AUD Study Notes 3
BEC Study Notes 4

REG Study Notes 3

REG - Notes Chapter 3 C Corps, Depreciation, and MACRS Formation Corporation tax consequences • No gain/loss recognized upon formation • Basis of property received by corporation is the greater of: - Adjusted NBV of the transferor + any gain recognized by the transferor - Debt assumed by the corporation - Exception: if the NBV is less than the FMV of the asset, the corp uses the FMV as basis to avoid built in losses Shareholder tax consequences • No gain/loss recognized when contributing property to a corp for stock if the following two have been met: - Shareholder has 80% control, and - Shareholder receives no boot (cash or cancellation of debt) Basis of common stock to shareholder • Cash – the amount shareholder contributed • Property – Adjusted basis (NBV) - The Adjusted basis of preoperty is reduced by any cancellation of debt - Add: taxable boot – debt exceeds asset’s adjusted basis – to bring stock basis to zero • Services rendered to corp at FMV Operations Book income vs. taxable income is reconciles on schedule M-1 Cash received in advance of accrual GAAP income is taxed such as: • Interest income received in advance • Rental income received in advance • Royalty income received in advance These create temporary differences Some GAAP income items are not includible at taxable income, such as: • Interest income from municipal or state bonds • Proceeds from life insurance on key officers’ lives where the corporation is the beneficiary These create permanent differences Trade or business deductions (ordinary and necessary expenses) Domestic production deduction – get a special deduction for keeping jobs in America and not outsourcing - 2006 – 3% deduction - ’07-‘09 – 6% deduction - 2009+ – 9% deduction The deduction is a percentage lesser of: • Qualified Production Activities Income (QPAI), or • Taxable income (disregarding the QPAI deduction) Domestic Production Gross Receipts [gross receipts derived from production within the U.S] (COGS) (Other directly allocable expenses or losses) (Proper share of other deductions) = Qualified Production Activities Income (QPAI) 1 REG - Notes Chapter 3 Bonuses paid by an accrual taxpayer are deductible in the current tax year, provided they are paid within 2 ½ months after year end (so if 12/31 year end, then pay by 3/15) Bad debts – specific charge-off method • Accrual basis – must use direct write off methods • Cash basis – not allowed a tax deduction Business interest expense • Interest incurred for business purposes are tax deductible • Interest expense on loans for investments is deductible but limited to net investment income • Prepaid interest expense – must allocate Charitable contributions is allowed a maximum deduction of 10% of adjusted taxable income Business losses or causualty losses related to business (its different than the individual/personal casualty loss) • No $100 deductible • No 10% of AGI reduction Organizational expenditures and start up costs • Corp can deduct up to $5,000 of organizational expenditures and $5,000 start up costs • Any excess costs are amortized over 180 months • GAAP rule - expense all • Exam trick: carefully look at the month the business started. They’ll have the business start in July, so you only get to 6 months on the excess amortization • These cost do not include the cost of raising capital (flotation costs, commissions, underwriter fees) Amortization, Depreciation, and Depletion • Purchased goodwill - Tax rule: amortize on straight-line basis over 15 years - GAAP rule: not amortized, test for impairment Life insurance premiums (expense) • Premiums paid by Corp on key employees, and Corp is beneficiary, not tax deductible • Employee names the beneficiary, it’s a employee benefit, and those premiums are tax deductible Business gifts - $25 is deductible Business meals and entertainment – 50% is tax deductible Penalties and illegal activities are not deductible Taxes • State, local and federal payroll taxes relating to business are deductible when incurred • Federal income taxes are not deductible • Foreign income taxes may be used as a credit Lobbying and political expenditures are not tax deductible Capital gains and losses • Capital losses can only be used to offset capital gains, so no deduction allowed 2 REG - Notes Chapter 3 • Net capital losses can be - Carried back 3 years - Carried forward 5 years • Capital gains taxed as ordinary income, no special 15% rate Net operating loss (same as individuals) - Carried back 2 years - Carried forward 20 years General business credit • Its generally net income less the greater of: - 25% of regular tax liability above $25,000 R3-21 corporation taxation summary between temp and permanent differences Dividends received deductions – you get to exclude a % of dividends based on ownership % % Ownership Div Rec Deduction (DRD) 0 - 19% 70% 20 - 79% 80% 80 - 100% 100% Requirements • 1st corporation is taxed • Owned for 45 days before or after • Take smaller of: - Div Rec Deduction % * dividends received, or - Div Rec Deduction % * Taxable income before DRD DRD does not apply to • Personal service corps, personal holding companies, personally taxes S corps Dividends from affiliated corps that file consolidated returns qualify for 100% deduction Depreciation