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Assignment 1: Client Letter
Due Week 2 and worth 150 points
Imagine that you are a Certified Public Accountant (CPA) with a new client who needs an opinion on the most advantageous capital structure of a new corporation. Your client formed the corporation in question to provide technology to the medical profession to facilitate compliance with the Health Insurance Portability and Accountability Act (HIPAA). Your client is very excited because of the ability to secure several significant contracts with sufficient capital.
Use the Internet and Strayer databases to research the advantages and disadvantages of debt for capital formation versus equity for capital formation of a corporation. Prepare a formal letter to the client using the six (6) step tax research process in Chapter 1 and demonstrated in Appendix A of your textbook as a guide.
Write a one to two (1-2) page letter in which you:
1.
Compare the tax advantages of debt versus equity capital formation of the corporation for the client.
2.
Recommend to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Provide a rationale for the response.
3.
Use the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
Your assignment must follow these formatting requirements:
· Be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides; citations and references must follow APA or school-specific format. Check with your professor for any additional instructions.
· Include a cover page containing the title of the assignment, the student’s name, the professor’s name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length
Running head: CLIENT LETTER
1
CLIENT LETTER 4
Client Letter
Karen
ACC 565
Organizational Tax Research and Planning
November 28, 2013
Dr. Michael Anyanwu
Professor
Richardson Accounting
143 Karen Ct
North Charleston, SC 29405
October 29, 2013
Keon Brown, Chief Financial Officer
Brown Industries
9876 State St.
Charleston, SC 29425
Dear Mr. Brown:
It is a pleasure to be able to address you today in reference to your new company, Brown Industries. As there is a drastic need for ways to ensure compliance with the Health Insurance Portability and Accountability Act (HIPAA) in the medical profession, I am excited to see the technology that you incorporate.
You contacted me on October 1, 2013 inquiring if it would be more advantageous to use debt or equity for capital formation of the new corporation. While both equity and debt capital have their own advantaged and disadvantages, debt capital holds the biggest tax advantages for you company.
In reaching this conclusion, research was performed on both debt and equity capital. Specific attention was paid to the tax advantages and disadvantages of each. Also taken into consideration was any information disclosed to us about your company and its operations.
The interest paid on debt capital is tax exempt; hence, the company’s loan costs are lowered. Creditors have no say in the conduct of the business, so by issuing debt capital, the company does not dilute the ownership rights of the shareholders. Also, as the interest rates are predetermined, the management is able to budget for the payments. During the initial years of the company’s formation, it is able to raise equity capital more easily than debt capital. The company is not, at any time, obligated to repay the money as long as it operates, and the company pays dividends only if it makes profits. However, tax payments are required on dividends.
Another consideration is that both instruments, debt and equity, are viewed and evaluated by credit rating agencies. Once all of the volatility and safety features related to each capital type have been dissected, the credit rating agency will make recommendations of where to invest. In this case, they agree that debt capital is currently the best option.
Conclusion
To re-iterate what has previously been said, according to the research conducted by Richardson Accounting and a credit rating agency on behalf of Brown Industries, it has been determined that currently debt capital is the best financing option due to tax advantages. Since this may not be the case in the future, it is suggested that research be conducted each time that additional capital is needed in order to verify which type of capital would best suit the company’s needs at that time.
If you have any questions concerning this recommendation, please call me via phone @ 843-987-6543 or email at Richardson@richardsonsaccounting.com.
Sincerely,
Karen Richardson
References
Raghavendra, P. (2010, December 3). Comparison of Issue Debt vs. Equity | eHow. eHow. Retrieved from http://www.ehow.com/about_7593181_comparison-issue-debt-vs-equity.html
Running head:
CLIENT LETTER
1
Client Letter
Karen
ACC 565
Organizational Tax Research and Planning
November 28, 2013
Dr. Michael Anyanwu
Professor
·
Assignment
1
: Client Letter
Due Week 2 and worth 150 points
Imagine that you are a Certified Public Accountant (CPA) with a
new client
who needs an opinion on the most advantageous
capital structure of a new corporation. Your client formed the
corporation in question to provide technology to the medical
profession to facilitate compliance with the Health Insurance
Portability and Accounta
bility Act (HIPAA). Your client is very
excited because of the ability to secure several significant
contracts with sufficient capital.
Use the Internet and Strayer databases to research the
advantages and disadvantages of debt for capital formation
versus
equity for capital formation of a corporation. Prepare a
formal letter to the client using the six (6) step tax research
process in Chapter 1 and demonstrated in Appendix A of your
textbook as a guide.
Write a one to two (1
–
2) page letter in which you:
1.
Co
mpare the tax advantages of debt versus equity capital
formation of the corporation for the client.
2.
Recommend to the client whether he / she should use debt or
equity for capital formation of the new corporation, based on
your research. Provide a rationale
for the response.
3.
Use the six (6) step tax research process, located in Chapter 1
and demonstrated in Appendix A of the textbook, to record your
research for communications to the client.
Your assignment must follow these formatting requirements:
.
Be typed
, double spaced, using Times New Roman font (size
12), with one
–
inch margins on all sides; citations and
references must follow APA or school
–
specific format. Check
with your professor for any additional instructions.
.
Include a cover page containing the ti
tle of the assignment, the
student’s name, the professor’s name, the course title, and the
date.
The cover page and the reference page are not included
in the required assignment page length
·
ACC565
–
A1
-1
1. Compare the tax advantages of debt versus equity capital formation of
the corporation for the client. Weight: 40%
51
(34%)
·
Levels of Achievement:
·
Unacceptable Below 70% F 0
(0%)
–
41.98
(27.99%)
· Did not submit or incompletely compared the tax advantages of debt versus equity capital formation of the corporation for the client.
· Fair 70-79% C 42 (28%) – 47.98 (31.99%)
· Partially compared the tax advantages of debt versus equity capital formation of the corporation for the client.
· Proficient 80-89% B 48 (32%) – 53.98 (35.99%)
· Satisfactorily compared the tax advantages of debt versus equity capital formation of the corporation for the client.
· Exemplary 90-100% A 54 (36%) – 60 (40%)
· Thoroughly compared the tax advantages of debt versus equity capital formation of the corporation for the client.
· Feedback:
· ACC565-A1-2
2. Recommend to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Provide a rationale for the response.
Weight: 40%21 (14%)
· Levels of Achievement:
· Unacceptable Below 70% F 0 (0%) – 41.98 (27.99%)
· Did not submit or incompletely recommended to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Did not submit or incompletely provided a rationale for the response.
· Fair 70-79% C 42 (28%) – 47.98 (31.99%)
· Partially recommended to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Partially provided a rationale for the response.
· Proficient 80-89% B 48 (32%) – 53.98 (35.99%)
· Satisfactorily recommended to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Satisfactorily provided a rationale for the response.
· Exemplary 90-100% A 54 (36%) – 60 (40%)
· Thoroughly recommended to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Thoroughly provided a rationale for the response.
· Feedback:
· ACC565-A1-3
3. Use the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
Weight: 10%5.25 (3.5%)
· Levels of Achievement:
· Unacceptable Below 70% F 0 (0%) – 10.48 (6.99%)
· Did not submit or incompletely used the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
· Fair 70-79% C 10.5 (7%) – 11.98 (7.99%)
· Partially used the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
· Proficient 80-89% B 12 (8%) – 13.48 (8.99%)
· Satisfactorily used the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
· Exemplary 90-100% A 13.5 (9%) – 15 (10%)
· Thoroughly used the six (6) step tax research process, located in Chapter 1 and demonstrated in Appendix A of the textbook, to record your research for communications to the client.
· Feedback:
· ACC565-A1-4
4. Clarity, writing mechanics, and formatting requirements Weight: 10%14.25 (9.5%)
· Levels of Achievement:
· Unacceptable Below 70% F 0 (0%) – 10.48 (6.99%)
· More than 6 errors present
· Fair 70-79% C 10.5 (7%) – 11.98 (7.99%)
· 5-6 errors present
· Proficient 80-89% B 12 (8%) – 13.48 (8.99%)
· 3-4 errors present
· Exemplary 90-100% A 13.5 (9%) – 15 (10%)
· 0-2 errors present
· Feedback:
· Raw Total: 91.50 (of 150.0)
· Feedback
· Where is the 6 research steps?
· Name:ACC565 Week 2 Assignment 1: Client Letter
· Description:ACC565 Week 2 Assignment 1: Client Letter
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·
Assignment 1: Client Letter
Due Week 2 and worth 150 points
Imagine that you are a Certified Public Accountant (CPA) with a
new client
who needs an opinion on the most advantageous
capital structure of a new corporation. Your client formed the
corporation in question to provide technology to the medical
profession to facilitate compliance with the Health Insurance
Portability and Accounta
bility Act (HIPAA). Your client is very
excited because of the ability to secure several significant
contracts with sufficient capital.
Use the Internet and Strayer databases to research the
advantages and disadvantages of debt for capital formation
versus
equity for capital formation of a corporation. Prepare a
formal letter to the client using the six (6) step tax research
process in Chapter 1 and demonstrated in Appendix A of your
textbook as a guide.
Write a one to two (1
–
2) page letter in which you:
1.
Co
mpare the tax advantages of debt versus equity capital
formation of the corporation for the client.
2.
Recommend to the client whether he / she should use debt or
equity for capital formation of the new corporation, based on
your research. Provide a rationale
for the response.
3.
Use the six (6) step tax research process, located in Chapter 1
and demonstrated in Appendix A of the textbook, to record your
research for communications to the client.
Your assignment must follow these formatting requirements:
·
Be typed
, double spaced, using Times New Roman font (size
12), with one
–
inch margins on all sides; citations and
references must follow APA or school
–
specific format. Check
with your professor for any additional instructions.
·
Include a cover page containing the ti
tle of the assignment, the
student’s name, the professor’s name, the course title, and the
date.
The cover page and the reference page are not included
in the required assignment page length
·
ACC565
–
A1
–
1
1. Compare the tax advantages of debt versus equity capital formation of
the corporation for the client. Weight: 40%
51
(34%)
·
Levels of Achievement:
·
Unacceptable Below 70% F 0
(0%)
–
41.98
(27.99%)
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1
TAX RESEARCH
1-1
LEARNING OBJECTIVES
After studying this chapter, you should be able to
1 Distinguish between closed fact and open fact tax situations
2 Describe the steps in the tax research process
3 Explain how the facts influence tax consequences
4 Identify the sources of tax law and assess the authoritative value of each
5 Consult tax services to research an issue
6 Apply the basics of Internet-based tax research
7 Use a citator to assess tax authorities
8 Describe the professional guidelines that CPAs in tax practice should
follow
9 Prepare work papers and communicate to clients
C H A P T E R
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Prentice Hall’s Federal Taxation 2014 Corporations, Partnerships, Estates & Trusts, Twenty-Seventh Edition, by Kenneth E. Anderson, Thomas R. Pope, and
Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
OBJECTIVE 1
Distinguish between
closed fact and open fact
tax situations
1-2 Corporations ▼ Chapter 1
This chapter introduces the reader to the tax research process. Its major focus is the
sources of the tax law (i.e., the Internal Revenue Code and other tax authorities) and the
relative weight given to each source. The chapter describes the steps in the tax research
process and places particular emphasis on the importance of the facts to the tax conse-
quences. It also describes the features of frequently used tax services and computer-based
tax research resources. Finally, it explains how to use a citator.
The end product of the tax research process—the communication of results to the
client—also is discussed. This text uses a hypothetical set of facts to provide a comprehen-
sive illustration of the process. Sample work papers demonstrating how to document the
results of research are included in Appendix A. The text also discusses two types of pro-
fessional guidelines for CPAs in tax practice: the American Institute of Certified Public
Accountants’ (AICPA’s) Statements on Standards for Tax Services (reproduced in
Appendix E) and Treasury Department Circular 230.
CHAPTER OUTLINE
Overview of Tax Research…1-2
Steps in the Tax Research
Process…1-3
Importance of the Facts to the Tax
Consequences…1-5
The Sources of Tax Law…1-7
Tax Services…1-25
The Internet as a Research
Tool…1-26
Citators…1-30
Professional Guidelines for Tax
Services…1-32
Sample Work Papers and Client
Letter…1-36
OVERVIEW OF TAX RESEARCH
ADDITIONAL
COMMENT
Closed-fact situations afford the
tax advisor the least amount of
flexibility. Because the facts are
already established, the tax advi-
sor must develop the best solu-
tion possible within certain prede-
termined constraints.
EXAMPLE C:1-1 �
ADDITIONAL
COMMENT
Open-fact or tax-planning situa-
tions give a tax advisor flexibility
to structure transactions to accom-
plish the client’s objectives. In this
type of situation, a creative tax
advisor can save taxpayers dollars
through effective tax planning.
EXAMPLE C:1-2 �
Tax research is the process of solving tax-related problems by applying tax law to specific
sets of facts. Sometimes it involves researching several issues and often is conducted to
formulate tax policy. For example, policy-oriented research would determine how far the
level of charitable contributions might decline if such contributions were no longer
deductible. Economists usually conduct this type of tax research to assess the effects of
government policy.
Tax research also is conducted to determine the tax consequences of transactions to
specific taxpayers. For example, client-oriented research would determine whether Smith
Corporation could deduct a particular expenditure as a trade or business expense.
Accounting and law firms generally engage in this type of research on behalf of their
clients.
This chapter deals only with client-oriented tax research, which occurs in two con-
texts:
1. Closed fact or tax compliance situations: The client contacts the tax advisor after
completing a transaction or while preparing a tax return. In such situations, the tax
consequences are fairly straightforward because the facts cannot be modified to obtain
different results. Consequently, tax saving opportunities may be lost.
Tom informs Carol, his tax advisor, that on November 4 of the current year, he sold land held as
an investment for $500,000 cash. His basis in the land was $50,000. On November 9, Tom rein-
vested the sales proceeds in another plot of investment property costing $500,000. This is a
closed fact situation. Tom wants to know the amount and the character of the gain (if any) he
must recognize. Because Tom solicits the tax advisor’s advice after the sale and reinvestment,
the opportunity for tax planning is limited. For example, the possibility of deferring taxes by
using a like-kind exchange or an installment sale is lost. �
2. Open fact or tax planning situations: Before structuring or concluding a transaction,
the client contacts the tax advisor to discuss tax planning opportunities. Tax-planning
situations generally are more difficult and challenging because the tax advisor must
consider the client’s tax and nontax objectives. Most clients will not engage in a trans-
action if it is inconsistent with their nontax objectives, even though it produces tax
savings.
Diane is a widow with three children and five grandchildren and at present owns property val-
ued at $10 million. She seeks advice from Carol, her tax advisor, about how to minimize her
estate taxes and convey the greatest value of property to her descendants. This is an open-
fact situation. Carol could advise Diane to leave all but a few hundred thousand dollars of her
property to a charitable organization so that her estate would owe no estate taxes. Although
this recommendation would eliminate Diane’s estate taxes, Diane is likely to reject it because
she wants her children or grandchildren to be her primary beneficiaries. Thus, reducing estate
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Prentice Hall’s Federal Taxation 2014 Corporations, Partnerships, Estates & Trusts, Twenty-Seventh Edition, by Kenneth E. Anderson, Thomas R. Pope, and
Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-3
taxes to zero is inconsistent with her objective of allowing her descendants to receive as much
after-tax wealth as possible. �
When conducting research in a tax planning context, the tax professional should keep
a number of points in mind. First, the objective is not to minimize taxes per se but rather
to maximize a taxpayer’s after-tax return. For example, if the federal income tax rate is a
constant 30%, an investor should not buy a tax-exempt bond yielding 5% when he or she
could buy a corporate bond of equal risk that yields 9% before tax and 6.3% after tax.
This is the case even though his or her explicit taxes (actual tax liability) would be mini-
mized by investing in the tax-exempt bond.1 Second, taxpayers typically do not engage in
unilateral or self-dealing transactions; thus, the tax ramifications for all parties to the
transaction should be considered. For example, in the executive compensation context,
employees may prefer to receive incentive stock options (because they will not recognize
income until they sell the stock), but the employer may prefer to grant a different type of
option (because the employer cannot deduct the value of incentive stock options upon
issuance). Thus, the employer might grant a different number of options if it uses one type
of stock option versus another type as compensation. Third, taxes are but one cost of
doing business. In deciding where to locate a manufacturing plant, for example, factors
more important to some businesses than the amount of state and local taxes paid might be
the proximity to raw materials, good transportation systems, the cost of labor, the quan-
tity of available skilled labor, and the quality of life in the area. Fourth, the time for tax
planning is not restricted to the beginning date of an investment, contract, or other
arrangement. Instead, the time extends throughout the duration of the activity. As tax
rules change or as business and economic environments change, the tax advisor must
reevaluate whether the taxpayer should hold onto an investment and must consider the
transaction costs of any alternatives.
One final note: the tax advisor should always bear in mind the financial accounting
implications of proposed transactions. An answer that may be desirable from a tax perspec-
tive may not always be desirable from a financial accounting perspective. Though interre-
lated, the two fields of accounting have different orientations and different objectives. Tax
accounting is oriented primarily to the Internal Revenue Service (IRS). Its objectives include
calculating, reporting, and predicting one’s tax liability according to legal principles.
Financial accounting is oriented primarily to shareholders, creditors, managers, and
employees. Its objectives include determining, reporting, and predicting a business’s finan-
cial position and operating results according to Generally Accepted Accounting Principles.
Because tax and financial accounting objectives may differ, planning conflicts could arise.
For example, management might be reluctant to engage in tax reduction strategies that also
reduce book income and reported earnings per share. Success in any tax practice, especially
at the managerial level, requires consideration of both sets of objectives and orientations.
ADDITIONAL
COMMENT
It is important to consider nontax
as well as tax objectives. In many
situations, the nontax considera-
tions outweigh the tax considera-
tions. Thus, the plan eventually
adopted by a taxpayer may not
always be the best when viewed
strictly from a tax perspective.
OBJECTIVE 2
Describe the steps in the
tax research process
STEPS IN THE TAX
RESEARCH PROCESS
1 For an excellent discussion of explicit and implicit taxes and tax planning
see M. S. Scholes, M. A. Wolfson, M. Erickson, L. Maydew, and T. Shevlin,
Taxes and Business Strategy: A Planning Approach, fourth edition (Upper
Saddle River, NJ: Pearson Prentice Hall, 2008). Also see Chapter I:18 of the
In both open- and closed-fact situations, the tax research process involves six basic steps:
1. Determine the facts.
2. Identify the issues (questions).
3. Locate the applicable authorities.
4. Evaluate the authorities and choose those to follow where the authorities conflict.
5. Analyze the facts in terms of the applicable authorities.
6. Communicate conclusions and recommendations to the client.
Individuals volume. An example of an implicit tax is the excess of the before-
tax earnings on a taxable bond over the risk-adjusted before-tax earnings on
a tax-favored investment (e.g., a municipal bond).
TAX STRATEGY TIP
Taxpayers should make invest-
ment decisions based on after-tax
rates of return or after-tax cash
flows.
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Prentice Hall’s Federal Taxation 2014 Corporations, Partnerships, Estates & Trusts, Twenty-Seventh Edition, by Kenneth E. Anderson, Thomas R. Pope, and
Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
1-4 Corporations ▼ Chapter 1
Identify the issues
(questions).
Locate the applicable
authorities.
Evaluate the authorities;
choose those to follow where
the authorities conflict.
Analyze the facts in
terms of the applicable
authorities.
You may need to
gather additional
facts.
You may need to
restate the
questions.
Determine the facts.
Communicate conclusions and
recommendations to the client.
FIGURE C:1-1 � STEPS IN THE TAX RESEARCH PROCESS
ADDITIONAL
COMMENT
The steps of tax research provide
an excellent format for a written
tax communication. For example,
a good format for a client memo
includes (1) statement of facts,
(2) list of issues, (3) discussion of
relevant authority, (4) analysis,
and (5) recommendations to the
client of appropriate actions
based on the research results.
TYPICAL
MISCONCEPTION
Many taxpayers think the tax law
is all black and white. However,
most tax research deals with gray
areas. Ultimately, when con-
fronted with tough issues, the
ability to develop strategies that
favor the taxpayer and then to
find relevant authority to support
those strategies will make a suc-
cessful tax advisor. Thus, recogniz-
ing planning opportunities and
avoiding potential traps is often
the real value added by a tax
advisor.
2 Often, in an employment context, supervisors define the questions to be
researched and the authorities that might be relevant to the tax consequences.
Although the above outline suggests a linear approach, the tax research process often is
circular. That is, it does not always proceed step-by-step. Figure C:1-1 illustrates a more
accurate process, and Appendix A provides a comprehensive example of this process.
In a closed-fact situation, the facts have already occurred, and the tax advisor’s task is
to analyze them to determine the appropriate tax treatment. In an open-fact situation, by
contrast, the facts have not yet occurred, and the tax advisor’s task is to plan for them or
shape them so as to produce a favorable tax result. The tax advisor performs the latter
task by reviewing the relevant legal authorities, particularly court cases and IRS rulings,
all the while bearing in mind the facts of those cases or rulings that produced favorable
results compared with those that produced unfavorable results. For example, if a client
wants to realize an ordinary loss (as opposed to a capital loss) on the sale of several plots
of land, the tax advisor might consult cases involving similar land sales. The advisor
might attempt to distinguish the facts of those cases in which the taxpayer realized an
ordinary loss from the facts of those cases in which the taxpayer realized a capital loss.
The advisor then might recommend that the client structure the transaction based on the
fact pattern in the ordinary loss cases.
Often, tax research involves a question to which no clearcut, unequivocally correct
answer exists. In such situations, probing a related issue might lead to a solution pertinent
to the central question. For example, in researching whether the taxpayer may deduct a
loss as ordinary instead of capital, the tax advisor might research the related issue of
whether the presence of an investment motive precludes classifying a loss as ordinary. The
solution to that issue might be relevant to the central question of whether the taxpayer
may deduct the loss as ordinary.
Identifying the issue(s) to be researched often is the most difficult step in the tax
research process. In some instances, the client defines the issue(s) for the tax advisor, such
as where the client asks, “May I deduct the costs of a winter trip to Florida recommended
by my physician?” In other instances, the tax advisor, after reviewing the documents sub-
mitted to him or her by the client, identifies and defines the issue(s) himself or herself.
Doing so presupposes a firm grounding in tax law.2
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-5
Once the tax advisor locates the applicable legal authorities, he or she might have to
obtain additional information from the client. Example C:1-3 illustrates the point. The
example assumes that all relevant tax authorities are in agreement.
Mark calls his tax advisor, Al, and states that he (1) incurred a loss on renting his beach cottage
during the current year and (2) wonders whether he may deduct the loss. He also states that he,
his wife, and their minor child occupied the cottage only eight days during the current year.
This is the first time Al has dealt with the Sec. 280A vacation home rules. On reading Sec.
280A(d), Al learns that a loss is not deductible if the taxpayer used the residence for personal
purposes for longer than the greater of (1) 14 days or (2) 10% of the number of days the unit
was rented at a fair rental value. He also learns that the property is deemed to be used by the
taxpayer for personal purposes on any days on which it is used by any member of his or her
family (as defined in Sec. 267(c)(4)). The Sec. 267(c)(4) definition of family members includes
brothers, sisters, spouse, ancestors, or lineal descendants (i.e., children and grandchildren).
Mark’s eight-day use is not long enough to make the rental loss nondeductible. However, Al
must inquire about the number of days, if any, Mark’s brothers, sisters, or parents used the
property. (He already knows about use by Mark, his spouse, and his lineal descendants.) In addi-
tion, Al must find out how many days the cottage was rented to other persons at a fair rental
value. Upon obtaining the additional information, Al proceeds to determine how to calculate
the deductible expenses. Al then derives his conclusion concerning the deductible loss, if any,
and communicates it to Mark. (This example assumes the passive activity and at-risk rules
restricting a taxpayer’s ability to deduct losses from real estate activities will not pose a problem
for Mark. See Chapter I:8 for a comprehensive discussion of these topics.) �
Many firms require that a researcher’s conclusions be communicated to the client in
writing. Members or employees of such firms may answer questions orally, but their oral
conclusions should be followed by a written communication. According to the AICPA’s
Statements on Standards for Tax Services (reproduced in Appendix E),
Although oral advice may serve a client’s needs appropriately in routine matters or in well-
defined areas, written communications are recommended in important, unusual, substantial
dollar value, or complicated transactions. The member may use professional judgment about
whether, subsequently, to document oral advice.3
In addition, Treasury Department Circular 230 covers all written advice communi-
cated to clients. These requirements are more fully discussed at the end of this chapter and
in Chapter C:15.
EXAMPLE C:1-3 �
OBJECTIVE 3
Explain how the
facts influence tax
consequences
3 AICPA, Statement on Standards for Tax Services, No. 7, “Form and
Content of Advice to Taxpayers,” 2010, Para. 6.
IMPORTANCE OF THE FACTS
TO THE TAX CONSEQUENCES
4 Sec. 152(e)(1)(A) and Sec. 152(d)(1)(C).
Many terms and phrases used in the Internal Revenue Code (IRC) and other tax authori-
ties are vague or ambiguous. Some provisions conflict with others or are difficult to rec-
oncile, creating for the researcher the dilemma of deciding which rules are applicable and
which tax results are proper. For example, as a condition to claiming another person as a
dependent, the taxpayer must provide a certain level of support for such person.4 Neither
the IRC nor the Treasury Regulations define “support.” This lack of definition could be
problematic. For example, if the taxpayer purchased a used automobile costing $8,000
for an elderly parent whose only source of income is $7,800 in Social Security benefits,
the question of whether the expenditure constitutes support would arise. The tax advisor
would have to consult court opinions, revenue rulings, and other IRS pronouncements to
ascertain the legal meaning of the term “support.” Only after thorough research would
the meaning of the term become clear.
