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Advanced Income Taxation Accounting

by: Morris Beer II

Advanced Income Taxation Accounting ACCT 5327

Marketplace > Texas Tech University > Accounting > ACCT 5327 > Advanced Income Taxation Accounting
Morris Beer II
GPA 3.94

Teresa Ann Lightner

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Teresa Ann Lightner
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This 81 page Class Notes was uploaded by Morris Beer II on Thursday October 22, 2015. The Class Notes belongs to ACCT 5327 at Texas Tech University taught by Teresa Ann Lightner in Fall. Since its upload, it has received 17 views. For similar materials see /class/226435/acct-5327-texas-tech-university in Accounting at Texas Tech University.

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Date Created: 10/22/15
Course Notes to Accompany ACCT 5327 Corporations Partnerships Estates amp Trusts Hoffman Raabe Smith amp Maloney Fall 2007 Chapter 2 Corporations Introduction Operating Rules and Related Corporations Various Business Forms 0 Sole Prorietorships 1 Not a separate taxable entity 2 Income reported on owner s Schedule C o Partnerships 1 Separate entity but does not pay tax 2 Allocates partnership income to partners Partners report partnership income on personal tax returns 3 Files information return 0 S Corporation 1 Separate entity only pays special taxes 2 Allocates entity income to shareholders Shareholders report entity income on personal taX return 4 Files information return 0 C Corporation 1 Separate taxpaying entity 2 Income taxed at corporate level and again at owner level when distributed as a dividend Dividends 39Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends 7 Generally dividends received in taxable years beginning after 2002 are taxed at same marginal rate applicable to a net capital gain olhus individuals otherwise subject to the 10 or 15 marginal tax rate pay 5 tax on quali ed dividends received Individuals subject to the 25 28 33 or 35 percent marginal tax rate pay a 15 tax on quali ed dividends Stock on which the dividend is paid must have been held for more than 60 days during the l20day period beginning 60 days before the exdividend date Nontax Issues in Selecting Entity Form 0 Liability Sole proprietors and some partners have unlimited liability for claims against the entity 0 Capitalraising Corporations and partnerships to a lesser extent can raise large amounts of capital for entity ventures o Transferability Corporate stock is easily sold but partners must approve partnership interest transfer 0 Continuity of Life Corporations exist indefinitely o Centralized Management Corporate actions are governed by a board of directors Partnership operations may be conducted by each partner without approval by other partners Limited Liability Companies LLC LLC s have proliferated since 1988 when IRS ruled it would treat LLC s as partnerships Major nontaX advantage Allows entity to avoid unlimited liability Major taX advantage Allows qualifying business to be treated as a partnership for taX purposes thereby avoiding double taxation associated with C corporations Entity Classification Prior to 1997 Sometimes difficult to determine if entity will be taxed as a corporation If entity has a majority of corporate characteristics it is taxed as a corporation Most entities have the following characteristics Associates Objective to carry on business and share pro ts If entity has a majority of the following relevant corporate characteristics it is treated as a corporation Continuity of life Centralized management Limited liability to owners Free transferability of ownership interests Entity Classification After 1996 o Checkthebox Regulations 1 Allows the taxpayer to choose tax status of entity without regard to corporate or noncorporate characteristics Entities with gt 1 owner can elect to be classi ed as partnership or corporation Entities with only 1 owner can elect to be classi ed as sole proprietorship or as a corporation If no election is made multiowned entities treated as partnerships single person businesses treated as sole proprietorships N Election is not available to E Entities incorporated under state law or Entities required to be incorporated under federal law Comparison of Corporate and Individual Tax Treatment 0 Similarities Gross income of a corporation and individual are very similar Includes compensation for services income from trade or business gains from property interest dividends etc 2 Corp tp s are allowed fewer exclusions 3 Nontaxable exchange treatment is similar 4 Depreciation recapture applies to both but corp may have additional recapture under Sec 291 o Dissimilarities Different tax rates apply All deductions of corp are business deductions l Corp does not calculate AGI 2 Corp does not calculate standard deduction itemized deductions or personal and dependency exemptions 3 Corp does not reduce casualty and theft loss by 100 statutory oor or 10 of AGI Accounting Periods and Methods Accounting periods Most C corps can use calendar year or scal year ending on last day ofa calendar month S corps and Personal Service Corporations PSC are limited in available year ends Accounting Methods Cash method can t be used by C corp unless o In farming or timber business 0 Quali ed PSC 0 Avg annual gross receipts lt 5000000 Capital Gains and Losses Individuals Net capital gains subject to the following preferential treatment 0 Net shortterm gains subject to regular taX rates 0 Net longterm gains maX taX rate 15 Net capital losses deductible up to 3000 with remainder carried to future years Corporations No special taX rates apply to capital gains 0 Entire gain is included in income subject to normal corporate taX rates Corp cannot take a deduction for net capital losses 0 Capital losses can be used only to offset capital gains 0 Unused capital losses are carried back 3 years and carried forward for 5 years Carried over losses are treated as shortterm Passive Losses Passive loss rules apply to 1 Individuals and PSC s Cannot offset passive losses against active or portfolio income 2 S corps and partnerships Passive income and loss ows through to owners and rules applied at owner level P Closely held C corps May offset passive losses against active income but not portfolio income Charitable Contributions Both corporate and noncorporate taxpayers may deduct charitable contributions in year paid Exception for accrual basis corporations allows deduction in year preceding payment if 1 Approved by board and 2 Paid within 212 months of yearend 0 Amount deductible for property contributions depends on type of property contributed 0 Longterm capital gain property deduction fair market value of property exception Corp may only deduct basis if tangible personal property contributed and not used by charity in its exempt function 0 Ordinary income property deduction basis in property exception Basis plus 50 of appreciation can be deducted if inventory or scienti c property is contributed which is used by charity as required by Code 0 Corporate charitable contribution deduction is limited to 10 of taxable income before Charitable contribution deduction NOL or capital loss carryback and Dividends received deduction 0 Contributions in excess of 10 limit can be carried forward for 5 years Net Operating Loss 0 Net operating loss of corporations and individual may be Carried back 2 years Unused portion carried forward 20 years Dividends Received Deduction o If corporation owns stock in another corporation and receives dividends a portion of dividends may be deducted from income Owned Deduction Percent Less than 20 70 20 but less than 80 80 80 or more and affiliated 100 1 Multiply dividends received by deduction percentage N Multiply taxable income by deduction percentage E Subtract 1 from taxable income If entity has income before DRD but DRD creates NOL amount in l is DRD If DRD does not create NOL deduction is limited to lesser of l or 2 Organizational Expenditures and Startup Costs A corporation may elect to amortize organizational expenses over a period of 15 years or more A special exception allows the corporation to immediately expense the first 5000 of these costs Phased out on a dollarfordollar basis when these expenses exceed 50000 Organizational Expenditures Organizational expenditures include the following iLegal services incident to organization iNecessary accounting services iExpenses of temporary directors and of organizational meetings of directors and shareholders iFees paid to the state of incorporation 39Expenditures connected with issuing or selling shares of stock or other securities or with the transfer of assets to a corporation do not qualify 7 Such expenditures reduce the amount of capital raised and are not deductible at all Startup Expenditures Startup expenditures include Various investigation expenses involved in entering a new business eg Travel market surveys nancial audits legal fees Also includes operating expenses such as rent and payroll that are incurred by a corporation before it actually begins to produce any gross income