Chapter 3 presentation

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporations, Partnerships,Estates & Trusts

Chapter 3

Corporations: Special Situations

The Big Picture (slide 1 of 2)

Determining DPGR for the Domestic Production Activities Deduction

• Mocha, Inc., produces and sells its ice cream to food stores and restaurants. – Mocha also operates snack shops next to its facilities where it sells ice

cream, coffee, and other snacks to the general public.

• Mocha has gross receipts of $42 million from the wholesale sale of its ice cream and $5 million from the operation of the snack shops. – What receipts are considered to be domestic production gross receipts

(DPGR) for the domestic production activities deduction (DPAD)?

• What planning tip might you give to Mocha? – Read the chapter and formulate your response.

The Big Picture (slide 2 of 2)

Who Pays the alternative minimum tax (AMT)?• Carmine, Inc., has a tentative minimum tax base of $7

million and average gross receipts for this year and the prior 3 years of < $7.5 million.

• Taupe, Inc., has a tentative minimum tax base of $7.1 million and average gross receipts for this year and the prior 3 years of < $7.5 million.

• Carmine is not subject to the AMT, but Taupe is.• How can this happen?

– Read the chapter and formulate your response.

Domestic Production Activities Deduction (slide 1 of 5)

• The American Jobs Creation Act of 2004 created a new deduction, the domestic production activities deduction (DPAD)– Based on income from manufacturing activities

– Calculated using the following formula:• 9% × Lesser of

– Qualified production activities income

– Taxable income (or modified AGI) or AMTI

– The deduction cannot exceed 50% of an employer’s W–2 wages properly allocable to domestic production gross receipts


• A phase-in provision increased the applicable rate for the production activities deduction as follows:

Rate Years

3% 2005-2006

6% 2007-2009

9% 2010 and thereafter


• Eligible taxpayers include:– Individuals, partnerships, S corporations, C

corporations, cooperatives, estates, and trusts• For a pass-through entity (e.g., partnerships, S

corporations), the deduction flows through to the individual owners

• For sole proprietors, a deduction for AGI results

• For C corporations, the deduction is included with other expenses in computing corporate taxable income


• Qualified production activities income is the excess of domestic production gross receipts over:– Cost of goods sold (CGS)– Direct costs– Allocable indirect costs


• Domestic production gross receipts (DPGR) include receipts from: – Lease, rental, license, sale, exchange, or other disposition

of qualified production property (QPP) that was manufactured, produced, grown, or extracted in the U.S.

– Qualified films largely created in the U.S.

– Production of electricity, natural gas, or potable water

– Construction performed in the U.S.

– Engineering and architectural services for domestic construction

Disallowed Production Activities-Preparation of Food & Beverages

• DPGR does not include gross receipts from the sale of food & beverages prepared by a taxpayer at a retail establishment– There is a 5 percent de minimis safe harbor

The Big Picture – Example 20DPGD – 5% De Minimis Rule

• Return to the facts of The Big Picture on p. 3–2. • Suppose that Mocha has the following sales:

– $42 million from the wholesale sale of its ice cream, and

– Only $2 million from the snack shops next to its facilities where it sells ice cream to the general public.

• The full $44 million is DPGR – The $2 million falls under the de minimis safe-harbor

exception

– $2 million is less than 5% of $44 million ($42 million + $2 million).

Alternative Minimum Tax (slide 1 of 3)

• Designed to ensure that corporations with substantial economic income pay at least a minimum amount of federal taxes

• Essentially, a separate tax system with a quasi-flat tax rate applied to a corporation’s economic income


• If tentative alternative minimum tax > regular corporate income tax, corporation must pay regular tax plus the excess, the alternative minimum tax (AMT)


• For tax years beginning after 1997, many small corporations are not subject to AMT– A small corporation has average annual gross

receipts of $5 million or less for the preceding three-year period

– Small corporation continues to qualify as long as average gross receipts for the preceding three-year period do not exceed $7.5 million

The Big Picture – Example 25Small Corporation Exemption

• Return to the facts of The Big Picture on p. 3–2.

• Suppose that Carmine, Inc., had gross receipts of $3.7 million, $4.8 million, and $4.6 million for tax years 2008, 2009, and 2010, respectively, for an average of $4.37 million.– For 2011 AMT purposes, Carmine is considered to

be a small corporation.

