BUSINESS - CORPORATIONS

Question 1

Corporations Defined

Answer 1

A form of business enterprise that is set up as a LEGAL ENTITY.

Its existence is distinct and SEPARATE from those who own and control it.

Question 2

Types of Corporations (D, F, CH, PH, P)

Answer 2

Domestic Corporation

Foreign Corporation

Closely-held Corporation

Publicly-held Corporation

Public Corporation (Municipal Corporation)

Question 3

Corporation Tax Classifications

Answer 3

C Corp

S Corp

Note: A Corporation can chose to be taxed as an S Corp, if it meets the rules of an S Corp

Question 4

Every Corporation is incorporated in a State.

True or False?

Answer 4

True.

There are no National or U.S Corporations.

Question 5

Advantages of Corporate Structure rather than being a Partnership or a Sole Proprietorship.

Answer 5

Separate Legal Entity

Limited Liability for the Shareholders.

Free transferability of ownership interests (Stock)

On-going life

Centralized Management

Single Taxation on Undistributed Corporate Income

No Mutual Agency

Ease of Capital Assembly

Question 6

Disadvantages of Incorporating

Answer 6

Formal incorporation process, and ongoing reporting.

Governmental regulation - this differs from state to state.

Double taxation on distributed corporate income

Question 7

Double Taxation on Distributed Income from a Corporation Explained

Answer 7

The Corp makes profit, and pays taxes on that profit.

The after-tax profit that is then distributed to shareholders are taxed again on the dividends received, at the shareholder level.

Question 8

Corporate Formation

Answer 8

A PROMOTER is an individual who performs the activities necessary to form a corporation.

The entity usually has no liability for pre-incorporation contracts.

During the formation process, the promoter often enters into contracts on behalf of the Corp that still doesn’t exist.

So, the Corp can’t be part of the contracts the Promoter enters into, and therefore has no liability yet.

The liability rests with the promoter. There are exceptions…

Question 9

Corporate Liability for Promoter’s Contracts

Answer 9

Exception 1: If a PRE-INCORPORATION contract contains a clause expressly negating the promoter’s liability, then the promoter will not be held liable.

Exception 2: If a corporation adopts a PRE-INCORPORATION contract or otherwise accepts the benefits of such a contract, then both the corporation and the promoter are liable.

Exception 3: If there is a NOVATION, then the corporation will be liable for pre-incorporation contracts.

Novation takes the name of the Promoter out of contracts made on behalf of the Corporation and replaces it with the Corp’s name.

Question 10

Corporate Formation Example 01

Bruno is a PROMOTER of the Polytone Corporation. Bruno signed a contract with a CPA, and the contract provided that the CPA would provide accounting services to Polytone. At the time of contract formation, Bruno did not inform the CPA that the Polytone Corporation was not yet formed. Before Polytone’s official incorporation, the CPA performed accounting services, but he received no payment from either Bruno or Polytone.

If the CPA sues for damages, what will be the result?

BRUNO will be liable in his capacity as promoter.

Answer 10

ALTERNATELY, if the CPA also had performed services for Polytone one month after Polytone’s incorporation?

If the CPA had performed services for Polytone both before and after incorporation, then both BRUNO and POLYTONE would be liable for the breach.

This is because, by accepting the services of the attorney after incorporation, Polytone will have RATIFIED the pre-incorporation contract by accepting the services of the CPA.

Question 11

Process of Incorporating

Answer 11

Corporations are formed under authority of STATE STATUES.

The intended corporation usually incorporates in the state where it intends to transact business.

States have their own rules, but in general States require an ARTICLE OF INCORPORATION (a Charter) to be filed with the State.

It is generally a standardized form.

Question 12

Articles of Incorporation

Answer 12

The NAME of the Corporation.

Its PURPOSE and NATURE of its business.

The authorized NUMBER OF SHARES of capital stock that can be issued with a description of the various classes of such stock.

The amount of INDEBTEDNESS the corporation may incur.

The STREET ADDRESS of the corporation’s principal office.

A statement of the duties of the officers of the corporation.

The names and addresses of the original directors.

The name and address of the corporation’s REGISTERED AGENT for receiving service of process and other notices.

The length of the corporation’s life, which is usually perpetual (meaning forever).

Question 13

Incorporators as well as the First Steps to form a Corporation

Answer 13

The individuals who sign the articles of incorporation are called the INCORPORATORS.

