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ACCY 509
Chapter 3
The Corporate Income Tax
I) Taxation of Corporations
a) Methods and periods
1) Accounting methods – cash, accrual, hybrid (i.e., accrual method for sales, COGS,
inventories, A/R, and AP, and cash for everything else.)
– Generally, tps use the same method of accounting for tax that they use for book.
§446(a)
If no method has been chosen or the chosen method does not “clearly reflect income,”
the IRS can select an appropriate method. §446(b)
(i) §448(a) specifically disallows the cash method of accounting for C
corporations, p/s with a C corporation partner, or tax shelters
(ii) unless the tp is a farming business, qualified PSC, or C corporation or p/s
whose average annual gross receipts for the previous 3 year period does not
exceed $5 million.

Must use the accrual for inventories and COGS if inventories are a material income
producing factor.

2) Accounting periods – Generally, C corporations can elect a calendar year or a fiscal

year. Tax year must be the same as year used for financial accounting purposes.
-- Generally, S corporations must use a calendar year.
-- All members of an affiliated group must use the same tax year as the parent corp.
-- PSC generally must use a calendar year (PSC=corp. whose principal activity is the
performance of personal services by its employee-owners). PSC can adopt a fye if it
can establish a business purpose.

b) Capital gains and losses -- The treatment of capital gains and losses is different for
corporations than for individuals.
-- Individuals get preferential treatment on capital gains (i.e., taxed at a lower rate) and
are allowed to deduct up to $3,000 of capital losses against ordinary income each year.
Capital losses in excess of the $3,000 are carried forward indefinitely to offset against
future capital gains or used $3,000 each year against ordinary income.

NOTE: JGTRRA ’03 lowered the maximum capital gains for individuals from 20% and
10% to 15% and 5%, respectively. The special rates for gains due to depreciation on real
property (25% rate gains) and gains on sales of collectibles (i.e., guns, coins, art) (28%
rate gain) are still in effect.

-- Corporations are required to include net capital gains in gross income, and those gains
receive no preferential treatment in terms of a lower tax rate. If the corporation has a net
capital loss, no amount of that loss is deductible. Corporation’s net capital losses can
only be used to offset capital gains. The can NEVER be used to offset ordinary income.
Any net capital loss must be carried back as a short-term capital loss to the three previous
tax years and used to offset capital gains in the earliest year possible. If the loss is not
totally absorbed as a carryback, the remainder is carried forward as a STCL for five
years. Any losses that remain at the end of the carryforward period are lost.
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c) §291: tax benefit recapture rule -- Corporations must recapture as ordinary income
20% of the additional ordinary income that w/h/b recognized had the property been
§1245 property.

d) Organizational expenditures -- Under §248, a corporation may elect to deduct up to

$5,000 of qualified organizational expenditures incurred after October 22, 2004. The
deduction is phased out, dollar-for-dollar, for organizational expenditures that exceed
$50,000. For organizational expenditures that are not immediately deductible, the
corporation may make an election to amortize those expenditures over a period of 180
months. The election must be made in a statement attached to the first return filed by the
corporation. Organizational expenditures incurred prior to October 23, 2004 must be
capitalized and amortized over a period of 60 months. Again a valid election must be
made for the amortization.

1) Organizational expenditures are expenditures incident to the creation of the

corporation including legal services incident the organization of the corporation,
accounting services necessary to create the corporation, expenses of temporary
directors and organizational meetings of directors and stockholders, and fees paid to
the state of incorporations. To qualify as organizational expenditures, the item must
be incurred before the end of the taxable year in which the corporation begins
business. Accounting method is of no consequence.

2) Syndication fees – expenditures connected with issuing or selling the corporation’s

stock (e.g., commissions, professional fees, printing costs of the corporation’s
prospectus). Syndication fees are not deductible or amortizable.

