2013 cch basic principles ch16 piii

Chapter 16
Partnerships, Corporations,
and S Corporations
Part III: C Corporations
©2012 CCH. All Rights Reserved.
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Chapter 16 Contents
1. Corporation Defined
2. C Corporations—Special Types
3. C Corporations—Tax Years
4. C Corporations—Accounting Methods
5. C Corporations—Tax Formula
6. C Corporations—Comparison with Individual Taxpayers
7. Income Items Requiring Special Treatment
8. Exclusions Requiring Special Treatment
9. Deductions Requiring Special Treatment—Organizational
Expenditures
10. Dividends Received Deduction—Example 1
11. Dividends Received Deduction—Example 2
12. Deductions Requiring Special Treatment—Charitable Contributions
13. Charitable Contributions—Example
14. Deductions Requiring Special Treatment
15. Deductions Requiring Special Treatment—Bond and Stock
Redemptions at a Premium
16. Deductions Requiring Special Treatment—Compensation and
Educational Reimbursement

Chapter 16, Exhibit Contents A CCH Federal Taxation Basic Principles2 of 92

Chapter 16 Contents
17. Educational Expenses
18. Rules For Net Operating Losses (NOLs)
19. Net Operating Losses (NOLs)—Example
20. Capital Gains and Losses
21. Depreciation Expense
22. Code Sec. 291 Depreciation for Corporations—Example
23. Reconciling Book and Taxable Income
24. Corporate Tax Rates
25. Corporate Tax Credits
26. Template for Computing the Foreign Tax Credit/Deduction
27. Foreign Tax Credits—Example
28. Formation of Corporations—Overview of Code Sec. 351
29. Code Sec. 351 Contribution of Part Property/Part Services—
Example
30. Code Sec. 351 Contributions—Tax Effect on Shareholders

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Chapter 16 Contents
30. Code Sec. 351 Contributions—Tax Effect on Shareholders
31. Code Sec. 351 Contributions—Tax Effect on Corporations
32. Code Sec. 351 Contributions—Example 1
33. Code Sec. 351 Contributions—Example 2
34. Nonstock Distributions—Effect on Shareholder of C Corporation

Chapter 16, Exhibit Contents C CCH Federal Taxation Basic Principles4 of 92

Corporation Defined

Definition of Corporation. Either an organization incorporated
under state law, or an unincorporated association that has
“checked the box” for corporate tax treatment on Form 8832
(Entity Classification Election). Code Sec. 7701; Reg.
§301.7701-1 to 3.

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Corporation Defined
Two Classifications of Corporate Entities.

 C corporations. Taxpaying entities. (This results in what is
known as a double tax effect. The corporation computes tax on
the net income. When a corporation distributes its income, the
corporation’s shareholders report dividend income on their
own tax returns.)

 S corporations. Not subject to regular corporate income tax.
They are treated in a manner similar to partnerships, i.e., as
pass-through entities, in that net profit or loss flows through to
the owners to be reported on their separate returns.

Chapter 16, Exhibit 1b CCH Federal Taxation Basic Principles6 of 92

C Corporations—Special Types

Professional association [PA]. An association of
professionals (e.g., accountants, doctors, lawyers)
treated as a C corporation for tax purposes if it has:

a. Organized under a state’s Professional
Association Act; AND
b. “Checked the box” on Form 8832 for
corporate tax treatment. [One individual may
be a professional association.]



Personal Service Corporation [PSC]. C corporation
whose shareholder-employee(s) owns over 10% of
the stock and provides personal services (e.g., acting,
entertainment, medical, legal, consulting, or other
services performed through their personal efforts).
Generally, a PSC must use a calendar tax year. Code
Sec. 441(i). PSCs are subject to a flat 35% tax rate.



Personal Holding Company [PHC]. A nonexempt,
closely held corporation, with a significant portion of
its income that is passive in nature (e.g., from
dividends or interest). PHCs are subject to a 15%
penalty tax on excess personal holding company
income in addition to the regular corporate income tax.

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Q: When is a corporation deemed to be “closely held”?
A: When more than 50% of the value of the outstanding
stock was owned by five or fewer individuals during
the second half of the year.

Q: When is passive income deemed to be “significant”?
A: When passive income is 60% or more of “adjusted
ordinary gross income” [AOGI]. AOGI is gross
income less capital gains and Code Sec. 1231 gains,
less adjustments such as certain expenses connected
with rental and royalty income.
Chapter 16, Exhibit 2d CCH Federal Taxation Basic Principles10 of 92

C Corporations—Tax Years

Every newly organized corporation other than a
personal service corporation (PSC) has the unrestricted
right to select its annual tax year, regardless of the tax
years employed by its shareholders.

PSCs generally must use a calendar year-end. However,
they may use a fiscal year-end under the same
conditions as listed for S corporations.

Chapter 16, Exhibit 3 CCH Federal Taxation Basic Principles11 of 92

C Corporations—Accounting Methods

Most corporations must use the accrual method.

The cash method MAY be used by C corporations that
have average annual gross receipts of $5 million or less
in the three preceding years, or by PSCs.


C Corporations— Tax Formula
Ord. and Cap. Income “From Whatever Source Derived”
– Exclusions
– Cost of Goods Sold
= Gross Income
– Deductions
= Taxable Income (Loss)
x Tax Rate
= Gross Regular Tax Liability
– Credits (If Any)
= Net Regular Tax Liability
+ Alt. Minimum Tax (If Any)
+ FICA Taxes
+ Accumulated Earnings Tax (If Any)
+ Personal Holding Co. Tax (If Any)
= Net Tax Due or Refundable

C Corporations—Tax Formula

AGI, standard deductions, personal exemptions, at-
risk rules, and passive activity loss rules do not
pertain to regular C corporations.