The incorporators elect the directors if the directors are not named in the articles.

The incorporators then RESIGN.

The DIRECTORS meet to:

1. Complete the ORG STRUCTURE.
2. Adopt BYLAWS
3. ELECT OFFICERS
4. Select the CORP BANK
5. Adopt, ratify or reject PRE_INCORPORATION contracts.
6. Adopt the FORM OF CERTIFICATE representing shares of the company’s stock
7. COMPLY with requirements for doing business in other states.
8. Adopt a CORPORATE SEAL
9. Consider all other transactions necessary or appropriate for carrying on the business purpose

Question 14

Defects in Corporation

Answer 14

Under common law, any entity that did not follow all the incorporation procedures would not become a corporation. However, since that is not the intention of anyone, there are 3 modes of a Corporation that avoids technicalities.

De Jure Corporation

Corporation by Estoppel

De Facto Corporation

Question 15

Financing the Corporation - Debt

Answer 15

Bonds are DEBT SECURITIES issued by a corporation.

Debt investors have a right to repayment of the bond’s principal (corpus) and interest.

Question 16

Financing the Corporation – EQUITY

Answer 16

Capital is the consideration a company receives in exchange for shares of its corporate stock.

Subscription Agreements are contracts for future purchases of shares of corporate stock at specified prices. The purchaser is known as a subscriber.

Pre-incorporation subscribers

Post-incorporation subscribers

Conditional subscription

Question 17

Authorized Stock( Shares)

Answer 17

Stock that is authorized to be issued in the articles of incorporation.

This is the total number of shares that exist, the total number of shares that can be sold.

Question 18

Issued Stock (Shares)

Answer 18

ISSUED STOCK is the portion of authorized stock that has actually been issued to shareholders.

Question 19

Outstanding Stock(Shares)

Answer 19

Outstanding Stock is the portion of authorized stock that has actually been issued to and is still owned by outside shareholders.

The difference between Outstanding Stock and Issued Stock are Treasury Shares. Shares that were issued and outstanding, were bought back by the Company. Not currently held by outside shareholders.

Question 20

Corporate Liabilities

Answer 20

A corporation is liable for the CONTRACTS of its employees and, in particular situations, for TORTS committed BY employees.

Question 21

Piercing The Corp Veil

Answer 21

If a corporation is used as a vehicle to perpetrate fraud or commit some other act of malfeasance, then the courts can disregard (ignore) the corporation as a separate entity and instead hold individual shareholders or corporate officers liable for wrongdoing perpetrated by the corporation.

Question 22

Common Situations where Piercing the Corp Veil is used.

Answer 22

FRAUDulently inducing someone into dealing with the corporation rather than the individual.

UNDERCAPITALIZATION - when the court determines that the amount of capital at the formation was not adequate.

COMMINGLING Personal and Corporate assets - contribute funds to better position oneself. For instance giving a loan rather than buy shares (a capital contribution).

FAILURE TO ACT as a corporation - example: if a subsidiary isn’t properly capitalized and it exists solely for the benefit of the parent company, the courts will treat the two entities as one and the parent company will be held liable for the debts of the subsidiary, even though only a shareholder of the subsidiary.

Question 23

Transfers of Property for Stock

Answer 23

In a transfer of property in exchange for stock, no gain or loss recognized by either party if both:

The property is transferred SOLEY in exchange for stock (no boot), and

The new owner(s) are in CONTROL of the corporation (80% or more ownership).

Question 24

Recognition of Gain with Boot

Answer 24

If the transferors receive something other than stock (called boot), a gain needs to be recognized by the transferor.

The amount of the gain is the difference between the FMV of what was received and the ADJUSTED BASIS of the property that was given up.

Question 25

ASSUMPTION OF A LIABILITY by the Corp for Property (BOOT) being Contributed.

Answer 25

The ASSUMPTION OF LIABILITIES by a Corp results in a gain for the transferor only if the amount of the liabilities assumed by the Corp is greater than the transferors BASIS in the property that was contributed.

