Chapter 14. C Corporations. Chapter 14. Teaching Suggestions

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1 247 C Corporations Teaching Suggestions Discuss the differences between the calculation of taxable income for corporations and individual taxpayers. Discussion should include: 1. Dividends received deduction 2. Charitable contributions 3. Capital gains and losses 4. Organizational and start-up costs Solutions to Questions and Problems 1. The tax laws now allow businesses to check-the-box to determine which type of entity they wished to be taxed as for purposes of Federal income taxes a. Normally no gain or loss is recognized by either the shareholder or the corporation when property is transferred to the corporation solely in exchange for stock upon the formation of the corporation. b. Sanchez s basis in the stock is her $30,000 basis in the land she contributes to the corporation. c. Sanchez s $30,000 basis in the land becomes the corporation s basis in the land a. Normally no gain or loss is recognized by either the shareholder or the corporation when property is transferred to the corporation solely in exchange for stock upon the formation of the corporation. b. Diaz s basis in the stock is his $30,000 basis in the land he contributes to the corporation. c. Diaz s $30,000 basis in the land becomes the corporation s basis in the land a. Neither Howard nor the corporation recognize any gain or loss on the transfer of property during the formation of the corporation. O Brien recognizes $25,000 of ordinary income for the services she performs in exchange for the stock in the corporation. b. Howard s basis in his shares is the $25,000 he contributes to the corporation. c. O Brien s basis in her shares is the $25,000 she contributes to the corporation (by paying tax on the service income). 5. a. Certain items related to the business of a sole proprietor are not deducted in computing the profits of the business on Schedule C. These include all gains and losses from the sale of business property, the deduction for the proprietor s health insurance, retirement plan contributions and one-half of the selfemployment tax. Although these deductions reduce AGI, they do not reduce the net profits of the business. Furthermore, all charitable contributions made by an individual are deductible as itemized deductions. In contrast, all business deductions are deducted from gross income on the corporate tax return b. Corporations do not have personal deductions. Therefore they do not distinguish between deductions for and from AGI A short-year return is a tax return that is for less than 12-months (one year). Corporations can have a tax year shorter than 12 months in three situations. The first is in the year in which the corporation is formed. The second generally occurs in the last year of the corporation s operations. The third is when a corporation changes its tax year

2 248 Essentials of Federal Income Taxation a. A calendar year is a 12-month period that ends in December. A fiscal year is any other 12-month period that ends in a month other than December. b. A week tax year is a tax accounting period that ends on the same day of the week each year. The day may be either the last one occurring in the last month of their tax year or the one occurring closest to their normal year end. Corporations select this tax year when they want their tax year to end on the same day of the week each year, for example the last Friday in December. c. A corporation that changes its tax year from October 31 to July 31 must get permission from the IRS to change its accounting period. For corporations, this is done by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year. Once permission is granted, the corporation must file a short-year return in the year of the change. For example, if the corporation wants to change its tax year effective July 31, 20x5, the period included on the short-year return would be from November 1, 20x4-July 31, 20x5. Its next tax year would include the period from August 1, 20x5-July 31, 20x6. 8. a. Unlike individuals who receive a lower tax rate on net capital gains, corporations pay tax on net capital gains at the ordinary tax rates. That is, the same tax rates as all other types of ordinary income b. Unlike individuals who can use up to $3,000 of net capital losses to offset ordinary income, corporations can only deduct capital losses to the extent they have capital gains. Any excess loss is carried back three years and then carried over five years a. The correct taxable income is $90,000 [$80,000 + ($17,000 $7,000)] b. The taxable income is $65,000. The capital loss ($9,000) can be taken only to the extent of the capital gain ($7,000). The short-term capital loss carryover is $2,000 ($9,000 $7,000) c. The carryover to the next tax year is $13,000, and it is all short-term. The nature of a capital loss carryback or carryover for a corporation is always short-term Unless the corporation can justify why it paid its CEO more than $1 million for the year, its tax deduction will be limited to $1 million for the payments made to the CEO. The CEO will be taxed on the entire $2 million of compensation The direct write-off method is the only acceptable method for tax purposes. This method must be used by both cash and accrual basis taxpayers $4,700. The corporation can take a bad debt deduction for only those receivables that it specifically identifies as being uncollectible. It cannot take a percentage of its sales as an allowance for bad debts as is done for financial accounting The charter and incorporation fees which total $1,700 are organizational costs. Corporations can elect to currently expense up to $5,000 of its organizational costs. The stock issue costs are not organizational costs. These costs are offset against the stock issue proceeds a. $5,889 ($5,000 + ($40,000/180 4 months)). Up to $5,000 of a corporation s organizational costs can be expensed provided that the total organizational costs do not exceed $50,000. The rest of the cost must be amortized over a period of 180 months beginning with the month that the corporation s business begins b. $4,089 (($5,000 $2,000 excess) + ($49,000/180 4 months)). When the corporation s organizational costs exceed $50,000, the $5,000 that can be expensed is reduced by the excess costs over $50, c. $1,667 ($75,000/180 4 months) a. $5,556 ($5,000 + ($10,000/ months)) in 2007; $667 in 2008 ($10,000/180 12). Up to $5,000 of a corporation s start-up costs can be expensed provided that the total start-up costs do not exceed $50,000. The rest of the cost must be amortized over a period of 180 months beginning with the month that the corporation s business begins b. $6,433 in 2007 (($5,000 $1,200 excess) + ($47,400/ months)); $3,160 in 2008 ($47,400/180 12). When the corporation s start-up costs exceed $50,000, the $5,000 that can be expensed is reduced by the excess costs over $50, c. $3,611 in 2007 ($65,000/ months); $4,333 in 2008 ($65,000/180 12) CCH. All Rights Reserved.