C Corporations—Comparison with Individual Taxpayers

Income
Similar Treatment Different Treatment
Most items of gross income receive the Bond Redemptions – Discounts.
same tax treatment. Sinking fund income.
Cost of goods sold (actually, part of gross
income) are similar.

Exclusions
Similar Tax Treatment Different Treatment
Most exclusions receive the same tax Capital contributions.
treatment. Gain/loss on sale of treasury stock


C Corporations—Comparison with Individual Taxpayers
Expenses
Similar Tax Treatment Different Treatment
 Travel, Meals and Entertainment  Organizational Expenditures
 Insurance Premiums  Dividend Received Deduction
 Research and Experimental  Charitable Contribution
 Fines (not deductible)  Interest Expense
 Bad Debts  Amortization of Original Issue
 Worthless Securities  Bond Redemptions-Premiums
 Casualty Losses (same as individuals’ business use  Stock Redemptions (not deductible)
casualty losses)  Compensation
 Taxes  Educational Expenses
 Depreciation (except Sec. 1250 recapture)  Net Operating Losses
 Amortization  Capital Gains and Losses
 Depletion
 Political Contributions & Lobbying
 Business Investigation Expense
 Business Start Up Expense


Income Items Requiring Special Treatment
Bond Repurchases.
A corporation’s income INCLUDES the original issue price of its
own bonds being repurchased,
MINUS (i) The repurchase price,
MINUS (ii) Any premium already recognized on the original
issuance.
PLUS (iii) Any discounts previously deducted.

Sinking Fund Income.
Interest or other income from property in a sinking fund
established to satisfy an obligation IS INCLUDED, even if in the
hands of a trustee (since both funded and nonforfeitable).


Exclusions Requiring Special Treatment

Treasury Stock.
No gain or loss is recognized by a corporation on the sale or
exchange of its own stock.


Capital Contributions.
Gifts from nonshareholders are excluded.
Noncash gifts. If a gift is property other than money, the
corporation carries it with a zero basis.
Cash gifts. When cash is contributed, reduce the basis of
corporate property in the following order:
(i) Property acquired within 1 year after the
contribution;
(ii) Then depreciable property in proportion to relative
bases;
(iii) Then, if there is a remaining balance, NON-
depreciable property acquired over 1 year after the
contribution.


Pro rata contributions from shareholders are excluded.

Whether voluntary or by assessment, shareholder contributions are
excluded from corporate income. The corporation carries the
property at the same basis as had been reported by the contributing
shareholder. That shareholder gets no deduction, but does get an
increase in stock basis, equal to the basis in the property
contributed.


Deductions Requiring Special Treatment—
Organizational Expenditures
Amortizable expenditures.
Organizational expenses qualify for amortization if:
(a) = Incurred incidental to formation of the corporation (e.g.,
legal fees for drafting the charter, state incorporation
fees, expenses for temporary directors and
organizational meeting costs), and
(b) = Incurred before the end of the tax year in which the
corporation commences business.
Amortization period must be over 180 months, starting with the
month that the corporation commences business.


Organizational Expenditures

Nonamortizable expenditures. Organizational expenses DO
NOT qualify for amortization if related to the transfer of assets
to the corporation or the issuance and sale of stock (e.g.,
printing stock certificates, professional fees for issuing stock and
broker’s commission on the sales of stock.) They are written off
when the corporation completely liquidates.


Dividends Received Deduction—Example 1
Dividends received from other corporations are included by both corporate and individual
shareholders, but deductible only by corporate shareholders within limits explained below.

Dividends Received Deduction (DRD)

% Ownership Tentative* DRD: Tentative* DRD Limit:
(Value and Voting) * (Subject to limit if DRD * (Does not apply if DRD
would NOT create an NOL) would create an NOL)

≥ <
--- 20% 70% div. received 70% ATI

20% 80% 80% div. received 80% ATI

80% & affiliated --- 100% div. received 100% ATI
ATI = Revenue - COGS - Operating expenses + Other income
(Another way to arrive at ATI is to start with taxable income and purge out three possible deductions:
ATI = TI + (1) Actual DRD + (2) NOL carryover + (3) Capital loss carryover).

“Affiliated” means owning ≥ 80% of both voting power and value of stock.



FACTS:
C Corp. has the following income and expenses:
Operating Revenue 800,000
COGS (300,000)
Operating expenses (520,000)
Other income (dividends received from
a 25%-owned corp.) 100,000


Note: The relevant DRD % is 80% since C Corp. owned ≥20% and < 80% of stock.
(a) Compute ATI (i.e., (a) = Rev. - COGS - ATI = $80,000
taxable income before Oper. exp. + Other inc. [= 800,000 - 300,000 - 520,000 + 100,000]
special deductions)

(b) Determine tentative (b) = 70% or 80% or Tentative DRD Limit = $64,000
DRD limit 100% x ATI [= 80% ATI = 80% x 80,000]

(c) Compute tentative (c) = 70% or 80% or Tentative DRD = $80,000
DRD 100% x Div. Rec’d [= 80% x $100,000]

(d) Determine actual (d) Actual DRD = $64,000
DRD If (a) - (c) ≥ 0, then (d) = $80,000 ATI - $80,000 tentative DRD is ≥ 0;
therefore, DRD = the lesser of:
the lesser of (b) or (c)
$64,000 tentative DRD limit, or $80,000 tentative
If (a) - (c) < 0, then (d) =
DRD
(c)

(e) Compute TI (e) = (a) - (d) TI =$16,000 [= ATI - DRD = 80,000 - 64,000]

(f) Compute tax (f) = (e) x appropriate tax Tax = $2,400
rates [From tax tables: 15% x $16,000 = $2,400]



FACTS:
Same as Example 1 except operating expenses are $520,001, not $520,000.