Question 26

Shareholder’s Basis in Stock

Answer 26

Add the Adjusted Basis of the property transferred + Any gain recognized (only if boot was received) - Any boot received = Shareholder Basis in Shares Acquired

Question 27

Corporation’s Basis in Property

Answer 27

Transferor’s adjusted basis + Any gain recognized by the transferor = Corp's Basis in Property

Question 28

Earnings and Profit

Answer 28

The process of determining if a dividend is taxable or not taxable. There are two types of E&P - Current E and P and (CEP) - Accumulated E and P. (AEP) The dividends that are distributed from CEP or AEP are taxable. Dividends that are not from E & P are considered a Return Of Capital, and is therefore not taxable and REDUCES THE BASIS of the shareholder.

Question 29

Non E&P Dividends

Answer 29

If the dividend does not come from E&P, the dividend is considered a RETURN OF CAPITAL (non taxable) and reduces the basis of the stock of the shareholder. You must know how to treat a dividend when there are different situations regarding the balances in current and accumulated E&P. Essentially, to the extent that there is E&P, the dividend is taxable.

Question 30

CEP = $100 AEP = $100 Cash Dividend = $250 With these numbers, how much of the Dividend is Taxable and how much is a Tax Free Return Of Capital?

Answer 30

Total E & P is $200 Taxable Dividend = $200 Tax-free Dividend = $50

Question 31

CEP = $100 AEP = ($200) Cash Dividend = $150 With these numbers, how much of the Dividend is Taxable and how much is a Tax Free Return Of Capital?

Answer 31

Total E & P is $100 Taxable Dividend = $100 from CEP Tax-free Dividend = $50 The taxable Dividend is $100 because CEP is ALWAYS FIRST, even though the AEP is negative.

Question 32

CEP = ($100) AEP = $200 Cash Dividend = $150 With these numbers, how much of the Dividend is Taxable and how much is a Tax Free Return Of Capital?

Answer 32

Total E & P is $100 Taxable Dividend = $100 Tax-free Dividend = $50 The taxable Dividend is $100 because the total E & P is $100, when the AEP and CEP are netted together.

Question 33

CEP = ($100) AEP = $200 Cash Dividend = $75 With these numbers, how much of the Dividend is Taxable and how much is a Tax Free Return Of Capital?

Answer 33

Total E & P is $100 Taxable Dividend = $75 Tax-free Dividend = $0 The taxable Dividend is $75 because the total E & P is $100, when the AEP and CEP are netted together, but the Dividend is only $75.

Question 34

CEP = ($100) AEP = $50 Cash Dividend = $75 With these numbers, how much of the Dividend is Taxable and how much is a Tax Free Return Of Capital?

Answer 34

Total E & P is ($50) Taxable Dividend = $0 Tax-free Dividend = $75 The taxable Dividend is $0 because the total E & P is ($50 loss), when the AEP and CEP are netted together. This means there is 0 earnings to distribute. The $75, then, is a Return of Capital.

Question 35

Calculating CEP

Answer 35

CEP is calculated by making some adjustments to taxable income. This is not a detailed calculation that you will need to make on the exam, but it is presented here to outline the differences between E&P and retained earnings.

Question 36

Added to Taxable Income to get to CEP

Answer 36

Tax-exempt income Capital losses not deducted Keyman life insurance proceeds Charitable contributions deduction carried forward Percentage depletion Accelerated depreciation greater than the straight-line amount Deferred gain on installment sale Intangible drilling costs deducted currently Mine exploration and development costs

Question 37

Subtracted from Taxable Income to get to CEP

Answer 37

Federal income taxes, Loss on sale between related parties, Keyman life insurance premiums, and Charitable contributions from this period in excess of 10% limitation.

Question 38

Non Cash Distribution to Shareholder

Answer 38

Generally, stock dividends are tax-free to the shareholder. The corporation treats the distribution of property as if it were a sale. The Corp recognizes a gain in the year of distribution that is equal to the difference of the Basis and the FMV. This gain/loss goes into the CEP to determine if a distribution is taxable or not.

Question 39

Property Dividends

Answer 39

When property dividends are distributed, the value used in the distribution for the shareholder is the fair market value of the property distributed, reduced by any liabilities assumed by the shareholder. To the extent of E&P, the distribution is a dividend and is taxed (not a cash dividend). The amount of the distribution ABOVE the the value of the E&P is a tax free ROC to the investment account of the shareholder. If the distribution is more than the remaining investment account of the shareholder, the amount above is a CAPITAL GAIN. When you get more back than what you've invested, it is a Capital Gain.

Question 40

Shareholder Basis in Property

Answer 40

The shareholder’s tax basis for distributed property is the property’s FMV at date of distribution. It's NOT reduced by liabilities!