3) Start-up expenditures (§195) Ordinary and necessary business expenses paid or

incurred to investigate the creation or acquisition of an active T or B; to create an
active T or B; to conduct an activity engaged in for profit or the production of income
before the time the activity becomes an active T or B. If they were incurred in
connection with the operation of an existing active T or B, they would be allowable as
a deduction for the year in which paid or incurred.

(i) §195 allows an immediate deduction of up to $5,000 of qualified start-up

expenditures incurred after October 22, 2004. The deduction is phased out,
dollar-for-dollar, for start-up expenditures that exceed $50,000. For start-up
expenditures that are not immediately deductible, the corporation may make an
election to amortize those expenditures over a period of 180 months. The election
must be made in a statement attached to the first return filed by the corporation.
Start-up expenditures incurred prior to October 23, 2004 must be capitalized and
amortized over a period of 60 months. Again a valid election must be made for
the amortization.

Organizational expenditures are outlays made in forming a corp., such as fees paid to the
state of incorporation. Start-up expenditures are outlays that would otherwise be
deductible as ordinary and necessary business expenses but that are capitalized b/c they
were incurred prior to the start of the corporation’s business activities. Syndication
expenses are not deductible or amortizable.
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e) Passive losses -- The passive loss rules do not apply to widely-held C corporations.
They only apply to individuals, partners, S corporation shareholders, closely held C
corporations (>50% of value of corp. owned directly or indirectly by five or fewer
individuals) and PSCs.

f) Limitation on accrued compensation -- In order to be deductible accrued compensation

must be paid within 2 ½ months after the tax year end.

g) Charitable contributions – Corporations are allowed a deduction for contributions to

qualified charitable organizations.
1) Generally, the contributions must have been paid by year end for a deduction to be
allowed for a given year. Corporations using the accrual method (not cash or hybrid),
may elect to treat part or all of a charitable contribution as having been made in the
year in which it was accrued if: a) the BOD authorized the contribution in the year it
was accrued, and b) the corporation pays the contribution on or before the fifteenth
day of the third month following the end of the accrual year (March 15 for calendar
year tps).
2) Generally, tps are allowed to deduct the FMV of property contributed when property,
instead of money, is contributed to a qualified charity. Special rules apply to
appreciated ordinary income and capital gain property.
(i) In general, the deduction for a contribution of ordinary income property is
limited to the basis of the property.
(A) Exception 1: If the property is inventory and it is used in a manner related to
the exempt purpose of the charity, then to tp is allowed to deduct the basis
plus 50% of the appreciation in inventory. To qualify for this exception, the
charity must use the property solely for the care of the ill, the needy, or
infants.
(B) Exception 2: If the gift is of scientific property donated to colleges and
certain scientific research organizations for use in research, then the donor
will be allowed to deduct the basis plus 50% of the appreciation.
(ii) As a general rule, the deduction for a contribution of long-term capital gain
property equals the property’s FMV.
(A) Exception 1: If a corporation donates tangible personal property to a
charitable organization and the organization’s use of the property is unrelated
to its tax-exempt purpose, then the amount of the corporation’s contribution
deduction is limited to the property’s basis.
(B) Exception 2: If a corporation donates appreciated capital gain property to
certain private nonoperating foundations, then the amount of the corporation’s
contribution deduction is limited to the property’s basis.

3) Contribution deductions by a corporation are limited to 10% of adjusted taxable

income computed without regard to a) the charitable contribution deduction, b) an
NOL carryback, c) a capital loss carryback, d) any DRD, or e) the QPAD.
Any contributions not deductible because of the 10% limitation are carried forward
for up to five tax years. Current year deductions must be applied against the 10%
limit before any carryforward deductions are allowed. Any amounts not deducted
within the five years are lost.