SOLUTION:
ATI = $79,999 [= 800,000 - 300,000 - 520,001 + 100,000]
 Tentative DRD Limit = $63,999 [= 80% ATI = 80% x 79,999 = 63,999]

 Tentative DRD = $80,000 [= 80% x $100,000]

 Actual DRD = $80,000 [Same as tentative DRD, since $79,999 ATI -

$80,000 Tentative DRD is < 0.]
 TI = $(1), an NOL [= ATI - DRD = 79,999 - 80,000]

 Tax = $0



Note that in Example 1, the tentative DRD limit
applies since the DRD does not create an NOL. In
Example 2, where operating expenses are $520,001
instead of $520,000, the tax results are much more
favorable. An additional $1 of operating expenses
saves $2,400 of taxes!


Charitable Contributions

Charitable contributions. As with individuals, corporate
charitable contributions are deductible if made to qualified
organizations. [i.e., Code Sec. 501(c) organizations]. Also, as
with individuals, corporate contributions in excess of deductions
are carried forward 5 years. No carrybacks are allowed for
corporations or individuals. The following DIFFERENCES
distinguish corporate tax treatment from individual tax treatment.


10% ATI limitation. Deductions are limited to 10% ATI. What is
ATI?

ATI for Charitable Deduction Computations.
= TI (i.e., after all deductions)
Addback:
+ DRD
+ NOL carryback
+ Capital loss carryback
+ Charitable deductions
Another way to compute ATI:
= Rev. - COGS - Operating expenses + Other income


2 1/2 Month Rule. If a charitable contribution is board-approved
in the current year and paid within 2 1/2 months of the subsequent
year, then a deduction is allowed in the current year. Not so for
individuals.

Inventory. Generally, as with individuals, corporations may
deduct only the basis of inventory contributed. However,
corporations may deduct 50 percent of market value if the
inventory is donated solely for care of infants, the ill, or the
needy.


Charitable Contributions—Example

FACTS:
 C Corp.’s taxable income BEFORE the charitable deduction
was $410,000.
 C Corp. contributed $40,000 to a qualified charitable
organization.
 Included in the $410,000 is a $20,000 DRD.
 C Corp. also has a $5,000 carryover contribution from a prior
year (not part of the $410,000).

QUESTION:
How much is the charitable deduction?


Charitable Contributions—Example
SOLUTION: $43,000

1. ATI = $430,000 [410,000 + 20,000]
2. 10% ATI Limitation = $43,000
[10% x 430,000 = 43,000]
3. Contribution = $45,000
[40,000 current year + 5,000 carryover]
4. Deduction = $43,000 [ Lesser of 2. or 3. above]


Deductions Requiring Special Treatment

Interest Expense. Interest expense on a corporation’s
own debt is fully deductible, even if in connection
with the repurchase of its own stock. Recall that
individuals’ investment interest deductions are
limited to net investment income. Not so with
corporations.



Original Issue Discounts. OID is deductible as interest
expense.
(1) Pre-7/1/82 issue bonds. Discount may be
amortized using the straight-line method over
the life of the bonds.
(2) Post-6/30/82 issue bonds. For bonds issued on
or after 7/1/82, discounts from face value must
be amortized using the effective yield method.


Example on OID, Post-6/30/82 Bonds (Effective Yield Method)
Facts:
 3/1/x1: A corporation hired an investment banking firm to underwrite and sell 5-

year, $10,000 bonds.
 6/15/x1: The bonds were printed when the market yielded 10% on five-year bonds of

comparable risk. Accordingly, the investment banking firm set the coupon rate at
10%.
 6/15/x1 - 6/30/x1: The market yield on comparable five-year bonds rose to 12%.

 6/30/x1: Five-year, $10,000, 10% bonds were issued to the public. Since the market

then yielded 12%, the bonds had to be discounted to $9,250 to be saleable.

Question: How much OID is deductible on one $10,000 bond in 20x1 and 20x2?

Solution: 20x1: $55.00; 20x2: $120.10 (i.e., $120.10 = $58.30 + $61.80)


Solution

(a) (b) = (a) x 12% (c) = (d) = (e) = (a) + (d)
10m x 10% (b) – (c)

Year AIP, x 12% yield Less: Interest AIP,
Beg Payment End. Bal. *
Bal. * Deduction

20x1 9,250 555.00 500 55.00 9,305
(2nd half) [9,250 x (12% x 1/2)] [1,000 x 1/2] 9,250 + 55 = 9,305

20x2 9,305 558.30 500 58.30 9,363
(1st half) [9,305 x (12% x 1/2)] 9,305 + 58.30 = 9,363

20x2 9,363 561.80 500 61.80 9,425
(2nd half) [9,363 x (12% x 1/2)] 9,363 + 61.80 = 9,425

* AIP = Adjusted Issue Price, the original issue price increased by the OID deduction.