At the election of the taxpayer such expenditures can be treated in the same manner as organizational expenditures Up to 5000 can be immediately expensed subject to the dollar cap and excessof 50000 phaseout Any remaining amounts are amortized over a period of 180 months or longer Start new or unrelated business deduct first 5000 capitalize and amortize remainder over 180 months Phaseout begins at 50000 over 5000 range Do not start new or unrelated business personal expenditures no deduction Investigate expanding an existing business Whether or not business opens a current deduction is allowed since business purpose exists Corporate Tax Formula Gross income Less Deductions except charitable Div Rec d NOL carryback STCL carryback Taxable income for charitable limitation Less Charitable contributions lt 10 of above Taxable income for DRD Less DRD Taxable income for carrybacks Less NOL carryback and STCL carryback TAXABLE INCOME Tax Liability of Related Corporations Related corps are subject to special rules for computing income taX Limits controlled group s taxable income in tax brackets below 35 to amount corporations ingroup would have if they were one corporation Controlled groups include Parentsubsidiary groups Brothersister groups Combined groups ParentSubsidiary Controlled Group Consists of one or more chains of corps connected through stock ownership with a common parent Ownership is established through either 0 Voting power test requires ownership of stock with at least 80 of total voting power of all classes of stock entitled to vote 0 Value test requires ownership of at least 80 of total value of all classes of stock BrotherSister Controlled Group Exists if 5 or fewer persons meet two 50 tests 50 total ownership test group owns 50 of vote or value of all classes of each corp s stock 50 identical common ownership test smallest amount owned by each shareholder in one of the entities is determined Amounts are summed for all sh s and must be gt 50 BrotherSister Group Example A i L gt50 test Bob 60 20 20 20 Alice 20 60 20 20 Ted 20 20 60 20 gt50 test 100 100 100 1 The group combined owns 100 of each entity s stock so meets 50 test 2 The lowest amount owned by Bob in any entity is 20 same for Alice and Ted Sum the 20 amounts for 60 This is gt 50 so 2nd test met Combined Groups 0 Exist if all of the following conditions are met Each corp is a member of either a parentsubsidiary or brothersister controlled group At least one of the corps is parent of a parentsubsidiary controlled group Parent corp is also a member of a brothersister controlled group Application of Sec 482 Sec 482 permits IRS to reallocate income deductions and credits between two or more businesses owned or controlled by the same interests Used to prevent avoidance of taxes or to re ect income properly Controlled groups of corps are especially vulnerable to Sec 482 Consolidated Returns Members of a parentsubsidiary affiliated group may be able to file a consolidated income tax return Corporate Filing Requirements Must file Form 1120 on or before the 15th day of the 3rd month following close of tax year Automatic 6month extensions are available by ling Form 7004 Must make estimated tax payments equal to lesser of 100 of corporation s nal tax or 100 of tax for preceding year No estimated tax payments required if tax liability expected to be less than 500 Schedule M1 Corporations must reconcile financial accounting income with taxable income on Sch M l Form 1120 Common reconciling items include 0 Federal tax liability 0 Net capital losses 0 Income reported for tax but not book income e g prepaid revenue and Vice versa 0 Expenses deucted for book income but not tax e g excess charitable contributions and Vice versa Schedule M2 0 Corporations must reconcile retained earnings at beginning of year with retained earnings at end of year using Sch M2 form 1120 Schedule M3 Corporate taxpayers with total assets of 10 million or more are now required to report much greater detail regarding differences in financial accounting income loss and taxable income loss iReported on new Schedule M 3 iMust be filed for years ending after December 31 2004 Schedule M 3 should iCreate greater transparency between corporate financial statements and taX returns iHelp the IRS identify corporations that engage in aggressive taX practices CHAPTER 3 Special Situations Manufacturers Deduction The American Jobs Creation Act of 2004 created a new deduction based on the income from manufacturing activities The manufacturers deduction is based on the following formula 3 X Lesser of Qualified production income Taxable or adjusted gross income The deduction cannot exceed 50 of an employer s W 2 wages Qualified production income is the total of qualified production receipts reduced by Cost of goods sold that are attributable to such receipts Other deductions expenses or losses that are directly allocable to such receipts A share of other deductions expenses and losses that are not directly allocable to such receipts or another class of income The term also includes receipts for certain services rendered in connection with construction projects in the United States Domestic Production Gross Receipts include gross receipts derived from any lease rental sale exchange or other disposition of a tangible personal property computer software and sound recordings which was manufactured produced grown or extracted quotNIPGEquot by the taxpayer in whole or in significant part within the US b any qualified fihn produced by the taxpayer and c electricity natural gas or potable water produced by the taxpayer in the U S but not the transmission or distribution Qualified production receipts do not include proceeds from the sale of food and beverages prepared at a retail establishment A phasein provision increases the applicable rate for the manufacturer s deduction as follows Rate Years 3 20052006 6 20072009 9 2010 and thereafter Eligible taxpayers include Individuals partnerships S corporations C corporations cooperatives estates and trusts For a passthrough entity e g partnerships S corporations the deduction flows through to the individual owners For sole proprietors a deduction for AGI results For C corporations the deduction is included with other expenses in computing corporate taxable income Chapter 4 CORPORATIONS ORGANIZATION AND CAPITAL STRUCTURE O Corporation Formation Transaction Cash nrOtherProperty Corporate charter Corporate Stock Cor oration Sharehomers Control required p shareholders must own 80 anerthe transfer o Formation Example Ron will incorporate his donut shop Asset Fair Mkt Tax Basis Value Cash 10000 10000 Furniture amp Fixtures 20000 60000 Building 40 000 100 000 Total 70000 170000 Without 351 gain of 100000 With 351 no gain or loss Ron s economic status has not changed o Consequences of 351 0 In general no gain or loss to transferors 39 On transfer of property to corporation 39 In exchange for stock 39 IF immediately after transfer transferors are in control of corporation If boot property other than stock received by transferors Gain recognized up to lesser of 39 Boot received or 39 Realized gain 39 No loss is recognized o Issues re Formation 0 Definition of property includes 39 Cash 39 Secret processes and formulas 39 Unrealized accounts receivable for cash basis taxpayer 39 Installment obligations Code specifically excludes services from definition of property Stock transferred 39 Includes common and most preferred stock 39 Does not include nonquali ed preferred stock which possesses many attributes of debt 39 Does not include stock rights or stock warrants 39 Does not include corporate debt or securities e g corporate bonds 39 Treated as boot 0 Transferors must be in control immediately after exchange to qualify for nontaxable treatment 39 To have control transferors must own 39 80 of total combined voting power of all classes of stock entitled to vote plus 39 80 of total number of shares of all other classes of stock 0 Immediately after the exchange 39 Does not require simultaneous transfers if more than one transferor 39 Rights of parties must be outlined before rst transfer 39 Transfers should occur as close together as possible 0 After control is achieved it is not necessarily lost upon the sale or gift of stock received in the transfer to others not party to the initial exchange 0 But sale might violate 351 if prearranged Transfers for property and services 39 May result in service provider being treated as a member of the 80 control group 39 Taxed on value of stock issued for services 39 Not taxed on value of stock received for property contributions 39 Service provider should transfer property having more than a relatively small value Subsequent transfers to corporation 39 Taxfree treatment still applies as long as transferors in subsequent transfer own 80 following exchange o Assumption of Liabilities Assumption of liabilities by corp DOES NOT result in boot to the transferor shareholder for gain recognition purposes 39 Liabilities ARE treated as boot for determining basis in acquired stock 39 Basis of stock received is reduced by amount