EXA

MPL

E

(3) Excess ($10,000) Reduces basis in stock, if in excess of basis, LTCG

V. TERMINATING THE ELECTION

A. WHEN S CORPORATION STATUS TERMINATES

The S corporation status will terminate as a result of any of the following:

1. Holders of a majority of the corporation's stock (any combination of voting and non-voting common stock) consent to a voluntary revocation;

2. The corporation fails to meet any or all of the eligibility requirements (qualifications) for S corporation status; or

3. More than 25% of the corporation's gross receipts come from passive investment income for three consecutive years and the corporation had C corporation earnings and profits at the end of each year. The S corporation status is terminated as of the beginning of the fourth year.

B. RE-ELECTING: 5 YEARS

Once an S corporation election is terminated or revoked, a new election cannot be made for five years unless the IRS consents to an earlier election. If the termination occurs in mid-year, the corporation will have two short years, a short S year and a short C year. Earnings are prorated on a daily basis to each of the short years. A special election may be made to "cut off" net income at the exact date of conversion.

TERMINATION OF ELECTION



NOTES



APPENDIX A MACRS Depreciation Calculation

The text covers the topic of tax depreciation beginning on page R3-26. The Modified Accelerated Cost Recovery System (MACRS) is used for the majority of depreciation expense for taxation. Historically, the CPA Exam has not tested the calculations of MACRS in much detail and has focused mainly on the "basics."

The lecture covers the material that has historically been tested on the CPA exam; however, the AICPA has recently included a simulation example on its website that is more detailed in nature (unfortunately, the example is one illustrating a short tax year, which tends to complicate the situation because in a short tax year, expense must be prorated from the date of beginning operations). In an effort to provide you with enhanced materials on the topic of MACRS, we are providing additional explanatory information in this appendix.

The lecture pages provide you with the rules for salvage value and half-year/mid-quarter conventions, but they do not address the factors that are used in the calculations of MACRS expense. The following table provides an example of the factors that are used to calculate MACRS depreciation expense under the half-year convention.

Remember that salvage value is ignored. Generally, the calculation of MACRS depreciation expense for an entity that has been in operation for the entire year is to take the purchase price (plus improvements) and multiply that amount by the applicable MACRS factor. Proration is not applicable in the general case and only applies to short tax years (i.e., when the entity begins operations some period of time into the tax year).

Example: Assume a company that started business in 2004 purchased office furniture on February 14, 2006, at a price of $10,000. Further assume that this was the only purchase of assets in the year (reason: avoid possibly applying the mid-quarter convention rules). Office equipment is MACRS 7-year property (refer to page R3-26). The depreciation expense for the year 2006 for the office equipment would be $10,000 x .1429 (per the table, below) = $1,429. The depreciation expense for 2007 would be $10,000 x .2449 = $2,449. Note that the expense is lower in the first year due to the half-year convention. The sum of the factors for a type of asset will equal 100. As you can see, the calculation of MACRS depreciation expense is quite simple once you can identify the applicable factor.



MACRS DEPRECIATION TABLE

General Depreciation System

Applicable Depreciation Method: 200 or 150 Percent Declining Balance Switching to Straight Line

Applicable Recovery Period: 3, 5, 7, 10, 15, 20 years

Applicable Convention: Half-year

If the Recovery Year is: and the Recovery Period is:

3-year 5-year 7-year 10-year 15-year 20-year 1 33.33 20 14.29 10 5 3.75

2 44.45 32 24.49 18 9.5 7.219

3 14.81 19.2 17.49 14.4 8.55 6.677

4 7.41 11.52 12.49 11.52 7.7 6.177

5 11.52 8.93 9.22 6.93 5.713

6 5.76 8.92 7.37 6.23 5.285

7 8.93 6.55 5.9 4.888

8 4.46 6.55 5.9 4.522

9 6.56 5.91 4.462

10 6.55 5.9 4.461

11 3.28 5.91 4.462

12 5.9 4.461

13 5.91 4.462

14 5.9 4.461

15 5.91 4.462

16 2.95 4.461

17 4.462

18 4.461

19 4.462

20 4.461

21 2.231



APPENDIX B Form 4797





REGULATION 3 Class Questions Answer Worksheet

MC Q

uest

ion

Num

ber

Firs

t Cho

ice A

nswe

r

Corre

ct A

nswe

r

NOTES

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Grade:

Multiple-choice Questions Correct / 24 = __________% Correct

Detailed explanations to the class questions are located in the back of this textbook.