Bond and Stock Redemptions at a Premium
Repurchasing Bonds at a Premium. A corporation that
repurchases its bonds may deduct as interest expense
the excess of the repurchase price over the adjusted
issue price.

Repurchasing Stock at a Premium. Amounts paid to
repurchase stock are not deductible. Both acquiring and
target corporations may capitalize legal fees, invest
banker fees and other cost associated with a takeover.


Bond and Stock Redemptions at a Premium
Example on Repurchasing Original Issue Bonds at a Premium

FACTS:
 ABC Corporation buys back one $10,000 bond on 1/1/x1 at a

repurchase price of $9,800.
 The adjusted issue price (AIP) on the bond is $9,425 as of

1/1/x1.

QUESTION:
How much of the payment premium is deductible in the year 20x1 as interest
expense?

SOLUTION:
$375 (i.e., $9,800 payment, less $9,425 AIP balance)


Compensation and Educational Reimbursement

Compensation. Four independent rules:
(1) Unreasonable compensation to a shareholder is generally treated
as a dividend, to the extent of earnings and profits.

(2) Informal short-term arrangements. Payments made by March
15 of the succeeding year may be accrued and expensed in the
current year if related to services incurred in the current year.



(3) Executive Compensation Limitations. Deductible compensation
for the top five executives of publicly traded companies is
limited to $1,000,000 for each executive unless performance
based.
(4) Restricted Stock. Compensation to an employee in the form of
stock is deductible when the employee reports the amount as
ordinary income. Employees must include the market value of
stock received for services in GI when (i) it is not subject to a
substantial risk of forfeiture, and (ii) its value is ascertainable.


Example on Restricted Stock Compensation:

FACTS:
 20x1: Employee purchases restricted stock (FMV = $1,000) from employer-corporation

for $500.
 The stock is forfeitable until the employee serves the employer 6 years.

 20x7: After 6 yrs., the restriction is lifted when the FMV = $2,000.

QUESTION:
What is the timing and amount of the employee’s taxable income & the corporate
employer’s deduction?

SOLUTION:
20x1: No TI to employee; no deduction to employer.
20x7: $1,500 ordinary income to employee; $1,500 corporate deduction 1,500
[2,000 - 500]


Educational Expenses

An employer’s expenditures for employee
education are deductible as business expenses.
An individual, in contrast, may deduct only
educational expenses required to maintain or
improve skills in a present position


Rules for Net Operating Losses (NOLs)
Comparison of NOL Rules Between Corporations and Proprietorships
Corporations Proprietorships
Excess business exp. over bus income

Definition of NOL Same general definition as
corporate.
Carryovers 2 years back, 20 years Same as corporate.
[NOLs from tax years forward. [For pre-8/5/97
beginning after 8/5/97.]: NOLs: 3 yrs. back; 15 yrs.
forward.]

If carried backward: Prior taxable income (TI) is Same as corporate.
recomputed, & taxpayer files
for a refund with an amended
return.

If carried forward.: Deduction from gross income in Deduction for AGI in a
a subsequent year. subsequent year.
Election: May elect to forego Same as corporate.
carrybacks.


Rules for Net Operating Losses (NOLs)
Comparison of NOL Rules Between Corporations and Proprietorships

Corporations Proprietorships
Calculation TI (a negative amount) TI (a negative amount)
+ NOL Carryovers + NOL Carryovers
+ Alimony
Deducted
+ IRA contributions
+ Charitable deductions + Nonbus. CLs in XS of nonbus. CGs
= NOL + Std. or itemized deductions, except personal
[Note that DRD is not added casualty. deductions are not added back.
back; also net capital losses are + Personal exemptions
not added back since they aren’t - Interest income
deductible in the first place.] - Dividend income
- Nonbus. CGs in XS of nonbus. CLs
- Other nonbusiness inc.
(except wages are not subtracted.)
= NOL

(Unlike individuals, corporations need not make adjustments to NOL for capital gains or losses. Also,
corporations are permitted the full DRD in computing NOLs.)


Net Operating Losses (NOLs)—Example
FACTS:
 Fred Corporation had $100,000 sales and $135,000 expenses, plus a
$(30,000) NOL carryover from 20 years ago.
 Fred Corporation also had the following income and expenses:
 $1,000 interest income on a savings account;

 $70,000 dividends from a 30% - owned corporation;

 $1,500 LTCG on the sale of business property;

 $(10,000) STCL on the sale of stock;

 $ 9,000 LTCG on the sale of a painting held for investment;

 $ (6,000) charitable contributions.

QUESTION: Compute Fred Corporation’s NOL.



Taxable Income = $(53,150):

Operating loss (35,000) 100,000 - 135,000 = (35,000)
– NOL carryover (30,000)
+ Interest income 1,000
+ Dividends received 70,000
– DRD (56,000) 80% x 70,000
+ Net LTCG 500 1,500 - 10,000 + 9,000
– Charitable deduction (3,650) 10% ATI where ATI =
The lesser of: (35,000) + 1,000+ 70,000
+500
(1) $6,000; or (2) 10% ATI

= Taxable income (53,150)



NOL = $(19,500):
TI (53,150)
+ NOL carryover 30,000
+ Charitable deduction 3,650
= NOL (19,500)


Capital Gains and Losses
Comparison Between Corporations and Individuals

Corporations Individuals
Determining long/short- Requires netting from a Requires netting among
term capital gains/losses: single “rate basket” several “rate baskets”
Tax on net long-term Ordinary corporate tax rates Ord. ind’l rates, up to
capital gains: 10%/15%/20%/28%
Tax on net short-term Ordinary corporate tax rates Ord. ind’l tax rates, no limit
capital gains:
Net long-short-term capital Not deductible Deductible up to $3m
losses: ($1.5m if married filing
separately.)
Carryovers: 3 yrs. back, 5 yrs. fwd. Carry forward (not back)
(Unlike with NOLs, no indefinitely
election allowed to forgo
carrybacks.)