of liabilities assumed by the corp Liabilities are NOT treated as boot for gain recognition unless 39 Liabilities incurred for no business purpose or as tax avoidance mechanism 39 Boot Entire amount of liability 39 Liabilities gt basis in assets transferred Gain recognized Excess amount liabilities basis o Formation with Liabilities Example Property transferred has Fair market value 150000 Basis 100000 Realized Gain 50000 20 Liabilities assumed by corp independent facts Business Business No Business Purpose Purpose Purpose Liability 80000 120000 120000 Boot None 20000 120000 Gain Recognized None 20000 50000 Gain is lesser of 50000 realized gain or boot o Basis Computation for 351 Exchange 0 Shareholder s basis in stock Adjusted basis of transferred assets Gain recognized on exchange Boot received Liabilities transferred to corporation Basis of stock received by shareholder o Basis Computation for 351 Exchange Corporation s basis in assets Adjusted basis of transferred assets Gain recognized by transferor shareholder Basis of assets to corporation o Basis in Stock in Last Example Adjusted Basis of transferred assets Liabilities assumed by corp independent facts Business Business No Business Purpose Purpose Purpose Liability 80000 120000 120000 Basis in assets Transferred 100000 100000 100000 Gain recognized None 20000 50000 21 100000 Liab Transferred 80 0001 1120 0001 1120 0001 Basis in stock 20000 0 30000 o Corporation s Basis Example in Assets Received in Last Liabilities assumed by corp Independent facts Business Business No Business Purpose Purpose Purpose Liability 80000 120000 120000 Basis of trans ferred assets 100000 100000 100000 Gain recognized by shareholder None 20 000 50 000 Basis to Corp 100000 120000 150000 o Holding Period 0 Holding period of stock received 39 For capital assets or 1231 property includes holding period of property transferred to corporation 39 For other property begins on day after exchange Corp s holding period for property acquired in the transfer is holding p eriod of transferor o Capital Contributions No gain or loss is recognized by corp on receipt of money or property in exchange for its stock 39 Also applies to additional voluntary pro rata contributions of money or property to a corp even though no additional shares are issued Capital contributions of property by nonshareholders 22 39 Not taxable to corporation 39 Basis of property received from nonshareholder is 0 Capital contributions of cash by nonshareholder 39 Must reduce basis of assets acquired during 12 month period following contribution 39 Any remaining amount reduces basis of other property owned by the corp 39 Applied in the following order to depreciable property amortizable property assets subject to depletion and other remaining assets o Debt Vs Equity 0 Debt 39 Corporation pays interest to debt holder which is deductible by corporation 39 Interest paid is taxable as ordinary income to individual or corporate recipient 39 Loan repayments are not taxable to investors unless repayments exceed basis 0 Equity 39 Corporation pays dividends which are not deductible 39 Taxable as ordinary income to recipient to extent corp has E amp P 39 Corporate shareholder may receive dividends received deduction o Reclassification of Debt As Equity 23 If corp is thinly capitalized ie has too much debt and too little equity 39 IRS may argue that debt is really equity and deny tax advantages of debt nancing 39 If debt has too many features of stock principal and interest payments may be treated as dividends Debt instrument documentation Debt terms eg reasonable rate of interest and definite maturity date Timeliness of repayment of debt Whether payments are contingent on earnings Subordination of debt to other liabilities Whether debt and stock holdings are proportionate Use of funds if used to nance initial operations or to acquire capital assets looks like equity Debt to equity ratio o Losses on Investment in Corporation Stock and security losses 39 If stocks and bonds are capital assets losses from worthlessness are capital losses 24 Loss is treated as occurring on last day of tax year in which they become worthless No loss for mere decline in value Stock and security losses 39 If stocks and bonds are not capital assets losses from worthlessness are ordinary losses eg broker owned 39 Sometimes an ordinary loss is allowed for worthlessness of stock of af liated company Business versus nonbusiness bad debts 39 General rule Losses on debt of corporation treated as business or nonbusiness bad debt 39 If noncorporate person lends as investment loss is nonbusiness bad debt 39 ShOIt term capital loss 39 Only deductible when fully worthless Business versus nonbusiness bad debts con t 39 If corporation is lender loss is business bad debt 39 Ordinary loss deduction 39 Deduction allowed for partial wonhlessness 39 All bad debts of corporate lender qualify as business bad debts 25 Business versus nonbusiness bad debts con t 39 Noncorporate lender may qualify for business bad debt treatment if 39 Loan is made in some capacity that quali es as a trade or business or 39 Shareholder is in the business of lending money or of buying promoting and selling corporations o 1244 stock 0 Treatment of 1244 stock 39 Ordinary loss treatment for loss on stock of small business corporation as de ned 39 Gain still capital gain 0 1244 stock 39 Total amount of stock at initial issuance cannot exceed 1000000 based on basis of property contributed less liabilities assumed by company 0 Annual loss limitation 39 50000 or 39 100000 if married ling joint return 39 Any remaining loss is a capital loss 26 Only original holder of 1244 stock quali es for ordinary loss treatment 39 Sale or contribution of stock results in loss of 1244 status 0 If 1244 stock is issued for property With basis gt fair market value For determining ordinary loss stock basis is reduced to fair market value on date of exchange o Gain From Qualified Small Business Stock Noncorporate shareholders may exclude 50 of gain from sale or exchange of such stock 39 Must have held stock for gt 5 years and acquired stock as part of original issue 39 50 exclusion can be applied to the greater of 39 10 million or 0 10 times shareholder s aggregate adjusted basis of qualified stock disposed of during year o Gain From Qualified Small Business Stock Qualified Small Business Corp 39 C corp with gross assets not greater than 50 million on date stock issued 39 Actively involved in a trade or business 27 39 At least 80 of corporate assets are used in the active conduct of one or more trade or businesses 28 Chapter 5 Corporations Earnings amp Profits and Dividend Distributions Taxable Dividends Distributions from corporate earnings and pro ts E amp P to shareholders are treated as a dividend distribution taxed at capital gains rates or at times ordinary income Distributions in excess of E amp P are nontaxable to extent of shareholder s basis ie a return of capital Excess over basis is capital gain Earnings amp Profits No de nition of E amp P in Code Similar to Retained Earnings nancial reporting but often not the same E amp P represents iUpper limit on amount of dividend income recognized on corporate distributions 7Corporation s economic ability to pay dividend without impairing capital 29 Calculating Earnings amp Profits Ca1cu1ation generally begins with taxable income plus or minus certain adjustments iAdd previously excluded items back to taxable income including Muni bond interest Excluded life insurance proceeds Federal income tax refunds Dividends received deduction Ca1cu1ation generally begins with taxable income plus or minus certain adjustments isubtract certain nondeductible items Relatedparty and excess capital losses Expenses incurred to produce taxexempt income Federal income taxes paid Key employee life insurance premiums Fines and penalties Certain E amp P adjustments shift effect of transaction to year of economic effect such as iCharitable contribution carryovers 7NOL carryovers iCapital loss carryovers Other adjustments iAccounting methods for E amp P are generally more conservative than for taxable income for example 30 Installment method is not permitted Altemative depreciation system required Percentage of completion must be used no completed contract method Summary of E amp P Adjustments Effect on taxable income for E amp P Transaction Add Subtract Taxexempt income Life insurance proceeds Deferred installment gain Excess charitable contribution Ded of prior excess contribution Federal income taxes Of cer s life insurance premium Accelerated depreciation Current vs Accumulated E amp P Current E amp P iTaxable income as adjusted Accumulated E amp P iTotal of all prior years current E amp P as of rst day of tax year reduced by distributions from E amp P Distinction between current and accumulated E amp P is important iTaxability of corporate distributions depends on how current and accumulated E amp P are allocated to each distribution made during year Allocating E amp P to Distributions If positive balance in both current and accumulated E amp P iDistributions are deemed