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1-6 Corporations ▼ Chapter 1
TYPICAL
MISCONCEPTION
Many taxpayers believe tax practi-
tioners spend most of their time
preparing tax returns. In reality,
providing tax advice that accom-
plishes the taxpayer’s objectives is
one of the most important
responsibilities of a tax advisor.
This latter activity is tax consulting
as compared to tax compliance.
5 Rev. Rul. 93-86, 1993-2 C.B. 71.
In other instances, the legal language is quite clear, but a question arises as to whether
the taxpayer’s transaction conforms to a specific pattern of facts that gives rise to a partic-
ular tax result. Ultimately, the peculiar facts of a transaction or event determine its tax
consequences. A change in the facts can significantly change the consequences. Consider
the following illustrations:
Illustration One
Facts: A holds stock, a capital asset, that he purchased two years ago at a cost of $1,000. He
sells the stock to B for $920. What are the tax consequences to A?
Result: Under Sec. 1001, A realizes an $80 capital loss. He recognizes this loss in the current
year. A must offset the loss against any capital gains recognized during the year. Any excess
loss is deductible from ordinary income up to a $3,000 annual limit.
Change of Facts: A is B’s son.
New Result: Under Sec. 267, A and B are related parties. Therefore, A may not recognize the
realized loss. However, B may use the loss if she subsequently sells the stock at a gain.
Illustration Two
Facts: C donates to State University ten acres of land that she purchased two years ago for
$10,000. The fair market value (FMV) of the land on the date of the donation is $25,000.
C’s adjusted gross income is $100,000. What is C’s charitable contribution deduction?
Result: Under Sec. 170, C is entitled to a $25,000 charitable contribution deduction (i.e., the
FMV of the property unreduced by the unrealized long-term gain).
Change of Facts: C purchased the land 11 months ago.
New Result: Under the same IRC section, C is entitled to only a $10,000 charitable contribu-
tion deduction (i.e., the FMV of the property reduced by the unrealized short-term gain).
Illustration Three
Facts: Acquiring Corporation pays Target Corporation’s shareholders one million shares of
Acquiring voting stock. In return, Target’s shareholders tender 98% of their Target voting
stock. The acquisition is for a bona fide business purpose. Acquiring continues Target’s busi-
ness. What are the tax consequences of the exchange to Target’s shareholders?
Result: Because the transaction qualifies as a reorganization under Sec. 368(a)(1)(B), Target’s
shareholders are not taxed on the exchange, which is solely for Acquiring voting stock.
Change of Facts: In the transaction, Acquiring purchases the remaining 2% of Target’s
shares with cash.
New Result: Under the same IRC provision, Target’s shareholders are now taxed on the
exchange, which is not solely for Acquiring voting stock.
CREATING A FACTUAL SITUATION
FAVORABLE TO THE TAXPAYER
Based on his or her research, a tax advisor might recommend to a taxpayer how to struc-
ture a transaction or plan an event so as to increase the likelihood that related expenses
will be deductible. For example, suppose a taxpayer is assigned a temporary task in a
location (City Y) different from the location (City X) of his or her permanent employ-
ment. Suppose also that the taxpayer wants to deduct the meal and lodging expenses
incurred in City Y as well as the cost of transportation thereto. To do so, the taxpayer
must establish that City X is his or her tax home and that he or she temporarily works in
City Y. (Section 162 provides that a taxpayer may deduct travel expenses while “away
from home” on business. A taxpayer is deemed to be “away from home” if his or her
employment at the new location does not exceed one year, i.e., it is “temporary.”)
Suppose the taxpayer wants to know the tax consequences of his or her working in City
Y for ten months and then, within that ten-month period, finding permanent employment
in City Y. What is tax research likely to reveal?
Tax research will lead to an IRS ruling stating that, in such circumstances, the employ-
ment will be deemed to be temporary until the date on which the realistic expectation
about the temporary nature of the assignment changes.5 After this date, the employment
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Tax Research ▼ Corporations 1-7
THE SOURCES OF TAX LAW
OBJECTIVE 4
Identify the sources of
tax law and assess the
authoritative value of each
ADDITIONAL
COMMENT
Committee reports can be helpful
in interpreting new legislation
because they indicate the intent
of Congress. With the prolifera-
tion of tax legislation, committee
reports have become especially
important because the Treasury
Department often is unable to
draft the needed regulations in a
timely manner.
6 The size of a conference committee can vary. It is made up of an equal num-
ber of members from the House and the Senate.
7 The Cumulative Bulletin is described in the discussion of revenue rulings on
page C:1-12.
The language of the IRC is general; that is, it prescribes the tax treatment of broad cat-
egories of transactions and events. The reason for the generality is that Congress can
neither foresee nor provide for every conceivable transaction or event. Even if it could,
doing so would render the statute narrow in scope and inflexible in application.
Accordingly, interpretations of the IRC—both administrative and judicial—are neces-
sary. Administrative interpretations are provided in Treasury Regulations, revenue rul-
ings, revenue procedures, and several other pronouncements discussed later in this
chapter. Judicial interpretations are presented in court opinions. The term tax law as
used by most tax advisors encompasses administrative and judicial interpretations in
addition to the IRC. It also includes the meaning conveyed in reports issued by
Congressional committees involved in the legislative process.
THE LEGISLATIVE PROCESS
Tax legislation begins in the House of Representatives. Initially, a tax proposal is incorpo-
rated in a bill. The bill is referred to the House Ways and Means Committee, which is
charged with reviewing all tax legislation. The Ways and Means Committee holds hearings in
which interested parties, such as the Treasury Secretary and IRS Commissioner, testify. At
the conclusion of the hearings, the Ways and Means Committee votes to approve or reject the
measure. If approved, the bill goes to the House floor where it is debated by the full member-
ship. If the House approves the measure, the bill moves to the Senate where it is taken up by
the Senate Finance Committee. Like Ways and Means, the Finance Committee holds hearings
in which Treasury officials, tax experts, and other interested parties testify. If the committee
approves the measure, the bill goes to the Senate floor where it is debated by the full member-
ship. Upon approval by the Senate, it is submitted to the President for his or her signature. If
the President signs the measure, the bill becomes public law. If the President vetoes it,
Congress can override the veto by at least a two-thirds majority vote in each chamber.
Generally, at each stage of the legislative process, the bill is subject to amendment. If
amended, and if the House version differs from the Senate version, the bill is referred to a
House-Senate conference committee.6 This committee attempts to resolve the differences
between the House and Senate versions. Ultimately, it submits a compromise version of the
measure to each chamber for its approval. Such referrals are common. For example, in 1998
the House and Senate disagreed over what the taxpayer must do to shift the burden of proof
to the IRS. The House proposed that the taxpayer assert a “reasonable dispute” regarding a
taxable item. The Senate proposed that the taxpayer introduce “credible evidence” regard-
ing the item. A conference committee was appointed to resolve the differences. This com-
mittee ultimately adopted the Senate proposal, which was later approved by both chambers.
After approving major legislation, the Ways and Means Committee and Senate
Finance Committee usually issue official reports. These reports, published by the U.S.
Government Printing Office (GPO) as part of the Cumulative Bulletin and as separate
documents, explain the committees’ reasoning for approving (and/or amending) the legis-
lation.7 In addition, the GPO publishes both records of the committee hearings and tran-
scripts of the floor debates. The records are published as separate House or Senate docu-
ments. The transcripts are incorporated in the Congressional Record for the day of the
will be deemed to be permanent, and travel expenses relating to it will be nondeductible.
Based on this finding, the tax advisor might advise the taxpayer to postpone his or her
permanent job search in City Y until the end of the ten-month period and simply treat his
or her assignment as temporary. So doing would lengthen the time he or she is deemed to
be “away from home” on business and thus increase the amount of meal, lodging, and
transportation costs deductible as travel expenses. The taxpayer should compare the tax
savings to any additional personal costs of maintaining two residences.
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1-8 Corporations ▼ Chapter 1
ADDITIONAL
COMMENT
The various tax services, discussed
later in this chapter, provide IRC
histories for researchers who need
to work with prior years’ tax law.
EXAMPLE C:1-5 �
EXAMPLE C:1-6 �
8 S. Rept. No. 105-174, 105th Cong., 1st Sess. (unpaginated) (1998).
debate. In tax research, these records, reports, and transcripts are useful in deciphering
the meaning of the statutory language. Where this language is ambiguous or vague, and
the courts have not interpreted it, the documents can shed light on Congressional intent,
i.e., what Congress intended by a particular term, phrase, or provision.
In 1998, Congress passed legislation concerning shifting the burden of proof to the IRS. This
legislation was codified in Sec. 7491. The question arises as to what constitutes “credible evi-
dence” because the taxpayer must introduce such evidence to shift the burden of proof to the
IRS. Section 7491 does not define the term. Because the provision was relatively new, few
courts had an opportunity to interpret what “credible evidence” means. In the absence of rele-
vant statutory or judicial authority, the researcher might have looked to the committee reports
to ascertain what Congress intended by the term. Senate Report No. 105-174 states that “cred-
ible evidence” means evidence of a quality, which, “after critical analysis, the court would find
sufficient upon which to base a decision on the issue if no contrary evidence were submitted.”8
This language suggests that Congress intended the term to mean evidence of a kind sufficient
to withstand judicial scrutiny. Such a meaning should be regarded as conclusive in the absence
of other authority. �
THE INTERNAL REVENUE CODE
The IRC, which comprises Title 26 of the United States Code, is the foundation of all tax
law. First codified (i.e., organized into a single compilation of revenue statutes) in 1939, the
tax law was recodified in 1954. The IRC was known as the Internal Revenue Code of 1954
until 1986, when its name was changed to the Internal Revenue Code of 1986. Whenever
changes to the IRC are approved, the old language is deleted and new language added.
Thus, the IRC is organized as an integrated document, and a researcher need not read
through the relevant parts of all previous tax bills to find the current version of the law.
Nevertheless, a researcher must be sure that he or she is working with the law in effect
when a particular transaction occurred.
The IRC contains provisions dealing with income taxes, estate and gift taxes, employ-
ment taxes, alcohol and tobacco taxes, and other excise taxes. Organizationally, the IRC
is divided into subtitles, chapters, subchapters, parts, subparts, sections, subsections, para-
graphs, subparagraphs, and clauses. Subtitle A contains rules relating to income taxes, and
Subtitle B deals with estate and gift taxes. A set of provisions concerned with one general
area constitutes a subchapter. For example, the topics of corporate distributions and
adjustments appear in Subchapter C, and topics relating to partners and partnerships
appear in Subchapter K. Figure C:1-2 presents the organizational scheme of the IRC.
An IRC section contains the operative provisions to which tax advisors most often
refer. For example, they speak of “Sec. 351 transactions,” “Sec. 306 stock,” and “Sec.
1231 gains and losses.” Although a tax advisor need not know all the IRC sections, para-
graphs, and parts, he or she must be familiar with the IRC’s organizational scheme to read
and interpret it correctly. The language of the IRC is replete with cross-references to titles,
paragraphs, subparagraphs, and so on.
Section 7701, a definitional section, begins, “When used in this title . . .” and then provides a
series of definitions. Because of this broad reference, a Sec. 7701 definition applies for all of
Title 26; that is, it applies for purposes of the income tax, estate and gift tax, excise tax, and
other taxes governed by Title 26. �
Section 302(b)(3) allows taxpayers whose stock holdings are completely terminated in a
redemption (a corporation’s purchase of its stock from one or more of its shareholders) to
receive capital gain treatment on the excess of the redemption proceeds over the stock’s basis
instead of ordinary income treatment on the entire proceeds. Section 302(c)(2)(A) states, “In
the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if. . . .”
Further, Sec. 302(c)(2)(C)(i) indicates “Subparagraph (A) shall not apply to a distribution to any
entity unless. . . .” Thus, in determining whether a taxpayer will receive capital gain treatment
in a stock redemption, a tax advisor must be able to locate and interpret various cross-
referenced IRC sections, subsections, paragraphs, subparagraphs, and clauses. �
EXAMPLE C:1-4 �
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Tax Research ▼ Corporations 1-9
Overall Scheme
Title 26. All matters concerned with taxation
Subtitle A. Income taxes
Chapter 1. Normal taxes and surtaxes
Subchapter A. Determination of tax liability
Part I. Tax on individuals
Sec. 1. Tax imposed
Scheme for Sections, Subsections, etc.
Sec. 165 (h) (2) (A) (i) and (ii)
Section Paragraph Clauses
Subsection Subparagraph
FIGURE C:1-2 � ORGANIZATIONAL SCHEME OF THE INTERNAL REVENUE CODE
TREASURY REGULATIONS
The Treasury Department issues regulations that expound upon the IRC. Treasury
Regulations often provide examples with computations that assist the reader in under-
standing how IRC provisions apply. Treasury Regulations are formulated on the basis of
Treasury Decisions (T.D.s). The numbers of the Treasury Decisions that form the basis of a
Treasury Regulation usually are found in the notes at the end of the regulation.
Because of frequent IRC changes, the Treasury Department does not always update the
regulations in a timely manner. Consequently, when consulting a regulation, a tax advisor
should check its introductory or end note to determine when the regulation was adopted.
If the regulation was adopted before the most recent revision of the applicable IRC sec-
tion, the regulation should be treated as authoritative to the extent consistent with the
revision. Thus, for example, if a regulation issued before the passage of an IRC amend-
ment specifies a dollar amount, and the amendment changed the dollar amount, the regu-
lation should be regarded as authoritative in all respects except for the dollar amount.
PROPOSED, TEMPORARY, AND FINAL REGULATIONS. A Treasury Regulation is
first issued in proposed form to the public, which is given an opportunity to comment on
it. Parties most likely to comment are individual tax practitioners and representatives of
organizations such as the American Bar Association, the Tax Division of the AICPA, and
the American Taxation Association. The comments may suggest that the proposed rules
could affect taxpayers more adversely than Congress had anticipated. In drafting a final
regulation, the Treasury Department generally considers the comments and may modify
the rules accordingly. If the comments are favorable, the Treasury Department usually
finalizes the regulation with minor revisions. If the comments are unfavorable, it usually
finalizes the regulation with major revisions or allows the proposed regulation to expire.
Proposed regulations are just that—proposed. Consequently, they carry no more
authoritative weight than do the arguments of the IRS in a court brief. Nevertheless, they
represent the Treasury Department’s official interpretation of the IRC. By contrast, tempo-
rary regulations are binding on the taxpayer. Effective as of the date of their publication,
they often are issued immediately after passage of a major tax act to guide taxpayers and
their advisors on procedural or computational matters. Regulations issued as temporary
are concurrently issued as proposed. Because their issuance is not preceded by a public
comment period, they are regarded as somewhat less authoritative than final regulations.
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1-10 Corporations ▼ Chapter 1
KEY POINT
The older a Treasury Regulation
becomes, the less likely a court is
to invalidate the regulation. The
legislative reenactment doctrine
holds that if a regulation did not
reflect the intent of Congress,
lawmakers would have changed
the statute in subsequent legisla-
tion to obtain their desired objec-
tives.
STOP & THINK
9 Sec. 7805(b).
10 Sec. 1501.
11 Mayo Foundation for Medical Education & Research, et al. v. U.S., 107
AFTR 2d 2011-341, 131 S.Ct. 704 (2011).
12 McDonald v. CIR, 56 AFTR 2d 85-5318, 85-2 USTC ¶9494 (5th Cir., 1985).
13 Jeanese, Inc. v. U.S., 15 AFTR 2d 429, 65-1 USTC ¶9259 (9th Cir., 1965).
14 United States v. Vogel Fertilizer Co., 49 AFTR 2d 82-491, 82-1 USTC
¶9134 (USSC, 1982).
15 United States v. Homer O. Correll, 20 AFTR 2d 5845, 68-1 USTC ¶9101
(USSC, 1967).
16 One can rebut the presumption that Congress approved of the regulation
by showing that Congress was unaware of the regulation when it reenacted
the statute.
Once finalized, regulations can be effective the earliest of (1) the date they were proposed;
(2) the date temporary regulations preceding them were first published in the Federal
Register, a daily publication that contains federal government pronouncements; or (3) the
date on which a notice describing the expected contents of the regulation was issued to the
public.9 For changes to the IRC enacted after July 29, 1996, the Treasury Department gen-
erally cannot issue regulations with retroactive effect.
INTERPRETATIVE AND LEGISLATIVE REGULATIONS. In addition to being offi-
cially classified as proposed, temporary, or final, Treasury Regulations are unofficially
classified as interpretative or legislative. Interpretative regulations are issued under the
general authority of Sec. 7805 and, as the name implies, merely make the IRC’s statutory
language easier to understand and apply. In addition, they often illustrate various compu-
tations. Legislative regulations, by contrast, arise where Congress delegates its rule-
making authority to the Treasury Department. When Congress believes it lacks the
expertise necessary to deal with a highly technical matter, it instructs the Treasury
Department to set forth substantive tax rules relating to the matter.
Whenever the IRC contains language such as “The Secretary shall prescribe such
regulations as he may deem necessary” or “under regulations prescribed by the
Secretary,” the regulations interpreting the IRC provision are legislative. The consolidated
tax return regulations are an example of legislative regulations. In Sec. 1502, Congress
delegated to the Treasury Department authority to issue regulations that determine the
tax liability of a group of affiliated corporations filing a consolidated tax return. As a pre-
condition to filing such a return, the corporations must consent to follow the consolidated
return regulations.10 Such consent generally precludes the corporations from later arguing
in court that the regulatory provisions are invalid.
AUTHORITATIVE WEIGHT. Final Treasury Regulations are presumed to be valid and
have almost the same authoritative weight as the IRC. Despite this presumption, taxpayers
occasionally argue that a regulation is invalid and, consequently, should not be followed.
Prior to 2011, courts held interpretive and legislative regulations to different standards, giv-
ing more authority to legislative regulations that Congress specifically delegated to the Treasury
Department to draft. The difference in authoritative weight largely disappeared, however, in
2011 with the Supreme Court decision in Mayo Foundation.11 Going forward, both types of
regulations will have the same authoritative weight and will be overturned only in very limited
cases such as when, in the Court’s opinion, the regulations exceed the scope of power delegated
to the Treasury Department,12 are contrary to the IRC,13 or are unreasonable.14
In assessing the validity of long-standing Treasury Regulations, some courts apply the
legislative reenactment doctrine. Under this doctrine, a regulation is deemed to receive
congressional approval whenever the IRC provision under which the regulation was
issued is reenacted without amendment.15 Underlying this doctrine is the rationale that, if
Congress believed that the regulation offered an erroneous interpretation of the IRC, it
would have amended the IRC to conform to its belief. Congress’s failure to amend the
IRC signifies approval of the regulation.16 This doctrine is predicated on Congress’s con-
stitutional authority to levy taxes. This authority implies that, if Congress is dissatisfied
with the manner in which either the executive or the judiciary has interpreted the IRC, it
can invalidate these interpretations through new legislation.
Question: You are researching the manner in which a deduction is calculated. You
consult Treasury Regulations for guidance because the IRC states that the calculation is to
be done “in a manner prescribed by the Secretary.” After reviewing these authorities, you
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Tax Research ▼ Corporations 1-11
conclude that another way of doing the calculation arguably is correct under an intuitive
approach. This approach would result in a lower tax liability for the client. Should you
follow the Treasury Regulations, or should you use the intuitive approach and argue that
the regulations are invalid?
Solution: Because of the language “in a manner prescribed by the Secretary,” the
Treasury Regulations dealing with the calculation are legislative. Whenever Congress calls
for legislative regulations, it explicitly authorizes (directs) the Treasury Department to
write the “rules.” Thus, a challenge based on the existence of a reasonable alternative
method is unlikely to succeed in court. Under the Mayo Foundation decision, you should
reach the same conclusion even if dealing with an interpretive Treasury Regulation.
CITATIONS. Citations to Treasury Regulations are relatively easy to understand. One
or more numbers appear before a decimal place, and several numbers follow the decimal
place. The numbers immediately following the decimal place indicate the IRC section
being interpreted. The numbers preceding the decimal place indicate the general subject of
the regulation. Numbers that often appear before the decimal place and their general sub-
jects are as follows:
Number General Subject Matter
1 Income tax
20 Estate tax
25 Gift tax
301 Administrative and procedural matters
601 Procedural rules
The number following the IRC section number indicates the numerical sequence of the
regulation, such as the fifth regulation. No relationship exists between this number and
the subsection of the IRC being interpreted. An example of a citation to a final regulation
is as follows:
Reg. Sec. 1.165 � 5
Income tax IRC section Fifth regulation
Citations to proposed or temporary regulations follow the same format. They are refer-
enced as Prop. Reg. Sec. or Temp. Reg. Sec. For temporary regulations the numbering sys-
tem following the IRC section number always begins with the number of the regulation
and an upper case T (e.g., -1T).
Section 165 addresses the broad topic of losses and is interpreted by several regula-
tions. According to its caption, the topic of Reg. Sec. 1.165-5 is worthless securities,
which also is addressed in subsection (g) of IRC Sec. 165. Parenthetical information fol-
lowing the text of the Treasury Regulation indicates that the regulation was last revised
on March 11, 2008, by Treasury Decision (T.D.) 9386. Section 165(g) was last amended
in 2000. A researcher must always check when the regulations were last amended and be
aware that an IRC change may have occurred after the most recent regulation amend-
ment, potentially making the regulation inapplicable.
When referencing a regulation, the researcher should fine-tune the citation to indicate
the precise passage that supports his or her conclusion. An example of such a detailed cita-
tion is Reg. Sec. 1.165-5(j), Ex. 2(i), which refers to paragraph (i) of Example 2, found in
paragraph (j) of the fifth regulation interpreting Sec. 165.
ADMINISTRATIVE PRONOUNCEMENTS
The IRS interprets the IRC through administrative pronouncements, the most important
of which are discussed below. After consulting the IRC and Treasury Regulations, tax
advisors are likely next to consult these pronouncements.
ADDITIONAL
COMMENT
Citations serve two purposes in
tax research: first, they substanti-
ate propositions; second, they
enable the reader to locate
underlying authority.
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1-12 Corporations ▼ Chapter 1
SELF-STUDY
QUESTION
Are letter rulings of precedential
value for third parties?
ANSWER
No. A letter ruling is binding only
on the taxpayer to whom the rul-
ing was issued. Nevertheless, let-
ter rulings can be very useful to
third parties because they provide
insight as to the IRS’s opinion
about the tax consequences of
various transactions.
17 Chapter C:15 discusses the authoritative support taxpayers and tax advi-
sors should have for positions they adopt on a tax return.
18 Chapter C:15 further discusses letter rulings.
REVENUE RULINGS. In revenue rulings, the IRS indicates the tax consequences of spe-
cific transactions encountered in practice. For example, in a revenue ruling, the IRS might
indicate whether the exchange of stock for stock derivatives in a corporate acquisition is
tax-free.
The IRS issues more than 50 revenue rulings a year. These rulings do not rank as high
in the hierarchy of authorities as do Treasury Regulations or federal court cases. They
simply represent the IRS’s view of the tax law. Taxpayers who do not follow a revenue
ruling will not incur a substantial understatement penalty if they have substantial author-
ity for different treatment.17 Nonetheless, the IRS presumes that the tax treatment speci-
fied in a revenue ruling is correct. Consequently, if an examining agent discovers in an
audit that a taxpayer did not adopt the position prescribed in a revenue ruling, the agent
will contend that the taxpayer’s tax liability should be adjusted to reflect that position.
Soon after it is issued, a revenue ruling appears in the weekly Internal Revenue
Bulletin (cited as I.R.B.), published by the U.S. Government Printing Office (GPO).
Revenue rulings later appear in the Cumulative Bulletin (cited as C.B.), a bound volume
issued semiannually by the GPO. An example of a citation to a revenue ruling appearing
in the Cumulative Bulletin is as follows:
Rev. Rul. 97-4, 1997-1 C.B. 5.
This is the fourth ruling issued in 1997, and it appears on page 5 of Volume 1 of the 1997
Cumulative Bulletin. Before the GPO publishes the pertinent volume of the Cumulative
Bulletin, researchers should use citations to the Internal Revenue Bulletin. An example of
such a citation follows:
Rev. Rul. 2009-3, 2009-5 I.R.B. 382.
For revenue rulings (and other IRS pronouncements) issued after 1999, the full four digits
of the year of issuance are set forth in the title. For revenue rulings (and other IRS pro-
nouncements) issued before 2000, only the last two digits of the year of issuance are set
forth in the title. The above citation represents the third ruling for 2009. This ruling is
located on page 382 of the Internal Revenue Bulletin for the fifth week of 2009. Once a
revenue ruling is published in the Cumulative Bulletin, only the citation to the Cumulative
Bulletin should be used. Thus, a citation to the I.R.B. is temporary.
REVENUE PROCEDURES. As the name suggests, revenue procedures are IRS pro-
nouncements that usually deal with the procedural aspects of tax practice. For example,
one revenue procedure deals with the manner in which tip income should be reported.
Another revenue procedure describes the requirements for reproducing paper substitutes
for informational returns such as Form 1099.
As with revenue rulings, revenue procedures are published first in the Internal Revenue
Bulletin, then in the Cumulative Bulletin. An example of a citation to a revenue procedure
appearing in the Cumulative Bulletin is as follows:
Rev. Proc. 97-19, 1997-1 C.B. 644.
This pronouncement is found in Volume 1 of the 1997 Cumulative Bulletin on page 644.
It is the nineteenth revenue procedure issued in 1997.
In addition to revenue rulings and revenue procedures, the Cumulative Bulletin con-
tains IRS notices, as well as the texts of proposed regulations, tax treaties, committee
reports, and U.S. Supreme Court decisions.