Capital Gains and Losses

Comparison Between Corporations and Individuals

Corporations Individuals
Character of capital loss Long and short-term capital Long/short-term loss
carryovers: losses carried over as short- carryovers retain their
term character.

Computing NOL: Net capital losses are never Net nonbusiness capital
part of NOL since they are not losses are added back to
deductible. Therefore, no taxable income (TI).
addback to taxable income (Note that they are always ≤
(TI). $3,000);
Net capital gains are not Net nonbusiness capital
subtracted from TI (i.e., capital gains are subtracted from
gains reduce NOLs). TI.


Depreciation Expense

Depreciation Including Code Sec. 179. Generally, the
rules for corporations are identical to the rules for
proprietorships. However, for Code Sec. 1250 assets,
an additional recapture amount is required under
Code Sec. 291.


Depreciation Expense

Code Sec. 291 Exception for Corporations. For
corporations, realized gain must be characterized as
Code Sec. 291 ordinary income (OI) to the extent of
20% of any excess of “pretend” Code Sec. 1245 OI
over Code Sec. 1250 OI.


Code Sec. 291 Depreciation for Corporations—
Example
FACTS:
 1/1/x1: ABC Corp. acquired an office building for
$450,000.
 1/1/x1 - 12/31/13: The building was depreciated using
15-year straight-line.
 1/1/14: The building was sold 13 years later for
$240,000.

QUESTION: Compute Code Sec. 291 OI and Code Sec. 1231 gain.


Example
SOLUTION:
Formula: Description 000’s Computations:
(a) Sales Price 240
Adjusted Basis:
(b) Cost 450
(c) Accumulated 390 (450,000 ÷ 15 years) x 13 yrs,
Depreciation (ignoring mid-month convention)
(d)=(b)-(c) Adjusted Basis 60
(e)=(a)-(d) Realized gain 180
(f)= < of (c) or (e) “Pretend” Sec. 180 < of 390,000 or 180,000
1245 OI


Example

SOLUTION:
Formula: Description 000’s Computations:
(g)= Excess accel OI under Sec. 1250 0 “$0” since ACRS (i.e., accelerated
depr. over S/L depreciation) was not used.
depreciation.
(h) = (f) - (g) Excess “pretend” 180
Sec. 1245 OI
(i) = (h) x 20% Sec. 291 OI 36 180,000 x 20%

(j) = (e) - (i) Sec. 1231 cap. gain 144 180,000 - 36,000


Reconciling Book and Taxable Income

Form 1120. A corporation files its federal return on
Form 1120.

Schedule M-1. Reconciling accounting and tax income
is done on Schedule M-1 of Form 1120. M-1 addresses
differences, both permanent and temporary, between
accounting and tax income. The differences are caused
by using different accounting and tax methods to report
income and expenses. In addition to tax reporting, the
M-1 is also useful for tax planning.


Example on M-1 Reconciling Items
FACTS:
ABC Corp. reports the following results of operations:
Net income per books, after taxes 88,000
Rent received in advance (booked as a liability) 11,000
Federal income taxes 13,750
Tax-exempt interest on Municipal bonds 3,000
Net capital loss (in XS of CGs) 1,250
Premium paid on life insurance for key employees (ABC = 1,000
Beneficiary)
Life ins. proceeds received due to death of key employee 10,000
XS MACRS over S/L depreciation (S/L is used for accounting 5,000
purposes.)
Charitable contribution carryover 7,000


Example on M-1 Reconciling Items:
Prepare an M-1 reconciliation and compute taxable income.
Net income per books 88,000

+ Expenses per books that are not deductible:
Federal income tax expense (not tax deductible) 13,750
XS capital losses over capital gains (not tax deductible) 1,250
Insurance premiums (not deductible since ABC is a beneficiary) 1,000
– Deductible expenses not booked for accounting purposes:
XS MACRS depr. per tax return over S/L depreciation per books (5,000)
Charitable contribution carryover (7,000)
– Income per books not taxable:
Tax-exempt interest on municipal bonds (3,000)
Life insurance proceeds received on death of key employee (10,000)
Taxable income not booked for accounting purposes
+ Future rent received in advance. 11,000
= Taxable income 90,000

Corporate Tax Rates
Computing Regular Income Tax. Corporations are subject to the 4-bracket graduated
tax rate structure below.

Tax Rates on Corporate Taxable Income

At Least: But Not Over: Marginal Tax Rate:
$ 0 $ 50,000 15% (1st bracket)
50,000 75,000 25% (2nd bracket)
75,000 100,000 34% (3rd bracket)
39% (3rd + 5% surc harge )

100,000 335,000
335,000 10,000,000 34% (3rd bracket)
10,000,000 15,000,000 35% (4th bracket)
15,000,000 18,333,333 38% (4th + 3% surcharge)
Over 18,333,333 35% (4th bracket)


Corporate Tax Rates
Surtaxes imputed in the table from the previous slide.
 A 5% surtax is charged on TI between $100,000 and

$335,000, which eliminates the “tax savings” on the first
$100,000 of TI.
 A 3% surtax is charged on TI between $15,000,000 and

$18,333,333, which recaptures the “tax savings” from
$335,000 to $10,000,000.