made rst from current E amp P then accumulated E amp P 31 71f distributions exceed current E amp P must allocate current and accumulated E amp P to each distribution Allocate current E amp P pro rata to each distribution Apply accumulated E amp P in chronological order If current E amp P is positive and accumulated E amp P has a de cit iAccumulated E amp P IS NOT netted against current E amp P Distribution is deemed to be taxable dividend to extent of positive current E amp P balance If accumulated E amp P is positive and current E amp P is a de cit net both at date of distribution 71f balance is zero or a de cit distribution is a return of capital 71f balance is positive distribution is a dividend to the extent of the balance Cash Distribution Example A 20000 cash distribution is made in each independent situation 1 2 3 Accumulated E amp P beginning of year 100000 100000 15000 Current E amp P 50000 50000 10000 Dividend 20000 20000 5000 Since there is a current de cit current and accumulated E amp P are netted before determining treatment of distribution 32 Property Dividends Effect on shareholder iAmount distributed equals FMV of property Taxable as dividend to extent of E amp P Excess is treated as return of capital to extent of basis in stock Any remaining amount is capital gain iReduce amount distributed by liabilities assumed by shareholder iBasis of distributed property fair market value Effect on corporation 7Corp is treated as if it sold the property for fair market value Corp recognizes gain but not loss 71f distributed property is subject to a liability in excess of basis Fair market value is treated as not being less than the amount of the liability Effect on corporation s E amp P ilncreases E amp P for excess of FMV over basis of property distributed iReduces E amp P by FMV of property distributed or basis if greater less liabilities on the property iDistributions of cash or property cannot generate or add to a de cit in E amp P De cits in E amp P can arise only through corporate losses 33 Property Distribution Example Property is distributed corporation s basis 20000 in each of the following independent situations Assume Current and Accumulated E amp P are both 100000 in each case 1 2 3 Fair market value of distributed property 60000 10000 40000 Liability on property 0 0 15000 Gainloss recognized 40000 0 20000 EampP increased by gain 40000 0 20000 E amp P decrease on dist 60000 20000 25000 Constructive Dividend Any economic bene t conveyed to a shareholder may be treated as dividend for taX purposes even though not formally declared iNeed not be pro rata Usually arises with closely held corporations Payment may be in lieu of actual dividend and is presumed to take form for taX avoidance purposes Payment is recharacterized as a dividend for all taX purposes Examples of Constructive Dividends Shareholder use of corporate property eg company car to nonemployee shareholder Bargain sale of property to shareholder eg sale for 1000 of property worth 10000 Bargain rental of corporate property 34 Payments on behalf of shareholder eg corporation makes estimated tax payments for shareholders Unreasonable compensation Below market interest rate loans to shareholders High rate interest on loans from shareholder to corporation Avoiding Unreasonable Compensation Documentation of the following attributes will help support payments made to an employeeshareholder iEmployee s quali cations 7Comparison of salaries with dividends made in past 7Comparable salaries for similar positions in same industry iNature and scope of employee s work isize and complexity of business 7Corporation s salary policy for other employees Stock Dividends Excluded from income if pro rata distribution of stock or stock rights paid on common stock iFive exceptions to nontaxable treatment deal with various disproportionate distribution situations Effect on E amp P 71f nontaxable E amp P is not reduced 71f taxable treat as any other taxable property distribution Basis of stock received 71f nontaxable If shares received are identical to shares previously owned basis cost of old sharestotal number of shares If shares received are not identical allocate basis of old stock between old and new shares based on relative fair market value 35 Holding period includes holding period of formerly held stock 71f taxable basis of new shares received is fair market value Stock Rights Tax treatment of stock rights is same as for stock dividends 71f stock rights are taxable Income recognized fair market value of stock rights received Basis fair market value of stock rights If exercised holding period begins on date rights are exercised iBasis of new stock basis of rights plus any other consideration given If stock rights are nontaxable 71f value of rights received lt 15 of value of old stock basis in rights 0 Election is available which allows allocation of some of basis of formerly held stock to rights 71f value of rights is 15 or more of value of old stock and rights are exercised or sold must allocate some of basis in formerly held stock to rights Corporate Distribution Planning Maintain ongoing records ofE amp P iEnsures return of capital is not taxed as dividend 7N0 statute of limitations on E amp P so IRS can redetermine at any time Accurate records minimize this possibility Adjust timing of distribution to optimize tax treatment 71f accumulated E amp P deficit and current E amp P loss make distribution by end of tax year to achieve return of capital 71f current E amp P is likely make distribution at beginning of next year to defer taxation 36 Avoiding Constructive Dividends Structure transactions on arms length basis iReasonable rent compensation interest rates etc Use mix of techniques to bail out corporate earnings such as ishareholder loans to corporation isalaries to shareholderemployee iRent property to corporation iPay some dividends Overdoing any one technique may attract attention of IRS 37 CHAPTER 6 Corporations Redemptions And Liquidations o Redemptions Transaction its stock from shareholder corporation purchases 39 If quali ed as a redemption from shareholder perspective same result as a sale to a third party 39 Shareholder has cash or other property instead of stock 39 Shareholder has less control over ownership of corporation From other shareholders perspective redemption does not resemble sale to third party 39 Less stock is outstanding so other shareholders ownership percentage is increased From corporate View does not resemble sale to third party 39 Corporation has less assets because some of these assets have been transferred to the shareholder redeeming stock 38 o Effect of Redemption If quali ed as a redemption treated as sale or exchange 39 Shareholder reports gain or loss on surrender of stock 39 Gain taxed at favorable capital gains rates 39 Only amount in excess of adjusted basis is taxed as a capital gain If transaction has appearance of a dividend redemption will not be qualified 39 For example if shareholder owns 100 and corporation buys 12 of stock for X shareholder still owns 100 0 If not qualified as a redemption 39 Shareholder reports dividend income 39 Taxed at favorable capital gains rates 39 However redemption proceeds may not be offset by basis in stock surrendered 39 Corporate shareholders may prefer dividend treatment because of the dividends received deduction o Transactions Treated as Redemptions The following types of distributions may be treated as a redemption of stock rather than a dividend Distributions not essentially equivalent to a dividend subjective test Disproportionate distributions mechanical rules 39 Distributions in termination of shareholder s interest mechanical rules Partial liquidations of a corporation where shareholder is not a corporation and either 39 Distribution is not essentially equivalent to a dividend or 39 An active business is terminated 0 May be subjective l or mechanical 2 Distributions to pay death taxes limitation on amount of allowed distribution is mechanical test 7 Stock attribution rules must be applied so distribution which appears to meet requirements may not qualify o Stock Attribution 7 Qualified stock redemption must result in substantial reduction in shareholder s ownership Stock ownership by certain related parties is attributed back to shareholder whose stock is redeemed 7 Attribution from family members Stock owned by spouse children grandchildren or parents attributed back to individual 40 7 Attribution from entity to owner Partner deemed owner of proportionate number of shares owned by partnership Beneficiary or heir deemed owner of proportionate shares owned by entity 50 or more shareholder deemed owner of proportionate shares owned by corporation 7 Attribution from owner to entity Partnership deemed owner of total shares owned by partner Estate or trust deemed owner of total shares owned by heir or beneficiary Corporation deemed owner of total shares owned by 50 or more shareholder 7 Family attribution rules do not apply to redemptions in complete termination of shareholder s interest 7 Stock attribution rules do not apply to redemptions to