AMT Formula for Corporations

AMT Adjustments (slide 1 of 2)

• The starting point for computing AMTI is taxable income before any NOL deduction– Certain adjustments must be made to this amount

• Tax preference items are always additions to taxable income

• AMT adjustments may either positive or negative– Positive adjustments result from timing differences

• Added to taxable income in computing AMTI

– When AMT adjustments reverse, they are deducted from taxable income to arrive at AMTI

AMT Adjustments (slide 2 of 2)

• AMT adjustments may either increase or decrease taxable income– e.g., The deduction for domestic manufacturing

activities (DPAD) is available for AMT purposes • DPAD for AMT is limited to the smaller of qualified

production income as determined for the regular income tax or for AMTI before the manufacturing deduction

Adjustments for AMT (slide 1 of 2)

• A portion of depreciation on property placed in service after 1986

• Difference between gain (loss) on sale of property for regular tax and AMT purposes

• Passive activity losses of certain closely held corporations and personal service corporations

• Mining exploration and development costs in excess of allowed AMT 10 year amortization

Adjustments for AMT (slide 2 of 2)

• Difference between percentage of completion and completed contract income

• Amortization claimed on certified pollution control facilities

• Difference between installment gain and total gain on certain dealer sales

• A portion of the difference between “ACE” and unadjusted AMTI

Tax Preference Items

• Accelerated depreciation on real property in excess of straight-line for property placed in service before 1987

• Tax-exempt interest on “private activity bonds”– Interest on such bonds issued in 2009 and 2010 is not

treated as a tax preference

• Percentage depletion in excess of the adjusted basis of property

• Certain intangible drilling costs for “integrated oil companies”

ACE Adjustment (slide 1 of 3)

• Ace adjustment = 75% of difference between unadjusted AMTI and ACE– Can be positive or negative– Negative adjustment is limited to aggregate

positive adjustments less previous negative adjustments


• Starting point for determining ACE is AMTI– AMTI is defined as regular taxable income after

AMT adjustments and tax preferences (other than the NOL and ACE adjustments)


• AMTI is adjusted to arrive at ACE – These adjustments include:

• Exclusion items—Income items that will never be included in regular taxable income or AMTI

• Disallowed items – e.g., dividends received deduction of 70% (less than 20% ownership)

• Other adjustments items including, for example, intangible drilling costs, circulation expenditures, organization expense amortization, LIFO inventory adjustments, installment sales, other items

Impact of CertainTransactions on ACE

Transaction

Effect on Unadjusted AMTI in Arriving at ACE

Tax exempt income (less expenes) Add

Federal income tax No Effect Dividends received deduction (70%) Add

DRD (80% and 100%) No Effect

Exemption ( up to $40,000) No Effect

Key employee insurance proceeds Add

Exemption

• Exemption amount for a corp = $40,000– Reduced by 25% of excess of AMTI over

$150,000– Exemption is totally phased-out when AMTI

reaches $310,000

Minimum Tax Credit (slide 1 of 2)

• AMT paid in one year can be used as a credit against future regular tax liability that exceeds its tentative minimum tax– Indefinite carryforward– Cannot be carried back– Cannot offset any future minimum tax liability

Minimum Tax Credit (slide 2 of 2)

• Small corporations (no longer subject to AMT) with unused minimum tax credits after 1997 may use them against regular tax liability

• Limit = regular tax – [25% × (regular tax – $25,000)]

AMT Example (slide 1 of 4)

Moreland Co. has the following income, etc. in 2011:

Taxable income $100,000Depreciation adjustment 18,000Installment gain (not on inventory sale) 80,000Federal income tax provision on financial stmts. 75,000Penalties and fines 2,000Private activity bond interest income (issued 2008) 25,000Other tax-exempt interest 20,000

– The depreciation adjustment is an AMT adjustment and the private activity bond interest is a tax preference for AMTI.