LETTER RULINGS. Letter rulings are initiated by taxpayers who ask the IRS to explain
the tax consequences of a particular transaction.18 The IRS provides its explanation in the
form of a letter ruling, a response personal to the taxpayer requesting an answer. Only the
TYPICAL
MISCONCEPTION
Even though revenue rulings do
not have the same weight as
Treasury Regulations or court
cases, one should not underesti-
mate their importance. Because a
revenue ruling is the official pub-
lished position of the IRS, in
audits the examining agent will
place considerable weight on any
applicable revenue rulings.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-13
ADDITIONAL
COMMENT
A technical advice memorandum
is published as a letter ruling.
Whereas a taxpayer-requested
letter ruling deals with prospec-
tive transactions, a technical
advice memorandum deals with
past or consummated transac-
tions.
ADDITIONAL
COMMENT
Announcements are used to sum-
marize new tax legislation or pub-
licize procedural matters.
Announcements generally are
aimed at tax practitioners and are
considered to be “substantial
authority” [Rev. Rul. 90-91, 1990-2
C.B. 262].
19 Sometimes a letter ruling is cited as PLR (private letter ruling) instead of
Ltr. Rul.
20 Technical advice memoranda are discussed further in Chapter C:15.
taxpayer to whom the ruling is addressed may rely on it as authority. Nevertheless, letter
rulings are relevant for other taxpayers and tax advisors because they offer insight into
the IRS’s position on the tax treatment of particular transactions.
Originally the public did not have access to letter rulings issued to other taxpayers. As
a result of Sec. 6110, enacted in 1976, letter rulings (with confidential information
deleted) are accessible to the general public and have been reproduced by major tax ser-
vices. An example of a citation to a letter ruling appears below:
Ltr. Rul. 200130006 (July 30, 2001).
The first four digits (two if issued before 2000) indicate the year in which the ruling was
made public, in this case, 2001.19 The next two digits denote the week in which the ruling
was made public, here the thirtieth. The last three numbers indicate the numerical sequence
of the ruling for the week, here the sixth. The date in parentheses denotes the date of the
ruling.
OTHER INTERPRETATIONS
Technical Advice Memoranda. When the IRS audits a taxpayer’s return, the IRS agent
might ask the IRS national office for advice on a complicated, technical matter. The
national office will provide its advice in a technical advice memorandum, released to the
public in the form of a letter ruling.20 Researchers can identify which letter rulings are
technical advice memoranda by introductory language such as, “In response to a request
for technical advice. . . .” An example of a citation to a technical advice memorandum is
as follows:
T.A.M. 9801001 (January 2, 1998).
This citation refers to the first technical advice memorandum issued in the first week of
1998. The memorandum is dated January 2, 1998.
Information Releases. If the IRS wants to disseminate information to the general pub-
lic, it will issue an information release. Information releases are written in lay terms
and are dispatched to thousands of newspapers throughout the country. The IRS, for
example, may issue an information release to announce the standard mileage rate for
business travel. An example of a citation to an information release is as follows:
I.R. 86-70 (June 12, 1986).
This citation is to the seventieth information release issued in 1986. The release is dated
June 12, 1986.
Announcements and Notices. The IRS also disseminates information to tax practitioners
in the form of announcements and notices. These pronouncements generally are more
technical than information releases and frequently address current tax developments.
After passage of a major tax act, and before the Treasury Department has had an oppor-
tunity to issue proposed or temporary regulations, the IRS may issue an announcement or
notice to clarify the legislation. The IRS is bound to follow the announcement or notice
just as it is bound to follow a revenue procedure or revenue ruling. Examples of citations
to announcements and notices are as follows:
Announcement 2007-3, 2007-1 C.B. 376.
Notice 2007-9, 2007-1 C.B. 401.
The first citation is to the third announcement issued in 2007. It can be found on page
376 of the first Cumulative Bulletin for 2007. The second citation is to the ninth
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1-14 Corporations ▼ Chapter 1
SELF-STUDY
QUESTION
What are some of the factors that
a taxpayer should consider when
deciding in which court to file a
tax-related claim?
ANSWER
(1) Each court’s published prece-
dent pertaining to the issue,
(2) desirability of a jury trial,
(3) tax expertise of each court,
and (4) when the deficiency must
be paid.
ADDITIONAL
COMMENT
Because the Tax Court deals only
with tax cases, it presumably has
a higher level of tax expertise
than do other courts. Tax Court
judges are appointed by the
President, in part, due to their
considerable tax experience. The
Tax Court typically maintains a
large backlog of tax cases, some-
times numbering in the tens of
thousands.
21 Revenue Procedure 2005-18, 2005-1 C.B. 798, provides procedures for
taxpayers to make remittances or apply overpayments to stop the accrual of
interest on deficiencies.
22 The Federal Circuit has nationwide jurisdiction to hear appeals in special-
ized cases, such as those involving patent laws.
23 The Court of Claims was reconstituted as the United States Court of Claims
in 1982. In 1992, this court was renamed the U.S. Court of Federal Claims.
24 The granting of certiorari signifies that the Supreme Court is granting an
appellate review. The denial of certiorari does not necessarily mean that the
Supreme Court endorses the lower court’s decision. It simply means the court
has decided not to hear the case.
25 The Tax Court also periodically appoints, depending on budgetary con-
straints, a number of trial judges and senior judges who hear cases and render
decisions with the same authority as the regular Tax Court judges.
notice issued in 2007. It can be found on page 401 of the first Cumulative Bulletin for
2007. Notices and announcements appear in both the Internal Revenue Bulletin and the
Cumulative Bulletin.
JUDICIAL DECISIONS
Judicial decisions are an important source of tax law. Judges are reputed to be unbiased
individuals who decide questions of fact (the existence of a fact or the occurrence of an
event) or questions of law (the applicability of a legal principle or the proper interpreta-
tion of a legal term or provision). Judges do not always agree on the tax consequences of
a particular transaction or event. Therefore, tax advisors often must derive conclusions
against a background of conflicting judicial authorities. For example, a U.S. district court
might disagree with the Tax Court on the deductibility of an expense. Likewise, one cir-
cuit court might disagree with another circuit court on the same issue.
OVERVIEW OF THE COURT SYSTEM. A taxpayer may begin tax litigation in any of
three courts: the U.S. Tax Court, the U.S. Court of Federal Claims (formerly the U.S.
Claims Court), or U.S. district courts. Court precedents are important in deciding where
to begin such litigation (see page C:1-21 for a discussion of precedent). Also important is
when the taxpayer must pay the deficiency the IRS contends is due. A taxpayer who
wants to litigate either in a U.S. district court or in the U.S. Court of Federal Claims must
first pay the deficiency. The taxpayer then files a claim for refund, which the IRS is likely
to deny. Following this denial, the taxpayer must petition the court for a refund. If the
court grants the taxpayer’s petition, he or she receives a refund of the taxes in question
plus accrued interest. If the taxpayer begins litigation in the Tax Court, on the other hand,
he or she need not pay the deficiency unless and until the court decides the case against
him or her. In that event, the taxpayer also must pay interest and penalties.21 A taxpayer
who believes that a jury would be sympathetic to his or her case should litigate in a
U.S. district court, the only forum where a jury trial is possible.
If a party loses at the trial court level, it can appeal the decision to a higher court.
Appeals of Tax Court and U.S. district court decisions are made to the court of appeals
for the taxpayer’s circuit. The appeals court system is comprised of 11 geographical
circuits designated by numbers, the District of Columbia Circuit, and the Federal
Circuit.22 Table C:1-1 shows the states that lie in the various circuits. California, for
example, lies in the Ninth Circuit. When referring to these appellate courts, instead of
saying, for example, “the Court of Appeals for the Ninth Circuit,” one generally says “the
Ninth Circuit.” All decisions of the U.S. Court of Federal Claims are appealable to one
court—the Court of Appeals for the Federal Circuit—irrespective of where the taxpayer
resides or does business.23 The only cases the Federal Circuit hears are those that origi-
nate in the U.S. Court of Federal Claims.
The party losing at the appellate level can petition the U.S. Supreme Court to review the
case under a writ of certiorari. If the Supreme Court agrees to hear the case, it grants cer-
tiorari.24 If it refuses to hear the case, it denies certiorari. In recent years, the Court has
granted certiorari in only about six to ten tax cases per year. Figure C:1-3 and Table
C:1-2 provide an overview and summary of the court system with respect to tax matters.
THE U.S. TAX COURT. The U.S. Tax Court was created in 1942 as a successor to the
Board of Tax Appeals. It is a court of national jurisdiction that hears only tax-related cases.
All taxpayers, regardless of their state of residence or place of business, may litigate in the
Tax Court. It has 19 judges, including one chief judge.25 The President, with the consent of
the Senate, appoints the judges for a 15-year term and may reappoint them for an additional
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-15
� TABLE C:1-1
Federal Judicial Circuits
Circuit States Included in Circuit
First Maine, Massachusetts, New Hampshire, Rhode Island, Puerto Rico
Second Connecticut, New York, Vermont
Third Delaware, New Jersey, Pennsylvania, Virgin Islands
Fourth Maryland, North Carolina, South Carolina, Virginia, West Virginia
Fifth Louisiana, Mississippi, Texas
Sixth Kentucky, Michigan, Ohio, Tennessee
Seventh Illinois, Indiana, Wisconsin
Eighth Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, South Dakota
Ninth Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington, Guam, Northern Marina Islands
Tenth Colorado, Kansas, New Mexico, Oklahoma, Utah, Wyoming
Eleventh Alabama, Florida, Georgia
D.C. District of Columbia
Federal All jurisdictions (for taxpayers appealing from the U.S. Court of Federal Claims)
a Cases are heard only if the Supreme Court grants certiorari.
Courts of
Original
Jurisdiction
(Trial
Courts):
Appellate
Courts:
Do Not Pay
Deficiency
First
Court of Appeals
for Federal Circuit
U.S. Court of
Federal Claims
Court of Appeals for
taxpayer’s geographical
jurisdiction (First through
Eleventh Circuits and
D.C. Circuit)
U.S.Tax
Court
Pay Deficiency First
U.S. Supreme Courta
U.S. District Court
for taxpayer’s
district
FIGURE C:1-3 � OVERVIEW OF COURT SYSTEM—TAX MATTERS
term. The judges, specialists in tax-related matters, periodically travel to roughly 100 cities
throughout the country to hear cases. In most instances, only one judge hears a case.
The Tax Court issues both regular and memorandum (memo) decisions. Generally, the
first time the Tax Court decides a legal issue, its decision appears as a regular decision. Memo
decisions, on the other hand, usually deal with factual variations of previously decided cases.
Nevertheless, regular and memo decisions carry the same authoritative weight.
At times, the chief judge determines that a particular case concerns an important issue
that the entire Tax Court should consider. In such a situation, the words reviewed by the
court appear at the end of the majority opinion. Any concurring or dissenting opinions
follow the majority opinion. A judge who issues a concurring opinion agrees with the
basic outcome of the majority’s decision but not with its rationale. A judge who issues a
dissenting opinion believes the majority reached an erroneous conclusion.
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1-16 Corporations
▼
Chapter 1
� TABLE C:1-2
Summary of Court System—Tax Matters
Number
of Subject Determines
Court(s) Judges Personal Matter Questions Trial by
(Number of) on Each Jurisdiction Jurisdiction of Fact Jury Precedents Followed Where Opinions Published
U.S. district courts 1–28* Local General Yes Yes Same court Federal Supplement
(over 95) Court for circuit where situated American Federal Tax Reports
U.S. Supreme Court United States Tax Cases
U.S. Tax Court (1) 19 National Tax Yes No Same court Tax Court of the U.S. Reports
Court for taxpayer’s circuit CCH Tax Court Memorandum Decisions
U.S. Supreme Court RIA Tax Court Memorandum Decisions
U.S. Court of 16 National Claims Yes No Same court Federal Reporter (pre-1982)
Federal Claims (1) against U.S. Federal Circuit Court U.S. Court of Federal Claims
Government U.S. Supreme Court American Federal Tax Reports
United States Tax Cases
U.S. Courts of About 20 Regional General No No Same court Federal Reporter
Appeals (13) U.S. Supreme Court American Federal Tax Reports
United States Tax Cases
U.S. Supreme 9 National General No No Same court U.S. Supreme Court Reports
Court (1) Supreme Court Reporter
United States Reports, Lawyers’
Edition
American Federal Tax Reports
United States Tax Cases
*Although the number of judges assigned to each court varies, only one judge hears a case.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-17
SELF-STUDY
QUESTION
What are some of the considera-
tions for litigating under the
small cases procedure of the Tax
Court?
ANSWER
The small cases procedure gives
the taxpayer the advantage of
having his or her “day in court”
without the expense of an attor-
ney. But if the taxpayer loses, the
decision cannot be appealed.
ADDITIONAL
COMMENT
The only cases with respect to
which the IRS will acquiesce or
nonacquiesce are decisions that
the government loses. Because
the majority of cases, particularly
Tax Court cases, are won by the
government, the IRS will poten-
tially acquiesce in only a small
number of cases.
ADDITIONAL
COMMENT
If a particular case is important,
the chief judge will instruct the
other judges to review the case. If
a case is reviewed by the entire
court, the phrase reviewed by the
court is inserted immediately
after the text of the majority
opinion. A reviewed decision pro-
vides an opportunity for Tax
Court judges to express their dis-
senting opinions.
26 Sec. 7463. The $50,000 amount includes penalties and additional taxes but
excludes interest.
27 Taxpayers also can represent themselves in regular Tax Court proceedings
even though they are not attorneys. Where taxpayers represent themselves,
the words pro se appear in the opinion after the taxpayer’s name. The Tax
Court is the only federal court before which non-attorneys, including CPAs,
may practice.
28 In a citation to a case decided by the Tax Court, only the name of the
plaintiff (taxpayer) is listed. The defendant is understood to be the
Commissioner of Internal Revenue whose name usually is not shown in the
citation. In cases decided by other courts, the name of the plaintiff is listed
first and the name of the defendant second. For non-Tax Court cases, the
Commissioner of Internal Revenue is referred to as CIR in our footnotes
and text.
Another phrase sometimes appearing at the end of a Tax Court opinion is Entered
under Rule 155. This phrase signifies that the court has reached a decision concerning the
tax treatment of an item but has left computation of the deficiency to the two litigating
parties.
Small Cases Procedure. Taxpayers have the option of having their cases heard under
the small cases procedure of the Tax Court if the amount in controversy on an annual
basis does not exceed $50,000.26 This procedure is less formal than the regular Tax
Court procedure, and taxpayers can represent themselves without an attorney.27 The
cases are heard by special commissioners instead of by one of the 19 Tax Court judges. A
disadvantage of the small cases procedure for the losing party is that the decision cannot
be appealed. The opinions of the commissioners generally are not published and have no
precedential value.
Acquiescence Policy. The IRS has adopted a policy of announcing whether, in future
cases involving similar facts and similar issues, it will follow federal court decisions that
are adverse to it. This policy is known as the IRS acquiescence policy. If the IRS wants tax-
payers to know that it will follow an adverse decision in future cases involving similar
facts and issues, it will announce its “acquiescence” in the decision. Conversely, if it wants
taxpayers to know that it will not follow the decision in such future cases, it will
announce its “nonacquiescence.” The IRS does not announce its acquiescence or nonac-
quiescence in every decision it loses.
The IRS publishes its acquiescences and nonacquiescences as “Actions on Decision”
first in the Internal Revenue Bulletin, then in the Cumulative Bulletin. Before 1991, the
IRS acquiesced or nonacquiesced in regular Tax Court decisions only. In 1991, it broad-
ened the scope of its policy to include adverse U.S. Claims Court, U.S. district court, and
U.S. circuit court decisions.
In cases involving multiple issues, the IRS may acquiesce in some issues but not others.
In decisions supported by extensive reasoning, it may acquiesce in the result but not the
rationale (acq. in result). Furthermore, it may retroactively revoke an acquiescence or
nonacquiescence. The footnotes to the relevant announcement in the Internal Revenue
Bulletin and Cumulative Bulletin indicate the nature and extent of IRS acquiescences and
nonacquiescences.
These acquiescences and nonacquiescences have important implications for taxpayers.
If a taxpayer bases his or her position on a decision in which the IRS has nonacquiesced,
he or she can expect an IRS challenge in the event of an audit. In such circumstances, the
taxpayer’s only recourse may be litigation. On the other hand, if the taxpayer bases his or
her position on a decision in which the IRS has acquiesced, he or she can expect little or
no challenge. In either case, the examining agent will be bound by the IRS position.
Published Opinions and Citations. Regular Tax Court decisions are published by the
U.S. Government Printing Office in a bound volume known as the Tax Court of the
United States Reports. Soon after a decision is made public, Research Institute of America
(RIA) and CCH Incorporated (CCH) each publish the decision in its respective reporter of
Tax Court decisions. An official citation to a Tax Court decision is as follows:28
MedChem Products, Inc., 116 T.C. 308 (2001).
The citation indicates that this case appears on page 308 in Volume 116 of Tax Court of
the United States Reports and that the case was decided in 2001.
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1-18 Corporations ▼ Chapter 1
ADDITIONAL
COMMENT
Once the IRS has acquiesced in a
federal court decision, other tax-
payers generally will not need to
litigate the same issue. However,
the IRS can change its mind and
revoke a previous acquiescence or
nonacquiescence. References to
acquiescences or nonacquies-
cences in federal court decisions
can be found in the citators.
KEY POINT
To access all Tax Court cases, a tax
advisor must refer to two differ-
ent publications. The regular
opinions appear in the Tax Court
of the United States Reports, pub-
lished by the U.S. Government
Printing Office, and the memo
decisions are published by both
RIA (formerly PH) and CCH in
their own court reporters.
29 For several years the Prentice Hall Information Services division published
its Federal Taxes 2nd tax service and a number of related publications, such
as the PH T.C. Memorandum Decisions. Changes in ownership occurred, and
in late 1991 Thomson Professional Publishing added the former Prentice Hall
tax materials to the product line of its RIA tax publishing division.
30 Taxpayers might prefer to have a jury trial if they believe a jury will be
sympathetic to their case.
From 1924 to 1942, regular decisions of the Board of Tax Appeals (predecessor of the
Tax Court) were published by the U.S. Government Printing Office in the United States
Board of Tax Appeals Reports. An example of a citation to a Board of Tax Appeals case
is as follows:
J.W. Wells Lumber Co. Trust A., 44 B.T.A. 551 (1941).
This case is found in Volume 44 of the United States Board of Tax Appeals Reports on
page 551. It is a 1941 decision.
If the IRS has acquiesced or nonacquiesced in a federal court decision, the IRS’s action
should be denoted in the citation. At times, the IRS will not announce its acquiescence or
nonacquiescence until several years after the date of the decision. An example of a citation
to a decision in which the IRS has acquiesced is as follows:
Security State Bank, 111 T.C. 210 (1998), acq. 2001-1 C.B. xix.
The case appears on page 210 of Volume 111 of the Tax Court of the United States
Reports and the acquiescence is reported on page xix of Volume 1 of the 2001 Cumulative
Bulletin. In 2001, the IRS acquiesced in this 1998 decision. A citation to a decision in
which the IRS has nonacquiesced is as follows:
Estate of Algerine Allen Smith, 108 T.C. 412 (1997), nonacq. 2000-1 C.B. xvi.
The case appears on page 412 of Volume 108 of the Tax Court of the United States
Reports. The nonacquiescence is reported on page xvi of Volume 1 of the 2000
Cumulative Bulletin. In 2000, the IRS nonacquiesced in this 1997 decision.
Tax Court memo decisions are not published by the U.S. Government Printing Office.
They are, however, published by RIA in RIA T.C. Memorandum Decisions and by CCH
in CCH Tax Court Memorandum Decisions. In addition, shortly after its issuance, an
opinion is made available electronically and in loose-leaf form by RIA and CCH in their
respective tax services. The following citation is to a Tax Court memo decision:
Edith G. McKinney, 1981 PH T.C. Memo ¶81,181 (T.C. Memo 1981-181), 41 TCM 1272.
McKinney is found at Paragraph 81,181 of Prentice Hall’s (now RIA’s)29 1981 PH T.C.
Memorandum Decisions reporter, and in Volume 41, page 1272, of CCH’s Tax Court
Memorandum Decisions. The 181 in the PH citation indicates that the case is the Tax
Court’s 181st memo decision of the year. A more recent citation is formatted in the same
way but refers to RIA memo decisions.
Paul F. Belloff, 1992 RIA T.C. Memo ¶92,346 (T.C. Memo 1992-346), 63 TCM 3150.
U.S. DISTRICT COURTS. Each state has at least one U.S. district court, and more pop-
ulous states have more than one. Each district court is independent of the others and is
thus free to issue its own decisions, subject to the precedential constraints discussed later
in this chapter. Different types of cases—not just tax-related—are adjudicated in this
forum. A district court is the only forum in which the taxpayer may have a jury decide
questions of fact. Depending on the circumstances, a jury trial might be advantageous for
the taxpayer.30
District court decisions are officially reported in the Federal Supplement (cited as
F. Supp.) published by West Publishing Co. (West). Some decisions are not officially
ADDITIONAL
COMMENT
In its Internet-based tax service
(see Page C:1-26), RIA uses a
different format for its Tax Court
Memorandum Decisions, which
in this textbook appear in paren-
theses after the “official” RIA
citation.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Tax Research ▼ Corporations 1-19
ADDITIONAL
COMMENT
A citation, at a minimum, should
contain the following informa-
tion: (1) the name of the case,
(2) the reporter that publishes the
case along with both a volume
and page (or paragraph) number,
(3) the year the case was decided,
and (4) the court that decided the
case.
ADDITIONAL
COMMENT
The U.S. Court of Federal Claims
adjudicates claims (including suits
to recover federal income taxes)
against the U.S. Government. This
court usually hears cases in
Washington, D.C., but will hold
sessions in other locations as the
court deems necessary.
31 The American Federal Tax Reports (AFTR) is published in two series. The
first series, which includes opinions issued up to 1957, is cited as AFTR. The
second series, which includes opinions issued after 1957, is cited as AFTR 2d.
The Alfred Abdo, Jr. decision cited as an illustration of a U.S. district court
decision appears in the second American Federal Tax Reports series.
32 Before the creation in 1982 of the U.S. Claims Court (and the Claims
Court Reporter), the opinions of the U.S. Court of Claims were reported in
either the Federal Supplement (F. Supp.) or the Federal Reporter, Second
Series (F.2d). The Federal Supplement is the primary source of U.S. Court of
Claims opinions from 1932 through January 19, 1960. Opinions issued from
January 20, 1960, to October 1982 are reported in the Federal Reporter,
Second Series.
reported and are referred to as unreported decisions. Decisions by U.S. district courts on
the topic of taxation also are published by RIA and CCH in secondary reporters that con-
tain only tax-related opinions. RIA’s reporter is American Federal Tax Reports (cited as
AFTR).31 CCH’s reporter is U.S. Tax Cases (cited as USTC). A case not offically reported
nevertheless might be published in the AFTR and USTC. An example of a complete cita-
tion to a U.S. district court decision is as follows:
Alfred Abdo, Jr. v. IRS, 234 F. Supp. 2d 533, 90 AFTR 2d 2002-7484, 2003-1 USTC
¶50,107 (DC North Carolina, 2002).
In the example above, the primary citation is to the Federal Supplement. The case appears
on page 533 of Volume 234 of the second series of this reporter. Secondary citations are to
American Federal Tax Reports and U.S. Tax Cases. The same case is found in Volume 90
of the second series of the AFTR, page 2002-7484 (meaning page 7484 in the volume
containing 2002 cases) and in Volume 1 of the 2003 USTC at Paragraph 50,107. The par-
enthetical information indicates that the case was decided in 2002 by the U.S. District
Court for North Carolina. Because some judicial decisions have greater precedential
weight than others (e.g., a Supreme Court decision versus a district court decision), infor-
mation relating to the identity of the adjudicating court is useful in evaluating the author-
itative value of the decision.
U.S. COURT OF FEDERAL CLAIMS. The U.S. Court of Federal Claims, another court
of first instance that addresses tax matters, has nationwide jurisdiction. Originally, this
court was called the U.S. Court of Claims (cited as Ct. Cl.), and its decisions were appeal-
able to the U.S. Supreme Court only. In a reorganization, effective October 1, 1982, the
reconstituted court was named the U.S. Claims Court (cited as Cl. Ct.), and its decisions
became appealable to the Circuit Court of Appeals for the Federal Circuit. In October
1992, the court’s name was again changed to the U.S. Court of Federal Claims (cited as
Fed. Cl.).
Beginning in 1982, U.S. Claims Court decisions were reported officially in the Claims
Court Reporter, published by West from 1982 to 1992.32 An example of a citation to a
U.S. Claims Court decision appears below:
Benjamin Raphan v. U.S., 3 Cl. Ct. 457, 52 AFTR 2d 83-5987, 83-2 USTC ¶9613
(1983).
The Raphan case appears on page 457 of Volume 3 of the Claims Court Reporter.
Secondary citations are to Volume 52, page 83-5987 of the AFTR, Second Series, and to
Volume 2 of the 1983 USTC at Paragraph 9613.
Effective with the 1992 reorganization, decisions of the U.S. Court of Federal Claims
are now reported in the Federal Claims Reporter. An example of a citation to an opinion
published in this reporter is presented below:
Jeffrey G. Sharp v. U.S., 27 Fed. Cl. 52, 70 AFTR 2d 92-6040, 92-2 USTC ¶50,561
(1992).
The Sharp case appears on page 52 of Volume 27 of the Federal Claims Reporter, on page
6040 of the 70th volume of the AFTR, Second Series, and at Paragraph 50,561 of Vol-
ume 2 of the 1992 USTC reporter. Note that, even though the name of the reporter pub-
lished by West has changed, the volume numbers continue in sequence as if no name
change had occurred.
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1-20 Corporations ▼ Chapter 1
ADDITIONAL
COMMENT
A judge is not required to follow
judicial precedent beyond his or
her jurisdiction. Thus, the Tax
Court, the U.S. district courts, and
the U.S. Court of Federal Claims
are not required to follow the
others’ decisions, nor is a circuit
court required to follow the deci-
sion of a different circuit court.