Question 41

Redemptions and Liquidations

Answer 41

If a corporation buys back its own shares from the shareholders, the transaction is treated like a sale of the shares by the shareholder for tax purposes.

Question 42

What are the 5 tests to determine if there is a Capital Gain or Loss on a (Sale) Redemption of Stock back to the Corp. Only 1 of the 5 needs to be met.

Answer 42

The redemption is not essentially a dividend. A.K.A, if, as a result, you are less of a shareholder than you were before because one's voting power, share in earnings, or the right to share in the distribution of assets has been reduced. The redemption is disproportionate between shareholders. All of the shareholder’s stock is redeemed. The redemption is from a noncorporate shareholder in a partial liquidation. The redemption is done to pay death taxes.

Question 43

Partial or Complete Liquidation

Answer 43

In a partial liquidation, the entire gain of the shareholder is recognized as capital gain. In a complete liquidation of a corporation, all of the corporation’s stock is redeemed.

Question 44

Complete Liquidation for Shareholder

Answer 44

The shareholder will recognize a capital gain or a loss on the transaction to the extent that cash and property received (FMV) is different from their basis in the stock. Property received will have a basis to the shareholder equal to the FMV of the property.

Question 45

Complete Liquidation for Company

Answer 45

Generally, a gain or loss is recognized as if the corporation had sold all of the property to the shareholders at FMV.

Question 46

What is a Demand Note?

Answer 46

A demand note is a loan where the lender can demand repayment at any time. A demand note allows the noteholder (lender) to call the note due at any time. Courts have restricted the circumstances under which a bank could enforce a demand for repayment under a demand note.

Question 47

§ 351 Exchange

Answer 47

The transfer of property (or money and property) to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock) is usually not taxable if immediately afterward the taxpayer is in control of the corporation. Note: This type of nontaxable §351 Exchange applies to both individuals and to groups who transfer property to a corp.

Question 48

Control of Corporation

Answer 48

To be in control of a corporation the transferors MUST own at least 80% of the total combined voting power of all classes of stock, and at least 80% of the outstanding shares of each class of nonvoting stock, immediately after the exchange.

Question 49

The value of stock received for services is considered income to the recipient. True or False?

Answer 49

True. The term "property" does NOT include "services rendered" to the issuing corporation. So, the basis of stock received for services is the amount the shareholder includes in income. If a shareholder performs services in exchange for stock, the control requirement for §351 can be lost! Only shares attributed to the exchange of "property" count toward the control requirement.

Question 50

The basis of stock received by a shareholder is generally the adjusted basis of the property transferred.

Answer 50

Increase basis by any amount treated as a dividend and by any gain recognized. Decrease basis by any cash received (other than payment for services), the FMV of any other property received, and any loss recognized on the exchange. Also decrease basis by liability.

Question 51

Paid-In-Capital

Answer 51

Contributions to the capital of a corporation, whether or not by shareholders, are Paid-In-Capital. These are NOT taxable to the corporation. The basis of property contributed to capital by a person other than a shareholder is $0.

Question 52

Election to Reduce Basis

Answer 52

In a §351 transaction, if the basis of the property transferred exceeds the property's FMV (a built-in loss), the parties may irrevocably elect under §362(e)(2)(C) to treat the basis of the stock received by the shareholder as having a basis equal to the FMV of the property transferred. The basis of the property received by the corporation is the same as the basis the shareholder had in the property. NOTE: This is the exact OPPOSITE of the general rule.

Question 53

What is the earliest date an S Corp status can be reinstated without IRS consent, if an election to terminate is made?

Answer 53

The 5th tax year after the first tax year in which the termination or revocation took effect. Before then, IRS consent is generally required for another election by the Corp on Form 2553.

Question 54

E&P is taxable income, plus or minus adjustments. Items the Corporation must add back to taxable income include:

Answer 54

- Muni bond interest - Excluded life insurance proceeds - Federal income tax refunds - Dividends received deduction. Shareholders of a corporation receive dividend tax treatment for a distribution of E&P regardless of whether the source of E&P is taxable or tax-free income.

Question 55

The Tax Cuts and Jobs Act shortens the carryback period for FARMING losses from five years to two years. The general 2-year net operating loss (NOL) carryback rule does not apply to NOLs arising in tax years ending after December 31, 2017. The taxpayer may carry the loss forward.