NOTES



CLASS QUESTIONS

1. CPA-02030

Lind and Post organized Ace Corp., which issued voting common stock with a fair market value of $120,000. They each transferred property in exchange for stock as follows:

Fair Percentage Adjusted market of Ace stock Property basis value acquired Lind Building $40,000 $82,000 60% Post Land $5,000 $48,000 40%

The building was subject to a $10,000 mortgage that was assumed by Ace. What amount of gain did Lind recognize on the exchange? a. $0 b. $10,000 c. $42,000 d. $52,000 2. CPA-02034



The building was subject to a $10,000 mortgage that was assumed by Ace. What was Ace's basis in the building? a. $30,000 b. $40,000 c. $72,000 d. $82,000 3. CPA-02036



The building was subject to a $10,000 mortgage that was assumed by Ace. What was Lind's basis in Ace stock? a. $82,000 b. $40,000 c. $30,000 d. $0



4. CPA-02106

Axis Corp. is an accrual basis calendar year corporation. On December 13, 1993, the Board of Directors declared a two percent of profits bonus to all employees for services rendered during 1993 and notified them in writing. None of the employees own stock in Axis. The amount represents reasonable compensation for services rendered and was paid on March 13, 1994. Axis' bonus expense may: a. Not be deducted on Axis' 1993 tax return because the per share employee amount cannot be

determined with reasonable accuracy at the time of the declaration of the bonus. b. Be deducted on Axis' 1993 tax return. c. Be deducted on Axis' 1994 tax return. d. Not be deducted on Axis' tax return because payment is a disguised dividend. 5. CPA-02039

In 1994, Starke Corp., an accrual-basis calendar year corporation, reported book income of $380,000. Included in that amount was $50,000 municipal bond interest income, $170,000 for federal income tax expense, and $2,000 interest expense on the debt incurred to carry the municipal bonds. What amount should Starke's taxable income be as reconciled on Starke's Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return? a. $330,000 b. $500,000 c. $502,000 d. $550,000 6. CPA-02149

Brown Corp., a calendar-year taxpayer, was organized and actively began operations on July 1, 2004, and incurred the following costs:

Legal fees to obtain corporate charter $41,000 Commission paid to underwriter 25,000 Other stock issue costs 10,000

Brown wishes to amortize its organizational costs over the shortest period allowed for tax purposes. In 2004, what amount should Brown deduct for the organizational expenses? a. $1,200 b. $5,000 c. $6,200 d. $8,600 7. CPA-02021

On January 2 of the current year, Shaw Corp., an accrual-basis, calendar-year C corporation, purchased all the assets of a sole proprietorship, including $300,000 in goodwill. Current-year federal income tax expense of $110,100 and $7,500 for goodwill impairment were deducted to arrive at Shaw's reported book income of $239,200. What should be the amount of Shaw's current-year taxable income, as reconciled on Shaw's Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return? a. $239,200 b. $329,300 c. $336,800 d. $349,300



8. CPA-02101

For the year ended December 31, 2004, Taylor Corp. had a net operating loss of $200,000. Taxable income for the earlier years of corporate existence, computed without reference to the net operating loss, was as follows:

Taxable income 1999 $5,000 2000 $10,000 2001 $20,000 2002 $30,000 2003 $40,000

What amount of net operating loss will be available to Taylor for the year ended December 31, 2005? a. $200,000 b. $130,000 c. $110,000 d. $95,000 9. CPA-02047

In 1994, Best Corp., an accrual-basis calendar-year C corporation, received $100,000 in dividend income from the common stock that it held in an unrelated domestic corporation. The stock was not debt-financed and was held for over a year. Best recorded the following information for 1994:

Loss from Best's operations $(10,000) Dividends received 100,000 Taxable income (before dividends-received deduction) $ 90,000

Best's dividends-received deduction on its 1994 tax return was: a. $100,000 b. $80,000 c. $70,000 d. $63,000 10. CPA-02042

Bent Corp., a calendar-year C corporation, purchased and placed into service residential real property during February 1998. No other property was placed into service during 1998. What convention must Bent use to determine the depreciation deduction for the alternative minimum tax? a. Full-year. b. Half-year. c. Mid-quarter. d. Mid-month. 11. CPA-02058

On August 1, 1994, Graham purchased and placed into service an office building costing $264,000 including $30,000 for the land. What was Graham's MACRS deduction for the office building in 1994? a. $9,600 b. $6,000 c. $3,600 d. $2,250



12. CPA-02085

Edge Corp., a calendar-year C corporation, had a net operating loss and zero tax liability for its 1994 tax year. To avoid the penalty for underpayment of estimated taxes, Edge could compute its first quarter 1995 estimated income tax payment using the: Annualized Preceding income method year method a. Yes Yes b. Yes No c. No Yes d. No No 13. CPA-02162

If a corporation's tentative minimum tax exceeds the regular tax, the excess amount is: a. Carried back to the first preceding taxable year. b. Carried back to the third preceding taxable year. c. Payable in addition to the regular tax. d. Subtracted from the regular tax. 14. CPA-02090

Edge Corp. met the stock ownership requirements of a personal holding company. What sources of income must Edge consider to determine if the income requirements for a personal holding company have been met? I. Interest earned on tax-exempt obligations. II. Dividends received from an unrelated domestic corporation.

