BUSINESS - CORPORATIONS Flashcards
Corporations Defined
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.
Types of Corporations (D, F, CH, PH, P)
Domestic Corporation
Foreign Corporation
Closely-held Corporation
Publicly-held Corporation
Public Corporation (Municipal Corporation)
Corporation Tax Classifications
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
Every Corporation is incorporated in a State.
True or False?
True.
There are no National or U.S Corporations.
Advantages of Corporate Structure rather than being a Partnership or a Sole Proprietorship.
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
Disadvantages of Incorporating
Formal incorporation process, and ongoing reporting.
Governmental regulation - this differs from state to state.
Double taxation on distributed corporate income
Double Taxation on Distributed Income from a Corporation Explained
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.
Corporate Formation
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…
Corporate Liability for Promoter’s Contracts
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.
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.
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.
Process of Incorporating
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.
Articles of Incorporation
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).
Incorporators as well as the First Steps to form a Corporation
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:
- Complete the ORG STRUCTURE.
- Adopt BYLAWS
- ELECT OFFICERS
- Select the CORP BANK
- Adopt, ratify or reject PRE_INCORPORATION contracts.
- Adopt the FORM OF CERTIFICATE representing shares of the company’s stock
- COMPLY with requirements for doing business in other states.
- Adopt a CORPORATE SEAL
- Consider all other transactions necessary or appropriate for carrying on the business purpose
Defects in Corporation
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
Financing the Corporation - Debt
Bonds are DEBT SECURITIES issued by a corporation.
Debt investors have a right to repayment of the bond’s principal (corpus) and interest.
Financing the Corporation – EQUITY
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
Authorized Stock( Shares)
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.
Issued Stock (Shares)
ISSUED STOCK is the portion of authorized stock that has actually been issued to shareholders.
Outstanding Stock(Shares)
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.
Corporate Liabilities
A corporation is liable for the CONTRACTS of its employees and, in particular situations, for TORTS committed BY employees.
Piercing The Corp Veil
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.
Common Situations where Piercing the Corp Veil is used.
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.
Transfers of Property for Stock
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).
Recognition of Gain with Boot
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.
ASSUMPTION OF A LIABILITY by the Corp for Property (BOOT) being Contributed.
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.
Shareholder’s Basis in Stock
Add the Adjusted Basis of the property transferred
+ Any gain recognized (only if boot was received)
- Any boot received
= Shareholder Basis in Shares Acquired
Corporation’s Basis in Property
Transferor’s adjusted basis
+ Any gain recognized by the transferor
= Corp’s Basis in Property
Earnings and Profit
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.
Non E&P Dividends
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.
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?
Total E & P is $200
Taxable Dividend = $200
Tax-free Dividend = $50
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?
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.
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?
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.
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?
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.
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?
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.
Calculating CEP
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.
Added to Taxable Income to get to CEP
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
Subtracted from Taxable Income to get to CEP
Federal income taxes,
Loss on sale between related parties,
Keyman life insurance premiums, and
Charitable contributions from this period in excess of 10% limitation.
Non Cash Distribution to Shareholder
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.
Property Dividends
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.
Shareholder Basis in Property
The shareholder’s tax basis for distributed property is the property’s FMV at date of distribution.
It’s NOT reduced by liabilities!
Redemptions and Liquidations
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.
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.
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.
Partial or Complete Liquidation
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.
Complete Liquidation for Shareholder
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.
Complete Liquidation for Company
Generally, a gain or loss is recognized as if the corporation had sold all of the property to the shareholders at FMV.
What is a Demand Note?
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.
§ 351 Exchange
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.
Control of Corporation
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.
The value of stock received for services is considered income to the recipient.
True or False?
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.
The basis of stock received by a shareholder is generally the adjusted basis of the property transferred.
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.
Paid-In-Capital
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.
Election to Reduce Basis
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.
What is the earliest date an S Corp status can be reinstated without IRS consent, if an election to terminate is made?
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.
E&P is taxable income, plus or minus adjustments. Items the Corporation must add back to taxable income include:
- 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.
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.
NOL may be carried forward indefinitely.
Net Pre-contribution Gain
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.
Domestic Corporation
A Corporation that does business in the State it is incorporated in.