EXAMPLE C:1-7 �
33 Bonner v. City of Prichard, 661 F.2d 1206 (11th Cir., 1981).
34 Vogel Fertilizer Co. v. U.S., 49 AFTR 2d 82-491, 82-1 USTC ¶9134
(USSC, 1982), is an example of a case the Supreme Court heard to settle a
split in judicial authority. The Fifth Circuit, the Tax Court, and the Court of
Claims had reached one conclusion on an issue, while the Second, Fourth,
and Eighth Circuits had reached another.
CIRCUIT COURTS OF APPEALS. Lower court decisions are appealable by the losing
party to the court of appeals for the circuit in which the litigation originated. Generally, if
the case began in the Tax Court or a U.S. district court, the case is appealable to the cir-
cuit for the individual’s residence as of the appeal date. For a corporation, the case is
appealable to the circuit for the corporation’s principal place of business. The Federal
Circuit hears all appeals of cases originating in the U.S. Court of Federal Claims.
As mentioned earlier, there are 11 geographical circuits designated by numbers, the
District of Columbia Circuit, and the Federal Circuit. In October 1981, the Eleventh
Circuit was created by moving Alabama, Georgia, and Florida from the Fifth to a new
geographical circuit. The Eleventh Circuit has adopted the policy of following as prece-
dent all decisions of the Fifth Circuit during the time the states currently constituting the
Eleventh Circuit were part of the Fifth Circuit.33
In the current year, the Eleventh Circuit first considered an issue in a case involving a Florida tax-
payer. In 1980, the Fifth Circuit had ruled on the same issue in a case involving a Louisiana tax-
payer. Because Florida was part of the Fifth Circuit in 1980, under the policy adopted by the
Eleventh Circuit, it will follow the Fifth Circuit’s earlier decision. Had the Fifth Circuit’s decision
been rendered in 1982—after the creation of the Eleventh Circuit—the Eleventh Circuit would
not have been bound by the Fifth Circuit’s decision. �
As the later discussion of precedent points out, different circuits may reach different con-
clusions concerning similar facts and issues.
Circuit court decisions—regardless of topic (e.g., civil rights, securities law, and taxa-
tion)—are now reported officially in the Federal Reporter, Third Series (cited as F.3d),
published by West. The third series was created in October 1993 after the volume number
for the second series reached 999. The primary citation to a circuit court opinion should
be to the Federal Reporter. Tax decisions of the circuit courts also appear in the American
Federal Tax Reports and U.S. Tax Cases. Below is an example of a citation to a 1994 cir-
cuit court decision:
Leonard Greene v. U.S., 13 F.3d 577, 73 AFTR 2d 94-746, 94-1 USTC ¶50,022 (2nd
Cir., 1994).
The Greene case appears on page 577 of Volume 13 of the Federal Reporter, Third Series.
It also is published in Volume 73, page 94-746 of the AFTR, Second Series, and in Volume
1, Paragraph 50,022, of the 1994 USTC. The parenthetical information indicates that the
Second Circuit decided the case in 1994. (A Federal Reporter, Second Series reference is
found in footnote 33 of this chapter.)
U.S. SUPREME COURT. Whichever party loses at the appellate level can request that
the U.S. Supreme Court hear the case. The Supreme Court, however, hears very few tax
cases. Unless the circuits are divided on the tax treatment of an item, or the issue is
deemed to be of great significance, the Supreme Court probably will not hear the case.34
Supreme Court decisions are the law of the land and take precedence over all other court
decisions, including the Supreme Court’s earlier decisions. As a practical matter, a
Supreme Court interpretation of the IRC is almost as authoritative as an act of Congress.
If Congress does not agree with the Court’s interpretation, it can amend the IRC to
achieve a different result and has in fact done so on a number of occasions. If the Supreme
Court declares a tax statute to be unconstitutional, the statute is invalid.
All Supreme Court decisions, regardless of subject, are published in the United States
Supreme Court Reports (cited as U.S.) by the U.S. Government Printing Office, the
Supreme Court Reporter (cited as S. Ct.) by West, and the United States Reports,
Lawyers’ Edition (cited as L. Ed.) by Lawyer’s Co-operative Publishing Co. In addition, ISB
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Tax Research ▼ Corporations 1-21
35 The Golsen Rule is based on the decision in Jack E. Golsen, 54 T.C. 742
(1970).
the AFTR and USTC reporters published by RIA and CCH, respectively, contain Supreme
Court decisions concerned with taxation. An example of a citation to a Supreme Court
opinion appears below:
Boeing Company v. U.S., 537 U.S. 437, 91 AFTR 2d 2003-1088, 2003-1 USTC ¶50,273
(USSC, 2003).
According to the primary citation, this case appears in Volume 537, page 437, of the
United States Supreme Court Reports. According to the secondary citation, it also
appears in Volume 91, page 2003-1088, of the AFTR, Second Series, and in Volume 1,
Paragraph 50,273, of the 2003 USTC.
Table C:1-3 provides a summary of how the IRC, court decisions, revenue rulings, rev-
enue procedures, and other administrative pronouncements should be cited. Primary cita-
tions are to the reporters published by West or the U.S. Government Printing Office, and
secondary citations are to the AFTR and USTC.
PRECEDENTIAL VALUE OF VARIOUS DECISIONS.
Tax Court. The Tax Court is a court of national jurisdiction. Consequently, it generally
rules uniformly for all taxpayers, regardless of their residence or place of business. It fol-
lows U.S. Supreme Court decisions and its own earlier decisions. It is not bound by cases
decided by the U.S. Court of Federal Claims or a U.S. district court, even if the district
court has jurisdiction over the taxpayer.
In 1970, the Tax Court adopted what is known as the Golsen Rule.35 Under this rule,
the Tax Court departs from its general policy of adjudicating uniformly for all taxpayers
and instead follows the decisions of the court of appeals to which the case in question is
appealable. Stated differently, the Golsen Rule mandates that the Tax Court rule consis-
tently with decisions of the court for the circuit where the taxpayer resides or does
business.
In the year in which an issue was first litigated, the Tax Court decided that an expenditure was
deductible. The government appealed the decision to the Tenth Circuit Court of Appeals and
won a reversal. This is the only appellate decision regarding the issue. If and when the Tax
Court addresses this issue again, it will hold, with one exception, that the expenditure is
deductible. The exception applies to taxpayers in the Tenth Circuit. Under the Golsen Rule,
these taxpayers will be denied the deduction. �
U.S. District Court. Because each U.S. district court is independent of the other district
courts, the decisions of each have precedential value only within its own jurisdiction (i.e.,
only with respect to subsequent cases brought before that court). District courts must fol-
low decisions of the U.S. Supreme Court, the circuit court to which the case is appealable,
and the district court’s own earlier decisions regarding similar facts and issues.
The U.S. District Court for Rhode Island, the Tax Court, and the Eleventh Circuit have decided
cases involving similar facts and issues. Any U.S. district court within the Eleventh Circuit must
follow that circuit’s decision in future cases involving similar facts and issues. Likewise, the U.S.
District Court for Rhode Island must decide such cases consistently with its previous decision.
Tax Court decisions are not binding on the district courts. Thus, all district courts other than
the one for Rhode Island and those within the Eleventh Circuit are free to decide such cases
independently. �
U.S. Court of Federal Claims. In adjudicating a case, the U.S. Court of Federal Claims
must rule consistently with U.S. Supreme Court decisions, decisions of the Circuit Court
of Appeals for the Federal Circuit, and its own earlier decisions, including those rendered
when the court had a different name. It need not follow decisions of other circuit courts,
the Tax Court, or U.S. district courts.
SELF-STUDY
QUESTION
Is it possible for the Tax Court to
intentionally issue conflicting
decisions?
ANSWER
Yes. If the Tax Court issues two
decisions that are appealable to
different circuit courts and these
courts have previously reached
different conclusions on the issue,
the Tax Court follows the respec-
tive precedent in each circuit and
issues conflicting decisions. This is
a result of the Golsen Rule.
EXAMPLE C:1-8 �
EXAMPLE C:1-9 �
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1-22 Corporations ▼ Chapter 1
� TABLE C:1-3
Summary of Tax-related Primary Sources—Statutory and Administrative
Source Name Publisher Materials Provided Citation Example
U.S. Code, Title 26 Government Printing Office Internal Revenue Code Sec. 441(b)
Code of Federal Regulations, Government Printing Office Treasury Regulations Reg. Sec. 1.461-1(c)
Title 26 (final)
Treasury Regulations Temp. Reg. Sec. 1.62-1T(e)
(temporary)
Internal Revenue Bulletin Government Printing Office Treasury Regulations Prop. Reg. Sec. 1.671-1(h)
(proposed)
Treasury decisions T.D. 8756 (January 13, 1998)
Revenue rulings Rev. Rul. 2009-33, 2009-40 I.R.B. 447
Revenue procedures Rev. Proc. 2009-52, 2009-49 I.R.B. 744
Committee reports S.Rept. No. 105-33, 105th Cong.,
1st Sess., p. 308 (1997)
Public laws P.L. 105-34, Sec. 224(a), enacted
August 6, 1997
Announcements Announcement 2007-3, 2007-4 I.R.B. 376
Notices Notice 2009-21, 2009-13 I.R.B. 724
Cumulative Bulletin Government Printing Office Treasury Regulations Prop. Reg. Sec. 1.671-1(h)
(proposed)
Treasury decisions T.D. 8756 (January 12, 1998)
Revenue rulings Rev. Rul. 84-111, 1984-2 C.B. 88
Revenue procedures Rev. Proc. 77-28, 1977-2 C.B. 537
Committee reports S.Rept. No. 105-33, 105th Cong.,
1st Sess., p. 308 (1997)
Public laws P.L. 105-34, Sec. 224(a), enacted
August 6, 1997
Announcements Announcement 2006-8, 2006-1 C.B. 344
Notices Notice 88-74, 1988-2 C.B. 385
Summary of Tax-related Primary and Secondary Sources—Judicial
Reporter Name Publisher Decisions Published Citation Example
U.S. Supreme Court Reports Government Printing Office U.S. Supreme Court Boeing Company v. U.S., 537 U.S. 437
(2003)
Supreme Court Reports West Publishing Company U.S. Supreme Court Boeing Company v. U.S., 123 S. Ct.
1099 (2003)
Federal Reporter West Publishing Company U.S. Court of Appeal Leonard Greene v. U.S., 13 F.3d 577
(1st–3rd Series) Pre-1982 Court of (2nd Cir., 1994)
Claims
Federal Supplement Series West Publishing Company U.S. District Court Alfred Abdo, Jr. v. IRS, 234
F. Supp. 2d 553 (DC North Carolina, 2002)
U.S. Court of Federal Claims West Publishing Company Court of Federal Claims Jeffery G. Sharp v. U.S., 27 Fed. Cl. 52
(1992)
Tax Court of the U.S. Reports Government Printing Office U.S. Tax Court regular Security State Bank, 111 T.C. 210 (1998),
acq. 2001-1 C.B. xix
Tax Court Memorandum CCH Incorporated U.S. Tax Court memo Paul F. Belloff, 63 TCM 3150 (1992)
Decisions
RIA Tax Court Memorandum Research Institute of U.S. Tax Court memo Paul F. Belloff, 1992 RIA T.C. Memo
Decisions America ¶92,346 (T.C. Memo 1992-346)
American Federal Tax Reports Research Institute of Tax: all federal courts Boeing Company v. U.S., 91 AFTR 2d
America except Tax Court 2003-1 (USSC, 2003)
U.S. Tax Cases CCH Incorporated Tax: all federal courts Ruddick Corp. v. U.S., 81-1 USTC
except Tax Court ¶9343 (Ct. Cls., 1981)
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Tax Research ▼ Corporations 1-23
EXAMPLE C:1-10 �
EXAMPLE C:1-11 �
36 Daniel M. Kelley v. CIR, 64 AFTR 2d 89-5025, 89-1 USTC ¶9360 (9th
Cir., 1989).
37 Sheldon B. Bufferd v. CIR, 69 AFTR 2d 92-465, 92-1 USTC ¶50,031 (2nd
Cir., 1992).
38 Robert Fehlhaber v. CIR, 69 AFTR 2d 92-850, 92-1 USTC ¶50,131 (11th
Cir., 1992).
39 Charles T. Green v. CIR, 70 AFTR 2d 92-5077, 92-2 USTC ¶50,340 (5th
Cir., 1992).
40 Sheldon B. Bufferd v. CIR, 71 AFTR 2d 93-573, 93-1 USTC ¶50,038
(USSC, 1993).
41 Central Illinois Public Service Co. v. CIR, 41 AFTR 2d 78-718, 78-1 USTC
¶9254 (USSC, 1978).
Assume the same facts as in Example C:1-9. In a later year, a case involving similar facts and
issues is heard by the U.S. Court of Federal Claims. This court is not bound by precedents set by
any of the other courts. Thus, it may reach a conclusion independently of the other courts. �
Circuit Courts of Appeals. A circuit court is bound by U.S. Supreme Court decisions and
its own earlier decisions. If neither the Supreme Court nor the circuit in question has
already decided an issue, the circuit court has no precedent that it must follow, regardless
of whether other circuits have ruled on the issue. In such circumstances, the circuit court
is said to be writing on a clean slate. In rendering a decision, the judges of that court may
adopt another circuit’s view, which they are likely to regard as relevant.
Assume the same facts as in Example C:1-9. Any circuit other than the Eleventh would be writ-
ing on a clean slate if it adjudicated a case involving similar facts and issues. After reviewing the
Eleventh Circuit’s decision, another circuit might find it relevant and rule in the same way. �
In such a case of “first impression,” when the court has had no precedent on which to
base a decision, a tax practitioner might look at past opinions of the court to see which
other judicial authority the court has found to be “persuasive.”
Forum Shopping. Not surprisingly, courts often disagree on the tax treatment of the
same item. This disagreement gives rise to differing precedents within the various jurisdic-
tions (what is called a “split in judicial authority”). Because taxpayers have the flexibility
of choosing where to file a lawsuit, these circumstances afford them the opportunity to
forum shop. Forum shopping involves choosing where among the courts to file a lawsuit
based on differing precedents.
An example of a split in judicial authority concerned the issue of when it became too
late for the IRS to question the tax treatment of items that “flowed through” an S corpo-
ration’s return to a shareholder’s return. The key question was this: if the time for assess-
ing a deficiency (limitations period) with respect to the corporation’s, but not the
shareholder’s, return had expired, was the IRS precluded from collecting additional taxes
from the shareholder? In Kelley,36 the Ninth Circuit Court of Appeals ruled that the IRS
would be barred from collecting additional taxes from the shareholder if the limitations
period for the S corporation’s return had expired. In Bufferd,37 Fehlhaber,38 and Green,39
three other circuit courts ruled that the IRS would be barred from collecting additional
taxes from the shareholder if the limitations period for the shareholder’s return had
expired. The Supreme Court affirmed the Bufferd decision,40 establishing that the statute
of limitations for the shareholder’s return governed. This action brought about certainty
and uniformity within the judicial system.
Dictum. At times, a court may comment on an issue or a set of facts not central to the
case under review. A court’s remark not essential to the determination of a disputed issue,
and therefore not binding authority, is called dictum. An example of dictum is found in
Central Illinois Public Service Co.41 In this case, the U.S. Supreme Court addressed
whether lunch reimbursements received by employees constitute wages subject to with-
holding. Justice Blackman remarked in passing that earnings in the form of interest, rents,
and dividends are not wages. This remark is dictum because it is not essential to the deter-
mination of whether lunch reimbursements are wages subject to withholding. Although
not authoritative, dictum may be cited by taxpayers to bolster an argument in favor of a
particular tax result.
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1-24 Corporations ▼ Chapter 1
ADDITIONAL
COMMENT
A tax treaty carries the same
authoritative weight as a federal
statute (IRC). A tax advisor should
be aware of provisions in tax
treaties that will affect a tax-
payer’s worldwide tax liability.
KEY POINT
Tax articles can be used to help
find answers to tax questions.
Where possible, the underlying
statutory, administrative, or judi-
cial sources referenced in the tax
article should be cited as author-
ity and not the author of the arti-
cle. The courts and the IRS will
place little, if any, reliance on
mere editorial opinion.
STOP & THINK Question: You have been researching whether an amount received by your new client can
be excluded from her gross income. The IRS is auditing the client’s prior year tax return,
which another firm prepared. In a similar case decided a few years ago, the Tax Court
allowed an exclusion, but the IRS nonacquiesced in the decision. The case involved a
taxpayer in the Fourth Circuit. Your client is a resident of Maine, which is in the First
Circuit. Twelve years ago, in a case involving another taxpayer, the federal court for the
client’s district ruled that this type of receipt is not excludable. No other precedent exists.
To sustain an exclusion, must your client litigate? Explain. If your client litigates, in which
court of first instance should she begin her litigation?
Solution: Because of its nonacquiescence, the IRS is likely to challenge your client’s tax
treatment. Thus, she may be compelled to litigate. She would not want to litigate in her
U.S. district court because it would be bound by its earlier decision, which is unfavorable
to taxpayers generally. A good place to begin would be the Tax Court because it is bound
by appellate court, but not district court, decisions and because of its earlier pro-taxpayer
position. No one can predict how the U.S. Court of Federal Claims would rule because no
precedent that it must follow exists.
TAX TREATIES
The United States has concluded tax treaties with numerous foreign countries. These
treaties address the alleviation of double taxation and other matters. A tax advisor
exploring the U.S. tax consequences of a U.S. corporation’s operations in another country
should determine whether a treaty between that country and the United States exists. If
one does, the tax advisor should ascertain the applicable provisions of the treaty. (See
Chapter C:16 of this text for a more extensive discussion of treaties.)
TAX PERIODICALS
Tax periodicals assist the researcher in tracing the development of, and analyzing tax law.
These periodicals are especially useful when they discuss the legislative history of a
recently enacted IRC statute that has little or no administrative or judicial authority
on point.
Tax experts write articles on landmark court decisions, proposed regulations, new tax
legislation, and other matters. Frequently, those who write articles of a highly technical
nature are attorneys, accountants, or professors. Among the periodicals that provide in-
depth coverage of tax-related matters are the following:
The Journal of Taxation
The Tax Adviser
Practical Tax Strategies
Taxes—The Tax Magazine
Tax Law Review
Tax Notes
Corporate Taxation
Business Entities
Real Estate Taxation
Estate Planning
The first six journals are generalized; that is, they deal with a variety of topics. As their titles
suggest, the next four are specialized; they deal with specific subjects. All these publications
(other than Tax Notes, which is published weekly) are published either monthly or
quarterly. Daily newsletters, such as the Daily Tax Report, published by the Bureau of
National Affairs (BNA) in print and electronic formats, are used by tax professionals when
they need updates more timely than can be provided by monthly or quarterly publications.
Tax periodicals and tax services are secondary authorities. The IRC, Treasury
Regulations, IRS pronouncements, and court opinions are primary authorities. In present-
ing research results, the tax advisor should always cite primary authorities.
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Tax Research ▼ Corporations 1-25
TAX SERVICES
Various publishers provide multivolume commentaries on the tax law in what are famil-
iarly referred to as tax services. Researchers often consult tax services at the beginning of
the research process because a tax service helps identify the tax authorities pertaining to a
particular tax issue. The actual tax authorities (e.g., IRC, Treasury Regulations, IRS pro-
nouncements, and court cases), and not the tax services, are generally cited as support for
a particular tax position. The services are available in print form via the publishers and
electronic form via the Internet. (See further discussion at “The Internet as a Research
Tool” later in this chapter). Although each major tax service is an outstanding resource,
significant differences exist in the content and organizational scheme from one publisher
to the next. For example, each service has its own special features and editorial approach
to tax issues along with a great deal of proprietary content. The best way to acquaint one-
self with the various tax services and the advantages and disadvantages of each is to use
them in researching hypothetical or actual problems.
Organizationally, tax services fall into two types: annotated and topical (although this
distinction has become somewhat blurred in the Internet version of these services). An
annotated tax service is organized by IRC section. The IRC-arranged subdivisions of this
service are likely to encompass several topics. The annotations accompany editorial com-
mentaries and include digests or summaries of IRS pronouncements and court opinions
that interpret a particular IRC section. They are classified by subtopic and cite pertinent
primary authorities. A topical tax service, on the other hand, is organized by broad topic,
including income taxes, estate and gift taxes, and excise taxes. The topically arranged sub-
divisions of this service are likely to encompass several IRC sections.
Annotated tax services include the United States Tax Reporter and the Standard Federal
Income Tax Reporter services, both of which are organized by IRC section. Many tax
advisors find these reporters easy to use because of their extensive indexing system. Topical
tax services include RIA’s Federal Tax Coordinator 2d and Bloomberg BNA’s Tax
Management Portfolios. Tax Management Portfolios are popular with many tax advisors
because they are very readable yet still provide a comprehensive discussion of a broad range
of tax issues. Each portfolio (e.g., Passive Loss Rules, Portfolio 549) covers a particular
topic in great detail. However, because the published portfolios do not cover all areas of the
tax law, another service may be necessary to supplement the gaps in a portfolio’s coverage.
Table C:1-4 summarizes the organization and key features of the major tax services.
OBJECTIVE 5
Consult tax services to
research an issue
� TABLE C:1-4
Summary of Key Features of Tax Services
Name Publisher Organization Key Features
United States Tax Reporter Thomson Reuters/RIA IRC section number • Editorial commentary
• Index and findings list
• Annotations
Standard Federal Income Wolters Kluwer/CCH IRC section number • Editorial commentary
Tax Reporter • Index and findings list
• Annotations
Federal Tax Coordinator 2d Thomson Reuters/RIA Tax topic (income tax by • Commentary organized by topic
topic, estate and gift taxes, with references to primary
excise taxes) authority and tabbed access to
IRC and Treasury Regulations.
Tax Management Portfolios Bloomberg BNA U.S. income, foreign income, • Over 400 specialized booklets
state tax, estate and gift tax with extensive commentary by
topic, heavily footnoted and
referenced to primary authority.
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1-26 Corporations ▼ Chapter 1
OBJECTIVE 6
Apply the basics of
Internet-based tax
research
42 Commerce Clearing House (CCH) is a member of the Wolters Kluwer Tax,
Accounting and Legal Division.
43 The research products discussed in this section (e.g., CHECKPOINT,
INTELLICONNECT, Westlaw, and LexisNexus) generally are available only
to paid subscribers.
Internet databases are rapidly replacing print-based services as the principal source of tax
related information. These databases encompass not only the IRC, Treasury Regulations,
court cases, state laws, and other primary authorities, but also citators and secondary
sources such as tax service reporters, treatises, journals, and newsletters. The principal
advantages of using Internet-based tax services are ease and speed of access. These services
eliminate the need for searching through several volumes of text, the need for consulting
numerous cumulative supplements, and the time required to regularly update a print-based
library. In addition, Internet based research tools put a vast amount of information in the
hands of a tax practitioner without the cost and space requirements of a well equipped
print-based tax library.
Because of these advantages, the Internet has become the principal medium for con-
veying tax related information to professionals. The most widely used Internet-based
research services are RIA’s CheckpointTM (hereafter CHECKPOINT), accessible at
http://checkpoint.riag.com, and CCH IntelliConnectTM (hereafter INTELLICONNECT),
accessible at http://intelliconnect.cch.com.42 Westlaw® and LexisNexus® are online legal
research services that are predominately used by legal professionals.43 This chapter limits
its discussion to CHECKPOINT and INTELLICONNECT. Both subscription-based
services are updated continuously and store information in databases, called libraries,
principal among which are the following:44
Newsstand Tax News, Journals, and Newsletters
Federal Federal Tax
State and Local State Tax
International International Tax
Estate Planning Financial and Estate Planning
Pension and Benefits Pension
Payroll Payroll
Newsstand on CHECKPOINT and Tax News, Journals, and Newsletters on
INTELLICONNECT provide daily updates on recent tax developments. The Federal
library on both series contains the text of the IRC, Treasury Regulations, IRS pronounce-
ments, court opinions, and other primary sources. In addition to primary sources, the
Federal library on CHECKPOINT contains the RIA citator, Federal Tax Coordinator 2d,
and United States Tax Reporter annotations and explanations. The Federal library on
INTELLICONNECT contains the Standard Federal Income Tax Reporter and the
Standard Federal Income Tax Reporter Explanations. Tax reporters for all 50 states as
well as multistate tax guides are found in the State and Local library on CHECKPOINT
and the State Tax library on INTELLICONNECT. International tax treaties are found in
the International library of both services. CHECKPOINT’s Estate Planning offers the text
of estate tax treaties, newsletters, journals, and Warren, Gorham & Lamont tax treatises.
INTELLICONNECT’s Financial and Estate Planning library supplies the Federal Estate
and Gift Tax Reporter, as well as the text of estate and gift tax statutes, cases, and rulings.
Finally, Pension and Benefits on CHECKPOINT and Pension on INTELLICONNECT
contain the text of the Employee Retirement Income Security Act (ERISA), related
Treasury Regulations, and Congressional committee reports, while Payroll provides the
text of state and federal employment regulations and current withholding tables.
INTELLICONNECTCHECKPOINT
44 INTELLICONNECT has numerous other databases, including Accounting
and Audit, Banking, Corporate Government, Energy & Natural Resources,
Health Care Compliance and Reimbursement. These specialty areas generally
fall outside the tax arena and therefore are not described in this chapter.