Capital gain rates. Same as ordinary rates. No rate breaks as with
individual tax rates.
Capital losses. Not deductible as with individuals, offset only against
capital gains.
Personal Service Corporations. Taxed at a flat rate of 35% on all
taxable income (TI).

Corporate Tax Rates

Controlled group of corporations. Rates are applied to the
aggregate TI of the group as if it were a single corporation. A
controlled group a parent corporation and one or more
subsidiaries in which the parent owns EITHER:

(a) 80% total voting power of Subsidiary, or
(b) 80% total value of Subsidiary’s stock.

Any additional corporation with an 80% connection to any
member of the controlled group becomes part of the controlled
group.


Corporate Tax Credits
General Availability of Credits. Most tax credits available to
individuals are available to corporations. Exceptions include:
• Earned income credit;

• Child and dependent care credit;

• Elderly and disabled credit;

• Hope credit;

• Lifetime Learning credit;

• Adoption credit.

Foreign Tax Credit (FTC) or Deduction (FTD). A U.S. citizen or
resident alien may elect either a credit or a deduction “FOR” AGI,
on taxes paid to other countries or U.S. possessions. The
maximum amount credited or deducted is determined from the
following table.


Template for Computing the Foreign Tax
Credit/Deduction
(a) U.S. income tax before the foreign tax credit or deduction.
(b) Foreign source taxable income (TI).
(c) Worldwide taxable income.
(d) = (a) x [(b) ÷ (c)] Allocation amount.
(e) Foreign taxes actually paid on worldwide TI.
(f) = < (d) or (e) Foreign tax credit or deduction.
 FTCs are credited against gross tax liability before all other credits.
• FTDs are deductible from gross income.

• FTC’s usually result in greater tax benefits than FTDs.

• Unused foreign tax credits or deductions are carried back 2 years and then carried

forward 5 years.
• For nonresident aliens, FTC is allowed to reduce U.S. tax on U.S. income but only to

the extent that foreign taxes have been paid on U.S. income.


Foreign Tax Credits—Example
FACTS:
U.S. Corp. has worldwide TI of $500,000, and a tentative U.S. tax liability of $170,000.
From its Chinese operations, U.S. Corp. had $100,000 of TI on which a $45,000 Chinese
tax was paid.

QUESTION:
What is U.S. Corp.’s FTC or FTD?

SOLUTION:
(

U.S. income tax before the FTC or FTD. a
) $170,000
(b) Foreign source TI 100,000
(c) Worldwide taxable income 500,000
(d) = (a) x [(b) ÷ (c)] Allocation amount. 34,000
(e) Foreign taxes actually paid on worldwide TI. 45,000
(f) = < (d) or (e) Foreign tax credit or deduction. 34,000


Formation of Corporations—Overview of
Code Sec. 351
What is the general rule on transferring property to a corporation
in exchange for stock?

Code Sec. 351 requires that no gain or loss is recognized if
property is transferred to a corporation by one or more persons
solely in exchange for stock in the corporation and immediately
after the exchange, such person or persons control the
corporation. This nonrecognition treatment is mandatory, not
elective. Note that Code Sec. 351 protects only the transfer of
property. It does not protect the transfer of services. Also, Code
Sec. 351 applies even after a corporation has been formed.


Code Sec. 351
What was Congress thinking when it enacted Code Sec. 351?

There are two reasons for Code Sec. 351. First, as the
stockholders receive only stock, they may not have the
wherewithal to pay taxes. Second, the incorporation of a
going concern is not an economic transaction but rather a
change in legal form only.


Code Sec. 351

What is “control”?

Control is ownership by all transferors of property of 80% or
more of BOTH the voting power AND the value of all classes
of stock. Do not include the % ownership of transferors of
services in this determination.


Code Sec. 351

What is “property”?

Consistent with Code Sec. 351(d) “property” includes just about
everything except services. (i.e., cash, inventory, receivables,
land, other tangible assets, nonexclusive licenses, and industry
know-how.)


Code Sec. 351

Why are “services” NOT “property’?

Under Code Sec. 351(d)(1), services are NOT property to ensure
that a person who provides ONLY services to a corporation (1) will
be taxed immediately (on the FMV of stock received); and (2) will
NOT be included in the 80% control computation.

Chapter 16, Exhibit 28e CCH Federal Taxation Basic Principles68 of 92

Code Sec. 351

How does Code Sec. 351 apply if a person contributes both
property and services?

The receipt of stock attributable to services will generally be
treated as a separate transaction outside the scope of Code Sec.
351. [However, the stock received in exchange for part property,
part services will ALL be included in the 80% control
computation!]

Chapter 16, Exhibit 28f CCH Federal Taxation Basic Principles69 of 92

Code Sec. 351 Contribution of Part
Property/Part Services—Example
FACTS:
A transfers land worth $50,000, and B transfers land worth $15,000 and
contributes services worth $35,000 to X Corp. in exchange for all of the stock of
X.

QUESTION 1: Has the 80% control requirement been met under Code Sec.
351?

SOLUTION 1: Yes, B’s stock attributable to services counts in the “control”
computation—and control by A and B after the exchange is 100%. Since
control immediately after the exchange ≥ 80%, the exchange qualifies as a Code
Sec. 351 exchange.