-- Individuals are subject to a 50% (or 30% in some circumstances) of AGI limitation
on charitable contribution deductions. Individuals are also allowed to carryover
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deductions in excess of the limitation. However individuals get to carry their
charitable contributions forward indefinitely and individuals use their deductions
chronologically.

h) U.S. Production Activities Deduction (aka the Manufacturers’ Deduction) -- §199,

effective for tax years after 2004, allows a U.S. production activities deduction equal to a
percentage times the lesser of (1) qualified production activities income for the year or
(2) taxable income before the U.S. production activities deduction. The phased-in
percentages are:

2005, 2006 3%
2007-2009 6%
2010 and thereafter 9%

1) The deduction cannot exceed 50% of the corporation’s W-2 wages for the year.

i) NOLs -- If a corporation’s deductions exceed its gross income for the year, the
corporation has a net operating loss. In computing an NOL for a given year, no
deduction is permitted for a carryover or carryback of an NOL from a preceding or
succeeding year.
1) A corporation carries back two years and carries forward 20 years. It carries to the
earliest of the two preceding years first and offsets TI reported in that year. If the loss
cannot be used in that year, it carries it to the immediately preceding year, and then to
the next 20 years in chronological order. The corporation can elect to forgo the
carryback period.
NOTE: In 2001, Congress passed temporary relief extending the carry-back period
from two to five years for 2001 and 2002 NOLs.

j) DRD -- Corporations must include in gross income any dividend it receives b/c of its
ownership in another corporation.
1) To mitigate the effects of multiple taxation of dividends, corporations are allowed a
dividends-received deduction for dividends received from other domestic
corporations.
Percentage of Deduction
Ownership Percentage

< 20% 70%

20 – < 80% 80%
>= 80% 100%

2) The DRD is limited to a percentage of taxable income. In the case of dividends

received from corporations that are less than 20% owned, the deduction is limited to
the lesser of 70% of the dividends received or 70% of TI computed without regard to
any NOL, capital loss carryback, or the DRD itself. In the case of dividends received
from a 20% or more owned coporation, the DRDis limited to the lesser of 80% of the
dividends received or 80% of TI computed without regard to any NOL, capital loss
carryback, or the DRD itself.

The TI limitation on the DRD does not apply if, after taking into account the full
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DRD, the corporation has an NOL for the year.

3) Other limitations on the DRD

(i) A corporation is not allowed to claim a DRD if it holds the dividend paying
stock for less than 46 days during the 91-day period that begins 45 days before the
stock becomes ex-dividend w.r.t. the dividend. The ex-dividend date is the first
day on which a purchaser of stock is not entitled to a previously declared
dividend. This rule prevents a corp. from claiming a DRD if it purchases the
stock shortly before an ex-dividend date and sells the stock shortly thereafter.

(ii) The DRD is not allowed to the extent the stock on which a dividend is paid is
debt-financed. This rule prevents a corporation from deducting interest paid on
money borrowed to purchase the stock, while paying little or no tax on the
dividends received on the stock.

k) Sequence of the deduction calculations:

1) All deductions other than the charitable contributions deduction, the DRD, and NOL.
2) The charitable contribution deduction -- limited to 10% of TI before charitable
contribution deduction, NOL carryback or capital loss carryback, or any DRD, but
after any NOL carryover deduction.
3) The DRD -- Once the charitable contributions deduction has been computed, any
NOL carryover deduction must be added back and the charitable contributions
deduction subtracted before the DRD is computed and subtracted.
4) The NOL -- Then the NOL deduction is subtracted
5) The U.S. production activities deduction.

Example: West Corporation reports the following results:

Gross income from operations $150,000

Dividends from 30%-owned domestic corporation 100,000
Operating expenses 100,000
Charitable contributions 30,000

In additions, West has $50,000 of qualified production activities income in the current year and a
$40,000 NOL carryforward from the previous year. What is West’s taxable income and tax
liability?

Assume instead that West has a $40,000 NOL carryback from a later year.
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II) Corporate Tax Liability
a) Estimated taxes
b) Filing requirements
1) When?

2) Forms
(i) Schedule M-1 (For tax years starting in 2005 this will be the M-3)

c) PSC -- Personal service corporation

(i) Principal activity is performance of personal services
(ii) Services are substantially performed by owner-employees
(iii) >10% of stock in value is held by owner-employees.

III) Controlled Groups