Answer 55

NOL may be carried forward indefinitely.

Question 56

Net Pre-contribution Gain

Answer 56

Net Precontribution Gain is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution, and held by the partnership immediately before the distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership.

Question 57

Domestic Corporation

Answer 57

A Corporation that does business in the State it is incorporated in.

Question 58

Foreign Corporation

Answer 58

A Corporation that does business in the State other than the one it is incorporated in.

Question 59

Closely-Held Corporation

Answer 59

A Corporation whose stock is owned by a small number of shareholders. The stock is NOT traded in primary or secondary markets.

Question 60

Publicly-Held Corporation

Answer 60

A Publicly-held Corporation is a corporation where the stock is actively traded in a primary or secondary stock market.

Question 61

Public Corporation (Municipal Corporation)

Answer 61

A Public Corporation is an entity created to administer the business affairs of a municipality (a town, county, or a Federal unit). Most Public Corporation's are also not-for-profit entities.

Question 62

dividends received deduction (DRD)

Answer 62

A Dividends Received Deduction (DRD) is a federal tax deduction in the United States that is given to certain corporations that get dividends from related entities. The amount of the dividend that a company can deduct from its income tax is tied to how much ownership the company has in the dividend-paying company. Designed to soften the TRIPLE TAXATION on Corporate Dividends. Limitations: - The DRD is only available to C Corporations; not LLCs, S corporations, or individuals. - 45-day minimum holding period - DRD does NOT apply to preferred stock.

Question 63

Preferred Stock

Answer 63

The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders. Note of Caution: The market price of preferred stock is interest-rate sensitive and can decrease sharply during periods of rapidly rising interest rates.

Question 64

What are the 4 characteristics needed for a company to be taxed as a Corporation? (Note: companies that are not Corporations can be taxed as a Corporations if they have these 4 characteristics)

Answer 64

For tax purposes, a corporation is defined by the tax code. 1. Limited liability 2. Free transferability of ownership 3. Centralized management 4. Continuity of life

Question 65

Structure of a Corporate Return (Calculation)

Answer 65

Total Gross Income Minus Deductions _________________ = TAXABLE INCOME Taxable Income Multiplied by Tax Rate _________________ = TOTAL TAX DUE Total Tax Due Minus Payments and Credits _________________ = AMOUNT OVERPAID or AMOUNT DUE

Question 66

Corporate Tax Rate

Answer 66

21% (for 2019) It used to be graduated. Note: personal Service Corporations are at 21% as well.

Question 67

There is NO LONGER a "Net Capital Gain Corporate Tax Rate"

Answer 67

So the benefit for Corps in a higher tax bracket to pay lower tax rates on Cap Gains.

Question 68

C Corp Filing Requirements

Answer 68

Form 1120 with either: M-1 or M-3. DETAILS File Form 1120 before the 15th day of the 4th month after the end of it's tax year. There is an automatic 6 month extension available for filing, but NOT for paying the taxes. AND, either an M-1 or M-3 must be filed with Form 1120 to reconcile book and taxable income.

Question 69

Penalties for a C Corp not filing the Due Date

Answer 69

Failure to File – 5% of the unpaid tax for each month that it is late, up to a maximum of 25% of the unpaid tax. Beginning in 2018, the minimum penalty for a return that is more than 60 days late is: is the smaller of the tax due, or $215 (2019).

Question 70

Penalties for a C Corp not paying the Taxes Due on time.

Answer 70

Failure to Pay – one-half of 1% (.005) of the unpaid tax each month. If both penalties (failure to file AND failure to pay) are in play (late filing and not paid), it is only a maximum of 5%/month charged. This 1/2 of 1% is not added to it.

Question 71

Estimated Tax Payments by a C Corp

Answer 71

If the corporation’s estimated tax is more than $500, it must make quarterly estimated tax payments due the 15th day of the 4th, 6th, 9th and 12th months of the year. If the corporation underpays its estimated tax payments, penalties will be charged.

Question 72

Avoiding Delinquent Tax Penalty as a C Corp

Answer 72

The delinquent tax penalty can be avoided if the estimated tax payments are at least equal to the smaller of: 100% of the current year’s final tax liability (the annualized income method), or 100% of the preceding year’s tax (the preceding year method).