THE INTERNET AS A
RESEARCH TOOL
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Tax Research ▼ Corporations 1-27
CHECKPOINT and INTELLICONNECT libraries and databases can be searched in
four basic ways:
� By keyword
� By index
� By citation
� By content
Rhonda Researcher’s client is a real estate developer and wants to exchange an office building
for a residential condominium in the same town. The client wants to know if he can structure
the transaction in a tax advantaged way. Rhonda immediately recognizes the situation as a
potential like-kind exchange of real property. Therefore, she undertakes a keyword search of
INTELLICONNECT using the term like kind exchange to quickly uncover potentially applicable
documents. She also knows that Sec. 1031 is the relevant IRC section and can search the IRC or
Treasury Regulations by citation. On the other hand, if she were unfamiliar with the topic, she
could employ several other options. For example, INTELLICONNECT’s Federal Tax editorial con-
tent has a heading for topical indexes. The “Exchange of property” term in the topical index
directs Rhonda to “See Like-kind Exchanges; Sales and Exchanges; and Tax-free Exchanges.”
The index entries under these headings direct Rhonda to a number of entries potentially appli-
cable to the transaction. Rhonda also conducts a similar research procedure on CHECKPOINT to
see whether this alternative service provides any additional information. In particular, she
searches in the Federal Tax Coordinator 2d, which is RIA’s topical service. �
KEY WORD SEARCHES
Searching CHECKPOINT and INTELLICONNECT by keyword is relatively simple, partic-
ularly if the researcher is familiar with the Internet. The first step is to activate a database or
multiple databases, perform an initial keyword search, and refine the results after the initial
query. The researcher can choose to search across any combination of the available data-
bases. The CHECKPOINT Federal databases include primary sources such as the Internal
Revenue Code, Treasury Regulations, and Federal Tax Cases along with editorial databases
such as RIA’s Federal Tax Coordinator 2d. Similar choices exist for INTELLICONNECT.
Deciding which database to include in the search depends partly on the expected complexity
of the research question and on the researcher’s familiarity with the topic.
The search engines within the services look for the terms selected and many variations of
the terms. For example, the search for auto will return documents with auto, car, automo-
bile, motor vehicle, passenger vehicle, sedan, and others.45 Searches will include both singu-
lar and plural variations. Any document with the term or terms is returned and ranked by
best match according to the search. If two terms are used, the best matches generally are
documents where the terms are close together. Picking key words and search terms is critical
to success. The search must be broad enough to include relevant documents but not so
broad to include hundreds or thousands of documents unlikely to be on point.
For example, if the researcher selects only the INTELLICONNECT Cases database, the
term property exchange returns thousands of results that have both the words property and
exchange somewhere in the document. Clearly this outcome is too broad for a researcher
just beginning his or her research. Fortunately, several methods of narrowing the search
exist. For example, the search for property exchange can be limited to all terms, any terms,
near phrase, or exact phrase. Specifically, the keyword search “property exchange” that
uses quotation marks around the search phrase will return documents only with that exact
phrase. Thus, quotation marks should be used sparingly and only when the researcher
knows the precise phrase. Using Boolean connectors is helpful as well. These connectors
force the search engine to narrow the search based on the parameters set. Table C:1-5
provides a partial list of connectors available in CHECKPOINT and INTELLICONNECT.
Another way to narrow a search is to focus on terms unique to the research question
at hand. The goal is to identify tax related terms likely to appear only in relevant tax
EXAMPLE C:1-12 �
45 Both CHECKPOINT and INTELLICONNECT provide a thesaurus tool,
which can identify synonyms and suggest alternative terms related to search
terms used by the researcher. The search engine automatically searches for
synonyms unless the researcher restricts the search to specific terms using
Boolean connectors or quotation marks. For example, a search for the spe-
cific phrase “automobile depreciation” will not return documents that refer
to auto, car, or vehicle.
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authorities. For example, stamps are a type of collectible, but the term also will appear in
documents discussing taxation of distilled spirits, food stamps, and store stamps and
coupons. The researcher should begin the search with limiting terms such as collectible
rather than the broader term stamps. Also, researchers with a good working knowledge of
the IRC quickly learn that using IRC sections in search terms is a great way to obtain rel-
evant documents.
Searching using key words is a skill that improves with practice. Researchers becoming
familiar with using the databases will learn to craft search terms that include the most rel-
evant elements of the question at hand. Once the researcher finds a document on point,
the information within that document often can be used to narrow future searches. The
search can be repeated by adding terms, or the documents returned originally can be
searched using a new set of terms. Also, the “search within results” feature offered by
both CHECKPOINT and INTELLICONNECT is helpful when the search returns too
many documents. However, if searches by key word search do not return the desired
results, other options exist.
SEARCH BY INDEX
Both CHECKPOINT and INTELLICONNECT offer traditional indexes. With INTELLI-
CONNECT, the user can click on most databases to see an index of the contents. For
example, clicking on the Standard Federal Income Tax Reporter Topical Index listed in the
Federal Tax Editorial content database reveals a list from A to Z, and the researcher can
easily click on a hyperlink for any letter and scroll through the alphabetized topics list. As
an example, one can find the letter C, then scroll through the screens and find the topic
“casualty losses” that directs the researcher to a variety of subheadings. CHECKPOINT
has an Indexes option under the Search area of the Research tab. In CHECKPOINT, the
researcher can choose the Federal Tax Coordinator 2d Topic Index database. Again, the
� TABLE C:1-5
Connectors Used in INTELLICONNECT and CHECKPOINT
INTELLICONNECT CHECKPOINT Description Examples
and &, and Retrieves documents with both terms. INTELLICONNECT: property and exchange
CHECKPOINT: property & exchange
or |, or Retrieves documents with either term. INTELLICONNECT: property or exchange
CHECKPOINT: property | exchange
not ^, not Retrieves documents with one term but INTELLICONNECT: property not exchange
not the other. CHECKPOINT: property ^ exchange
w/n /n Retrieves documents in which the first INTELLICONNECT: property w/5 exchange
term is separated from the second term CHECKPOINT: property /5 exchange
by no more than n number of words. Locates property within 5 words of
exchange
w/sen /s Retrieves documents that contain the first INTELLICONNECT: property w/sen exchange
term within 20 words of the second term CHECKPOINT: property /s exchange
(or within the same sentence for RIA).
w/par /p Retrieves documents that contain the first INTELLICONNECT: property w/par exchange
term within 80 words of the second term CHECKPOINT: property /p exchange
(or within the same paragraph for RIA).
“ ” “ ” Exact phrase. INTELLICONNECT and CHECKPOINT:
“property exchange”
* * Keyword variation. Deprecia* returns depreciation, depreciate,
depreciated, depreciating
? ? Keyword variation. Advis?r returns advisor and adviser
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Tax Research ▼ Corporations 1-29
researcher will find the letter C and scroll through the topics to find “casualty losses,”
which leads the researcher to subheadings with hyperlinks to CHECKPOINT’s editorial
materials.
In addition, both INTELLICONNECT and CHECKPOINT have topical indexes that
use hyperlinks to the Internal Revenue Code. In INTELLICONNECT, the researcher
begins with the Topical Index option located under Federal Tax Primary Sources, selects the
Current Internal Revenue Code Topical Index, and begins his or her research with an A to
Z list. In CHECKPOINT, the researcher selects the Current Code Topic Index located in the
Indexes link on the Search tab.
SEARCH BY CITATION
Often the desired document is a specific IRC section, Treasury Regulation, court case, IRS
pronouncement, or other document. If so, both services offer searches by specific citation.
Researchers must be careful to use exact citations using this tool because close matches
will not return the desired document.
Both CHECKPOINT and INTELLICONNECT citation search tools provide dedicated
boxes in which to type the specific type of document requested. For example, to search for
IRC Sec. 267, the researcher simply types 267 in the box labeled Current Code in CHECK-
POINT under the “Find by Citation” link, or IRC Code & Hist. Sec. in INTELLICONNECT
under the “Citations” link. Specific boxes also exist for various court decisions, revenue
rulings, revenue procedures, and other IRS pronouncements.
SEARCH BY CONTENT
Each database also can be searched by content. Clicking on the hyperlink for each data-
base will return a table of contents. Clicking through an entry will take the researcher
further into the table of contents. For example, in INTELLICONNECT, several docu-
ments discussing adoption credits can be located by clicking on the following series of
hyperlinks:
Federal Tax
Federal Tax Editorial Content
Standard Federal Tax Reporter
Credits
Adoption expenses – Sec. 23
CHECKPOINT also has a Table of Contents tab. Documents discussing adoption credits
may be found by clicking on the following series of hyperlinks:
Federal Library
Federal Editorial Materials
Federal Tax Coordinator 2d
Chapter A Individuals and Self-Employment Tax
A-4400 Adoption Expense Credit
NONCOMMERCIAL INTERNET SERVICES
Many noncommercial institutions, such as governments and universities, allow access to
their tax-related databases via the Internet. In “tax-surfing” the Internet, the researcher
might first visit the IRS site located at www.irs.gov. Although oriented to the layman, this
site contains a wealth of information useful to the tax professional. Such information
includes guidelines for electronic filing, IRS forms and instructions, the full text of
Treasury Regulations, and recent issues of the Internal Revenue Bulletin. Other useful
sites include those maintained by the Library of Congress at thomas.loc.gov and the
U.S. Government Printing Office Federal Digital System at www.gpo.gov/fdsys/. From
these sites, the researcher can retrieve the text of recent court opinions, tax legislation,
committee reports, state and federal tax laws, and much more.
An excellent gateway for starting tax related research is the Tax, Accounting, and
Payroll Sites Directory at www.taxsites.com, maintained by AccountantsWorld,
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Citators serve two functions. First, they trace the judicial history of a particular case
(e.g., if the case under analysis is an appeals court decision, the citator indicates the lower
court that heard the case and whether the Supreme Court reviewed the case). Second, they
list other authorities (e.g., cases and IRS pronouncements) that cite the case or authority
in question. These listed authorities are called citing cases or citing rulings. The judicial
history also indicates whether the case is affirmed, reversed or remanded.46
Because tax law relies heavily on precedent, the citator provides an index of citing
cases and rulings that help the researcher determine the strength of the case or ruling he or
she is evaluating. The citator gives full citations for the citing case and lists where the cit-
ing cases can be found. It is important to note that the same case may have as many as
three decisions (i.e., lower court, court of appeals, and Supreme Court) with each listing
having its own list of citing cases. Therefore, if a citing case cites only the Supreme Court
decision, the citator will list it only under the Supreme Court cite.
Two principal tax related commercial citators are those in INTELLICONNECT and
CHECKPOINT. Both citators allow the researcher to enter case names or case citations.
The discussion in this section focuses on the electronic version of the citators, although
both CCH and RIA offer print versions as well.
The INTELLICONNECT citator analyzes every decision reported in the Standard
Federal Income Tax Reporter, the Excise Tax Reporter, and the Federal Estate and Gift
Tax Reporter and selectively lists cases that cite the decision under analysis. INTELLI-
CONNECT lists only the citing cases that its editors believe will influence the preceden-
tial weight of the decision under analysis.
The CHECKPOINT citator also provides the history of each authority and lists the
cases and pronouncements that have cited the authority. This citator, however, differs
from the INTELLICONNECT citator in a couple of important ways. First, CHECK-
POINT lists all citing cases, and not just those that the editors believe will serve as rele-
vant precedent. Second, the CHECKPOINT citator provides additional information
about the citing case, showing whether the citing authorities comment favorably or
unfavorably on the cited case or whether they can be distinguished from the cited
case.47
In addition to tax cases, the CHECKPOINT and INTELLICONNECT citators eval-
uate revenue rulings and other IRS pronouncements and lists any status changes. Before
relying on a revenue ruling or pronouncement, a researcher must confirm that the pro-
nouncement reflects the current position of the IRS. For example, a revoked ruling is
CITATORS
OBJECTIVE 7
Use a citator to assess tax
authorities
46 If a case is affirmed, the decision of the lower court is upheld. Reversed
means the higher court invalidated the decision of the lower court because it
reached a conclusion different from that derived by the lower court.
Remanded signifies that the higher court sent the case back to the lower court
with instructions to address matters consistent with the higher court’s ruling.
47 When a court distinguishes the facts of one case from those of an earlier
case, it suggests that its departure from the earlier decision is justified because
the facts of the two cases are different.
LLC. This site provides hundreds of hyperlinks to federal, state, and international tax
law and tax form databases. Instrumental in financial accounting searches is the
Electronic Data Gathering, Analysis, and Retrieval (EDGAR) site at www.sec.gov/
edgar.shtml. EDGAR is a document filing and retrieval service sponsored by the U.S.
Securities and Exchange Commission (SEC). It provides access to the full text of docu-
ments filed with the SEC by publicly traded companies. These documents include annual
financial statements on Form 10-K, quarterly financial statements on Form 10-Q, proxy
statements, and prospectuses. The EDGAR database extends from January 1994 to the
present and is accessible by company name, central index key, document file number, and
keyword.
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Tax Research ▼ Corporations 1-31
� TABLE C:1-6
Terms to Describe Status Changes to IRS Rulings
Term Description of Term
Amplified No change in the prior published position has occurred, but the prior position is
extended to cover a variation of the fact situation previously addressed.
Clarified Language used in a prior published position is being made clear because the
previous language has caused or could cause confusion.
Distinguished The ruling mentions a prior ruling but points out an essential difference between
the two rulings.
Modified The substance of a previously published ruling is being changed, but the prior
ruling remains in effect.
Obsoleted A previously published ruling is no longer determinative with respect to future
transactions, e.g., because laws or regulations have changed, or the substance of
the ruling has been adopted into regulations.
Revoked A previously published ruling has been determined to be incorrect, and the
correct position is being stated in the new ruling.
Superseded The new ruling merely restates the substance of a previously published ruling or
series of rulings.
Supplemented The ruling expands a previous ruling, e.g., by adding items to a list.
Suspended The previously published ruling will not be applied pending some future action,
such as the issuance of new or amended regulations.
Source: www.irs.gov.
one in which the ruling is no longer correct and the correct position is being stated in
the new ruling. The IRS does not remove the old ruling from the Internal Revenue
Bulletin or Cumulative Bulletin, but the old ruling does not have authority regarding a
transaction occurring after the revocation. Thus, failure to confirm its status could
result in an incorrect conclusion. Table C:1-6 provides a list of terms the IRS uses to
describe changes in the status of a ruling.
USING THE CITATOR
Internet-based versions of the citators are easier to use than print-based citators. For exam-
ple, assume the researcher is currently reading Leonarda C. Diaz v. Commissioner of
Internal Revenue, 70 TC 1067 (1978). Using INTELLICONNECT, the researcher can
click on the Citator button in the left column at the top left of the page, and the service
opens up a new tab with a summary of activity of the case. The information in bold print
with bullets to the left denotes that the Diaz case was first decided by the Tax Court (i.e.,
TC), and then by the Second Circuit Court of Appeals (i.e., CA-2). It shows that the
Second Circuit affirmed (upheld) the Tax Court’s decision. The three cases underneath the
Second Circuit decision cite the Diaz decision and might be useful for the researcher to bet-
ter understand the impact of the case. The seven cases listed beneath the Tax Court deci-
sion cite the Tax Court’s opinion.
The CHECKPOINT citator is similarly easy to use. Once again, if the researcher is read-
ing the Diaz case, he or she simply clicks on the Citator button at the top of the case window.
The two main decisions (Tax Court and Second Circuit) appear in a list. Clicking on either
case brings up the court decisions that have cited the Diaz decision. CHECKPOINT some-
times lists more cases than does INTELLICONNECT. In this example, CHECKPOINT lists
ten cases that have cited the Diaz Second Circuit decision and 25 cases that have cited the
Tax Court decision. CHECKPOINT also adds a brief description of the type of citation—
cited favorably, cited unfavorable, case distinguished, or reasoning followed.
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Professional guidelines for tax services are contained in both government-imposed and
professional-imposed tax standards. The following sections briefly describe two types of
guidelines—Treasury Department Circular 230 (Rev. 8-2011) and the American Institute
of Certified Public Accountants (AICPA) Statements on Standards for Tax Services
(SSTSs). A fuller discussion of these standards appears in Chapter C:15.
TREASURY DEPARTMENT CIRCULAR 230
Circular 230 sets forth rules to practice before the Internal Revenue Service and pertains
to certified public accountants, attorneys, enrolled agents, and other persons representing
taxpayers before the IRS. It presents the duties and restrictions relating to such practice
and prescribes sanctions and disciplinary proceedings for violating these regulations.
Circular 230 rules, however, are not ethical standards. Instead, the document focuses
on the right to represent clients before the IRS. These standards differ from the AICPA’s
SSTSs in the following ways:
� They apply only to federal tax issues and not state authorities.
� They generally apply only to federal income tax practice.
� They do not provide the depth of guidance found in the SSTSs.
� They give the government the authority to impose monetary penalties for violations of
the rules.
Circular 230 also provides guidelines for written advice to taxpayers. These guidelines
fall into two categories: (1) covered opinions48 and (2) all other written advice.49 The
rules govern written advice in opinion letters, memoranda, presentations, studies, facsim-
iles, e-mail, and instant messaging, but they exclude oral advice, tax return preparation,
certain post-filing advice, and internal written advice.
Tax advisors are often asked to give their opinion on the tax treatment of a transaction
or proposed transaction. The advisor’s written conclusions are called “reliance opinions”
in Circular 230 and include any written advice that concludes, at a confidence level of
more likely than not, that a tax issue would be resolved in a taxpayer’s favor. These opin-
ions might include many routine tax issues encountered in a standard practice. Rather
than comply with the detailed due diligence burdens imposed by Circular 230, many prac-
titioners now include a standard disclaimer for routine written advice. See the sample
client letter in Appendix A for the language of such disclaimers.
AICPA’S STATEMENTS ON TAX STANDARDS
Tax advisors confronted with ethical issues frequently turn to a professional organization
for guidance. Although the guidelines set forth by such organizations are not legally
enforceable, they carry significant moral weight, and may be cited in a negligence lawsuit
as the proper “standard of care” for tax practitioners. They also may provide grounds for
the termination or suspension of one’s professional license. One such set of guidelines is
the Statements on Standards for Tax Services (SSTSs),50 issued by the American Institute
of Certified Public Accountants (AICPA) and reproduced in Appendix E.
The SSTSs provide an ethical framework to govern the normative relationship
between a tax advisor and his or her client, where, unlike an auditor, a tax advisor acts
as the client’s advocate. Thus, his or her primary duty is to the client, not the IRS. In
PROFESSIONAL GUIDELINES
FOR TAX SERVICES
OBJECTIVE 8
Describe the professional
guidelines that CPAs in tax
practice should follow
48 Covered opinions include tax shelters, reportable transactions, marketed
opinions as well as reliance opinions.
49 Circular 230 Section 10.35 applies to covered opinions and Section 10.37
applies to all other written advice.
50 AICPA, Statements on Standards for Tax Services, 2009, effective January 1,
2010.
ADDITIONAL
COMMENT
In September 2012, the IRS pro-
posed new regulations that
replace the covered opinion
requirements in Sec. 10.35 of
Circular 230 with an expanded
Sec. 10.37. The written tax advice
under the revised rules would
depend on the scope of the
engagement and the type of
advice sought.
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Tax Research ▼ Corporations 1-33
fulfilling this duty, the advisor is bound by the highest standards of care. The most recent
version of the SSTSs includes seven standards that provide guidance for AICPA members
in their professional tax practice.
SSTS No. 1—Tax Return Positions. Tax professionals often provide tax advice in situa-
tions where the authority is unclear or evolving. Frequently this advice involves recom-
mending positions that could be reversed upon audit. This statement describes the
minimum level of confidence a CPA must achieve to recommend a tax return position to
a taxpayer. Members first must determine and comply with all standards imposed by the
various taxing authorities. Regardless of those standards, a member should not recom-
mend a position unless he or she has a good faith belief that the position has a “realistic
possibility” of being sustained administratively or judicially on its merits if challenged.
Members are not permitted to take the probability of audit into account.
If the position does not meet the realistic probability standard, a member still may
recommend a tax return position if he or she concludes that the position has a “reason-
able basis” and the position is properly disclosed. When recommending a tax return posi-
tion and when preparing or signing a return on which a tax return position is taken, a
member should, when relevant, advise the taxpayer regarding potential penalty conse-
quences of such tax return position and the opportunity, if any, to avoid such penalties
through disclosure.
The standard highlights the dual responsibility of the member. The U.S. tax system
can function only when taxpayers file “true, correct, and complete” returns, but tax-
payers also have no obligation to pay more in tax than they legally owe. The tax profes-
sional’s duty is to meet his or her responsibilities to both the tax system and the taxpayer
client.
SSTS No. 2—Answers to Questions on Returns. Return preparers often must sign a
declaration that the return is “true, correct, and complete.” A member should make a rea-
sonable effort to obtain from the taxpayer the information necessary to provide appropriate
answers to all questions on a tax return before signing as preparer. However, in certain cir-
cumstances, questions or information applicable to the taxpayer may be omitted.
Reasonable grounds include the following situtations:
� The omitted information is not readily available or is immaterial and has little effect
on taxable income or loss or the tax liability.
� The meaning of the question as it relates to the taxpayer is uncertain.
� The requested information is voluminous, in which case the taxpayer can attach a
statement indicating that the requested information will be supplied upon request.
SSTS No. 3—Certain Procedural Aspects of Preparing Returns. Tax returns are based
on information provided by the client. This statement sets forth the applicable standards
for members concerning this information. Specifically, in preparing or signing a return,
members are not required to examine or verify a client’s supporting data. A member may
rely on information supplied by the taxpayer unless the information appears to be incor-
rect, incomplete, inconsistent, or unreasonable under the circumstances. However, if the
applicable law or regulations impose a specific record keeping requirement to claim a
deduction, the member should inquire and satisfy himself or herself that the required
records do exist.
Members are specifically encouraged to make use of a taxpayer’s returns for one or
more prior years in preparing the current return, whenever feasible. The practice should
help avoid the omission or duplication of items and provide a basis for the treatment of
similar or related transactions.
SSTS No. 4—Use of Estimates. For various reasons, precise information about an amount
required on a tax return might not be available at the time the tax return is prepared. For
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example, the taxpayer might not have a record of small transactions or might be missing
certain records. In such cases, a member may advise on estimates used in the preparation of
the tax return, but the taxpayer has the responsibility to provide the estimated data.
Appraisals and valuations are not considered estimates.
If estimates are used, they generally need not be labeled as estimates, but they should
not be presented in a manner that provides a misleading impression about the degree of
factual accuracy. However, disclosure that estimates were used should be made in some
unusual situations, including:
� A taxpayer has died or is ill at the time the return is prepared.
� A taxpayer has not received a schedule K-1 at the time the tax return is to be filed.
� Litigation is pending that affects the return.
� Fire, computer failure, or a natural disaster has destroyed the relevant records.
Notwithstanding this statement, the tax practitioner may not use estimates when such
use is implicitly prohibited by the IRC. For example, Sec. 274(d) disallows deductions for
certain expenses (e.g., meals and entertainment) unless the taxpayer can substantiate the
expenses with adequate records or sufficient corroborating information. The documenta-
tion requirement effectively precludes the taxpayer from estimating such expenses and the
practitioner from using such estimates.
SSTS No. 5—Departure from a Position Previously Concluded in an Administrative
Proceeding or Court Decisions. Members can take positions that differ from a position
determined in an administrative proceeding with respect to the taxpayer’s prior return
(such as an IRS audit, IRS appeals conference, or a court decision.) Departure might be
warranted because of a change in the law or regulations, or favorable court decisions. In
any event, if the member can otherwise meet the standards of SSTS No. 1, departure from
previous positions is permissible.
SSTS No. 6—Knowledge of Error: Return Preparation and Administrative Proceedings.
For purposes of this standard, the definition of an error has the common meaning,
including a mathematical error, but the definition also encompasses any position
that does not meet the standards of SSTS No. 1. A position also qualifies as an error if it
met the standard when a return was originally filed but no longer does because of a
retroactive legislative or legal proceeding. An error for this purpose does not include
immaterial items.
A member should inform the taxpayer promptly upon becoming aware of (1) an error
in a previously filed return, (2) an error in a return that is the subject of an administrative
proceeding (e.g., an IRS audit or appeals conference), or (3) a taxpayer’s failure to file a
required return. A member should advise the taxpayer of the potential consequences of
the error and recommend corrective measures to be taken. This advice can be given orally.
The member is not obligated to inform the taxing authority of an error and, in fact, may
not do so without the taxpayer’s permission except when required by law.
However, if the taxpayer requests that a member prepare the current year’s return
and the taxpayer has not taken appropriate action to correct an error in a prior year’s
return, the member should consider whether to withdraw from preparing the return and
whether to continue a professional or employment relationship with the taxpayer.
The standard recognizes that conflicts can arise between the member’s interests and
those of the client. For example, withdrawal from an engagement could have an adverse
impact on the taxpayer. In some situations, the member should consult his or her own
legal counsel before deciding on recommendations to the taxpayer and whether to con-
tinue the engagement. In situations involving potential fraud or criminal charges, the
member should advise the client to consult with an attorney before taking any action.
SSTS No. 7—Form and Content of Advice to Taxpayers. A member should use profes-
sional judgment to ensure that tax advice provided to a taxpayer reflects competence and
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appropriately serves the taxpayer’s needs. The advice can be communicated in writing or
orally. When communicating tax advice to a taxpayer in writing, a member should com-
ply with relevant taxing authorities’ standards applicable to written tax advice. A member
should use professional judgment about any need to document oral advice.
In deciding on the form of advice provided to a taxpayer, a member should consider
factors such as:
� The importance of the transaction and the amounts involved
� The technical complexity involved
� The existence of authorities and precedents
� The tax sophistication of the taxpayer
� The need to seek other professional advice
� The potential penalty consequences of a tax return position and whether any penalties
can be avoided through disclosure
This statement implies that practitioner-taxpayer dealings should not be casual,
nonconsensual, or open ended. Rather, they should be professional, contractual, and
definite. Oral advice may be appropriate in routine matters, but written communications
are recommended in important, complicated, or significant dollar value transactions.
