# Corporate Income Taxation

## Regular Income Tax Liability

The regular tax liability calculation itself is very straightforward:

``````Tax liability
= Tax base ร Tax rate``````

The complexity of corporate income tax thus stems from the rules and regulations that shape and define the tax base, i.e. corporate taxable income. For tax years beginning after 2017, the Tax Cuts and Jobs Act reduced the corporate tax rate to a flat 21 percent.

### Corporate Income Tax Formulas

Comparing the individual and corporate income tax formulas, it is easy to see that the overall structure of the two formulas is quite similar. Both start with the all-inclusive concept of income, then apply deductions to arrive at taxable income, which is then used to determine tax liability. Next tax credits and prepayments are applied to compute the net amount due or refunded.

``````Income
- Exclusions
= Gross income
- Deductions except for NOL and DRD
= Taxable income before NOL and DRD
- Net operating loss deduction (NOL)
= Taxable income
ร Tax rate
= Tax on taxable income
- Tax credit
= Tax due or refund``````

There are more differences that are not obvious from comparing the tax formulas:

## Special Corporate Deductions

There are two deductions available only to corporations: the dividends received deduction (DRD) and the organizational expenditures deduction.

Like individuals, corporations pay tax on the dividends they receive from other corporations (often, at higher ordinary income tax rates). Without special rules, the situation is costly because it subjects corporate income to three or more levels of taxation.

``````Pre-tax income
โ
Corporation A โ Tax
โ
โ Dividends
โ
Corporation B โ Tax
โ
โ Dividends
โ
Individuals   โ Tax``````

The dividends received deduction (DRD) aims to mitigate such multi-level taxation by making only some or none of the dividend income received by a corporation subject to tax. The amount of the DRD depends on:

1. the domestic corporation making the dividend distribution
2. the percentage of ownership the dividend receiving corporation holds

In many cases, the DRD cannot exceed a special taxable income limitation, which is defined as

``DRD percentage ร Taxable income before NOL and DRD and capital loss carrybacks``

This taxable income limitation does not apply however if a corporation has a current year net operating loss (NOL) after deducting the full DRD, that is negative taxable income). Also note that no DRD is permitted unless the corporation has held the stock for more than 45 days.

#### Example

CorpA, in current tax year (post-2017), receives \$450,000 in dividends from a 70% ownership interest in a U.S. corporation it has held for 6 years. It assumes \$170,000 of ยง162 expenses. CorpA forecasts 3 levels of gross income, what is the DRD in each scenario?

### Organizational Expenditures Deduction

Organizational expenses are incurred in connection with the initial organization of a corporation. They include the costs of:

1. Legal services for establishing the articles of incorporation and bylaws
2. Accounting services
3. Expenses of temporary directors and organizational meetings
4. Fees paid to the state of incorporation

However they do not include costs of:

1. Issuing or selling shares of stock
2. Transferring assets to a corporation

Organizational expenses are also distinct from start-up expenses under ยง195, which also include business investigation costs, such as market surveys and operating expenses like payroll, incurred before a business officially opens its doors.

You may recall that code section 162(a) states:

There shall be allowed as deduction all the ordinary and necessary expenses paid or incurred during the taxable year carrying on a trade or business….

However there is no business yet being carried on in the organizational phase. As a result, capitalization rather than deduction of these expenditures makes conceptual sense. To solve this problem, Congress enacted Section 248 to permits a corporation to

1. Elect to immediately deduct the first \$5,000 of organizational expenditures
• However, the \$5,000 immediate deduction phases out dollar for dollar, when total organizational expenditure costs exceed \$50,000.
2. Any overage is amortized over the 180-month period beginning with the month in which the corporation begins business.

To qualify, expenses must be incurred before the end of the tax year in which the corporation begins business. By default, the election is assumed, however a corporation can forego the deemed election by capitalizing all organizational expenditures, and deducting them upon corporate liquidation or termination.

#### Example:

CorpB, an accrual basis corporation, was formed and began business on May 1st. It incurred the following expenses during the year:

Recall that expenditures related to issuing or selling shares of stock are not deductible as organizational expenditures. So the allowable deduction is `\$47,750` in total.

• Provided the total allowable deduction does not exceed \$50,000, Section 248 allows a corporation to:
1. Immediately deduct up to \$5,000 of organizational expenses
2. With any overage (over the \$5,000), amortize them over the 180 months, beginning in the month in which the corporation begins business
• If total expenses exceed \$50,000, then the \$5,000 immediate expense amount phases out dollar for dollar.
``````Deductible organization expenditures    \$47,750
Immediate deduction                    -\$ 5,000
Amount to amortize                      \$42,750
Months to amortize                          180
Amortization per month                  \$   237.50
Applicable months                             8
Total amortization                      \$ 1,900