Question 73

Reconciliation of Book and Tax Income - REQUIRED FILING

Answer 73

Schedule M-1 of Form 1120 is used as the reporting of the reconciliation between book income and taxable income. Large and mid-size corporations have to file Schedule M-3. The M-3 is more detailed, and requires that Income and Expense differences be reported separately.

Question 74

M-3 Additional Requirement

Answer 74

Reconciliation of World Wide Net Income per the income statements to the net income of reported tax groups, and requires that the differences are ID'd as either temporary or permanent.

Question 75

Regarding M-1 and M-3 questions, it is important to remember how the item is accounted for book purposes and how that might be different than for tax purposes.

Answer 75

When something is recognized as Revenue on the Income Statement and when something is recognized as Taxable on the Tax Return. And when an Expense is recognized on the Income Statement, and when an item is going to be deductible for Tax purposes.

Question 76

Items Added to Book Income

Answer 76

Federal income tax expense Excess of capital losses over capital gains Unearned income (included in taxable income b/c cash has been received, but not yet in Book Income) Expenses deducted for book purposes, but not tax purposes (including accrued contingent liabilities) - Premiums on Key-man life insurance policies - Charitable contributions in excess of 10% - Business gifts in excess of $25 - Expenses incurred in connection with tax-exempt income - Depreciation differences resulting from different methods (The Difference is ADDED when the tax depreciation is GREATER THAN Book depreciation.) - Difference in bad debt deductions - 50% of meals and entertainment

Question 77

Items Subtracted from Book Income

Answer 77

Income reported in the books, but not on the tax return: - Accounts receivable sales - Life insurance proceeds from policies paid for by the company - Tax-exempt bond interest

Question 78

Deductions reported on the Tax Return, but NOT charged to Book Income:

Answer 78

- The dividends received deduction - Charitable contribution carryovers - Depreciation differences resulting from different methods (The Difference is SUBTRACTED when the tax depreciation is LESS THAN Book depreciation.)

Question 79

The level of detail in Form M-3 is such that, by filing Schedule M-3, taxpayers may satisfy the requirements of IRS Form 8886 “Reportable Transaction Disclosure Statement.” True or False?

Answer 79

True.

Question 80

What are the "Reportable Transactions" that are listed on Form 8886?

Answer 80

Any listed transaction, which are ID'd by the IRS as "Tax Avoidance Transactions" Any transaction offered under conditions of confidentiality for which the corporation (or a related party) paid an advisor a fee of at least $250,000. Certain transactions for which the corporation (or related party) has contractual protection against disallowance of tax benefits. Certain transactions resulting in a loss of at least $10 million in any single year or $20 million in any combination of years. Any transaction identified by the IRS by notice, regulation, or other published guidance as a “transaction of interest.” (If the M-3 is properly filled out, then a Form 8886 is not necessary.)

Question 81

Form M-2

Answer 81

This is the reconciliation of beginning and ending unappropriated retained earnings. The main addition to beginning retained earnings is the net income for the period.

Question 82

M-2 Adjustments

Answer 82

INCREASES: - Tax Refunds because this amount is NOT reported as income on the books DECREASES: - Distributions, which are NOT reflected in Book Income. - Reserves for contingencies, which are NOT reflected in Book Income.

Question 83

Dividend Received Deduction

Answer 83

C Corporations are entitled to a special deduction from income for dividends received from Domestic Corporations. (A.K.A - A US company invests in another US company) No deduction is allowed for shares that are not held for more than 45 days of the 91-day period that ends 45 days after the dividend is declared.

Question 84

Dividend Received Deduction: 3-Step Calculation

Answer 84

1. Calculate the MAXIMUM Amount of Dividends that MIGHT NOT BE TAXABLE 2. Calculate a LIMIT on the Amount that is NOT TAXABLE 3. Consider EXCEPTIONS to the Limit

Question 85

Dividend Received Deduction: (Step 01) Maximum Possible Amount

Answer 85

The maximum amount of the dividends that might be deductible from taxable income is determined by what amount of the company is owned by the recipient. Less than 20% ownership (called an unaffiliated or unrelated company) – 50% of the dividends received might not be taxable 20-79% ownership – 65% of the dividends received might not be taxable 80% and more ownership – 100% of the dividends received will not be taxable

Question 86

Dividend Received Deduction: (Step 02) Limit on Not Taxable Amount

Answer 86

For dividends from companies that are less than 80% owned the amount of deduction that may be taken is limited to 65% of taxable income (or 50% in the case of less than 20% ownership). When there is 80% or more ownership, 100% of the dividend is deductible. There is no limitation on the deduction in these cases.