In addition to these obligations, the tax advisor has a strict duty of confidentiality to
the client. Although not encompassed under the SSTSs, this duty is implied in the account-
ant client privilege. (For a discussion of this privilege, see Chapter C:15.)
Question: As described in the Stop & Think box on pages C:1-10 and C:1-11, you are
researching the manner in which a deduction is calculated. The IRC states that the
calculation is to be made “in a manner prescribed by the Secretary.” After studying the
IRC, Treasury Regulations, and committee reports, you conclude that another way of
doing the calculation is arguably correct under an intuitive approach. This approach
would result in a lower tax liability for the client. According to the Statements on
Standards for Tax Services, may you take a position contrary to final Treasury
Regulations based on the argument that the regulations are not valid?
Solution: You should not take a position contrary to the Treasury Regulations unless you
have a “good-faith belief that the position has a realistic possibility of being sustained
administratively or judicially on its merits.” However, you can take a position that does
not meet the above standard, provided you adequately disclose the position, and the posi-
tion has a reasonable basis. Whether or not you have met the standard depends on all the
facts and circumstances. Chapter C:15 discusses tax return preparer positions contrary to
Treasury Regulations.
Tax Research ▼ Corporations 1-35
STOP & THINK
WHAT WOULD YOU DO IN THIS SITUATION?
Regal Enterprises and Macon Industries, unaf-
filiated corporations, have hired you to prepare
their respective income tax returns. In prepar-
ing Regal’s return, you notice that Regal has claimed a
depreciation deduction for equipment purchased from
Macon on February 22 at a cost of $2 million. In prepar-
ing Macon’s return, you notice that Macon has reported
sales proceeds of $1.5 million from the sale of equip-
ment to Regal on February 22. One of the two figures
must be incorrect. How do you proceed to correct it?
Hint: See SSTS No. 3 in Appendix E.
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1-36 Corporations ▼ Chapter 1
SAMPLE WORK PAPERS
AND CLIENT LETTER
Appendix A presents a set of sample work papers, including a draft of a client letter and a
memo to the file. The work papers indicate the issues to be researched, the authorities
addressing the issues, and the researcher’s conclusions concerning the appropriate tax
treatment, with rationale therefor.
The format and other details of work papers differ from firm to firm. The sample in
this text offers general guidance concerning the content of work papers. In practice, work
papers may include less detail.
OBJECTIVE 9
Prepare work papers and
communicate to clients
PR O B L E M M A T E R I A L S
DISCUSSION QUESTIONS
C:1-1 Explain the difference between closed-fact and
open-fact situations.
C:1-2 According to the AICPA’s Statements on Standards
for Tax Services, what duties does the tax practi-
tioner owe the client?
C:1-3 Explain what is encompassed by the term tax law
as used by tax advisors.
C:1-4 The U.S. Government Printing Office publishes
both hearings on proposed legislation and com-
mittee reports. Distinguish between the two.
C:1-5 Explain how committee reports can be used in
tax research. What do they indicate?
C:1-6 A friend notices that you are reading the Internal
Revenue Code of 1986. Your friend inquires why
you are consulting a 1986 publication, especially
when tax laws change so frequently. What is your
response?
C:1-7 Does Title 26 contain statutory provisions deal-
ing only with income taxation? Explain.
C:1-8 Refer to IRC Sec. 301.
a. Which subsection discusses the general rule for
the tax treatment of a property distribution?
b. Where should one look for exceptions to the
general rule?
c. What type of Treasury Regulations would
relate to subsection (e)?
C:1-9 Why should tax researchers note the date on
which a Treasury Regulation was adopted?
C:1-10 a. Distinguish between proposed, temporary, and
final Treasury Regulations.
b. Distinguish between interpretative and legisla-
tive Treasury Regulations.
C:1-11 Which type of regulation is more difficult for a
taxpayer to successfully challenge, and why?
C:1-12 Explain the legislative reenactment doctrine.
C:1-13 a. Discuss the authoritative weight of revenue
rulings.
b. As a practical matter, what consequences are
likely to ensue if a taxpayer does not follow a
revenue ruling and the IRS audits his or her
return?
C:1-14 a. In which courts may litigation dealing with tax
matters begin?
b. Discuss the factors that might be considered in
deciding where to litigate.
c. Describe the appeals process in tax litigation.
C:1-15 May a taxpayer appeal a case litigated under the
Small Cases Procedure of the Tax Court?
C:1-16 Explain whether the following decisions are of the
same precedential value: (1) Tax Court regular deci-
sions, (2) Tax Court memo decisions, (3) decisions
under the Small Cases Procedures of the Tax Court.
C:1-17 Does the IRS acquiesce in decisions of U.S. dis-
trict courts?
C:1-18 The decisions of which courts are reported in the
AFTR? In the USTC?
C:1-19 Why do some revenue ruling citations refer to the
Internal Revenue Bulletin (I.R.B.) and others to a
Cumulative Bulletin (C.B.)?
C:1-20 Explain the Golsen Rule. Give an example of its
application.
C:1-21 Assume that the only precedents relating to a par-
ticular issue are as follows:
Tax Court—decided for the taxpayer
Eighth Circuit Court of Appeals—decided for the
taxpayer (affirming the Tax Court)
U.S. District Court for Eastern Louisiana—
decided for the taxpayer
Fifth Circuit Court of Appeals—decided for the
government (reversing the U.S. District Court of
Eastern Louisiana)
a. Discuss the precedential value of the foregoing
decisions for your client, who is a California
resident.
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Tax Research ▼ Corporations 1-37
b. If your client, a Texas resident, litigates in the
Tax Court, how will the court rule? Explain.
C:1-22 Which official publication(s) contain(s) the fol-
lowing:
a. Transcripts of Senate floor debates
b. IRS announcements
c. Tax Court regular opinions
d. Treasury decisions
e. U.S. district court opinions
f. Technical advice memoranda
C:1-23 Under what circumstances might a tax advisor
find the provisions of a tax treaty useful?
C:1-24 What two functions does a citator serve?
C:1-25 Describe two ways that the information avail-
able from the CHECKPOINT citator differs
from that available from the INTELLICONNECT
citator.
C:1-26 List four methods of searching the CHECKPOINT
and INTELLICONNECT databases.
C:1-27 Access INTELLICONNECT at http://intelliconnect
.cch.com and RIA CHECKPOINT™ at http://
checkpoint.riag.com. Then answer the following
questions:
a. What are the principal primary sources found
in both Internet tax services?
b. What are the principal secondary sources
found in each Internet tax service?
C:1-28 Compare the features of the computerized tax
services with those of Internet sites maintained by
noncommercial institutions. What are the relative
advantages and disadvantages of each? Could the
latter sites serve as a substitute for a commercial
tax service?
C:1-29 According to the Statements on Standards for Tax
Services, what belief should a CPA have before
taking a pro-taxpayer position on a tax return?
C:1-30 List an advisor’s duties that are excluded under the
AICPA’s Statements on Standards for Tax Services.
C:1-31 List the two classifications of written advice
under Treasury Department Circular 230.
C:1-32 Explain how Treasury Department Circular 230
differs from the AICPA’s Statements on Standards
for Tax Services.
PROBLEMS
C:1-33 Interpreting the IRC. Under a divorce agreement executed in the current year, an ex-wife
receives from her former husband cash of $25,000 per year for eight years. The agreement
does not explicitly state that the payments are excludable from gross income.
a. Does the ex-wife have gross income? If so, how much?
b. Is the former husband entitled to a deduction? If so, is it for or from AGI?
Refer only to the IRC in answering this question. Start with Sec. 71.
C:1-34 Interpreting the IRC. Refer to Sec. 385 and answer the questions below.
a. Whenever Treasury Regulations are issued under this section, what type are they likely
to be: legislative or interpretative? Explain.
b. Assume Treasury Regulations under Sec. 385 have been finalized. Will they be relevant
to estate tax matters? Explain.
C:1-35 Using IRS Rulings. Locate PLR 8733007 and Rev. Rul. 81-219.
a. Briefly summarize the tax issue and conclusion of each ruling.
b. Under what circumstances can a researcher rely on the private letter ruling?
c. Under what circumstances can a researcher rely on the revenue ruling?
C:1-36 Using Treasury pronouncements. Which IRC section(s) does Rev. Rul. 2001-29 interpret?
(Hint: consult the official pronouncement of the IRS.)
C:1-37 Using CHECKPOINT for a Keyword Search. The objective is to locate a general
overview of available home office deductions. On the main research tab, select the United
States Tax Reporter—Explanations (RIA) library. How many results does CHECK-
POINT return for each search term?
a. Search term: home office deduction.
b. Search term: “home office” deduction.
c. Search term: “home office” /5 deduction.
d. Perform the search in Part a above. Select Sort by Relevance. How does this sort change
the results? Does the sort make it easier to locate relevant documents?
C:1-38 Using INTELLICONNECT for a Keyword Search. The search objective is to determine
the amount generally excludable on the sale of a married couple’s home. Using Browse,
locate the Standard Federal Tax Reporter—Explanations library. How many results does
INTELLICONNECT return for each search term?
a. Search term: home sale gain exclusion.
b. Search term: “home sale” gain exclusion.
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1-38 Corporations ▼ Chapter 1
c. Does limiting the results to only those documents containing the specific term “home
sale” improve your results?
d. How do most tax documents refer to a person’s home?
C:1-39 Determining Acquiescence.
a. What official action (acquiescence or nonacquiescence) did the IRS Commissioner take
regarding the 1985 Tax Court decision in John McIntosh, 85 T.C. 31 (1985)? (Hint:
Consult Actions on Decisions.)
b. Did this action concern all issues in the case? If not, explain. (Before answering this
question, consult the headnote to the court opinion.)
C:1-40 Determining Acquiescence.
a. What original action (acquiescence or nonacquiescence) did the IRS Commissioner
take regarding the 1952 Tax Court decision in Streckfus Steamers, Inc., 19 T.C.
1 (1952)? (Hint: Consult Actions on Decisions.)
b. Was the action complete or partial?
c. Did the IRS Commissioner subsequently change his mind? If so, when?
C:1-41 Determining Acquiescence.
a. What original action (acquiescence or nonacquiescence) did the IRS Commissioner
take regarding the 1982 Tax Court decision in Doyle, Dane, Bernbach, Inc., 79 T.C.
101 (1982)? (Hint: Consult Actions on Decisions.)
b. Did the IRS Commissioner subsequently change his mind? If so, when?
C:1-42 Evaluating a Case. Look up James E. Threlkeld, 87 T.C. 1294 (1988) and answer the
questions below.
a. Was the case reviewed by the court? If so, was the decision unanimous? Explain.
b. Was the decision entered under Rule 155?
c. Consult a citator. Was the case reviewed by an appellate court? If so, which one?
C:1-43 Evaluating a Case. Look up Bush Brothers & Co., 73 T.C. 424 (1979) and answer the
questions below.
a. Was the case reviewed by the court? If so, was the decision unanimous? Explain.
b. Was the decision entered under Rule 155?
c. Consult a citator. Was the case reviewed by an appellate court? If so, which one?
C:1-44 Writing Citations. Provide the proper citations (including both primary and secondary
citations where applicable) for the authorities listed below. (For secondary citations, refer-
ence both the AFTR and USTC.)
a. National Cash Register Co., a 6th Circuit Court decision
b. Thomas M. Dragoun v. CIR, a Tax Court memo decision
c. John M. Grabinski v. U.S., a U.S. district court decision
d. John M. Grabinski v. U.S., an Eighth Circuit Court decision
e. Rebekah Harkness, a 1972 Court of Claims decision
f. Hillsboro National Bank v. CIR, a Supreme Court decision
g. Rev. Rul. 78-129
C:1-45 Writing Citations. Provide the proper citations (including both primary and secondary
citations where applicable) for the authorities listed below. (For secondary citations, refer-
ence both the AFTR and USTC.)
a. Rev. Rul. 99-7
b. Frank H. Sullivan, a Board of Tax Appeals decision
c. Tate & Lyle, Inc., a 1994 Tax Court decision
d. Ralph L. Rogers v. U.S., a U.S. district court decision
e. Norman Rodman v. CIR, a Second Circuit Court decision
C:1-46 Interpreting Citations. Indicate which courts decided the cases cited below. Also indicate
on which pages and in which publications the authority is reported.
a. Lloyd M. Shumaker v. CIR, 648 F.2d 1198, 48 AFTR 2d 81-5353 (9th Cir., 1981)
b. Xerox Corp. v. U.S., 14 Cl. Ct. 455, 88-1 USTC ¶9231 (1988)
c. Real Estate Land Title & Trust Co. v. U.S., 309 U.S. 13, 23 AFTR 816 (USSC, 1940)
d. J. B. Morris v. U.S., 441 F. Supp. 76, 41 AFTR 2d 78-335 (DC TX, 1977)
e. Rev. Rul. 83-3, 1983-1 C.B. 72
f. Malone & Hyde, Inc. v. U.S., 568 F.2d 474, 78-1 USTC ¶9199 (6th Cir., 1978)
C:1-47 Using a Tax Service. Use the topical index of the United States Tax Reporter to locate
authorities dealing with the deductibility of the cost of a facelift.
a. In which paragraph(s) does the United States Tax Reporter summarize and cite these authorities?
b. List the authorities.
c. May a taxpayer deduct the cost of a facelift paid in the current year? Explain.
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Tax Research ▼ Corporations 1-39
C:1-48 Using a Tax Service. Locate Reg. Sec. 1.302-1 using either CHECKPOINT or INTELLI-
CONNECT. Does this Treasury Regulation reflect recent amendments to the IRC? Explain.
C:1-49 Using a Tax Service. Using the topical index of the Standard Federal Income Tax
Reporter in INTELLICONNECT, locate authorities addressing whether termite damage
constitutes a casualty loss.
a. In which paragraph(s) does the Standard Federal Income Tax Reporter summarize and
cite these authorities?
b. List the authorities.
C:1-50 Using a Tax Service.
a. Using the Standard Federal Income Tax Reporter in INTELLICONNECT, locate
where Sec. 303(b)(2)(A) appears. This provision states that Sec. 303(a) applies only if the
stock in question meets a certain percentage test. What is the applicable percentage?
b. Locate Reg. Sec. 1.303-2(a) in the same service. Does this Treasury Regulation reflect
recent amendments to the IRC with respect to the percentage test addressed in Part a?
Explain.
C:1-51 Using a Tax Service. Using the BNA tax service, identify the number of the BNA portfolio
for the following subjects.
a. Innocent spouse relief.
b. Accounting methods.
c. Involuntary conversions.
d. IRAs.
e. Deductibility of legal and accounting fees, bribes, and illegal payments.
C:1-52 Using a Tax Service. This problem deals with CHECKPOINT’s Federal Tax Coordinator 2d.
Use the topical index CHECKPOINT to locate authorities dealing with the deductibility
of the cost of work clothing by ministers (clergymen). List the authorities.
C:1-53 Using a Citator. Trace Biltmore Homes, Inc., a 1960 Tax Court memo decision, in both
the INTELLICONNECT and CHECKPOINT citators.
a. According to the CHECKPOINT citator, how many times has the Tax Court decision
been cited by other courts on Headnote Number 5?
b. How many issues did the lower court address in its opinion? (Hint: Refer to the case
headnote numbers.)
c. Did an appellate court review the case? If so, which one?
d. According to the INTELLICONNECT citator, how many times has the Tax Court
decision been cited by other courts?
e. According to the INTELLICONNECT citator, how many times has the circuit court
decision been cited by other courts on Headnote Number 5?
C:1-54 Using a Citator. Trace Stephen Bolaris, 776 F.2d 1428, in both the INTELLICONNECT
and CHECKPOINT citators.
a. According to the CHECKPOINT citator, how many times has the Ninth Circuit’s deci-
sion been cited?
b. Did the decision address more than one issue? Explain.
c. Was the decision ever cited unfavorably? Explain.
d. According to the INTELLICONNECT citator, how many times has the Ninth Circuit’s
decision been cited?
e. According to the INTELLICONNECT citator, how many times has the Tax Court’s
decision been cited on Headnote Number 1?
C:1-55 Interpreting a Case. Using either CHECKPOINT or INTELLICONNECT refer
to the Holden Fuel Oil Company, RIA T.C. Memo ¶72,045 (T.C. Memo 1972-45),
31 TCM 184.
a. In which year was the case decided?
b. What controversy was litigated?
c. Who won the case?
d. Was the decision reviewed at the lower court level?
e. Was the decision appealed?
f. Has the decision been cited in other cases?
C:1-56 Internet Research. Access the IRS Internet site at http://www.irs.gov and answer the fol-
lowing questions:
a. How does one file a tax return electronically?
b. How can the taxpayer transmit funds electronically?
c. What are the advantages of electronic filing?
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1-40 Corporations ▼ Chapter 1
C:1-57 Internet Research. Access the IRS Internet site at http://www.irs.gov and indicate the
titles of the following IRS forms:
a. Form 4506
b. Form 973
c. Form 8725
C:1-58 Internet Research. Access the Federation of Tax Administrators Internet site at
http://www.taxadmin.org/fta/link/forms.html and indicate the titles of the following state
tax forms and publications:
a. Minnesota Form M-100
b. Illinois Individual Schedule CR
c. New York State Corporate Form CT-3-C
C:1-59 Internet Research. Access the Urban Institute and Brookings Institution Tax Policy
Center at http://taxpolicycenter.org. On the home page, search for state individual income
tax rates and locate the Tax Policy Center’s latest summary of each state’s rates.
Researchers also can locate the file by looking under the State tab, Main Features of State
Tax Systems.
a. How many states do not have a state individual income tax?
b. How many states tax only interest and dividends for individuals?
c. What is the top marginal individual income tax rate in Oregon?
d. Of those that do impose an income tax, which state’s top marginal rate is lowest?
COMPREHENSIVE PROBLEM
C:1-60 Your client, a physician, recently purchased a yacht on which he flies a pennant with a
medical emblem on it. He recently informed you that he purchased the yacht and flies the
pennant to advertise his occupation and thus attract new patients. He has asked you if he
may deduct as ordinary and necessary business expenses the costs of insuring and main-
taining the yacht. In search of an answer, consult either INTELLICONNECT’s Standard
Federal Income Tax Reporter or CHECKPOINT’s United States Tax Reporter. Explain
the steps taken to find your answer.
TAX STRATEGY PROBLEM
C:1-61 Your client, Home Products Universal (HPU), distributes home improvement products to
independent retailers throughout the country. Its management wants to explore the possi-
bility of opening its own home improvement centers. Accordingly, it commissions a con-
sulting firm to conduct a feasibility study, which ultimately persuades HPU to expand into
retail sales. The consulting firm bills HPU $150,000, which HPU deducts on its current
year tax return. The IRS disputes the deduction, contending that, because the cost relates
to entering a new business, it should be capitalized. HPU’s management, on the other
hand, firmly believes that, because the cost relates to expanding HPU’s existing business,
it should be deducted. In contemplating legal action against the IRS, HPU’s management
considers the state of judicial precedent: The federal court for HPU’s district has ruled
that the cost of expanding from distribution into retail sales should be capitalized. The
appellate court for HPU’s circuit has stated in dictum that, although in some circum-
stances switching from product distribution to product sales entails entering a new trade
or business, improving customer access to one’s existing products generally does not. The
Federal Circuit Court has ruled that wholesale distribution and retail sales, even of the
same product, constitute distinct businesses. In a case involving a taxpayer from another
circuit, the Tax Court has ruled that such costs invariably should be capitalized. HPU’s
Chief Financial Officer approaches you with the question, “In which judicial forum
should HPU file a lawsuit against the IRS: (1) U.S. district court, (2) the Tax Court, or (3)
the U.S. Court of Federal Claims?” What do you tell her?
CASE STUDY PROBLEM
C:1-62 A client, Mal Manley, fills out his client questionnaire for the previous year and on it
provides information for the preparation of his individual income tax return. The IRS
has never audited Mal’s returns. Mal reports that he made over 100 relatively small
cash contributions totaling $24,785 to charitable organizations. In the last few years,
Mal’s charitable contributions have averaged about $15,000 per year. For the previous
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Tax Research ▼ Corporations 1-41
year, Mal’s adjusted gross income was roughly $350,000, about a 10% increase from
the year before.
Required: Applying Statements on Standards for Tax Services No. 3, determine
whether you can accept at face value Mal’s information concerning his charitable contri-
butions. Now assume that the IRS recently audited Mal’s tax return for two years ago and
denied 75% of that year’s charitable contribution deduction because the deduction was
not substantiated. Assume also that Mal indicates that, in the previous year, he con-
tributed $25,000 (instead of $24,785). How do these changes of fact affect your earlier
decision?
TAX RESEARCH PROBLEMS
C:1-63 The purpose of this problem is to enhance your skills in interpreting the authorities that
you locate in your research. In answering the questions that follow, refer only to Thomas
A. Curtis, M.D., Inc., 1994 RIA TC Memo ¶94,015 (T.C. Memo 1994-15), 67 TCM 1958.
a. What was the principal controversy litigated in this case?
b. Which party—the taxpayer or the IRS—won?
c. Why is the corporation instead of Dr. and/or Ms. Curtis listed as the plaintiff?
d. What is the relationship between Ellen Barnert Curtis and Dr. Thomas A. Curtis?
e. Approximately how many hours a week did Ms. Curtis work, and what were her cre-
dentials?
f. For the fiscal year ending in 1989, what salary did the corporation pay Ms. Curtis?
What amount did the court decide was reasonable?
g. What dividends did the corporation pay for its fiscal years ending in 1988 and 1989?
h. To which circuit would this decision be appealable?
i. According to Curtis, what five factors did the Ninth Circuit mention in Elliotts, Inc. as
relevant in determining reasonable compensation?
C:1-64 Josh contributes $5,000 toward the support of his widowed mother, aged 69, a U.S. citi-
zen and resident. She earns gross income of $2,000 and spends it all for her own support.
In addition, Medicare pays $3,200 of her medical expenses. She does not receive financial
support from sources other than those described above. Must the Medicare payments be
included in the support that Josh’s mother is deemed to provide for herself?
Prepare work papers and a client letter (to Josh) dealing with the issue.
C:1-65 Amy owns a vacation cottage in Maine. She predicts that the time during which the cot-
tage will be used in the current year is as follows:
By Amy, solely for vacation 12 days
By Amy, making repairs ten hours per day
and vacationing the rest of the day 2 days
By her sister, who paid fair rental value 8 days
By her cousin, who paid fair rental value 4 days
By her friend, who paid a token amount of rent 2 days
By three families from the Northeast, who paid
fair rental value for 40 days each 120 days
Not used 217 days
Calculate the ratio for allocating the following expenses to the rental income expected to
be received from the cottage: interest, taxes, repairs, insurance, and depreciation. The
ratio will be used to determine the amount of expenses that are deductible and, thus,
Amy’s taxable income for the year.
For the tax manager to whom you report, prepare work papers in which you discuss
the calculation method. Also, draft a memo to the file dealing with the results of your
research.
C:1-66 Look up Summit Publishing Company, 1990 PH T.C. Memo ¶90,288, 59 (T.C. Memo
1990-288) TCM 833, and J.B.S. Enterprises, 1991 PH T.C. Memo ¶91,254, (T.C. Memo
1991-254) 61 TCM 2829, and answer the following questions:
a. What was the principal issue in these cases?
b. What factors did the Tax Court consider in resolving the central issue?
c. How are the facts of these cases similar? How are they dissimilar?
C:1-67 Your supervisor would like to set up a single Sec. 401(k) plan exclusively for the managers
of your organization. Concerned that this arrangement might not meet the requirementsIS
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1-42 Corporations ▼ Chapter 1
for a qualified plan, he has asked you to request a determination letter from the IRS. In a
brief memorandum, address the following issues:
a. What IRS pronouncements govern requests for determination letters?
b. What IRS forms must be filed with the request?
c. What information must be provided in the request?
d. What actions must accompany the filing?
e. Where must the request be filed?
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2
CORPORATE
FORMATIONS
AND CAPITAL
STRUCTURE
2-1
LEARNING OBJECTIVES
After studying this chapter, you should be able to
1 Discuss the tax advantages and disadvantages of alternative business
forms
2 Apply the check-the-box regulations to partnerships, corporations, and
trusts
3 Recognize the legal requirements and tax considerations related to
forming a corporation
4 Discuss the requirements for deferring gain or loss upon incorporation
5 Explain the tax implications of alternative capital structures
6 Determine the tax consequences of worthless stock or debt obligations
7 Identify tax planning opportunities in corporate formations
8 Comply with procedural rules for corporate formations
C H A P T E R
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2-2 Corporations ▼ Chapter 2
When starting a business, entrepreneurs must decide whether to organize it as a sole pro-
prietorship, partnership, corporation, limited liability company, or limited liability part-
nership. This chapter discusses the advantages and disadvantages of each form of business
association. Because many entrepreneurs find organizing their business as a corporation
advantageous, the chapter looks at the definition of a corporation for federal income tax
purposes. It also discusses the tax consequences of incorporating a business. The chapter
closes by examining the tax implications of capitalizing a corporation with equity and/or
debt and describing the advantages and disadvantages of alternative capital structures.
This textbook takes a life-cycle approach to corporate taxation. The corporate life
cycle starts with corporate formation, discussed in this chapter. Once formed and operat-
ing, the corporation generates taxable income (or loss), incurs federal income tax and
other liabilities, and makes distributions to its shareholders. Finally, at some point, the
corporation might outlive its usefulness and be liquidated and dissolved. The corporate
life cycle is too complex to discuss in one chapter. Therefore, additional coverage follows
in Chapters C:3 through C:8.