pay death taxes o Not Essentially Equivalent Redemptions 7 Redemption quali es for sale or exchange treatment if not essentially equivalent to a dividend 41 39 Subjective test 39 Provision was added to deal speci cally with redemptions of preferred stock 0 Shareholders often have no control over when preferred shares redeemed 0 Also applies to common stock redemptions 7 To qualify redemption must result in a meaningful reduction in shareholder s interest in redeeming corp 39 Stock attribution rules apply 7 If redemption is treated as ordinary dividend Basis in stock redeemed attaches to remaining stock owned directly or constructively o Qualifying Disproportionate Redemption 7 Redemption qualifies as disproportionate redemption if Shareholder owns less than 80 of the interest owned prior to redemption Shareholder owns less than 50 of the total combined voting power in the corporation 42 Setting Shareholder Has 60 ownership represented by 60 of 100 60 T quoter5h p outstanding voting shares Corporation o Qualifying Disproportionate Redemption Redemption Shareholder Corporation pays cash and for Shareholder transfers 25 voting shares to propeer to shareholder orali 26 voting shares Corporation I Shareholder has 46 23 ownership represented by 35 voting shares 6025 of 75 10025 outstanding voting shares 7 Redemption is qualified disproportionate redemption because o Complete Termination Redemptions 7 Termination of entire interest generally quali es for sale or exchange treatment 43 Often Will not qualify as disproportionate redemption due to stock attribution rules Family attribution rules will not apply if 0 Former shareholder has no interest other than as creditor for at least 10 years 0 Agree to notify IRS of any disallowed interest within 10 year period o Redemptions In Partial Liquidation 7 Noncorporate shareholder gets sale or exchange treatment for partial liquidation including Distribution not essentially equivalent to a dividend Distribution pursuant to termination of an active business o Redemptions In Partial Liquidation 7 To qualify distribution must be made Within taxable year plan is adopted or the succeeding taxable year 7 Not essentially equivalent test looks at effect on corporation Requires genuine contraction of the business of the corporation 0 Difficult to apply due to lack of objective tests 0 Advanced ruling from IRS should be obtained 44 7 To meet the complete termination of a business test the corporation must Have gt one trade or business two or more of which have been in existence for at least five years Terminate one trade or business and continue a remaining trade or business o Redemptions To Pay Death Taxes 7 Allows sale or exchange treatment if value of stock exceeds 35 of value of adjusted gross estate Stock of 2 or more corps may be treated as stock of single corp for 35 test if 20 or more of each corp was owned by decedent Special treatment limited to sum of 0 Death Taxes 0 Funeral and administration expenses 7 Basis of stock is stepped up to fair market value on date of death or alternate valuation date When redemption price equals steppedup basis no tax consequences to estate 45 o Effect of Redemption on Corporation 7 Gain or loss recognition If property other than cash used for redemption Corporation recognizes gain on distribution of appreciated Property 0 Loss is not recognized Corporation should sell property recognize loss and use proceeds from sale for redemption Effect on Earnings and Profits E amp P is reduced in a qualified stock redemption by ratable share of E amp P attributable to stock redeemed o Stock RedemptionsNo Sale Or Exchange Treatment Redemptions not qualifying under previous provisions Treated as dividend distribution to extent of E amp P Attempts by taxpayers to circumvent redemption provisions led to rules covering 0 Preferred stock bailouts 0 Sales of stock to related corporations o Effect of Preferred Stock Bailout 0 Preferred stock bailout involves 46 Corporate distribution of nontaxable nonvoting preferred stock dividend on common stock Portion of basis in common stock is allocated to preferred stock Shareholder then sells the preferred stock to third party 0 Effect is bailout of corporate profits as a capital gain 0 To minimize abuse potential Code requires this treatment Shareholder has ordinary income 306 taint on sale of preferred stock to third party Amount of ordinary income is FMV of preferred stock on date received as distribution from corporation limited by E amp P of company but does not reduce entity E amp P No loss recognized on sale of tainted preferred stock If stock is redeemed by corporation proceeds treated as a dividend 7 306 stock is stock Which is not common stock Received as a nontaxable stock dividend Received taxfree in a corporate reorganization plus other requirements or Has a basis determined by reference to other 306 stock 47 o LiquidationsIn General 7 Corporation Winds up affairs pays debts and distributes remaining assets to shareholders Produces sale or exchange treatment to shareholder Liquidating corporation recognizes gains and losses upon distribution of its assets With certain exceptions o LiquidationsEffect On Corporation Gain or loss is recognized by corporation on distribution in complete liquidation Loss may be disallowed or limited if Property distributed to related parties or 0 Property distributed has builtin losses Property treated as if sold for FMV Result 0 Liquidating distribution subject to corporate level taX gain and shareholder level taX receipt of proceeds Limitations on lossesRelated Party Situations Losses are disallowed on liquidating distributions to related parties if 48 39 Distnbuuon rs notpro rota o mesamanurmunommHsHAnErmtnmm va nimsHAnEormrr 55H 39 Property distnbutedrs disquali ed property o mommmmrvrsm mrrAEQummwcmmAsmrmacrmu nunmnmnvemmuonnmmnoumrrormsmrmmu o quuidations Effect On Corporation 7 Limitations on lossesBuil in Loss Situations Losses are disallowed when property distributed was acquired in a 351 transaction and principal purpose was to cause recognition of loss by corp on liquidation Purpose is presumed if transfer occurs Within two years of adopting liquidation plan 0 Distribution of Loss Property in liquidation Liquidatmg r 333mgquot Was the momquot nunrpm retain a related pany 7 5 property 2 msmnmeu property msquatmed penyacqwed bythe liquidating as Wasth pmpenypm corporation or a ass transtevuv a contribution in camel ma WWW period mm on the data m m msrmmrum Loss is msaumxedi No in Lass rs down Was the msommrumu 3 mm paw ion V25 Emltrm loss loss that Wasthe 1mm al in usemtvanstemn m m an in me qulllrdatriig E Lm ym me vecugngrtmn 5 3 3y named mmnu We theliquidatingcuvpmatrunsuchpuvpuseis 12 2d 398quotszth mm m the quotmy occurred Wm m years mm m We WWWquot rs enumanuvmepranuvmumanum msaumu m o LiquidationsEffect On Shareholder 7 Gain or loss recognized on receipt of property from liquidating corporation Amount FMV of property received basis in stock 0 Generally capital gain or loss Basis in assets received in liquidating distribution FMV on date of distribution o LiquidationsEffect On Shareholder Special rule for installment obligations Shareholder may defer gain recognition to point of collection Corporation must recognize all gain on distribution Cha ter 12 S Corporations Subchapter S Issues 7 S Corporation status is elective Failure to make the election in the manner prescribed results in the entity being taxed as a C Corporation However the IRS has authority to waive the effect of an invalid election caused by inadvertent failure to qualify or to obtain required shareholder consents IRS can also treat a late election as timely where there was reasonable cause S Corporations are still corporations for legal purposes Owners receive the bene ts of limited liability ability to raise capital within limits etc Taxation resembles partnership taxation Certain items primarily business income and certain expenses are accumulated and passed through to shareholders Other items are separately stated and each item is passed through to shareholders 7 An S corporation is a reporting rather than taxpaying entity Tax liability may still arise at the entity level for Built in gains tax or Passive investment income penalty tax An S Corporation is not subject to the following taxes Corporate income tax Accumulated earnings tax Personal holding company tax Corporate alternative minimum tax 7 Entity is subject to Subchapter C rules for a transaction unless Subchapter S provides alternate rules When To Elect S Corp Status Following factors should be considered If shareholders have high marginal tax rates vs Corp rates If NOLs are anticipated If currently C corp any NOL carryovers from prior years can t be used during S corp years Still reduces 20 year carryover period Character of anticipated ow through items S Cor uali cation Re uirements To elect under Subchapter S a corporation must meet the following requirements Must be a domestic corporation Must not otherwise be ineligible Ineligible corporations include certain banks insurance companies and foreign corporations S