MACRS depreciation rules for machinery and equipment • Salvage value is ignored • Half year convention – applies to personal property places in service or disposed of during a taxable year is treated as being placed or disposed at the midpoint of the year • Mid-Quarter convention – if more than 40% of depreciable property is placed in service in the last quarter of the year, the mid quarter convention must be used MACRS: real estate (buildings) • Salvage value ignored • Subtract land cost • Residential rental property (apartments, rental homes) – 27.5 year straight line • Non-residential real property (office building, warehouses) – 39 year straight line • Mid month convention – straight line depreciation is computed based on the number of months the property was in service. ½ month is taken in the month the property was placed in service. ½ month is taken for the month in which the property was disposed. Expense deduction in leiu of depreciation (section 179) 3 REG - Notes Chapter 3 Each tax year, a tax payer may deduct a fixed amount of depreciation (machinery and property). • The limit for 2006 is $108,000 on new or used property that is acquired during the year • The max amount is reduced dollar for dollar by the amount of property palce in service during the year that exceeds $430,000 in 2006 • The deduction is not permitted when a net loss exists or if it would create a net loss • SUV’s: limit the cost of sport utility vehicle (SUV) that may be expensed under section 179 to $25,000 Depletion • GAAP is cost depletion calculation (R3 – 28) • % Depletion (non GAAP) - The deduction is limited to 50% of taxable income - Allowable percentages range from 5%-22% depending on the mineral being extracted Amortization • Intangibles such as goodwill, licences, franchises, and trademarks are amortized SL over 15 years • Business start up costs and organization costs – 5,000 is expensed and excess is amortized SL over 180 months (explained earlier) Summary of Section 1231, 1245, and 1250 assets Section 1231 – depreciable personal and real property used in taxpayers trade or business and held over 1 year • Special capital gain treatment on net gains from sales, exchanges of certain non-capital assets • All 1231 losses are treated as ordinary income Section 1245 (machinery and equipment, gains only) – personal business property assets used in trade or business for over a year (autos) • Upon a sale of a 1245 asset all accumulated depreciation is recaptured as ordinary income • Any remaining gain is a capital gain under section 1231 Section 1250 (buildings, gains only) – real business property used in trade or business for over 1 year (warehouse) • Recaptures deprecation in excess of straight line Taxation of a C Corporation Filing requirements – 15th day of the third month after tax year end, so 12/31 yr end, file by 3/15 Estimated payments of corporate tax • Large corporations – must pay 100% of tax as shown on the current year tax return • Not large corporations (less than a $1 million in taxable income in the past 3 years) - 100% of tax as shown on the current year tax return - 100% of tax as shown on the previous years tax return An affiliated group of corporations may elect to be taxed a single unit, thereby eliminating intercompany gains/losses • An affiliated group means that a common parent owns: - 80% or more of the voting power of all outstanding stock, and - 80% or more of the value of all outstanding stock of each corporation Alternative minimum tax Adjustments – add or subtract items to income – LIE • Long term contracts – difference between completed contract and percentage of completion 4 REG - Notes Chapter 3 • Installment sale dealer – difference between full accrual and installment sales • Excess Depreciation over 40 yr-SL for real property, 150% DDB for personal property using normal life Preferences – add items to increase income – PPP • Percentage depletion – excess percentage depletion over the adjusted basis of the property • Private activity (tax exempt interest income) • Pre ’87 ACRS excess depreciation over SL Adjusted Current Earnings – increase or decrease – MIND • Muni interest income (tax exempt interest income) • Increase CSV life insurance • Non S/L depreciation (excess over SL) • Div Rec deduction – when you have under 20% ownership Exemption Formula – the exemption amount is $40,000 less 25% of AMTI in excess of $150,000. As a result, the exemption is completely phaseout for AMTI over $310,000 40,000 – [(Minimum taxable income – $150,000) * 25%] = Exemption allowed The tax rate on the AMTI is a flat 20% Foreign tax credit is allowed Minimum tax credit (MTC) • AMT can be used as a credit against future regular tax • Can be carried forward forever The accumulated earnings tax is imposed on regular C corps whose accumulated (retained) earnings are in excess of $250,000 is improperly retained • 15% additional tax if found guilty Personal holding company tax – corps set up by rich people to channel their investment income to corporate tax rates (15-25%) instead of paying their higher individual rate Personal holding company – corps more than 50% owned by 5 or less individuals and having 60% of adjusted gross income consisting of: • Net rent • Interest that is taxable (non taxable is excluded) • Royalties (not