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Chapter 11

The Corporate Taxpayer

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The Corporate Taxpayer

æIdentify legal characteristics of corporations

æCompute the dividends-received deduction
æPrepare a Schedule M-1 reconciliation
æCompute regular tax on corporate income
æDiscuss corporate AMT
æDescribe payment and filing requirements
æExplain why dividends are taxed twice
æDiscuss the incidence of the corporate income tax
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Corporation Legal Characteristics

æLimited liability of shareholders

æOwners of closely-held corporations often are required to personally
guarantee repayment of debt
æLicensed professionals must still carry malpractice insurance
æUnlimited life
æLegal existence not affected by changes in ownership
æFree transferability of interests
æThrough regulated markets with maximum
convenience and minimal transaction cost
æFor closely-held corporations, a buy-sell
agreement may prevent transferability
æCentralized management
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Affiliated Groups and Consolidations

æAffiliated groups = a parent corporation that directly

owns at least 80% of at least one domestic
subsidiary + all other domestic subsidiaries that are
80% owned within the group
æAffiliated groups may elect to file a consolidated tax
return - applies to all members of affiliated group
æAdvantage: losses and profits of
affiliated members offset each other
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Parent Inc. is the parent corporation of the affiliated group because of its
direct 90 percent ownership of Subsidiary 1. Subsidiaries 2 and 3 are
also included in the group because 100 percent of each corporation’s
outstanding stock is owned within the group.
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Nonprofit Corporations

æIncludes corporations formed exclusively for

“religious, charitable, scientific, literary, educational
purposes, etc.”
æSection 501(c)(3) organizations require IRS
recognition of tax-exempt status
æNevertheless, tax-exempt organizations may pay
tax on “unrelated business taxable income”
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Computing Corporate Taxable Income

æPage 1 of the Form 1120 resembles a financial

income statement or a Schedule C in a personal tax
return (Ch 10)
æSee Chapters 6, 7, 8 and 9 for general rules
on business income
æCorporations are entitled to dividends-received deduction
æDeduct charitable contributions up to 10% of taxable
income BEFORE charitable deductions and before
dividends-received deduction
æExcess contributions can be carried forward for 5 years
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Dividends-Received Deduction

æCorporations receiving dividends from other

taxable domestic corporations are entitled to this
deduction
Ownership % Deduction
æ< 20% 50% DRD
æ20% or more but < 80% 65% DRD
æ80% or more 100% DRD
æWhat was Congress’ reasoning behind the DRD?
æTo mitigate “double” taxation
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Dividends-Received Deduction Example

æAragorn Corp. owns 35% of Ent Corp. and 88% of

Legolas Corp. If Aragorn receives dividends of
$10,000 from Ent and $15,000 from Legolas,
calculate Aragorn’s DRD.
$10,000 x 65% = $ 6,500
$15,000 x 100% = $15,000
Total DRD $21,500
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Book Versus Taxable Income - Schedule M-1 & M-3

æSchedules M-1 and M-3 reconcile book income to

taxable income
æThe M-1 was used by all corporations until 2004
and can still be used by corporations with total
assets less than $10 million
æIn 2004, the IRS developed the M-3 for use by
large corporations (assets > $10 million); it requires
more detailed information than the M-1 and
enhances the transparency of book/tax differences
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Schedule M-1

æNet book income - line 1

æFederal tax expense for books - line 2
æLines 3 - 6 explain increases in taxable income
relative to books
æLines 7 - 9 explain decreases in taxable income
relative to books
æLine 10 = taxable income before
NOL and DRD = Line 28, page 1,
form 1120
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Example: Schedule M-1

æWilson Inc. reported $149,250 of net income after
tax on its financial statements
æWilson reported federal income tax expense of $61,250
æMeals expense = $15,000
æMACRS depreciation = $60,000; book depreciation =
$42,000
æPrepare Wilson Inc.’s M-1
æNet book income $149,250
æ+ Federal tax expense + 61,250
æ+ 50% of meals + 7,500
æ- MACRS over SL - 18,000
æTaxable Income $200,000
æ If the expense is lower under book income: subtract the difference
æ If the expense is higher under book income: add the difference
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Book Income Taxable Income