FACTS:
contributes services worth $35,000 to X Corp. in exchange for all of the stock
of X.

QUESTION 2: What would be the result if B contributed ONLY services?

SOLUTION 2: Then B’s stock would not count in the control computation, and
control immediately after the exchange would be limited to A’s 50%. Since
50% < 80%, this would not have been a Code Sec. 351 exchange.


FACTS:
contributes services worth $35,000 to X Corp. in exchange for all of the stock of
X.

QUESTION 3: Can B get Code Sec. 351 tax free treatment for the $35,000
services contributed?

SOLUTION 3: No, services are not property under Code Sec. 351(d)(1).
Therefore, B will recognize $35,000 OI as compensation for his services.


Code Sec. 351 Contributions—
Tax Effect on Shareholders
What is the recognized gain of shareholders in a Code Sec. 351
transfer of property for stock?

Code Sec. 351(b) provides that a shareholder’s recognized gain will
be the smaller of (1) boot received or (2) realized gain. (Students
should not confuse Code Sec. 351 boot with Code Sec. 1031 “net
boot received”—that term applied to like-kind exchanges under
Code Sec. 1031.) Here, boot is money and the FMV of property
other than the common stock of the corporation received in the
exchange. Also, under Code Sec. 358(c), a shareholder liability
assumed by the corporation is boot if it exceeds the AB of all
property contributed by the shareholder. If not, then it’s not boot.


How is the basis of the stockholder in the stock determined?

Code Sec. 358 provides the following formula (referred to as the
“front-in” approach):
AB in contributed property
– FMV of boot received, including liabilities assumed by
corporation that ARE boot
– Liabilities of shareholder assumed by corporation that are
NOT boot. Code Sec. 358(d)
+ Gain recognized by the shareholder
– Loss recognized by the shareholder
= SHAREHOLDER BASIS OF STOCK.

How is a shareholder’s holding period in the stock
determined?
The holding period of the property contributed tacks on to the
stock received. If several properties have been contributed, the
stock will have a split holding period!

What is a shareholder’s basis and holding period in the boot
received?
The shareholder’s basis in boot received is generally the
corporation’s basis (not FMV). The holding period of boot
received does not tack on as does stock received. Instead, it
begins on the day AFTER receipt.


Tax Effect on Corporations
What is the corporation’s basis in the assets transferred by
shareholders?

Code Sec. 362 provides that the basis of assets received by a
corporation in a Code Sec. 351 transfer will be (a) + (b), where:
(a) = Shareholder’s basis in contributed property
(b) = Gain recognized by the shareholder, allocated using
relative FMVs.
(a) = (a) + (b) = Corporation’s basis in assets contributed by
S/H.


Tax Effect on Corporations
What is the corporation’s holding period in the assets contributed by
a shareholder?
Same as the holding period of the shareholder.

Does the corporation recognize gain or loss on the exchange of its
stock for property under Code Sec. 351?
No, never.

What about property other than stock transferred by the
corporation?
If a corporation transfers other property to shareholder, then YES, it
generally recognizes gain (but not loss) based on [FMV - AB].


Code Sec. 351 Contributions—Example 1
Facts: On 12/31/x1, Dennis forms a new corporation and receives
100% of the corporation’s stock after contributing the following
property:

Land Building

Holding period Began 3/21/97 Began 8/19/x1

FMV, 12/31/x1 1,000,000 14,000,000

Basis, 12/31/x1 2,000,000 3,000,000

Bldg. mtg.assumed by corporation 6,000,000



Question:
Compute the following items:
 Dennis’ realized gain.

 Dennis’ boot received.

 Dennis’ recognized gain.

 Dennis’ postponed gain.

 Dennis’ basis in the stock received.

 Dennis’ holding period in the stock received.

 The corporation’s basis in the land and building contributed by Dennis.

 The corporation’s holding period in the land and building.


Solution: Formula Computation 000’s

(a) Dennis’ (a) = Amt. Realized Note: Dennis’ stock is not publicly 4
realized gain - Basis of traded. However, its value may be
assumed to be equal to the net value
contributed of assets received by the corporation:
property
FMV of land........................... 1
= Realized gain + FMV of bldg......................+ 14
- Mtg. assumed by corp....... (6)
(Similar to rules for any = Net value of assets .(i.e.,
disposition) Dennis’ amt. realized)........... 9
- Basis of contributed property
(2mm land + 3mm bldg)..... 5
= Dennis’ realized gain.......... 4




(b) Dennis’ (b) = Excess debt Dennis’ debt relief.................... 6 1
boot relief (i.e., debt relief - Basis of contributed property
received: —AB of assets (2mm land + 3mm bldg)...... (5)
contributed)
= Excess debt relief..........…... 1
+ FMV of other boot
received + FMV of other boot received.. 0
= Dennis’ total boot received.. 1




(c) Dennis’ (c) = Lesser of (a) or (a) = 4,000,000 1
recognized gain (b) (b) = 1,000,000
(Similar to “like-kind” (c) = 1,000,000 (the lesser
exchange rules) amount)

(d) Dennis’ (d) = (a) - (c) (d) = 4,000,000 – 1,000,000 = 3
postponed gain: 3,000,000