3 Textbook Solutions The total charitable contribution deduction for a C corporation is limited to 10% of the corporation s taxable income before deducting any charitable contributions, dividends received deduction, domestic production activities deduction, NOL carryback, and any capital loss carryback for the tax year. Any charitable contributions that exceed the 10% rule can be carried over for five succeeding tax years a. The maximum allowable contributions deduction is $2, Gross income... $115,000 Less: Business deductions exclusive of contributions... (90,000) Taxable income before deductions... $ 25,000 Limitation for contributions (10% $25,000)... $ 2,500 b. Taxable income is $20, Taxable income before contributions and special deductions... $25,000 Less deductions: Charitable contributions... $2,500 Dividends received deduction (80% $2,000)... 1,600 (4,100) Taxable income... $20,900 c. The amount of the contribution deduction carryover is $250 ($2,750 $2,500) $17,500. M Company can deduct its basis in the blankets of $10,000 plus one-half of the appreciation in value $7,500 (($25,000 $10,000) 2) The corporation can deduct $10,700 against gross income in the current year ($107,000 10%). It will carry forward the $19,300 excess for five years ($30,000 $10,700) a. Gross sales and receipts... $700,000 Less: Returns and allowances... ( 12,000) Net Sales... $688,000 Less: Cost of good sold... (330,000) Gross profit... $358,000 Plus: Interest received... 20,000 Less Expenses: Rent expense... $ 55,000 Wage expense ,000 Other operating expenses... 75,000 Depreciation expense... 15,000 (285,000) Taxable income before CC deduction... $ 93,000 Charitable contribution deduction... (9,300) Taxable Income... $ 83,700 b. The corporation carries forward for five years the $2,700 ($12,000 $9,300) excess charitable contributions.

4 250 Essentials of Federal Income Taxation 21. a Dividend income... $ 50,000 Sales revenue ,000 Less: Operating expenses... (375,000) Taxable income before DRD... $ 75,000 Less: DRD ($50,000 80%)... (40,000) Taxable income... $ 35,000 b. Treeline s DRD would be $35,000 ($50,000 70%). Its taxable income would be $40,000 ($75,000 $35,000) c. Dividend income... $ 50,000 Sales revenue ,000 Less: Operating expenses... (375,000) Taxable income before DRD... $ 45,000 Less: DRD ($45,000 80%)... (36,000) Taxable income... $ 9,000 Because deducting 80% of the dividends received would not produce a taxable loss ($45,000 $40,000 = $5,000 taxable income), the taxable income limit would apply and the corporation s DRD equals $36,000 (the lesser of (i) 80% $50,000 or (ii) 80% of $45,000) a. Dividend income... $120,000 Sales revenue ,000 Less: Operating expenses... (390,000) Taxable income before DRD... $100,000 Less: DRD ($100,000 80%)... (80,000) Taxable income... $ 20,000 Because deducting 80% of the dividends received would not produce a taxable loss ($100,000 $96,000 = $4,000 taxable income), the taxable income limit would apply and the corporation s DRD equals $80,000 (the lesser of (i) 80% $120,000 or (ii) 80% of $100,000) b. Treeline s DRD would be $120,000 ($120, %). This would result in a taxable loss of $20,000 ($100,000 $120,000). When 80% or more of the corporation s stock is owned, the DRD increases to 100%. Furthermore, the taxable income limitation does not apply when ownership equals or exceeds 80% a. March 15 (2 1 /2 months after the close of the year) b. September 15 (six months after the original March 15 filing deadline) c. August 15 (2 1 /2 months after the close of the year) d. February 15 (six months after the original August 15 filing deadline) e. November 15 (2 1 /2 months after the close of the year) f. July 15 (six months after the original January 15 filing deadline) 2007 CCH. All Rights Reserved.