mineral, oil, gas or copyright royalties) • Dividends from an unrelated domestic corp Personal holding companies are taxed an additional 15% on net income not distributed Corporate distributions Dividends defined – earnings and profits (E&P) • Current E&P (by year end) = taxable dividend • Accumulated E&P (dist. date) = taxable dividend • Return of Capital (No E&P) = tax free and reduced basis of common stock • Capital Gain Distribution (No E&P/No Basis) = taxable income as capital gain Matching cash dividends to source • Current earnings and profit – allocated on a pro rata basis to each distribution 5 REG - Notes Chapter 3 • Accumulated earnings and profits – applied in chronological order, beginning with the earliest distribution Stock dividends – not taxable Corp paying dividend • The payment of the dividend does not create a taxable event • Property dividends recognizes a gain as if the property had been sold (FMV – adjusted basis) Stock redemption/buyback • Proportional buyback – taxable dividend income (to shareholder – ordinary income) • Disproportional (only shares from certain stockholders were bought back) – sale by shareholder is subject to capital g/l to shareholder Corporate liquidation – corp and shareholder recognize g/l (double taxation). Two types of corporate liquidations • Corp sells assets and distributes cash to shareholders - The corp recognizes a g/l on the sale of the assets, and - Shareholders recognize a g/l to the extent the cash exceeds adjusted basis • Corp distributes assets to shareholders - Corp recognizes g/l as if it sold the assets for the FMV (FMV-basis = g/l) - Shareholder recognizes g/l to extent FMV of assets received exceed the adjusted basis in the stock Re-organizations are a tax free event • Because it results in the continuation of a business in a modified form. In order to meet the “continuity requirement” the acquiring corporation must continue the business of the old entity or use a significant portion of the old corporations assets Worthless stock – Section 1244 stock (small business stock) • An original stockholder can be treated as having an ordinary loss (fully tax deductible), instead of a capital loss • Up to S $50,000 (MFJ $100,000) • Any loss in excess of this amount would be a capital loss, which would offset capital gains and then a maximum $3,000 per year would be deductible Small Business stock • A non corporate shareholder, who holds qualified small business stock for more than 5 years, may exclude 50% of the gain on the sale or exchange of the stock Small Business Corps – S Corps Eligible S Corp Shareholders • Must be an individual, estate or certain type of trust (no corps or P/S not allowed) • May not be a non-resident alien • Limit of 100 shareholders • Only one class of stock allowed. Differences among common stock voting rights are allowed. (no preferred) If you elect to be an S corp by March 15, then it takes effect for the whole year S corps must adopt a calendar year, unless there is valid business purpose 6 REG - Notes Chapter 3 Pass-through entity, no tax at the corporate level Exception: Taxed at corporate level if both conditions exist: - A C corp elects S corp status, and - FMV of the corporate assets exceeds the adj basis of on the election date Pass through income/losses to shareholder K-1 • Like P/S, S corps report both separately and non-separately stated items of income and/or loss • Allocations to shareholders are made on a per share, per day basis • Losses are limited to a shareholders adj basis in S corp stock + direct shareholder loans to the corp - in a P/S, liabilities increase basis Computing shareholder basis in S corp stock Initial basis + Income & additional investment into the stock - Distribution & losses = Ending basis An S corp shareholder is permitted to deduct (on their personal income tax return their pro rate share of the S corp loss based on the following limitation: Loss limitation = Basis + direct shareholder loans – distributions Taxability of distributions to shareholders S Corp with no C Corp E&P Distribution Treatment To extent of basis in stock return of capital In excess of basis of stock capital gain distribution S Corp with C Corp E&P Distribution To extent of AAA To extent of C corp E&P To extent of basis in stock In excess of basis of stock Treatment S-corp profits (already taxed) old C corp div return of capital capital gain distribution Tax Result not taxable, reduce basis in stock taxed as ST ot LT capital gain Tax Result not taxable, reduce basis in stock taxed as div, no basis reduction not taxable, reduce basis in stock taxed as ST ot LT capital gain AAA = Accumulated Adjustments Account = the cumulative amount of S corp income or loss (like R/E) Terminating the S selection • Holders of the majority of the corporations stock consent to a voluntary revocation • The corporation fails to meet any or all of the eligibility requirements (lets a foreigner be a shareholder) • More than 25% of the corp’s gross receipts come from passive investments for 3 consecutive years and the corporation had C corp earnings and profits at the end of each year Once an S corp election is terminated or revoked, a new election cannot be made for 5 years unless the IRS agrees otherwise. 7

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