Question 87

Dividend Received Deduction: (Step 03) Exception to the Limit

Answer 87

If the maximum potential deduction will either cause a tax loss, or increase a tax loss, for the company, then the maximum deduction is allowed and the company will have a tax loss. If the full deduction will still result in a gain for the company, the deduction is limited by the percentage of taxable income.

Question 88

Additional Penalty Taxes

Answer 88

In addition to income taxes, corporations may have to pay additional penalty taxes in certain situations. The two penalty taxes that we will look at are the Accumulated Earnings Tax and Personal Holding Company (PHC) Tax.

Question 89

Accumulated Earnings Tax (1st penalty Tax)

Answer 89

This is a tax placed on accumulated retained earnings that are greater than the reasonable needs of the business. Corporations in general may be liable for the accumulated earnings tax and it does not matter how many shareholders the corporation has.

Question 90

Exempt Organizations from the Accumulated Earnings Tax

Answer 90

Exempt Organizations are: - S Corporations, - Personal Holding Companies, - Foreign Personal Holding Companies, - Tax-exempt organizations and - Passive Foreign Investment Companies All are exempt from this tax.

Question 91

Accumulated Earnings Calculation

Answer 91

To calculate an Accumulated Taxable Income (ATI), corporations are given two deductions from taxable income after federal income tax before the calculation of the penalty tax. The greater of: a $250,000 credit ($150,000 for certain types of personal service companies), or an amount accumulated to meet the reasonable needs of the business, and A deduction for any dividends paid during the first 2 1/2 months of the next tax year minus the accumulated E&P at the close of the preceding tax year. The excess of accumulated earnings over these two deductions is taxed at a 20% rate.

Question 92

Personal Holding Company Tax (2nd penalty Tax)

Answer 92

This tax is an additional tax in addition to regular income tax and it is designed to discourage Personal Holding Companies (PHC) from keeping certain types of passive income in the corporation rather than distributing it to the shareholders. This is a self-assessed tax that the PHC must report by filing Form 1120 PH in addition to Form 1120.

Question 93

What defines a PHC (Personal Holding Company)?

Answer 93

2 Tests must be met: 1. 60% or more of the adjusted gross income of the company consists of passive income, and (ie. Dividends, Rents, Royalties, personal Service Contracts) 2. 50% or more of the value of the outstanding stock is owned either directly or indirectly by 5 or fewer individuals at any time during the last half of the tax year. Indirect Ownership example is, owned by a Trust while the beneficiary is a shareholder.

Question 94

PHC Tax Calculation to get Adjusted Taxable Income (ATI)

Answer 94

``` Taxable Income + Dividend Received Deduction + NOL Deduction - Federal and Foreign Income Taxes - Charitable Cont. in excess of 10% limit - Net Capital Loss - Net LT capital gain over net ST capital loss ``` = Adjusted Taxable Income

Question 95

PHC Tax Calculation from the Adjusted Taxable Income (ATI) to the Accumulated Earnings Tax

Answer 95

``` Adjusted Taxable Income - Dividends paid last 9.5 months of tax year and within 2.5 months after end of year - Consent Dividends - Accumulated Earning Credit ``` = Accumulated Tax Income x 20% = Accumulated Earnings Tax

Question 96

How is the Dividend Year different than the Tax Year?

Answer 96

The Dividend Tax year includes the 9.5 months of Tax Year and within 2.5 months AFTER the end of the Tax Year.

Question 97

Consent Dividends

Answer 97

A PHC can avoid paying the PHC Tax IF all of the shareholders agree to pay tax on the theoretical amount that should be distributed, even if it is not distributed. This is called a CONSENT DIVIDEND and is treated as a dividend distributed from the standpoint of the company.

Question 98

What are S Corps? (Formal IRS Defenition)

Answer 98

“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”

Question 99

What is an S Corp? (Informally)

Answer 99

Classified as a corporation, but taxed at the shareholder level rather than at the corporation level. More similar to a Partnership taxation, but with the limited liability benefit of a Corp.