a. I only. b. II only. c. Both I and II. d. Neither I nor II. 15. CPA-02131

On January 1, 1993, Kee Corp., a C corporation, had a $50,000 deficit in earnings and profits. For 1993 Kee had current earnings and profits of $10,000 and made a $30,000 cash distribution to its stockholders. What amount of the distribution is taxable as dividend income to Kee's stockholders? a. $30,000 b. $20,000 c. $10,000 d. $0 16. CPA-02120

Tank Corp., which had earnings and profits of $500,000, made a nonliquidating distribution of property to its shareholders in 1993 as a dividend in kind. This property, which had an adjusted basis of $20,000 and a fair market value of $30,000 at the date of distribution, did not constitute assets used in the active conduct of Tank's business. How much gain did Tank recognize on this distribution? a. $30,000 b. $20,000 c. $10,000 d. $0



17. CPA-02026

Elm Corp. is an accrual-basis calendar-year C corporation with 100,000 shares of voting common stock issued and outstanding as of December 28, 1995. On Friday, December 29, 1995, Hall surrendered 2,000 shares of Elm stock to Elm in exchange for $33,000 cash. Hall had no direct or indirect interest in Elm after the stock surrender. Additional information follows:

Hall's adjusted basis in 2,000 shares of Elm on December 29, 1995 ($8 per share) $16,000 Elm's accumulated earnings and profits at January 1, 1995 25,000 Elm's 1995 net operating loss (7,000)

What amount of income did Hall recognize from the stock surrender? a. $33,000 dividend. b. $25,000 dividend. c. $18,000 capital gain. d. $17,000 capital gain. 18. CPA-02027

Mintee Corp., an accrual-basis calendar-year C corporation, had no corporate shareholders when it liquidated in 1996. In cancellation of all their Mintee stock, each Mintee shareholder received in 1996 a liquidating distribution of $2,000 cash and land with tax basis of $5,000 and a fair market value of $10,500. Before the distribution, each shareholder's tax basis in Mintee stock was $6,500. What amount of gain should each Mintee shareholder recognize on the liquidating distribution? a. $0 b. $500 c. $4,000 d. $6,000 19. CPA-02081

Ace Corp. and Bate Corp. combine in a qualifying reorganization and form Carr Corp., the only surviving corporation. This reorganization is tax-free to the: Shareholders Corporations a. Yes Yes b. Yes No c. No Yes d. No No 20. CPA-01984

Which of the following conditions will prevent a corporation from qualifying as an S Corporation? a. The corporation has both common and preferred stock. b. The corporation has one class of stock with different voting rights. c. One shareholder is an estate. d. One shareholder is a grantor trust.



21. CPA-01974

On February 10, 1994, Ace Corp., a calendar-year corporation, elected S corporation status and all shareholders consented to the election. There was no change in shareholders in 1994. Ace met all eligibility requirements for S status during the preelection portion of the year. What is the earliest date on which Ace can be recognized as an S corporation? a. February 10, 1995. b. February 10, 1994. c. January 1, 1995. d. January 1, 1994. 22. CPA-01966

Bristol Corp. was formed as a C corporation on January 1, 2000, and elected S corporation status on January 1, 2002. At the time of the election, Bristol had accumulated C corporation earnings and profits, which have not been distributed. Bristol has had the same 25 shareholders throughout its existence. In 2005 Bristol's S election will terminate if it: a. Increases the number of shareholders to 100. b. Adds a decedent's estate as a shareholder to the existing shareholders. c. Takes a charitable contribution deduction. d. Has passive investment income exceeding 90% of gross receipts in each of the three consecutive

years ending December 31, 2004. 23. CPA-01955

Lane Inc., an S corporation, pays single coverage health insurance premiums of $4,800 per year and family coverage premiums of $7,200 per year. Mill is a ten percent shareholder-employee in Lane. On Mill's behalf, Lane pays Mill's family coverage under the health insurance plan. What amount of insurance premiums is includible in Mill's gross income? a. $0 b. $720 c. $4,800 d. $7,200 24. CPA-01957

Beck Corp. has been a calendar-year S corporation since its inception on January 2, 1995. On January 1, 1998, Lazur and Lyle each owned 50% of the Beck stock, in which their respective tax bases were $12,000 and $9,000. For the year ended December 31, 1998, Beck had $81,000 in ordinary business income and $10,000 in tax-exempt income. Beck made a $51,000 cash distribution to each shareholder on December 31, 1998. What was Lazur's tax basis in Beck after the distribution? a. $1,500 b. $6,500 c. $52,500 d. $57,500

2009 R-3 Lecture

Documents

basis of common stock

corporation net basis

gain gain

corporation transferors

negative basis

duffys stock basis

new basis of stock

corporation common stock