CHAPTER OUTLINE
Organization Forms Available…2-2
Check-the-Box Regulations…2-8
Legal Requirements and Tax
Considerations Related to
Forming a Corporation…2-9
Section 351: Deferring Gain or
Loss Upon Incorporation…2-12
Choice of Capital Structure…2-27
Worthlessness of Stock or Debt
Obligations…2-32
Tax Planning Considerations…2-34
Compliance and Procedural
Considerations…2-36
ORGANIZATION FORMS
AVAILABLE
OBJECTIVE 1
Discuss the tax advantages
and disadvantages of
alternative business forms
ADDITIONAL
COMMENT
The income/loss of a sole propri-
etorship reported on Schedule C
carries to page 1 of Form 1040
and is included in the computa-
tion of the individual’s taxable
income. Net income, if any, also
carries to Schedule SE of Form
1040 for computation of the sole
proprietor’s self-employment tax.
EXAMPLE C:2-1 �
EXAMPLE C:2-2 �
1 The $15,000 Schedule C profit in Example C:2-1 will increase adjusted gross
income (AGI). The AGI level affects certain deduction calculations (e.g., medical,
charitable contributions, and miscellaneous itemized) and, because of limitations,
may result in a taxable income increase different from the $15,000 AGI increase.
Businesses can be organized in several forms including
� Sole proprietorships
� Partnerships
� Corporations
� Limited liability companies
� Limited liability partnerships
A discussion of the tax implications of each form is presented below.
SOLE PROPRIETORSHIPS
A sole proprietorship is an unincorporated business owned by one individual. It often is
selected by entrepreneurs who are beginning a new business with a modest amount of
capital. From a tax and legal perspective, a sole proprietorship is not a separate entity.
Rather, it is a legal extension of its individual owner. Thus, the individual owns all the
business assets and reports income or loss from the sole proprietorship directly on his or
her individual tax return. Specifically, the individual owner (proprietor) reports all the
business’s income and expenses for the year on Schedule C (Profit or Loss from Business)
or Schedule C-EZ (Net Profit from Business) of Form 1040. A completed Schedule C is
included in Appendix B, where a common set of facts (with minor modifications) illus-
trates the similarities and differences in sole proprietorship, C corporation, partnership,
and S corporation tax reporting.
If the business is profitable, the profit is added to the proprietor’s other income.
John, a single taxpayer, starts a new computer store, which he operates as a sole proprietorship.
John reports a $15,000 profit from the store in its first year of operation. Assuming his marginal
tax rate is 33%, John’s tax on the $15,000 of profit from the store is $4,950 (0.33 � $15,000).1 �
If the business is unprofitable, the loss reduces the proprietor’s total taxable income,
thereby generating tax savings.
Assume the same facts as in Example C:2-1 except John reports a $15,000 loss instead of a
$15,000 profit in the first year of operation. Assuming he still is taxed at a 33% marginal tax
rate, the $15,000 loss produces tax savings of $4,950 (0.33 � $15,000). �
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Corporate Formations and Capital Structure ▼ Corporations 2-3
ADDITIONAL
COMMENT
Although this chapter emphasizes
the tax consequences of selecting
the entity in which a business will
be conducted, other issues also
are important in making such a
decision. For example, the
amount of legal liability assumed
by an owner is important and can
vary substantially among the dif-
ferent business entities.
ADDITIONAL
COMMENT
In 2011 and 2012, the employee’s
half of Social Security taxes was
reduced from 6.2% to 4.2%. In
2013, the employee’s share
returns to 6.2%. Also, beginning
in 2013, an additional 0.9% for
the Medicare hospital insurance
tax applies to the employee’s
portion of wages exceeding
$200,000 ($250,000 for married
filing jointly).
REAL-WORLD
EXAMPLE
Entities filed the following
number of tax returns in 2011:
Entity Number
Partnership 3.6 million
C corporation 2.3 million
S corporation 4.5 million
2 Section 162(l ) permits self-employed individuals to deduct as a trade or
business expense all of the health insurance costs incurred on behalf of them-
selves, their spouses, and their dependents.
TAX ADVANTAGES. The tax advantages of conducting business as a sole proprietor-
ship are as follows:
� The sole proprietorship is not subject to taxation as a separate entity. Rather, the sole
proprietor, as an individual, is taxed at his or her marginal rate on income earned by
the business.
� The proprietor’s marginal tax rate may be lower than the marginal tax rate that would
have applied had the business been organized as a corporation.
� The owner may contribute cash to, or withdraw profits from, the business without tax
consequences.
� Although the owner usually maintains separate books, records, and bank accounts for
the business, the money in these accounts belongs to the owner personally.
� The owner may contribute property to, or withdraw property from, the business with-
out recognizing gain or loss.
� Business losses may offset nonbusiness income, such as interest, dividends, and any
salary earned by the sole proprietor or his or her spouse, subject to the passive activity
loss rules.
TAX DISADVANTAGES. The tax disadvantages of conducting business as a sole propri-
etorship are as follows:
� The profits of a sole proprietorship are currently taxed to the individual owner,
whether or not the profits are retained in the business or withdrawn for personal use.
By contrast, the profits of a corporation are taxed to its shareholders only if and when
the corporation distributes the earnings as dividends.
� At times, corporate tax rates have been lower than individual tax rates. In such times,
businesses conducted as sole proprietorships have been taxed more heavily than busi-
nesses organized as corporations.
� A sole proprietor must pay the full amount of Social Security taxes because he or she is
not considered to be an employee of the business. By contrast, shareholder-employees
must pay only half their Social Security taxes; the corporate employer pays the other
half. (The employer, however, might pass this half onto employees in the form of lower
wages or fewer employees hired.)
� Sole proprietorships may not deduct compensation paid to owner-employees. By con-
trast, corporations may deduct compensation paid to shareholder-employees.
� Certain tax-exempt benefits (e.g., premiums for group term life insurance) available to
shareholder-employees are not available to owner-employees.2
� A sole proprietor must use the same accounting period for business and personal pur-
poses. Thus, he or she cannot defer income by choosing a business fiscal year that dif-
fers from the individual’s calendar year. By contrast, a corporation may choose a fiscal
year that differs from the shareholders’ calendar years.
PARTNERSHIPS
A partnership is an unincorporated business carried on by two or more individuals or
entities for profit. The partnership form often is used by friends or relatives who engage in
a business and by groups of investors who want to share the profits, losses, and expenses
of an investment such as a real estate project.
A partnership is a tax reporting, but not taxpaying, entity. The partnership acts as a
conduit for its owners. Its income, expenses, losses, credits, and other tax-related items
pass through to the partners who report these items on their separate tax returns.
Each year a partnership must file a tax return (Form 1065—U.S. Partnership Return of
Income) to report the results of its operations. When the partnership return is filed, the
preparer must send each partner a statement (Schedule K-1, Form 1065) that reports the
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EXAMPLE C:2-4 �
ADDITIONAL
COMMENT
If two or more owners exist, a
business cannot be conducted as a
sole proprietorship. From a tax
compliance and recordkeeping
perspective, conducting a business
as a partnership is more compli-
cated than conducting the busi-
ness as a sole proprietorship.
partner’s allocable share of partnership income, expenses, losses, credits, and other tax-
related items. The partner then must report these items on his or her separate tax return.
As with a sole proprietorship, the partner’s allocable share of business profits is added to
the partner’s other income and taxed at that partner’s marginal tax rate. A completed
Form 1065 appears in Appendix B.
Bob, a single taxpayer, owns a 50% interest in the BT Partnership, a calendar year entity. The BT
Partnership reports a $30,000 profit in its first year of operation. Bob’s $15,000 share flows
through from the partnership to Bob’s individual tax return. Assuming Bob is taxed at a 33%
marginal rate, his tax on the $15,000 is $4,950 (0.33 � $15,000). Bob must pay the $4,950 tax
whether or not the BT Partnership distributes any of its profits to him. �
If a partnership reports a loss, the partner’s allocable share of the loss reduces that
partner’s other income and provides tax savings based on the partner’s marginal tax rate.
The passive activity loss rules, however, may limit the amount of any loss deduction avail-
able to the partner. (For a discussion of these rules, see Chapter C:9 of this textbook.)
Assume the same facts as in Example C:2-3 except that, instead of a profit, the BT Partnership
sustains a $30,000 loss in its first year of operation. Assuming Bob is taxed at a 33% marginal
rate, his $15,000 share of the first year loss produces a $4,950 (0.33 � $15,000) tax savings. �
Organizationally, a partnership can be either general or limited. In a general partner-
ship, the liability of each partner for partnership debts is unlimited. Thus, these part-
ners are at risk for more than the amount of their capital investment in the partnership.
In a limited partnership, at least one partner must be a general partner, and at least one
partner must be a limited partner. As in a general partnership, the general partners are
liable for all partnership debts, and the limited partners are liable only to the extent of
their capital investment in the partnership, plus any amount they are obligated to con-
tribute under their partnership agreement. Unless specified in that agreement, limited
partners generally may not participate in the management of the partnership business.
TAX ADVANTAGES. The tax advantages of doing business as a partnership are as
follows:
� The partnership as an entity pays no tax. Rather, the income of the partnership passes
through to the separate returns of the partners and is taxed directly to them.
� A partner’s tax rate may be lower than a corporation’s tax rate for the same level of
taxable income.
� Partnership income is not subject to double taxation. Although partnership profits are
accounted for at the partnership level, they are taxed only at the partner level.
� Additional taxes generally are not imposed on distributions to the partners. With lim-
ited exceptions, partners can contribute money or property to, or withdraw money or
property from, the partnership without recognizing gain or loss.
� Subject to limitations, partners can use losses to offset income from other sources.
� A partner’s basis in a partnership interest is increased by his or her share of partnership
income. This basis adjustment reduces the amount of gain recognized when the part-
ner sells his or her partnership interest, thereby preventing double taxation.
TAX DISADVANTAGES. The tax disadvantages of doing business as a partnership are
as follows:
� All the partnership’s profits are taxed to the partners when earned, even if not
distributed.
� A partner’s tax rate could be higher than a corporation’s tax rate for the same level of
taxable income.
� A partner is not considered to be an employee of the partnership. Therefore, he or she
must pay the full amount of self-employment taxes on his or her share of partnership
2-4 Corporations ▼ Chapter 2
EXAMPLE C:2-3 �
ADDITIONAL
COMMENT
In some states, a limited partner-
ship can operate as a limited lia-
bility limited partnership (LLLP)
whereby the general partners
obtain limited liability. See
Chapter C:10 for additional dis-
cussion.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Corporate Formations and Capital Structure ▼ Corporations 2-5
ADDITIONAL
COMMENT
Unlike a sole proprietorship and a
partnership, a C corporation is a
separate taxpaying entity. This
form can be an advantage because
corporate rates start at 15%,
which may be much lower than an
individual shareholder’s rate,
which might be as high as 39.6%.
EXAMPLE C:2-5 �
income. Some tax-exempt fringe benefits (e.g., premiums for group term life insur-
ance) are not available to partners.3
� Partners generally cannot defer income by choosing a fiscal year for the partnership that dif-
fers from the tax year of the principal partner(s). However, if the partnership demonstrates
a business purpose, or if it makes a special election, it may use a fiscal year in general.
Chapters C:9 and C:10 of this volume discuss partnerships in greater detail.
CORPORATIONS
Corporations fall into two categories: C corporations and S corporations. Both have limited
liability. A C corporation is subject to double taxation. Its earnings are taxed first at the cor-
porate level when earned, then again at the shareholder level when distributed as dividends.
An S corporation, by contrast, is subject to single-level taxation, much like a partnership. Its
earnings are accounted for at the corporate level but are taxed only at the shareholder level.
C CORPORATIONS. A C corporation is a separate entity taxed on its income at rates
ranging from 15% to 35%.4 A C corporation must report all its income and expenses and
compute its tax liability on Form 1120 (U.S. Corporation Income Tax Return). A completed
Form 1120 appears in Appendix B. Shareholders are not taxed on the corporation’s earn-
ings unless these earnings are distributed as dividends. After 2012, the applicable capital
gains tax rate for net capital gains and qualified dividends of noncorporate taxpayers is 0%
for taxpayers in tax brackets of 15% and below, 15% for taxpayers in the 25% through
35% tax brackets, and 20% for taxpayers in the 39.6% tax bracket. Also, 25% and 28%
rates apply for gains on certain types of property. In addition, an incremental 3.8% rate
applies to net investment income for taxpayers whose modified AGI exceeds $200,000
($250,000 for married filing jointly). Net investment income includes, among other things,
interest, dividends, annuities, royalties, rents, and net gains from the disposition of property
not used in a trade or business, all reduced by deductions allocable to such income or gains.
Jane owns 100% of York Corporation stock. York reports taxable income of $50,000 for the cur-
rent year. The first $50,000 of taxable income is taxed at a 15% rate, so York pays a corporate
income tax of $7,500 (0.15 � $50,000). If the corporation distributes none of its earnings to
Jane during the year, she pays no tax on York’s earnings. However, if York distributes its current
after-tax earnings to Jane, she must pay tax on $42,500 ($50,000 � $7,500) of dividend income.
Assuming Jane’s capital gains tax rate is 15%, her tax on the dividend income is $6,375 (0.15
� $42,500). The total tax on York’s $50,000 of profits is $13,875 ($7,500 paid by York � $6,375
paid by Jane). �
Even when a corporation does not distribute its profits, double taxation may result.
The profits are taxed to the corporation when they are earned. Then, effectively, they may
be taxed a second time (as capital gains) when the shareholder sells his or her stock or
when the corporation liquidates.
On January 2 of the current year, Carl purchases 100% of York Corporation stock for $60,000. In
the same year, York reports taxable income of $50,000, on which it pays tax of $7,500. The cor-
poration distributes none of the remaining $42,500 to Carl. On January 3 of the next year, Carl
sells his stock to Mary for $102,500 (his initial investment plus the current year’s accumulated
earnings). Carl must report a capital gain of $42,500 ($102,500 � $60,000). Thus, York’s profit is
effectively taxed twice—first at the corporate level when earned and again at the shareholder
level when Carl sells the appreciated stock at a gain. �
Tax Advantages. The tax advantages of doing business as a C corporation are as follows:
� A C corporation is an entity separate and distinct from its owners. Its marginal tax
rate may be lower than its owners’ marginal tax rates. So long as these earnings are not
distributed and taxed to both the shareholders and the corporation, aggregate tax sav-
ings may result. If retained in the business, the earnings may be used for reinvestment
and the retirement of debt. This advantage, however, may be limited by the accumu-
lated earnings tax and the personal holding company tax. (See Chapter C:5 for a dis-
cussion of these two taxes.)
EXAMPLE C:2-6 �
TAX STRATEGY TIP
If a shareholder is also an
employee of the corporation, the
corporation can avoid double tax-
ation by paying a deductible
salary instead of a dividend. The
salary, however, must be reason-
able in amount. See Tax Planning
Considerations in Chapter C:3 for
further discussion of this tech-
nique along with an example
demonstrating how the reduced
tax rate on dividends lessens the
difference between salary and
dividend payments.
TAX STRATEGY TIP
By having a corporation accumu-
late earnings instead of paying
dividends, the shareholder con-
verts current ordinary income into
deferred capital gains. The corpo-
ration, however, must avoid the
accumulated earnings tax (see
Chapter C:5).
3 Partners are eligible to deduct their health insurance costs in the same man-
ner as a sole proprietor. See footnote 2 for details.
4 As discussed in Chapter C:3, the corporate tax rate is 39% and 38% for cer-
tain levels of taxable income.
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SELF-STUDY
QUESTION
How are corporate earnings sub-
ject to double taxation?
ANSWER
Corporate earnings initially are
taxed to the corporation. In addi-
tion, once these earnings are dis-
tributed to the shareholders (divi-
dends), they are taxed again.
Because the corporation does not
receive a deduction for the distri-
bution, these earnings have been
taxed twice. Also, double taxation
can occur when a shareholder
sells his or her stock at a gain.
In either case, the dividends or
capital gains are taxed at the
applicable capital gains rate.
5 Sec. 441. See Chapter C:3 for the special tax year restrictions applying to
personal service corporations.
� Shareholders employed by the corporation are considered to be employees for tax pur-
poses. Consequently, they are liable for only half their Social Security taxes, while their
corporate employer is liable for the other half.
� Shareholder-employees are entitled to nontaxable fringe benefits (e.g., premiums paid
on group term life insurance and accident and health insurance). The corporation can
provide these benefits with before-tax dollars (instead of after-tax dollars). By con-
trast, because sole proprietors and partners are not considered to be employees for tax
purposes, they are ineligible for certain tax-free fringe benefits, although they are per-
mitted to deduct their health insurance premiums.
� A corporation may deduct as an ordinary and necessary business expense compensation
and certain benefits paid to shareholder-employees. Within reasonable limits, it may
adjust this compensation and these benefits upward to shelter corporate taxable income.
� A C corporation can use a fiscal instead of a calendar year as its reporting period. A fis-
cal year could permit a corporation to defer income to a later reporting period. (A per-
sonal service corporation, however, generally must use a calendar year as its tax year.5)
� Special rules allow a shareholder to exclude 50% of the gain realized on the sale or
exchange of stock held more than five years, provided the corporation meets certain
requirements.
Tax Disadvantages. The tax disadvantages of doing business as a C corporation are as
follows:
� Double taxation of income results when the corporation distributes its earnings as div-
idends to shareholders or, effectively, when shareholders sell or exchange their stock.
� Shareholders generally cannot withdraw money or property from the corporation
without recognizing income. A distribution of cash or property to a shareholder gener-
ally is taxable as a dividend if the corporation has sufficient earnings and profits
(E&P). (See Chapter C:4 for a discussion of E&P.)
� Net operating losses confer no tax benefit to the owners in the year the corporation
incurs them. They can be carried back or carried forward to offset the corporation’s
income in other years. For start-up corporations, these losses provide no tax benefit
until the corporation earns a profit in a subsequent year. Shareholders cannot use these
losses to offset income from other sources.
� Capital losses confer no tax benefit to the owners in the year the corporation incurs
them. They cannot offset the ordinary income of either the corporation or its share-
holders. These losses must be carried back or carried forward to offset corporate capi-
tal gains realized in other years.
S CORPORATIONS. An S corporation is so designated because special rules governing
its tax treatment are found in Subchapter S of the IRC. Nevertheless, the general corporate
tax rules apply unless overridden by the Subchapter S provisions. Like a partnership, an S
corporation is a pass-through entity. Income, deductions, losses, and credits are accounted
for by the S corporation, which generally is not subject to taxation. They pass through to
the separate returns of its owners, who generally are subject to taxation. An S corporation
offers its owners less flexibility than does a partnership. For example, the number and type
of S corporation shareholders are limited, and the shareholders cannot allocate income,
deductions, losses, and credits in a way that differs from their proportionate ownership. As
mentioned before, like C corporation shareholders, S corporation shareholders enjoy lim-
ited liability.
To obtain S corporation status, a corporation must make a special election, and its
shareholders must consent to that election. Each year, an S corporation files an informa-
tion return, Form 1120S (U.S. Income Tax Return for an S Corporation), which reports
the results of its operations and indicates the items of income, deduction, loss, and credit
that pass through to the separate returns of its shareholders.
2-6 Corporations ▼ Chapter 2
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
EXAMPLE C:2-7 �
Corporate Formations and Capital Structure ▼ Corporations 2-7
6 S corporation shareholders may deduct their health insurance costs in the
same manner as sole proprietors and partners. See footnote 2 for details.
Chuck owns 50% of the stock in Maine, an S corporation that uses the calendar year as its tax
year. In its first year of operation, Maine reports $30,000 of taxable income, all ordinary in
character. Maine pays no corporate income tax. Chuck, however, must pay tax on his $15,000
(0.50 � $30,000) share of Maine’s income whether or not the corporation distributes this
income to him. If his marginal rate is 33%, Chuck pays $4,950 (0.33 � $15,000) of tax on this
share. If Maine instead reports a $30,000 loss, Chuck’s $15,000 share of the loss reduces his tax
liability by $4,950 (0.33 � $15,000). �
Tax Advantages. The tax advantages of doing business as an S corporation are as follows:
� S corporations generally pay no tax. Corporate income passes through and is taxed to
the shareholders.
� The shareholders’ marginal tax rates may be lower than a C corporation’s marginal
tax rate, thereby producing overall tax savings.
� Corporate losses flow through to the separate returns of the shareholders and may be
used to offset income earned from other sources. (Passive loss and basis rules, how-
ever, may limit loss deductions to shareholders. See Chapter C:11.) This treatment can
be beneficial to owners of start-up corporations that generate losses in their early years
of operation.
� Because capital gains, as well as other tax-related items, retain their character when
they pass through to the separate returns of shareholders, the shareholders are taxed
on these gains as though they directly realized them. Consequently, they can offset the
gains against capital losses from other sources. Furthermore, they are taxed on these
gains at their own capital gains rates.
� Shareholders generally can contribute money to or withdraw money from an S corpo-
ration without recognizing gain.
� Corporate profits are taxed only at the shareholder level in the year earned. Generally,
the shareholders incur no additional tax liability when the corporation distributes the
profits.
� A shareholder’s basis in S corporation stock is increased by his or her share of corpo-
rate income. This basis adjustment reduces the shareholder’s gain when he or she later
sells the stock, thereby avoiding double taxation.
Tax Disadvantages. The tax disadvantages of doing business as an S corporation are as
follows:
� Shareholders are taxed on all of an S corporation’s current year profits whether or not
the corporation distributes these profits and whether or not the shareholders have the
wherewithal to pay the tax on these profits.
� If the shareholders’ marginal tax rates exceed those for a C corporation, the overall
tax burden may be heavier, and the after-tax earnings available for reinvestment and
debt retirement may be reduced.
� Nontaxable fringe benefits generally are not available to S corporation shareholder-
employees.6 Ordinarily, fringe benefits provided by an S corporation are deductible by
the corporation and taxable to the shareholder. On the other hand, S corporation
shareholder-employees pay half of Social Security taxes while the S corporation
employer pays the other half.
� S corporations generally cannot defer income by choosing a fiscal year other than a
calendar year unless the S corporation can establish a legitimate business purpose for a
fiscal year or unless it makes a special election.
Chapter C:11 discusses S corporations in greater detail. In addition, Appendix F com-
pares the tax treatment of C corporations, partnerships, and S corporations.
TAX STRATEGY TIP
If a corporation anticipates losses
in its early years, it might consider
operating as an S corporation so
that the losses pass through to
the shareholders. When the cor-
poration becomes profitable, it
can revoke the S election if it
wishes to accumulate earnings for
growth.
TAX STRATEGY TIP
Relatively low individual tax rates
may increase the attractiveness of
an S corporation relative to the
C corporation form of doing
business.
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LIMITED LIABILITY COMPANIES
A limited liability company (LLC) combines the best features of a partnership with those
of a corporation even though, from a legal perspective, it is neither. While offering its
owners the limited liability of a corporation, an LLC with more than one owner generally
is treated as a partnership for tax purposes. This limited liability extends to all the LLC’s
owners. In this respect, the LLC is analogous to a limited partnership with no general
partners. Unlike an S corporation, an LLC may have an unlimited number of owners who
can be individuals, corporations, estates, and trusts. As discussed below, under the check-
the-box regulations, the LLC may elect to be taxed as a corporation or be treated by
default as a partnership. If treated as a partnership, the LLC files Form 1065 (U.S.
Partnership Return of Income) with the IRS.
LIMITED LIABILITY PARTNERSHIPS
Many states allow a business to operate as a limited liability partnership (LLP). This busi-
ness form is attractive to professional service organizations, such as public accounting
firms, that adopt LLP status primarily to limit their legal liability. Under state LLP laws,
partners are liable for their own acts and omissions as well as the acts and omissions of
individuals under their direction. On the other hand, LLP partners are not liable for the
negligence or misconduct of the other partners. Thus, from a legal liability perspective, an
LLP partner is like a limited partner with respect to other partners’ acts but like a general
partner with respect to his or her own acts, as well as the acts of his or her agents. Like a
general partnership or LLC with more than one owner, an LLP can elect to be taxed as a
corporation under the check-the-box regulations. If treated as a partnership by default,
the LLP files Form 1065 (U.S. Partnership Return of Income) with the IRS.
2-8 Corporations ▼ Chapter 2
OBJECTIVE 2
Apply the check-the-box
regulations to
partnerships, corporations,
and trusts
TAX STRATEGY TIP
When applying the federal check-
the-box regulations, taxpayers
also must check to see whether or
not their state will treat the
entity in a consistent manner.
EXAMPLE C:2-8 �
7 This rule does not apply to corporations, trusts, or certain special entities
such as real estate investment trusts, real estate mortgage investment con-
duits, or publicly traded partnerships. Reg. Sec. 301.7701-2(b)(8). Publicly
traded partnerships are discussed in Chapter C:10. Special check-the-box
rules apply to foreign corporations. These rules are beyond the scope of this
text.
Most unincorporated businesses may choose to be taxed as a partnership or a corporation
under rules commonly referred to as the check-the-box regulations. According to these
regulations, an unincorporated business with two or more owners is treated by default as
a partnership for tax purposes unless it elects to be taxed as a corporation. An unincorpo-
rated business with one owner is disregarded as a separate entity and thus treated as a sole
proprietorship by default unless it elects to be taxed as a corporation.7
An eligible entity (i.e., an unincorporated business) may elect its classification by filing
Form 8832 (Entity Classification Election) with the IRS. The form must be signed by each
owner of the entity, or any officer, manager, or owner of the entity authorized to make the
election. The signatures must specify the date on which the election will be effective. The
effective date cannot be more than 75 days before or 12 months after the date the entity
files Form 8832. A copy of the form must be attached to the entity’s tax return for the
election year.
On January 10 of the current year, a group of ten individuals organizes an LLC to conduct a
bookbinding business in Texas. In the current year, the LLC is an eligible entity under the check-
the-box regulations and thus may elect (with the owners’ consent) to be taxed as a corporation.