corps can own up to 100 of a C corp After 1996 S corps can also have wholly owned S corporation subsidiaries Corporation may have only one class of stock Can have stock with differences in voting rights but not in distribution or liquidation rights It is possible for debt to be reclassi ed as stock Results in unexpected loss of S corp status Safe harbor provisions mitigate concern over reclassification of debt Must have 100 or less shareholders oAfter 2004 family members may elect to be treated as one shareholder Shareholders can only include individuals estates certain trusts and certain taxexempt organizations oPartnerships Corps LLCs LLPs and IRAs cannot own S corp stock but S corps can be partners in a partnership or shareholders in a corporation Shareholders cannot include any nonresident aliens Making The Election To become an S corp must make a valid election that is Filed timely All shareholders must consent to the election 7 To be effective for current year Make election by 15th day of third month of current tax year or File in previous year 7 Shareholder Consent 7Each shareholder owning stock during election year must sign consent for election even if stock is no longer owned at election date 7May be able to obtain extension of time for ling consent from IRS 7Available only if Form 2553 is led on a timely basis reasonable cause is given and the interests of the government are not jeopardized Election is not effective if entity does not meet S corporation requirements at time election is filed Termination of Election 7 The S election is lost in any ofthe following ways 1 Shareholders owning a majority of shares revoke the election Revocation must be led by 15th day of third month to be effective for entire year Otherwise it is effective for rst day of following year or any other speci ed future date 2 New shareholder owning gt 50 of entity refuses to consent to election 3 Entity no longer quali es as S Corp eg the entity has gt 100 shareholders or a nonresident alien shareholder a second class of stock exists etc Election is terminated on date disquali cation occurs 4 The corporation has excess passive investment income PII for three years in a row The entity has excess PII if passive investment income net of passive investment expenses gt 25 of Gross Receipts This test only applies if the entity has E amp P from a prior year in which the entity was a Subchapter C corporation Election is terminated the rst day of the fourth year 7 A new election normally cannot be made Within ve years after termination of a prior election Five year waiting period is waived if There is a gt 50 change in ownership after first year termination is applicable Event causing termination was not reasonably within control of the S corp or its majority shareholders Computation Of Taxable Income Determined in a manner similar to partnerships except S corp can amortize organizational costs S corp must recognize gain but not losses on distribution of appreciated property to shareholders 7 S corp items are divided into Nonseparately stated income or loss Essentially constitutes Subchapter S taxable income or loss 7 oepalawly h s uniquely affect mx liabilin of shareholders Identical to separately slated items for pannerships Flow The h of S C0 omilon Items s Cnrpnrzlinn corporame Level Ommavy Tladeul uslness Depve clallun I lneeme Ex an s Recaelme CnrpnrzleVeil gt P355 J1 TawExemm GemLess ND lneeme nsepsyslely Cumpuled Ameunl lnveslmem sbemleym 9 lmevesx I Caema GemLessl AMT Preferences PDMDHD quot aneAe uslmemsl lneeme i 3 charitable LungTerm lt Cumrlbuuun I capltal GemLess sharehnmerLevel Separately Stated Items 7 Include Tax7exempt inceme 7 Gainslnsses mm dispesal at business pmperty and capiml assets 7 Charitable cuntributiuns r Incumeluss mm rental at real estate Interest dividend or royalty income Tax preference items Allocation Of Income And Loss 7 Each shareholder is allocated a pro rata portion of nonseparately stated income loss and all separately stated items If stock holdings change during year shareholder is allocated a pro rata share of each item for each day Shortyear election is available if a shareholder s interest is completely terminated through disposition or death Allows tax year to be treated as two tax years 7 Results in interim closing of books on date of termination Shareholders report their shares of S corp items as they occurred during year S Corporation Distributions 7 Amount of distribution to shareholder cash FMV of any other property distributed 7 Taxation of distribution depends on Whether the S corp has accumulated EampP from C corp years 7 Where no Earnings and Pro ts exist 1 Nontaxable to the extent of adjusted basis in stock Equot Excess treated as gain from the sale or exchange of property capital gain in most cases Where Earnings and Pro ts exist 1quot Tax free to the extent of accumulated adjustments account N Any PTI from pre 1983 tax years can be distributed tax free Equot Remaining distribution is ordinary dividend from AEP 5 Tax free to extent of Other Adjustments Account 5 Tax free reductions in basis of stock 6 Excess treated as gain from the sale or exchange of stock capital gain in most cases Once stock basis reaches zero any distribution from AAA is treated as a gain from sale or exchange of stock Basis is the maximum tax free distribution a shareholder can receive AAA bypass election is available 7 Accumulated Adjustments Account AAA Represents cumulative total undistributed nonseparately and separately stated items Mechanism to ensure that earnings of an S corp are taxed to shareholders only Once Accumulated Adjustments Account AAA is adjusted as follows 7 Increased by Nonseparately computed income and Schedule K items other than tax exempt income Depletion in excess of basis in property 7 Decreased by Adjustments other than distributions losses and deductions Portion of distribution treated as taXfree from AAA but not below zero Other issues regarding distributions Distributions of cash during a one year period following S election termination receives special treatment Treated as a taXfree recovery of stock basis to the extent it does not exceed AAA account Since only cash distributions receive this special treatment the corp should not distribute property during this postelection termination period Other issues regarding distributions If E amp P exists the entity may elect to rst distribute E amp P before reducing AAA Distributions Of Propegv If the entity distributes appreciated property Gain must be recognized Treated as if property sold to shareholder for FMV Gain is allocated to shareholders and increases shareholders basis in stock in the entity before considering the effect of the distribution Basis of asset distributed FMV Shareholder s Basis Determination of initial basis is similar to that of basis of stock in C corp 7 Depends on manner stock was acquired e g gift inheritance purchase exchange Basis is increased by Stock purchases Capital contributions Nonseparately computed income Separately stated income items Depletion in excess of basis Basis is decreased by Distributions not reported as income by shareholders eg from AAA or PTI Nondeductible expenses eg fines penalties Nonseparately computed loss Separately stated loss and deduction items Similar to partnership basis rules First increase basis by income items Then decrease it by distributions and finally losses Shareholder s basis cannot be negative Once basis is reduced to zero any additional reductions losses or deductions but not distributions decrease but not below zero basis in loans made to S corp 60 Any excess losses or deductions are suspended Once basis of debt is reduced it is increased by subsequent net increases from all positive and negative adjustments 7 Basis rules are similar to partnership rules except Partner s basis in partnership interest includes direct investment plus a ratable share of partnership liabilities Except for loans from a shareholder to the S Corp corporate borrowing does not affect shareholder s basis Treatment of Losses Step 1 Allocate total loss to the shareholder on a daily basis based upon stock ownership Step 2 If shareholder s loss exceeds stock basis apply any excess to adjusted basis of indebtedness to the shareholder Distributions do not reduce debt basis Step 3 Where loss gt debt basis excess is suspended and carried over to future tax years Step 4 In future tax years any net increase in basis adjustment restores debt basis rst up to its original amount Step 5 Once debt basis is restored remaining net increase is used to increase stock basis Step 6 Suspended loss from a previous year now reduces stock basis rst and debt basis second Step 7 If S election terminates any loss carryover remaining at the end of the post termination transition period is lost forever Passive Losses And Credits An S corp is not directly subject to the passive loss rules 61 If the corporation is involved in rental activities or shareholders do not materially participate Passive losses and credits ow through to shareholders Shareholder s stock basis is reduced even if passive