Calculation of AMTI before ACE:

Taxable income $100,000

Plus: private activity bond income 25,000

Plus: depreciation adjustment 18,000

AMTI $143,000


Calculation of ACE Adjustment:

AMTI before ACE $143,000

Plus: deferred installment gain 80,000

Plus: other tax-exempt income 20,000

Adjusted current earnings $243,000

Less: AMTI 143,000

Base amount for Ace Adjustment $100,000

Times rate: 75%

ACE Adjustment (positive) $75,000


Calculation of AMT:AMTI before ACE $143,000Plus: ACE Adjustment 75,000AMTI $218,000Less: Exemption 23,000Tentative minimum tax base $195,00020% rate × 20%Tentative minimum tax $ 39,000Less: regular tax (22,250)AMT(TMT-Regular tax) $ 16,750

Total cash paid = Regular tax + AMT = $ 39,000

Accumulated Earnings Tax(slide 1 of 5)

• Penalty tax designed to discourage the retention of corporate earnings unrelated to the business needs of the company


• Tax of 15% is imposed on accumulated taxable income (ATI), determined as follows:

• ATI = Taxable income ± Adjustments - Dividends paid - Accumulated earnings credit

• Adjustments to taxable income generally pertain to a corporation’s ability to pay a dividend– Thus, deductions include the corporate income tax and

excess charitable contributions, while additions include the NOL and dividends received deductions


• An accumulated earnings credit is allowed even when accumulations are beyond reasonable business needs


• The accumulated earnings credit is the greater of:– Current E&P needed to meet “reasonable needs”

of the business, or– Amount by which $250,000 ($150,000 for service

companies) exceeds Accumulated E&P as of close of preceding tax year (the minimum credit)

Accumulated Earnings Tax -Reasonable Needs Of The Business (slide 5 of 5)

• Legitimate reasons– Business expansion

– Capital asset replacement

– Working capital needs

– Product liability loss

– Loans to suppliers or customers

• Invalid Reasons– Loans to shareholders

– Unrealistic contingencies

– Investment in unrelated business assets

Personal Holding Company Tax

• Personal Holding Company (PHC) tax is designed to discourage sheltering of certain types of passive income in corporations– Like the accumulated earnings tax, the purpose is

to force the distribution of corporate earnings to shareholders

Definition of PHC

• A company is a PHC if:– More than 50% of the value of stock is owned by 5 or

fewer individuals during the last half of the year • Broad constructive ownership rules apply in determining stock

ownership

– 60% or more of gross income (as adjusted) must consist of personal holding company income (PHCI)

• Examples are dividends, interest, rents, royalties, and certain personal service income

• Rents or royalties may be excluded if they are significant in amount (i.e., comprise more than 50% of the adjusted gross income)

Calculation of PHC Tax

• Once classified as a PHC, the tax base must be calculated– Penalty tax rate = 15%– Tax base is undistributed Personal Holding

Company income (UPHC income)• Amount is taxable income plus or minus certain

adjustments, minus the dividends paid deduction

Dividends Paid

• Dividend payments reduce both ATI and undistributed PHCI– As these are the bases on which the § 531 tax or

the § 541 tax is imposed, either tax can be completely avoided by paying sufficient dividends

Refocus On The Big Picture (slide 1 of 4)

• Determining DPGR for the DPAD

• The $42 million gross receipts from the wholesale sale of Mocha’s ice cream are considered DPGR. – However, the de minimis safe-harbor 5%

exception does not apply to include the gross receipts from the snack shops

• $5 million ÷ $47 million = 10.6%.


• The sales from the snack shops could qualify as DPGR if Mocha were to restrict snack shop sales. – For example, keeping snack sales at around $2.2 million

would satisfy the 5 % exception.

• Thus, Mocha will have to decide whether the 9 % DPAD is worth forgoing the profit on the snack sales.

• Keep in mind that the DPAD is allowed for the AMT.


• Who Pays the AMT?

• Carmine, Inc., has met several gross receipts tests, including initially qualifying as a ‘‘small corporation.’’

• To qualify as a ‘‘small corporation,’’ the business must have had average gross receipts of $5 million or less in the preceding 3 years.


• Once qualified as a ‘‘small corporation’’ it will continue to be exempt from the AMT as long as its average gross receipts for the 3 preceding taxable years do not exceed $7.5 million.

• Unfortunately, Taupe, Inc., did not meet the initial $5 million test, so it does not fall within the $7.5 million exemption.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPAtrippedr @oneonta.edu

SUNY Oneonta

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