Federal Income Tax Accounting Unit 15 ReviewTaxation of Corporations

Key Concepts and Definitions

• Corporation a separate legal entity owned by shareholders that provides limited liability protection
• C corporation default corporate tax structure taxed as a separate entity from its owners
• S corporation pass-through tax structure where income and losses flow through to shareholders' individual tax returns
• Dividend distribution of a corporation's earnings to its shareholders
• Basis shareholder's investment in the corporation used to calculate gains or losses
• Liquidation process of dissolving a corporation and distributing its assets to shareholders
• Reorganization restructuring of a corporation through merger, acquisition, or division

Corporate Tax Structure Basics

• Corporations taxed as separate entities from their owners at the corporate tax rate
• Corporate income subject to double taxation once at the corporate level and again when distributed to shareholders as dividends
• Corporations must file Form 1120 (U.S. Corporation Income Tax Return) annually
• Fiscal year corporations can choose a tax year different from the calendar year
• Corporations must make estimated tax payments throughout the year
• Alternative Minimum Tax (AMT) applies to corporations to ensure they pay a minimum amount of tax
  • AMT calculated separately from regular corporate income tax
  • Corporations must pay the higher of regular tax or AMT

Types of Corporations and Their Tax Treatment

• C corporations default corporate tax structure
  • Taxed as separate entities from their owners
  • Income taxed at the corporate level and dividends taxed at the shareholder level
• S corporations pass-through tax structure
  • Income and losses flow through to shareholders' individual tax returns
  • Avoids double taxation but has strict eligibility requirements
• Closely held corporations owned by a small group of shareholders
  • May be subject to additional tax rules to prevent tax avoidance
• Personal holding companies (PHCs) corporations with primarily passive income
  • Subject to additional tax to discourage using corporations to hold investments
• Publicly traded partnerships (PTPs) partnerships traded on public exchanges
  • Taxed as corporations unless they meet specific exemption requirements

Corporate Income and Deductions

• Gross income includes all income from any source, such as sales, investments, and foreign income
• Deductions allowed for ordinary and necessary business expenses
  • Salaries and wages
  • Rent and utilities
  • Depreciation of assets
  • Interest expense
• Net operating losses (NOLs) occur when deductions exceed gross income
  • NOLs can be carried forward to offset future taxable income
• Charitable contributions deductible up to 10% of taxable income
• Meals and entertainment expenses subject to 50% deduction limitation
• Certain expenses, such as penalties and fines, are not deductible

Tax Implications of Corporate Formations

• Incorporation transfer of assets and liabilities from owners to the corporation in exchange for stock
  • Generally tax-free under IRC Section 351 if owners hold 80% or more of the corporation's stock
• Basis in stock equal to the basis of assets contributed to the corporation
• Liabilities assumed by the corporation treated as money received by the owners
• Built-in gains on contributed assets may be subject to tax if sold within 5 years
• Organizational costs (legal and accounting fees) deductible over 180 months
• Startup costs (business expenses before active trade) deductible up to $5,000 in the first year, remainder amortized over 180 months

Corporate Distributions and Dividends

• Dividends distributions of corporate earnings to shareholders
  • Taxed as ordinary income to shareholders
  • Not deductible by the corporation
• Qualified dividends taxed at preferential long-term capital gains rates for individual shareholders
• Basis in stock reduced by non-dividend distributions (return of capital)
• Accumulated earnings tax (AET) imposed on corporations retaining earnings to avoid shareholder taxation
• Personal holding company tax (PHC tax) imposed on undistributed passive income of closely held corporations
• Redemptions corporation's purchase of its own stock from shareholders treated as a sale or exchange

Stock Transactions and Capital Gains

• Capital gains and losses result from the sale or exchange of corporate stock
• Basis in stock equal to the purchase price plus any commissions or fees
• Holding period determines tax treatment (long-term if held for more than one year)
• Net capital gains (long-term gains minus long-term losses) taxed at preferential rates for individual shareholders
• Capital losses deductible against capital gains and up to $3,000 of ordinary income for individual shareholders
  • Excess capital losses carried forward to future tax years
• Wash sale rule disallows loss deduction if substantially identical stock is purchased within 30 days before or after the sale

Corporate Liquidations and Reorganizations

• Liquidation distribution of all corporate assets to shareholders in exchange for their stock
  • Gain or loss recognized by both the corporation and shareholders
  • Shareholders receive fair market value (FMV) basis in assets received
• 12-month liquidation (IRC Section 337) gain on asset sales not recognized by the corporation if all assets are distributed within 12 months
• Reorganizations tax-free restructuring of corporations
  • Types include mergers, acquisitions, spin-offs, and recapitalizations
  • Continuity of interest (COI) requirement shareholders must maintain a substantial interest in the reorganized corporation
  • Continuity of business enterprise (COBE) requirement reorganized corporation must continue the historic business or use a significant portion of the historic assets
• Carryover basis in tax-free reorganizations shareholders and corporation retain their original basis

Special Tax Considerations for Corporations

• Accumulated earnings tax (AET) imposed on corporations retaining earnings to avoid shareholder taxation
  • Applies if accumulated earnings exceed $250,000 ($150,000 for personal service corporations)
• Personal holding company tax (PHC tax) imposed on undistributed passive income of closely held corporations
  • Passive income includes dividends, interest, royalties, and rents
• Alternative Minimum Tax (AMT) ensures corporations pay a minimum amount of tax
  • Adjustments and preferences added back to regular taxable income
  • AMT credit can be carried forward to offset regular tax in future years
• Section 179 expensing allows immediate deduction for qualifying business property
  • Limit of $1,080,000 for 2022 (adjusted annually for inflation)
• Charitable contributions deductible up to 10% of taxable income
  • Excess contributions carried forward for up to 5 years