losses are not currently deductible AtRisk Rules Generally apply to S corp shareholders o Atrisk amounts include Cash and adjusted basis of property contributed to corp Any amount borrowed for use in the activity for which the shareholder is personally liable Net FMV of personal assets that secure nonrecourse borrowing 7 Losses suspended under at risk rules are carried forward and are available during post termination transition period Builtin Gains Tax Generally applies to C corporations converting to S Corp status after 1986 Corporatelevel tax on builtin gain recognized in a taxable disposition Within 10 calendar years after the effective date of the S corp election 7 Tax base includes unrealized gain on assets held on date ofS corp election Highest corporate taX rates apply cLurently 35 o This gain passes through to shareholders as taxable gain 62 7 Amount of builtin gain recognized in any year is further limited to an as if taxable income computed as if the corp were a C corp 7 Any gain that escapes taxation under this limit is carried forward and recognized in future years LIFO recapture tax Any LIFO recapture amount at time of S corp election is subject to a corporate level tax Taxable LIFO recapture amount excess of inventory s value under FIFO over the LIFO value Resulting tax is payable in four annual installments First payment is due on or before due date of last C corp tax return Computation of Builtin Gains Tax Step 1 Select the smaller of built in gains or taxable income Step 2 Deduct unexpired NOLs and capital losses from C corporation tax years Step 3 Multiply the tax base from step 2 by the top corporate tax rate Any net recognized built in gain gt taxable income is carried forward to the next year as long as the next year is within the 10 year recognition period Step 4 Deduct business credit carryforwards and AMT credit carryovers from a C corporation tax year from the amount obtained in step 3 Step 5 The corporation pays any tax resulting in step 4 63 Passive Investment Income Penalg Tax If an S corp has accumulated EampP AEP from C corp years A tax is imposed on excess net passive income ENPI calculated as follows Passive investment income Net passive ENPI gt 25 of gross receipts X investment Passive investment income income for for the year the year 39 Passive investment income includes royalties rents dividends interest annuities and sales and exchanges of stocks and securities 39 Only net gain from disposition of capital assets not stocks and securities is included 39 Net passive income is passive income less directly related deductions 39 Excess net passive income cannot exceed corp taxable income before considering any NOL or other special deductions 39 Tax rate applied is the highest corporate tax rate for the year 64 Chapter 15 Multistate Corporate Taxation Overview 46 states and District of Columbia impose a tax based on corp s taxable income 7 Majority of states piggyback onto Federal income tax base Essentially they have adopted part or all of the Federal tax provisions Computing Corporate State Income Tax Liability slide 1 of 2 Starting point in computing taxable income i State modi cation items State tax base i Total net allocable incomeloss nonbusiness income Total apportionable income loss business income X State s apportionment percentage Income apportioned to the state Most states use either line 28 or line 30 ofthe Federal corp tax return Form 1120 In other states the corp must identify and report each element of income and deduction on the state return Computing Corporate State Income Tax Liability slide 2 of 2 Income apportioned to the state i Income1 loss allocated to the state State taxable incomeloss X State tax rate Gross income tax liability for state State s tax credits Net income tax liability for the state 65 Common State Additions Interest income on statemunicipal obligations and other interest income exempt from Federal income tax 7 May exclude interest income on obligations within that state to encourage investment in instate bonds State income taxes deducted on Federal return 7 Includes franchise taxes based on income Federal depreciation in excess of amount allowed by state if depreciation systems differ State gain in excess of Federal gain on assets Federal loss in excess of state loss on assets Adjustments to amounts under Federal elections Federal Net Operating Loss Deduction Common State Subtractions Interest on US obligations to extent included in Federal taxable income 7 States cannot impose income tax on income from US obligations but may assess incomebased franchise tax State depreciation in excess of Federal if depreciation systems differ Federal gain in excess of state gain on assets State loss in excess of Federal loss of assets Adjustments to amounts under Federal elections State Net Operating Loss Deduction Dividends received from certain outofstate corps to extent included in Federal return Federal income taxes paid 66 UDITPA and the Multistate Tax Commission Uniform Division of Income for Tax Purposes Act UDITPA is a model law relating to assignment of income among states for multistate corps Many states have adopted UDITPA either by joining the Multistate Tax Compact or modeling their laws after UDITPA Nexus for Income Tax Purposes Nexus is the degree of business activity which must be present before a state can impose tax on an outofstate entity s income Sufficient nexus typically exists if 7 Income is derived from within state 7 Property is owned or leased in state 7 Persons are employed in state 7 Physical or nancial capital is located in state No nexus if only connection to state is solicitation for sale of tangible personal property with orders sent outside state for approval and shipping to customer Public Law 86 272 Sales tax can still apply Independent Contractors May generally engage in the following activities without establishing nexus for the company 7 Solicit sales 7 Make sales 7 Maintain sales of ce Source Public law 86272 67 Allocation and Apportionment of Income Apportionment is the means by which business income is divided among states in which it conducts business 7 Corp determines net income for the company as a whole and then apportions some to a given state according to an approved formula Allocation is a method used to directly assign speci c components of a corp s income net of related expenses to a speci c state Allocable income generally includes Income or loss from sale of nonbusiness property Income or losses from rents or royalties from nonbusiness real or tangible personal property Typically allocable income loss is removed from corporate net income before the state s apportionment formula is applied 7 Nonapportionable income loss assigned to a state is then combined with income apportionable to the state to arrive at total income subject to taX in the state Business income is assigned to states using an apportionment formula 7 Business income arises from the regular course of business Integral part of taxpayer s regular business Nonbusiness income is apportioned or allocated to the state in which the income producing asset is located Apportionment Factors Apportionment formulas vary among states 7 Traditionally states use a threefactor formula that equally weights sales property and payroll 68 7 Many states use a modi ed formula where sales factor receives a larger weight Tends to pull larger amount of outof state corporation s income into the state May provide taX relief to corps domiciled in the state Sales Factor Sales factor is a fraction 7 Numerator is corp s sales in the state 7 Denominator is corp s total sales everywhere Most states follow UDITPA s ultimate destination concept 7 Tangible asset sales are assumed to take place at point of delivery not where shipping originates 7 Dock sales occur when delivery is taken at seller s shipping dock Most states apply the destination test to dock sales 7 If purchaser has outofstate location to which it returns with the product sale is assigned to purchaser s state 7 Throwback rule If adopted by state requires that outofstate sales not subject to taX in destination state be pulled back into origination state Treats such sales as instate sales of the origination state Payroll Factor Payroll factor is a fraction 7 Numerator is compensation paid within a state 7 Denominator is total compensation paid by the corporation 69 Compensation includes wages salaries commissions etc 7 Amounts paid to independent contractors are excluded 7 Some states exclude amounts paid to corporate officers 7 Some states require that deferred compensation amounts be included in the payroll factor e g 401k plans Compensation of an employee is usually not split between states unless employee is transferred or changes positions 7 Usually allocated to state in which services are primarily performed If more than one state attribute to 7 Employee s base of operations or if none 7 Place where work is directed or controlled or if none 7 Employee s state of residency Only compensation related to production of apportionable income is included in payroll factor 7 In states that