Chapter 16, Exhibit 32e CCH Federal Taxation Basic Principles82 of 92


(e) Dennis’ stock Front-in approach: Back-in approach: 0
Dennis’ basis can be (Here, the stock’s FMV
basis in determined two
ways: Stock basis: must first be “plugged”
the stock  Using the Sec. from amount realized):
received: + AB in cont’d
358 formula, i.e., FMV of stock:
property....... 5
the “front-in” Amt realized........ 9
approach (shown - Boot rec’d... (1)
above) - Debt relief.......... (6)
- Debt relief,
 Using the
nonboot ....... (5) = Stock FMV........ 3
“back-in” Stock basis:
approach, as was + Gain recog’d.. 1
Stock FMV......... 3
done for like- - Loss recog’d.. 0
kind property -Postponed gain....(3)
= Stock basis ... 0
received = Stock basis......... 0

Chapter 16, Exhibit 32f CCH Federal Taxation Basic Principles83 of 92


(f) Dennis’ (f) = Same as holding period of
holding the contributed property  HP of 1/15 share begins
period in the Note 1. Since more than one on 3/21/97;
stock property was contributed for the  HP of 14/15 share begins
received: stock, each share will have a on 8/19/x1.
split holding period (HP). (Thus, as of 12/31/x1, 1/15
of each share is deemed to
Note 2. The HP rules for Sec. be long-term, and 14/15
351 stock is similar to HP rules short-term!)
for like-kind assets received
under Sec. 1031.

Chapter 16, Exhibit 32g CCH Federal Taxation Basic Principles84 of 92

F

Solution: Computation 000’s
o
r
m
u
l
a

(g) The The corporation’s Land Bldg.
corporation’s basis in the land Dennis’ asset basis 2,000,000 3,000,000
basis in the and building can + Alloc. of recog. gain:
assets be determined
1 mm x [ 1 ÷ (1 + 14)] 66,667
received: using the Sec. 362 1 mm x [14 ÷ (1 + 14)] 933,333
above.
Corporation’s basis 2,066,667 3,933,333

(h) The (h) = Same as Land Bldg.
corporation’s shareholder’s HP HP beginning date 3/15/97 8/19/x1
holding period
in assets
received: (Same as Dennis’ HP)

Chapter 16, Exhibit 32h CCH Federal Taxation Basic Principles85 of 92

FACTS:
Anu, Ellsworth, and Tebessum decided to pool their efforts and form a corporation.
They made the following contributions to the corporation:

Stockholder Asset FMV AB to S/H # shares issued

Anu Services $ 30,000 $ 0 30

Ellsworth Land 70,000 20,000 60

Tebessum Equipment 10,000 11,000 10

TOTALS $110,000 100

The FMV of the stock is $1,000 per share. Ellsworth’s land is subject to a $10,000
mortgage which the corporation assumed.


QUESTION 1: Does this transfer of assets qualify for Code Sec.
351 treatment?

SOLUTION 1: No, Anu is not a transferor of property. Only
Ellsworth and Tebessum can be included in the control
computation. Since their combined control is only 70% [(60 +
10) ÷100], the ≥ 80% control requirement has not been met.
What would be the result if Anu had also contributed $1.00?


QUESTION 2: Assuming the previous transaction did qualify under Code Sec. 351, fill in the
blanks below. (Answers provided.)

SOLUTION 2:

Stockholder Realized G/L Recog. Gain/Loss Basis of stock
(FMV - AB) (< Real gain or boot (AB - debt relief + recog’d
rec’d) gain - recog’d loss)

Anu 30,000 (30m - 0) 30,000 (services 30,000 (0 - 0 + 30m)
income)

Ellsworth 50,000 (70m - 20m) 0 ($0 boot received) 10,000 (20m - 10m + 0)

Tebessum (1,000) (10m - 11m) 0 ($0 boot received) 11,000 (11m -0 + 0)

Basis of the land to the corporation: $20,000. (Ellworth’s AB of $20m + $0 gain recognized by
Ellsworth)


QUESTION 3: Assuming the previous transaction did NOT qualify under Code Sec.
351, fill in the blanks below. (Answers provided.)

SOLUTION 3:
Stockholder Realized G/L Recog. G/L Basis of stock
(FMV – AB) (FMV – AB) (AB – debt relief + recog’d gain –
recog’d loss)

Anu 30,000 30,000 30,000 (0 - 0 + 30,000)
Ellsworth 50,000 50,000 60,000 (20,000 – 10,000 + 50,000)

Tebessum (1,000) (1,000) 10,000 (11,000 – 0 – 1,000)


Nonstock Distributions—
Effect on Shareholder of C Corporation

What is the amount of “distributions other than stock”?

The amount of distribution other than stock of the corporation is:
(a) - (b), where
(a) = The fair market value of all property received (other
than the common stock of the distributing corporation).
(b) = Liabilities of the distributing corporation, both recourse
and nonrecourse, assumed by the shareholder.



Do shareholders of C corporations recognize income on nonstock
distributions?

Yes, then yes, then no, then yes. That is, when a corporation
distributes property other than its own stock to shareholders, the
tax treatment to shareholders moves in different directions,
according to the following pecking order:


Tier Distributions Other Than Stock, to the Extent Tax Treatment to S/H:
of:

1st Current earnings and profits (E&P) Ordinary income based on FMV

2nd Accumulated E&P Ordinary income based on FMV

3rd S/H’s basis in the stock Nontaxable return of capital

Any balance remaining Capital gain
What is a shareholder’s basis in the non-stock property distributed by the C corporation?

Basis = FMV of the asset. The assumption of a liability does not affect basis.


2013 cch basic principles ch16 piii

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