Total organizational expenditure deduction
= Immediate deduction + Amortization
= \$5,000 + \$1,900
= \$6,900 ``````

Assume the same set of facts, except the Legal fees for drafting Articles of Incorporation and Bylaws increase to \$27,250, now the allowable deduction increases to `\$53,000` in total, which invokes the phase out for the immediate expense amount.

``````Immediate deduction
= \$5,000 - (\$53,000 - \$50,000)
= \$2,000 ``````

We now proceed as we did previously:

``````Deductible organization expenditures    \$53,000
Immediate deduction                    -\$ 2,000
Amount to amortize                      \$51,000
Months to amortize                          180
Amortization per month                  \$   283.33
Applicable months                             8
Total amortization                      \$ 2,267

Total organizational expenditure deduction
= Immediate deduction + Amortization
= \$2,000 + \$2,267
= \$4,267``````

## Corporate Alternative Minimum Tax

Note that the corporate Alternative Minimum Tax or AMT has been repealed. Congress created AMT to ensure that no taxpayer with substantial economic income could avoid significant tax liability by using exclusions, deductions, and credits. AMT acted as a safeguard to ensure that taxpayers pay their fair share. However the AMT was both cumbersome and complicated.

From a conceptual standpoint, AMT is a completely separate and distinct tax system that ran parallel to the regular tax system. The AMT system operated by limiting or eliminating certain tax deductions, credits, and other preference items. Most corporations were required to calculate tax liability under both systems and then pay the higher of the two.

There are steps in computing AMT:

1. Determine AMT income, which was essentially regular taxable income with numerous adjustments.
2. Reduce AMT income by an exemption amount, which began at \$40,000 and phased out as AMTI increased.
3. Multiply corporate AMT tax rate 20%, i.e. `(AMTI - exemption) ร 20%`. The result was referred to as Tentative Minimum Tax (TMT).
4. AMT was the amount by which the TMT exceeded the corporation’s regular tax, i.e. `AMT = TMT - Regular`

Small corporations were exempted from AMT. The AMT was criticized for:

• failing to advance any legitimate policy objectives
• raising insufficient revenue
• reducing the value of investment that Congress intended to encourage
• imposing hefty compliance costs

## Penalty Taxes

The regular corporate income tax is augmented by two special penalty taxes imposed on corporations to restrict the accumulation of income inside the firm. The purpose is to prevent corporations and their shareholders from circumventing the double taxation of dividends and the steeply progressive marginal tax rates.

Beginning in 2018, under the tax cuts and jobs act, the importance of this prevention has been re-established by the enactment of a flat 21% corporate tax rate and 37% marginal tax rate for the highest income individuals, because a high income individual now has a 16% incentive to shift personal income to the corporate form.

## Related Corporations

Businesses often conduct activities within multiple distinct entities for a variety of reasons. Taxation of multiple corporations under common shareholders control is complex. The related corporations are subject to special tax rules, otherwise shareholders could allocate corporate income across two or more entities to take advantage of lower marginal tax rates and other benefits.

Controlled group of corporations is when two or more corporations are owned either directly or indirectly, by the same shareholder or group of shareholders. Controlled groups fall into three categories:

• Parent-subsidiary controlled group – when one corporation owns at least 80% of the voting power OR stock value of another corporation on the last day of the tax year.
• Brother-sister controlled group
• Combined controlled group

Affiliated group is similar but not identical, it exists when one corporation owns at least 80% of the voting power AND at least 80% of the stock value of another corporation. Affiliated groups can elect to file a single consolidated income tax return.

## Book-Tax Difference

To determine taxable income, many corporations begin with income computed under Generally Accepted Accounting Principles (GAAP), that is financial reporting or book purposes. And then make adjustments for book-tax reporting differences. Financial reporting focuses on informing stakeholders, while tax reporting aims to raise revenue for the government.

Each book-tax difference can be unfavorable or favorable from the taxpayer’s perspective:

• Favorable: decrease book income to compute taxable income
• Unfavorable: increase book income to compute taxable income

Book-tax differences are also categorized as permanent or temporary:

• Permanent: differences arise in one year and never reverse
• Temporary: differences arise in one year and later reverse

Let’s now examine some of the many possible book-tax differences

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