distinguish between business and nonbusiness income compensation related to nonbusiness income is not included 7 Compensation related to both business and nonbusiness income is prorated between the two Property Factor Property factor generally includes average value of real and tangible personal property owned or rented 7 Numerator is amount used in the state 7 Denominator is all of corp s property owned or rented 70 Property includes 7 Land buildings machinery inventory etc 7 May include construction in progress offshore property outer space property satellites and partnership property Property in transit is included in numerator of destination state Property is typically valued at average historical cost plus additions and improvements 7 Some states allow net book value or adjusted basis to be used Leased property when included in the property factor is valued at eight times its annual rental payments Allocation Apportionment Example Total allocable income State A 100000 Apportionable income States A and B 800 000 Total income 900000 All sales payroll and property is divided equally between states A and B Both states use identical apportionment formulas Taxable income State A State B 12 Apportionable income 400000 400000 Allocable income 100 000 0 Total state taxable income 500000 400000 Americo Inc operates in three states with the following apportionment systems W s factors average of four factors sales doubleweighted X s factors average of three factors equally weighted Y s factors sales factor only 71 State W X Y Total Sales 400000 100000 500000 1000000 Factor 40 10 50 Payroll 90000 150000 60000 300000 Factor 30 50 20 Property 120000 240000 40000 400000 Factor 30 60 10 Taxable income for year all states 100000 State i A L Sales 40 10 50 Sales 40 N A N A Payroll 30 50 N A Property 30 60 N A Total 140 120 50 Average 35 40 50 Taxable income to each state 3500 40000 50000 Total taxed in all states 125000 NA not applicable Example 2 Americo Inc moves most personnel and property to state Y State W X Y Total Sales 400000 100000 500000 1000000 Factor 40 10 50 Payroll 30000 30000 240000 300000 Factor 10 10 80 Property 40000 40000 320000 400000 Factor 10 10 80 W s factors average of four factors sales doubleweighted X s factors average of three factors equally weighted Y s factors sales factor only 72 Taxable income for year all states 100000 State W l l Sales 40 10 50 Sales 40 N A N A Payroll 10 10 N A Property 10 10 N A Total 100 30 50 Average 25 10 50 Taxable income to each state 25000 10000 50000 Total taxed in all states 85000 NA not applicable Unitary Taxation Theory operating divisions are interdependent so cannot be segregated into separate units 7 Each unit deemed to contribute to overall pro ts 7 Unitary theory ignores separate legal existence of companies all combined for apportionment For multistate apportionment all divisions or entities are treated as single unitary base 7 Larger apportionment base all companies activities 7 Smaller apportionment factors each state s 73 Other MultiEntity Considerations Multinational operations If state uses Unitary system it may require inclusion of worldwide activities in determining apportionment Most unitary states allow Water s Edge election so only US operations are included 7 Cost of election may include Speci ed number of years before revocation Additional taX for privilege of excluding foreign entities Combined reporting 7 Some states allow or require unitary companies to le together in state to simplify reporting Consolidated returns 7 Some states allow or require consolidated return if led for Federal Taxation of S Corps Majority of states with corporate income taX have special provisions that govern S corporations 7 Only a few states do not provide special treatment for S corps In nonS election states S corps are taxed the same as C corps 7 Must have valid S corp election at federal level to get S corp treatment in states Multistate S corps must apportion and allocate income in same manner as regular corp 7 Must le a state taX return in each state with nexus 7 Must inform shareholders of their share of income for each state so their taX returns can be prepared S corp may be allowed to le a single return and pay taX for all shareholders 74 Taxation of LLC s and Partnerships Most states treat partnerships LLCs and LLPs in a manner that parallels Federal treatment 7 Entity is a taxreporting not a taXpaying entity 7 Income loss and credit items are allocated and apportioned among the partners according to the terms of the partnership agreement Some states 7 Require entity make est taX pymts for outofstate partners 7 Apply an entitylevel taX on operating income 7 Allow composite returns to be led for outofstate partners Generally an instate partner computes the income taX resulting from all of the owthrough income from the entity 7 Partner is allowed a credit for Sales and Use Taxes Sales taX Consumers taX on tangible personal property acquired for use or consumption 7 Vendor acts as collection agent 7 Not assessed on goods purchased for shipment outofstate Use taX complements sales tax 7 Consumers bringing purchased goods into state pay taX to state in which property is used 7 States have dif culty enforcing use taX 75 Solicitation by independent brokers is suf cient nexus for sales tax purposes 7 Turns use tax into sales tax for that state 7 Seller required to collect taX 7 Facilitates collection by state 76 Cha ter 10 Partnerships Partnership Definition An association of two or more persons to carry on a trade or business 7Contribute money property labor iExpect to share in pro t and losses Entities Taxed As Partnerships General partnership Consists of at least 2 partners Partners are jointly and severally liable Creditors can collect from both partnership and partners personal assets General partner s assets are at risk for malpractice of other partners even though not personally involved oLimited liability partnership LLP An LLP partner is not liable for malpractice committed by other partners Popular organizational form for large accounting firms oLimited partnership Has at least one general partner One or more limited partners Only general partners are liable to creditors Limited partners loss is limited to equity investment 77 oLimited Liability Company LLC Combines the corporate benefit of limited liability with benefits of partnership taxation Unlike corporations income is subject to tax only once Special allocations of income losses and cash ow are available Owners are members not partners but if properly structured will receive partnership tax treatment CheckTheBox Regs Allows most unincorporated entities to select their federal tax status 71f 2 or more owners can choose to be treated as Partnership or Corporation iPermits some exibility Not all entities have a choice eg New publicly traded partnerships must be taxed as corporations Some entities can be excluded from partnership treatment if organized for lnvestment not active trade or business Joint production extraction or use of property Undervvriting selling or distributing a specific security Owners simply report their share of operations on their own tax return 78 Partnership Taxation Partnership is not a taxable entity Flow through entity Income taxed to owners not entity Partners report their share of partnership income or loss on their own tax return Generally the calculation of partnership income is a 2step approach Step 1 Net ordinary income and expenses related to the trade or business of the partnership Step 2 Segregate and report separately some partnership items 71f an item of income expense gain or loss might affect any 2 partners tax liabilities differently it is separately stated 7e g Charitable contributions Electing large partnerships can net some items that would otherwise be separately stated Must have at least 100 partners and elect simplified reporting procedures Report no more than 16 separately stated items eg Net shortterm and longterm capital gains and losses at partnership level and report the net amount to partners Partnership files Form 1065 lncludes Schedule K which accumulates the information to be reported to partners Pr0Vides ordinary income and separately stated items in total Each partner and the IRS receives a Schedule Kl for each partner Reports each partner s share of income expense gain and loss 79 Partner s Ownership Interest oEach owner normally has a Capital interest Measured by capital sharing ratio iPartner s percentage ownership of capital Profitsloss interest Pa1tner s allocation of partnership ordinary income loss and separately stated items Certain items may be specially allocated Specified in the partnership agreement Basis Issues Each partner has a basis in their partnership interest Partner s basis is adjusted for income and losses that ow through This ensures that partnership income is only taxed once Partner s basis is important for determining Deductibility of partnership losses TaX treatment of partnership distributions Gain or loss on disposition of partnership interest


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