Question 100

S Corp Requirements

Answer 100

There must be: 1. Only one class of stock, and the rights to profits, and assets on liquidation must be identical. 2. The number of shareholders must not exceed 100, 3. A nonresident alien cannot own shares, 4. Each shareholder must be either an INDIVIDUAL, an ESTATE or a QUALIFIED TRUST, and 5. The corporation must be a domestic corporation and not be a Financial Institution or Insurance Company.

Question 101

S Corp Election

Answer 101

The eligible corporation must make the election to become an S corporation and ALL shareholders (and former shareholders from that year) must agree to that election to be an S corporation. The election must be made in the first 2½ months of the tax year in order for it to be effective that tax year.

Question 102

S Corp Termination

Answer 102

A revocation by the shareholders. More than 1/2 of the total shares owned must agree. Any eligibility requirement no longer is satisfied. Passive investment income levels trigger termination. That is, if the S Corp's passive investment income for 3 consecutive tax years is more than 25% of Gross Receipts, and during those 3 years the Corp had retained earnings for a period as a C CORPORATION. NOTE: So if you've always been an S Corp, you can't lose your S Corp status from Passive Income.

Question 103

S Corp Tax Administration

Answer 103

S Corps do not have to use the accrual method, but they must adopt a calendar-year tax year. There are some situations where a fiscal year can be chosen, but don't worry about it for now) For tax purposes, the S corporation files a tax return by the 15th day of the 3rd month after the end of the Tax Year. (March 15th is a Calendar year) Each shareholder must report his/her pro rata share of the income or loss on their individual return.

Question 104

How do you calculate a Corporation's basis in property contributed by a shareholder?

Answer 104

A corporation's basis of property contributed by a shareholder is the same as the basis the shareholder had in the property, increased by any gain the shareholder recognized on the exchange. NOTE: If by the exchange the Shareholder is in control of the corporation (owns 80% of stock) following the exchange, the basis of the stock received by the shareholder would equal their basis in the property exchanged.

Question 105

Tax rule for S Corps that converted from C Corps within the 5 years since the conversion.

Answer 105

If an S Corp was a C corporation before making the S election, it is subject to the built-in gains tax on appreciated property that is not held for more than 5 years after making the S election. The top marginal tax rate for C corporations is 21%. C corporations pay tax on capital gains at ordinary rates, not the lower capital gains rates for individuals. Therefore, a C corporation can pay 21% on a large capital gain. If the tax on built-in gains did not exist, a C corp with substantially appreciated property could convert to an S Corp and avoid the higher tax rate on gains. If an S Corp holds the property 5 years following the conversion from the C Corporation, they wouldn’t owe built-in gains tax.

Question 106

Form 1099-DIV - when must they be furnished?

Answer 106

A Corporation must generally send Forms 1099-DIV to the IRS with Form 1096 by February 28 (March 31 if filing electronically) of the year following the year of the distribution. Generally, a corporation must furnish Forms 1099-DIV to shareholders by January 31 of the year following the close of the calendar year during which the corporation made the distributions. It is necessary to file a Form 1099-DIV with the IRS for each person the corporation: 1. Paid dividends (including capital gain dividends) and other distributions on stock of $10 or more, 2. Withheld and paid any foreign tax on dividends and other distributions on stock, 3. Withheld any federal income tax on dividends under the backup withholding rules, or 4. Paid $600 or more as part of a liquidation. File Form 1099-PATR, Taxable Distributions Received From Cooperatives, for each person to whom the cooperative has paid at least $10 in patronage dividends

Question 107

What is the rule on deducting Capital Losses by a Corporation?

Answer 107

A corporation can deduct capital losses only up to amount of its capital gains. In other words, if a corporation has an excess capital loss, it cannot deduct the loss in the current tax year. Instead, it carries the loss to other years and deducts it from any net capital gains that occur those years. A net capital loss is carried back to the three preceding years and then forward five years as a short term capital loss.

Question 108

When must 1099-DIVs be filed to the IRS and to Recipients? FYI - Mailed and electronic dates are different.

Answer 108

File Form 1099-DIV with the IRS for each shareholder to whom you have paid dividends and other distributions on stock of $10 or more during a calendar year. You must generally send Forms 1099-DIV to the IRS with Form 1096 by FEBRUARY 28 (MARCH 31 if filing electronically) of the year following the year of the distribution. Generally, you must furnish Forms 1099-DIV to shareholders by JANUARY 31 of the year following the close of the calendar year during which the corporation made the distributions.