(Income statement) (Tax returns)
$ $
Operating profit 267,500 267,500
Depreciation (42,000) (60,000)
Meals (15,000) ( 7,500)
Net profit before tax 210,500 taxable income 200,000
Tax (61,250)
Net profit after tax 149,250
If the expense is lower under book income: subtract
If the expense is higher under book income: add
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Computing Regular Tax

æCorporations with taxable income

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Computing Regular Tax

æPersonal service corporations are taxed at a flat

35% rate
æIncludes health, law, engineering, architecture,
accounting, actuarial science, performing arts, &
consulting professionals
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Domestic Production Activities Deduction

æAvailable to US taxpayers deriving income from

domestic production activities
æFor 2015, deduction is equal to 9% of the lesser of
net production income (10k) or taxable income
before the deduction (9.5k) 855
æDeduction can’t exceed 50% of US
compensation expense 500
æDeduction is equivalent to a reduced
tax rate on domestic production income
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Tax Credits

æCredits directly reduce computed tax

æ$1 of credit provides $1 of benefit
æ$1 of deduction only provides ($1 x the tax rate) of benefit
æTax credits are generally limited to some % of tax
before credits. Often a provision
permits carry back or carry forward of
excess credits
æBiggest credits: R&D credit,
foreign tax credit (see Chapter 13)
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Tax Credits

æTo be eligible, taxpayers must engage in specific

activities that Congress believes are worthy of
government support
æThe list of credits changes as Congress
experiments with new credits and discards those
that fail to produce the intended behavioral result
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Alternative Minimum Tax

æA second federal tax system parallel to the regular

income tax
æCreated to ensure that every corporation pays a
“fair share” of taxes
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Alternative Minimum Tax - Who is Subject?

æNew corporation is exempt in Year 1

æExempt in Year 2 if Year 1 sales <=$5 million
æExempt in Year 3 if average sales in years 1 and 2
<= $7.5 million
æExempt in subsequent years if average gross
receipts for three prior years <= $7.5 million
æOnce a corporation fails to be exempt, it is
ineligible for AMT exemption for all subsequent tax
years
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Example: AMT Exemption

æYear 1 sales = $4 million

æExempt from AMT because it’s year 1
æYear 2 sales = $8 million
æExempt because Year 1 sales <=$5 million
æYear 3 sales = $12 million
æExempt because average of years 1 and 2 = $6
million, which is <= $7.5 million
æYear 4 sales = $2 million
æSubject to AMT because average of years 1, 2 & 3 =
$8 million, which is > $7.5 million
æThus, the firm is subject to AMT in all
subsequent years
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Payment and Filing Requirements

æTax return due 15th day of 3rd month, may extend

to 15th day of 9th month
æHowever, the extension does not extend the payment
deadline
æEstimated payments are due on the 15th day of
4th, 6th, 9th, and 12th months
æMust pay 100% of tax due; Small corporations
(TI < $1 million) may use safe-harbor rule of paying
100% of prior year tax
æUnderpayment penalty is computed like
interest expense but is nondeductible
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Distributions to Investors
(Creditors & Shareholders)
æInterest payments are deductible, while payments
on stock (i.e., dividends) are non-deductible
æThis creates a bias in favor of debt financing
æNon-tax costs associated with debt financing
include large cash flow commitments and a greater
risk of insolvency
æThe non-tax costs often outweigh
the tax savings associated with debt
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Alternatives to Double Taxation of Dividends

æTreat corporations as pass-through entities

æAdministratively cumbersome, if not impossible
æMake dividends nontaxable
æCurrent policy of taxing dividends to individuals at 15% is
a step in this direction
æTax credit for individuals for the corporate tax
attributable to dividends included in individual
taxpayers’ income
æAll of these alternatives would result in
significant revenue loss to the Treasury
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Incidence of the Corporate Tax

æCorporations do not pay taxes - people do

æWhat are examples of ways that the incidence of
the corporate tax could be born by individual
taxpayers in the U.S.?
æHigher consumer prices
æLower employee wages
æLower dividends
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