Foreign Corporation
A Corporation that does business in the State other than the one it is incorporated in.
Closely-Held Corporation
A Corporation whose stock is owned by a small number of shareholders.
The stock is NOT traded in primary or secondary markets.
Publicly-Held Corporation
A Publicly-held Corporation is a corporation where the stock is actively traded in a primary or secondary stock market.
Public Corporation (Municipal Corporation)
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.
dividends received deduction (DRD)
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.
Preferred Stock
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.
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)
For tax purposes, a corporation is defined by the tax code.
- Limited liability
- Free transferability of ownership
- Centralized management
- Continuity of life
Structure of a Corporate Return (Calculation)
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
Corporate Tax Rate
21% (for 2019)
It used to be graduated.
Note: personal Service Corporations are at 21% as well.
There is NO LONGER a “Net Capital Gain Corporate Tax Rate”
So the benefit for Corps in a higher tax bracket to pay lower tax rates on Cap Gains.
C Corp Filing Requirements
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.
Penalties for a C Corp not filing the Due Date
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).
Penalties for a C Corp not paying the Taxes Due on time.
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.
Estimated Tax Payments by a C Corp
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.
Avoiding Delinquent Tax Penalty as a C Corp
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).
Reconciliation of Book and Tax Income - REQUIRED FILING
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.
M-3 Additional Requirement
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.
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.
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.
Items Added to Book Income
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
Items Subtracted from Book Income
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
Deductions reported on the Tax Return, but NOT charged to Book Income:
- 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.)
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?
True.
What are the “Reportable Transactions” that are listed on Form 8886?
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.)
Form M-2
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.
M-2 Adjustments
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.
Dividend Received Deduction
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.
Dividend Received Deduction: 3-Step Calculation
- Calculate the MAXIMUM Amount of Dividends that MIGHT NOT BE TAXABLE
- Calculate a LIMIT on the Amount that is NOT TAXABLE
- Consider EXCEPTIONS to the Limit
Dividend Received Deduction: (Step 01) Maximum Possible Amount
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
Dividend Received Deduction: (Step 02) Limit on Not Taxable Amount
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.
Dividend Received Deduction: (Step 03) Exception to the Limit
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.
Additional Penalty Taxes
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.
Accumulated Earnings Tax (1st penalty Tax)
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.
Exempt Organizations from the Accumulated Earnings Tax
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.
Accumulated Earnings Calculation
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.
Personal Holding Company Tax (2nd penalty Tax)
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.
What defines a PHC (Personal Holding Company)?
2 Tests must be met:
- 60% or more of the adjusted gross income of the company consists of passive income, and
(ie. Dividends, Rents, Royalties, personal Service Contracts) - 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.
PHC Tax Calculation to get Adjusted Taxable Income (ATI)
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
PHC Tax Calculation from the Adjusted Taxable Income (ATI) to the Accumulated Earnings Tax
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
How is the Dividend Year different than the Tax Year?
The Dividend Tax year includes the 9.5 months of Tax Year and within 2.5 months AFTER the end of the Tax Year.
Consent Dividends
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.
What are S Corps? (Formal IRS Defenition)
“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.”
What is an S Corp? (Informally)
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.
S Corp Requirements
There must be:
- Only one class of stock, and the rights to profits, and assets on liquidation must be identical.
- The number of shareholders must not exceed 100,
- A nonresident alien cannot own shares,
- Each shareholder must be either an INDIVIDUAL, an ESTATE or a QUALIFIED TRUST, and
- The corporation must be a domestic corporation and not be a Financial Institution or Insurance Company.
S Corp Election
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.
S Corp Termination
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.
S Corp Tax Administration
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.
How do you calculate a Corporation’s basis in property contributed by a shareholder?
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.
Tax rule for S Corps that converted from C Corps within the 5 years since the conversion.
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.
Form 1099-DIV - when must they be furnished?
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:
- Paid dividends (including capital gain dividends) and other distributions on stock of $10 or more,
- Withheld and paid any foreign tax on dividends and other distributions on stock,
- Withheld any federal income tax on dividends under the backup withholding rules, or
- 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
What is the rule on deducting Capital Losses by a Corporation?
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.
When must 1099-DIVs be filed to the IRS and to Recipients?
FYI - Mailed and electronic dates are different.
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.