5 Textbook Solutions a. $3,750 ($25,000 15%) b. $32,000 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($25,000 39%)] c. $80,750 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($150,000 39%)] d. $510,000 ($1,500,000 34% flat rate) or [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($235,000 39%) + ($1,165,000 34%)] e. $1,275,000 ($3,750,000 34%) f. $11,812,500 ($33,750,000 35%) Gross income from business... $150,000 Dividends received... 10,000 Gross income... $160,000 Less: Business expenses... (40,000) Income before dividends received deduction... $120,000 Less: Dividends received deduction (70% $10,000)... (7,000) Taxable income... $113,000 Tax computation: $ 113,000 50,000 15%... $ 7,500 $ 63,000 25,000 25%... 6,250 $ 38,000 25,000 34%... 8,500 $ 13,000 39%... 5,070 Total Tax $27, a. $20,000 of the distribution comes from E&P (AE&P + CE&P). Therefore, $20,000 is taxed as dividend income to the shareholder and reduces the corporation s AE&P to $0. The remaining $4,000 distribution is a return of capital, which is not taxable to the shareholder and reduces the shareholder s basis in the stock to $5, b. The corporation recognizes $7,000 gain on the distribution of appreciated property ($24,000 $17,000). This gain increases the corporation s CE&P to $15,000 ($8,000 + $7,000). Since the corporation s E&P ($12,000 AE&P + $15,000 CE&P) exceeds the amount of the distribution ($24,000 FMV of the property distributed), the full amount of the distribution comes from E&P The shareholder reports $24,000 of dividend income in gross income. The shareholder s basis in the stock remains at $9,000. The corporation s E&P after the distribution is $3,000 ($27,000 $24,000) c. The first $20,000 of the distribution comes from E&P (AE&P + CE&P). Therefore, $20,000 is taxed as dividend income to the shareholder and reduces the corporation s E&P to $0. The next $9,000 distributed is a return of capital. This amount is not taxable to the shareholder and reduces the shareholder s basis in the stock to $0. The remaining $5,000 is taxed as capital gain to the shareholder

6 252 Essentials of Federal Income Taxation 27. a. Gross income 1... $960,000 Less deductions 2... (704,000) Taxable income for computing CC deduction... $256,000 Less charitable contribution deduction 3... (25,600) Less DPA deduction 4... (8,100) Taxable income for figuring DRD... $222,300 Less DRD 5... (48,000) Taxable Income... $174,300 1 $830,000 + ($15,000 capital gains $15,000 capital losses) + $60,000 + $70, $444,000 + $260, $256,000 10%. 4 $135,000 6%. 5 Lesser of (i) $60,000 80% or (ii) 80% $222,300. Tax liability = $51,227 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) ($74,300 39%)] 1402, b. The corporation will carryover to 2008 charitable contributions of $46,400 ($72,000 $25,600) and a $20,000 short-term capital loss ($35,000 $15,000) See Form 1120 and Schedule D for Randolph Manufacturing Company DPA deduction (Form 1120, line 25): $37,720 6% = $2, CCH. All Rights Reserved.

7 Textbook Solutions 253 Filled-in Form 1120, page 1, for Randolph Manufacturing Company.

8 254 Essentials of Federal Income Taxation Filled-in Form 1120, page 2, for Randolph Manufacturing Company CCH. All Rights Reserved.

9 Textbook Solutions 255 Filled-in Form 1120, page 3, for Randolph Manufacturing Company.

10 256 Essentials of Federal Income Taxation Filled-in Form 1120, page 4, for Randolph Manufacturing Company CCH. All Rights Reserved.

11 Textbook Solutions 257 Filled-in Schedule D (Form 1120) for Randolph Manufacturing Company.