If the LLC does not make the election, it will be treated as a partnership for tax purposes by
default. �
Assume the same facts as in Example C:2-8 except only one individual organized the LLC. Unless
the LLC elects to be taxed as a corporation, it will be disregarded for tax purposes
by default. Consequently, its income will be taxed directly to the owner as if it were a sole
proprietorship. �
CHECK-THE-BOX
REGULATIONS
REAL-WORLD
EXAMPLE
All the Big 4 accounting firms
have converted general partner-
ships into LLPs.
EXAMPLE C:2-9 �
ADDITIONAL
COMMENT
All 50 states have adopted
statutes allowing LLCs.
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Corporate Formations and Capital Structure ▼ Corporations 2-9
LEGAL REQUIREMENTS
AND TAX CONSIDERATIONS
RELATED TO FORMING
A CORPORATIONOBJECTIVE 3
Recognize the legal
requirements and tax
considerations related
to forming a corporation
LEGAL REQUIREMENTS
The legal requirements for forming a corporation depend on state law. These require-
ments generally include
� Investing a minimum amount of capital
� Filing articles of incorporation
� Issuing stock
� Paying state incorporation fees
One of the first decisions an entrepreneur must make when organizing a corporation is
choosing a state of incorporation. Although most entrepreneurs incorporate in the state where
they conduct business, many incorporate in other states with more favorable corporation
laws. Such laws might provide for little or no income, sales, or use taxes; low minimum capi-
tal requirements; and modest incorporation fees. Regardless of the state of incorporation, the
entrepreneur must follow the incorporation procedure set forth in the relevant state statute.
Typically, under this procedure, the entrepreneur must file articles of incorporation with the
appropriate state agency. The articles must specify certain information, such as the formal
name of the corporation; its purpose; the par value, number of shares, and classes of stock it is
authorized to issue; and the names of the individuals who will initially serve on the corpora-
tion’s board of directors. The state usually charges a fee for incorporation or filing. In addi-
tion, it periodically may assess a franchise tax for the privilege of doing business in the state.
ADDITIONAL
COMMENT
States are not consistent in how
they tax corporations. Certain
states have no state income taxes.
Other states do not recognize an
S corporation election, thereby
taxing an S corporation as
a C corporation.
TAX CONSIDERATIONS
8 Reg. Sec. 301.7701-3(g). An alternative way for a corporation to be taxed
as a pass-through entity is to make an election to be taxed as an S corpora-
tion. See Chapter C:11.
9 Sec. 1001.
Once the entrepreneur decides on the corporate form, he or she must transfer cash, prop-
erty (e.g., equipment, furniture, inventory, and receivables), or services (e.g., accounting,
legal, or architectural services) to the corporation in exchange for its debt or equity. These
transfers may have tax consequences for both the transferor investor and the transferee
corporation. For instance, the sale of property for stock usually is taxable to the trans-
feror.9 However, if Sec. 351(a) (which treats an investor’s interest in certain transferred
business assets to be “changed in form” rather than “disposed of”) applies, any gain or
loss realized on the exchange may be deferred. In determining the tax consequences of
incorporation, one must answer the following questions:
� What property should be transferred to the corporation?
� What services should the transferors or third parties provide for the corporation?
If an entity elects to change its tax classification, it cannot make another election until
60 months after the effective date of the initial election. Following the election, certain tax
consequences ensue. For example, following a partnership’s election to be taxed as a corpo-
ration, the partnership is deemed to distribute its assets to the partners, who are then
deemed to contribute the assets to a new corporation in a nontaxable exchange for stock. If
an eligible entity that previously elected to be taxed as a corporation subsequently elects to
be treated as a partnership or a disregarded entity, it is deemed to have distributed its assets
and liabilities to its owners or owner in a liquidation as described in Chapter C:6. If a part-
nership, the deemed distribution is followed by a deemed contribution of assets and liabili-
ties to a newly formed partnership.8
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EXAMPLE C:2-10 �
� What liabilities, in addition to property, should be transferred?
� How should the property be transferred (e.g., sale, contribution to capital, or loan)?
Example C:2-10 and Table C:2-1 compare the tax consequences of taxable and nontax-
able property transfers.
For several years Brad has operated a successful manufacturing business as a sole proprietor-
ship. To limit his liability, he decides to incorporate his business as Block Corporation.
Immediately preceding the incorporation, he reports the following balance sheet for his sole
proprietorship, which uses the accrual method of accounting:
Assets:
Cash $ 10,000 $ 10,000
Accounts receivable 15,000 15,000
Inventory 20,000 25,000
Equipment $120,000
Minus: Depreciation )
Total
Liabilities and owner’s equity:
Accounts payable $ 30,000 $ 30,000
Note payable on equipment 50,000 50,000
Owner’s equity
Total
When Brad transfers the assets to Block in exchange for its stock, he realizes a gain because
the value of the stock received exceeds his basis in the assets. If the exchange is taxable, Brad
recognizes $5,000 of ordinary income on the transfer of the inventory ($25,000 FMV � $20,000
basis) and, because of depreciation recapture, $15,000 of ordinary income on the transfer of
the equipment ($100,000 FMV � $85,000 basis). However, if the exchange meets the require-
ments of Sec. 351(a), it is nontaxable. In other words, Brad recognizes none of the income or
gain realized on the transfer of assets and liabilities to Block. �
Question: Joyce has conducted a business as a sole proprietorship for several years. She
needs additional capital and wants to incorporate her business. The assets of her business
(building, land, inventory, etc.) have a $400,000 adjusted basis and a $1.5 million FMV.
Joyce is willing to exchange the assets for 1,500 shares of Ace Corporation stock, each
having a $1,000 fair market value. Bill and John each are willing to invest $500,000 in
Joyce’s business for 500 shares of stock. Why is Sec. 351 relevant to Joyce? Does it matter
to Bill and John?
Solution: If not for Sec. 351, Joyce would recognize gain on the incorporation of her
business. She realizes a gain of $1.1 million ($1,500,000 � $400,000) on her contribution
of proprietorship assets to a new corporation in exchange for 60% of its outstanding
shares (1,500 � [1,500 � 500 � 500] � 0.60). However, she recognizes none of this gain
because she meets the requirements of Sec. 351. Section 351 does not affect Bill or John
because each is simply purchasing 20% of the new corporation’s stock for $500,000 cash.
They will not realize or recognize gain or loss unless they subsequently sell their stock at
a price above or below the $500,000 cost.
If all exchanges of property for corporate stock were taxable, many entrepreneurs would
find the tax cost of incorporating their business prohibitively high. In Example C:2-10, for
example, Brad would recognize a $20,000 gain on the exchange of his assets for the corpo-
rate stock. Moreover, because losses also are realized in an exchange, without special rules,
taxpayers could exchange loss property for stock and recognize the loss while maintaining
an equity interest in the property transferred.
$150,000$130,000
70,00050,000
$150,000$130,000
100,00085,000(35,000
Fair Market
Value
Adjusted
Basis
STOP & THINK
2-10 Corporations ▼ Chapter 2
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Corporate Formations and Capital Structure ▼ Corporations 2-11
� TABLE C:2-1
Overview of Corporate Formation Rules
Tax Treatment for: Taxable Property Transfer Nontaxable Property Transfer
Transferors:
1. Gain realized FMV of stock received Same as taxable transaction
Money received
FMV of noncash boot property (including
securities) received
Amount of liabilities assumed by transferee
corporation
Minus: Adjusted basis of property transferred
Realized gain (Sec. 1001(a))
2. Gain recognized Transferors recognize the entire amount of Transferors recognize none of the realized gain unless
realized gain (Sec. 1001(c)) one of the following exceptions applies (Sec. 351(a)):
Losses may be disallowed under related party a. Boot property is received (Sec. 351(b))
rules (Sec. 267(a)(1)) b. Liabilities are transferred to the corporation
Installment sale rules may apply to the for a nonbusiness or tax avoidance purpose
realized gain (Sec. 453) (Sec. 357(b))
c. Liabilities exceeding basis are transferred
to the corporation (Sec. 357(c))
d. Services, certain corporate indebtednesses, and
interest claims are transferred to the
corporation (Sec. 351(d))
The installment method may defer recognition of
gain when a shareholder receives a corporate note
as boot (Sec. 453)
3. Basis of property FMV (Cost) (Sec. 1012) Basis of property transferred to the corporation
received Plus: Gain recognized
Minus: Money received (including liabilities treated as
money)
FMV of noncash boot property
Total basis of stock received (Sec. 358(a))
Allocation of total stock basis is based on relative FMVs
Basis of noncash boot property is its FMV
4. Holding period of Day after the exchange date Holding period of stock received includes holding
property received period of Sec. 1231 property or capital assets
transferred; otherwise it begins the day after
the exchange date
Transferee Corporation:
1. Gain recognized The corporation recognizes no gain or loss Same as taxable transaction except the corporation
on the receipt of money or other may recognize gain under Sec. 311 if it transfers
property in exchange for its stock appreciated noncash boot property (Sec. 351(f))
(including treasury stock) (Sec. 1032)
2. Basis FMV (Cost) (Sec. 1012) Generally, same as in transferor’s hands plus any
gain recognized by transferor (Sec. 362)
If the total adjusted basis of all transferred property
exceeds the total FMV of the property, the total basis
to the transferor is limited to the property’s total FMV
3. Holding period Day after the exchange date Transferor’s carryover holding period for the property
transferred regardless of the property’s character
(Sec. 1223(2))
Day after the exchange date if basis is reduced to FMV
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2-12 Corporations ▼ Chapter 2
SECTION 351: DEFERRING
GAIN OR LOSS UPON
INCORPORATION
OBJECTIVE 4
Discuss the requirements
for deferring gain or loss
upon incorporation
EXAMPLE C:2-11 �
Section 351(a) provides that transferors recognize no gain or loss when they transfer
property to a corporation solely in exchange for the corporation’s stock provided that,
immediately after the exchange, the transferors are in control of the corporation. Section
351 does not apply to a transfer of property to an investment company, nor does it apply
in certain bankruptcy cases.
This rule is based on the premise that, when property is transferred to a controlled
corporation, the transferors merely exchange direct ownership for indirect ownership
through stock in the transferee corporation, which gives them an equity interest in the
underlying assets. In other words, the transferors maintain a continuity of interest in the
transferred property. Furthermore, if the only consideration the shareholders receive is
stock, they have not generated cash with which to pay their taxes. If the transferors of
property receive other consideration in addition to stock, such as cash or debt instruments,
they will have the wherewithal to pay taxes and, under Sec. 351(b), may have to recognize
some or all of their realized gain.
A transferor’s realized gain or loss that is unrecognized for tax purposes, however, is
not exempt from taxation. It is only deferred until the shareholder sells or exchanges the
stock received in the Sec. 351 exchange. Shareholders who receive stock in such an
exchange take a stock basis that reflects the deferred gain or loss. For example, if a share-
holder receives stock in exchange for property and recognizes no gain or loss, the stock
basis equals the basis of property transferred less liabilities assumed by the corporation
(see Table C:2-1). This tax treatment is discussed later in this chapter. Under an alterna-
tive approach, the stock basis can be calculated as follows: FMV of qualified stock
received, minus any deferred gain (or plus any deferred loss). This latter approach high-
lights the deferral aspect of this type of transaction. If the shareholder later sells the stock,
he or she will recognize the deferred gain or loss inherent in the basis adjustment.
Assume the same facts as in Example C:2-10. If Brad satisfies the conditions of Sec. 351, he will
not recognize the $20,000 realized gain ($15,000 gain on equipment � $5,000 gain on inven-
tory) when he transfers the assets and liabilities of his sole proprietorship to Block Corporation.
Under the alternative approach, Brad’s basis in the Block stock is decreased to reflect the
deferred gain. Thus, Brad’s basis in the Block stock is $50,000 ($70,000 FMV � $20,000 deferred
gain). If Brad later sells his stock for its $70,000 FMV, he will recognize the $20,000 gain at
that time. �
The specific requirements for deferral of gain and loss under Sec. 351(a) are
� The transferors must transfer property to the corporation.
� They must receive stock of the transferee corporation in exchange for their property.
� They must be in control of the corporation immediately after the exchange.
Each of these requirements is explained below.
THE PROPERTY REQUIREMENT
The rule of gain or loss nonrecognition applies only to transfers of property to a corpora-
tion in exchange for the corporation’s stock. Section 351 does not define the term prop-
erty. However, the courts and the IRS have defined property to include cash and almost
any other asset, including installment obligations, accounts receivable, inventory, equip-
TAX STRATEGY TIP
A transferor who wishes to recog-
nize gain or loss must take steps
to avoid Sec. 351 by deliberately
failing at least one of its require-
ments or by engaging in sales
transactions. See Tax Planning
Considerations later in this
chapter for details.
To allow taxpayers to incorporate without incurring a high tax cost and to prevent
taxpayers from recognizing losses while maintaining an equity claim to the loss assets,
Congress enacted Sec. 351.
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EXAMPLE C:2-12 �
EXAMPLE C:2-13 �
EXAMPLE C:2-14 �
10 For an excellent discussion of the definition of property, see footnote 6 of
D.N. Stafford v. U.S., 45 AFTR 2d 80-785, 80-1 USTC ¶9218 (5th Cir., 1980).
11 Sec. 351(d).
12 Secs. 61 and 83.
13 In determining whether the 80% requirements are satisfied, the construc-
tive ownership rules of Sec. 318 do not apply (see Rev. Rul. 56-613, 1956-2
C.B. 212). See Chapter C:4 for an explanation of Sec. 318.
14 Rev. Rul. 59-259, 1959-2 C.B. 115, as modified by Rev. Rul. 81-17, 1981-1
C.B. 75.
ment, patents and other intangibles representing know-how, trademarks, trade names,
and computer software.10
Excluded from the statutory definition of property are11
� Services (such as legal or accounting services) rendered to the corporation in exchange
for its stock
� Indebtedness of the transferee corporation not evidenced by a security
� Interest on transferee corporation debt that accrued on or after the beginning of the
transferor’s holding period for the debt
The first of these exclusions perhaps is the most important. A person receiving stock in
compensation for services must recognize the stock’s FMV as ordinary income for tax
purposes. In other words, an exchange of services for stock is a taxable transaction even
where concurrent transfers of property for stock are nontaxable under Sec. 351.12 A
shareholder’s basis in the stock received in compensation for services is the stock’s FMV
(not necessarily the FMV of the services).
Amy and Bill form West Corporation. Amy exchanges property for 90 shares (90% of the out-
standing shares) of West stock. Amy’s exchange is nontaxable because Amy has exchanged
property for stock and controls West immediately after the exchange. Bill performs accounting
services that he normally bills for $12,000 in exchange for ten shares of West stock worth
$10,000. Bill’s exchange is taxable because he has provided services in exchange for stock. Thus,
Bill recognizes $10,000 of ordinary income—the FMV of the stock—as compensation for his
services. Bill’s basis in the stock is its $10,000 FMV. �
THE CONTROL REQUIREMENT
Section 351 requires the transferors, as a group, to be in control of the transferee corpo-
ration immediately after the exchange. A transferor may be an individual or any type of
tax entity (such as a partnership, another corporation, or a trust). Section 368(c) defines
control as ownership of at least 80% of the total combined voting power of all classes of
stock entitled to vote and at least 80% of the total number of shares of all other classes
of stock (e.g., nonvoting preferred stock).13 The minimum ownership levels for nonvoting
stock apply to each class of stock rather than to the nonvoting stock in total.14
Dan exchanges property having a $22,000 adjusted basis and a $30,000 FMV for 60% of newly
created Sun Corporation’s single class of stock. Ed exchanges $20,000 cash for the remaining 40%
of Sun stock. The transaction qualifies as a nontaxable exchange under Sec. 351 because the
transferors, Dan and Ed, together own at least 80% of the Sun stock immediately after the
exchange. Therefore, Dan defers recognition of his $8,000 ($30,000 � $22,000) realized gain. (Ed
realizes no gain because he contributes cash.) �
Because services do not qualify as property, stock received by a person who exclusively
provides services does not count toward the 80% control threshold. Unless transferors of
property own at least 80% of the corporation’s stock immediately after the exchange, the
control requirement will not be met, and the entire transaction will be taxable.
Dana transfers property having an $18,000 adjusted basis and a $35,000 FMV to newly created
York Corporation for 70 shares of York stock. Ellen provides legal services for the remaining
30 shares of York stock valued at $15,000. Because Ellen does not transfer property to York, her
stock is not counted toward the 80% ownership threshold. On the other hand, because Dana
transfers property to York, his stock is counted toward this threshold. However, Dana is not in
control of York immediately after the exchange because he owns only 70% of York stock. There-
fore, Dana recognizes all $17,000 ($35,000 � $18,000) of his gain realized on the exchange.
Dana’s basis in his York stock is its $35,000 FMV. Ellen recognizes $15,000 of ordinary income, the
FMV of stock received for her services. Ellen’s basis in her York stock is $15,000. The tax conse-
quences to Ellen are the same whether or not Dana meets the control requirement. �
Corporate Formations and Capital Structure ▼ Corporations 2-13
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2-14 Corporations ▼ Chapter 2
EXAMPLE C:2-15 �
EXAMPLE C:2-16 �
EXAMPLE C:2-17 �
EXAMPLE C:2-18 �
15 Reg. Sec. 1.351-1(a)(2), Ex. (3).
16 Reg. Sec. 1.351-1(a)(1)(ii).
17 Rev. Proc. 77-37, 1977-2 C.B. 568, Sec. 3.07, as modified by T.D. 8761,
1998-1 C.B. 812.
If the property transferors own at least 80% of the stock immediately after the exchange,
they, but not the provider of services, will be in control of the transferee corporation.
Assume the same facts as in Example C:2-14, except a third individual, Fred, contributes $35,000
in cash for 70 shares of York stock. Now Dana and Fred together own more than 80% of the
York stock (140 � 170 � 0.82) immediately after the exchange. Therefore, the Sec. 351 control
requirement is met, and neither Dana nor Fred recognizes gain on the exchange. Ellen still must
recognize $15,000 of ordinary income, the FMV of the stock she receives for her services. �
TRANSFERORS OF BOTH PROPERTY AND SERVICES. If a person transfers both
services and property to a corporation in exchange for the corporation’s stock, all the
stock received by that person, including stock received in exchange for services, is counted
toward the 80% control threshold.15
Assume the same facts as in Example C:2-14 except that, in addition to providing legal services in
exchange for stock worth $15,000, Ellen contributes property worth at least $1,500. In this case,
all of Ellen’s stock counts toward the 80% ownership threshold. Because Dana and Ellen
together own 100% of the York stock, the exchange meets the Sec. 351 control requirement.
Therefore, Dana recognizes no gain on his property exchange. However, Ellen still must recog-
nize $15,000 of ordinary income, the FMV of the stock received as compensation for services.�
When a person transfers both property and services in exchange for a corporation’s
stock, the property must have more than nominal value for that person’s stock to count
toward the 80% control threshold.16 The IRS generally requires that the FMV of the
stock received for transferred property be at least 10% of the value of the stock received
for services provided. If the value of the stock received for the property is less than 10%
of the value of the stock received for the services, the IRS will not issue an advance ruling
to the effect that the transaction meets the requirements of Sec. 351.17
Assume the same facts as in Example C:2-16 except that Ellen contributes only $1,000 worth of
property in addition to the legal services. In this case, the IRS will not issue an advance ruling that
the transaction meets the Sec. 351 requirements because the FMV of stock received for the
property ($1,000) is less than 10% of the value of the stock received for the services ($1,500 � 0.10
� $15,000). Consequently, if the IRS audits Ellen’s tax return for the year of transfer, it probably
will challenge Dana’s and Ellen’s position that the transfer is nontaxable under Sec. 351. �
TRANSFERS TO EXISTING CORPORATIONS. Section 351 applies to transfers to an
existing corporation as well as transfers to a newly created corporation. The same
requirements must be met in both cases. Property must be transferred in exchange for
stock, and the property transferors must be in control of the corporation immediately
after the exchange.
Jack and Karen own 75 and 25 shares, respectively, of Texas Corporation stock. Jack transfers
property with a $15,000 adjusted basis and a $25,000 FMV to the corporation in exchange for
an additional 25 shares of Texas stock. The Sec. 351 control requirement is met because, imme-
diately after the exchange, Jack owns 80% (100 � 125 � 0.80) of Texas stock. Therefore, Jack
recognizes no gain. �
If a shareholder transfers property to an existing corporation for additional stock but
does not own at least 80% of the stock after the exchange, the control requirement is not
met. Thus, Sec. 351 denies tax-free treatment for many transfers of property to an exist-
ing corporation by a new shareholder. A new shareholder’s transfer of property to an
existing corporation is nontaxable only if that shareholder acquires at least 80% of the
corporation’s stock, or if enough existing shareholders also transfer additional property
so that the transferors as a group, including the new shareholder, control the corporation
immediately after the exchange.
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EXAMPLE C:2-19 �
EXAMPLE C:2-20 �
STOP & THINK
EXAMPLE C:2-21 �
18 Reg. Sec. 1.351-1(a)(1)(ii).
19 Rev. Proc. 77-37, 1977-2 C.B. 568, Sec. 3.07, as modified by T.D. 8761,
1998-1 C.B. 812.
20 Reg. Sec. 1.351-1(b)(1).
Alice owns all 100 shares of Local Corporation stock, valued at $100,000. Beth owns property
with a $15,000 adjusted basis and a $100,000 FMV. Beth contributes the property to Local in
exchange for 100 shares of newly issued Local stock. The Sec. 351 control requirement is not
met because Beth owns only 50% of Local stock immediately after the exchange. Consequently,
Beth recognizes an $85,000 ($100,000 � $15,000) gain. �
If an existing shareholder exchanges property for additional stock to enable another
shareholder to qualify for tax-free treatment under Sec. 351, the stock received must be of
more than nominal value.18 For advance ruling purposes, the IRS requires that this value
be at least 10% of the value of the stock already owned.19
Assume the same facts as in Example C:2-19 except that Alice transfers additional property
worth $10,000 for an additional ten shares of Local stock. Now both Alice and Beth are trans-
ferors, and the Sec. 351 control requirement is met. Consequently, neither Alice nor Beth recog-
nizes gain on the exchange. If Alice receives fewer than ten shares, the IRS will not issue an
advance ruling that the exchange is tax-free under Sec. 351. �
Question: Matthew and Michael each own 50 shares of Main Corporation stock having
a $250,000 FMV. Matthew wants to transfer property with a $40,000 adjusted basis and
a $100,000 FMV to Main in exchange for an additional 20 shares. Can Matthew avoid
recognizing $60,000 ($100,000 � $40,000) of the gain realized on the transfer?
Solution: If Matthew simply exchanges the property for additional stock, he must recognize
the gain. The Sec. 351 control requirement will not have been met because Matthew will
own only 70 of the 120 outstanding shares (or 58.33%) immediately after the exchange.
Gain recognition can be avoided in two ways:
1. Matthew can transfer sufficient property (i.e., $750,000 worth) to Main to receive 150
additional shares so that, immediately after the exchange, he will own 80% (200 out
of 250 shares) of Main stock.
2. Alternatively, Michael also can contribute additional property to qualify as a trans-
feror. Specifically, he can contribute to the corporation at least $25,000, or 10% of the
$250,000 value of the Main stock that he already owns so that together the two trans-
ferors will own 100% of Main stock immediately after the exchange.
DISPROPORTIONATE EXCHANGES OF PROPERTY AND STOCK. Section 351 does
not require that the value of the stock received by the transferors be proportionate to the
value of the property transferred. However, if the value of the stock received is not propor-
tionate to the value of the property transferred, the exchange may be treated in accordance
with its economic effect, that is, a proportional exchange followed by a constructive gift,
compensation payment, or extinguishment of a liability owed by one shareholder to
another.20 If the deemed effect of the transaction is a gift from one transferor to another,
for example, the “donor” will be treated as though he or she received stock equal in value
to that of the property contributed and then gave some of the stock to the “donee.”
Don and his son John transfer property worth $75,000 (adjusted basis of $42,000 to Don) and
$25,000 (adjusted basis of $20,000 to John), respectively, to newly formed Star Corporation in
exchange for all 100 shares of Star stock. Don and John receive 25 and 75 Star shares, respec-
tively. Because Don and John are in control of Star immediately after the exchange, they recog-
nize no gain or loss. However, because Don and John did not receive the stock in proportion to
the FMV of their respective property contributions, Don might be deemed to have received
75 shares (worth $75,000), then to have given 50 shares (worth $50,000) to John. If the IRS
deems such a gift, it might require Don to pay gift taxes. Don’s basis in his remaining 25 shares
is $14,000 [(25 � 75) � $42,000 basis in the property transferred]. John’s basis in the 75 shares is
$48,000 [$20,000 basis in the property transferred by John � ($42,000 � $14,000) basis in the
shares deemed to have been gifted by Don]. �
Corporate Formations and Capital Structure ▼ Corporations 2-15
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2-16 Corporations ▼ Chapter 2
EXAMPLE C:2-22 �
TAX STRATEGY TIP
If one shareholder has a pre-
arranged plan to dispose of his or
her stock, and the disposition
drops the ownership of the trans-
feror shareholders below the
required 80% control, such dispo-
sition can disqualify the Sec. 351
transaction for all the sharehold-
ers. As a possible protection, all
shareholders could provide a writ-
ten representation that they do
not currently have a plan to dis-
pose of their stock.
EXAMPLE C:2-23 �
21 Reg. Sec. 1.351-1(a)(1).
22 Rev. Rul. 79-70, 1979-1 C.B. 144.
23 Reg. Sec. 1.351-1(a)(1)(ii).
IMMEDIATELY AFTER THE EXCHANGE. Section 351 requires that the transferors
be in control of the transferee corporation “immediately after the exchange.” This
requirement does not mean that all transferors must simultaneously exchange their prop-
erty for stock. It does mean, however, that all the exchanges must be agreed to before-
hand, and the agreement must be executed in an expeditious and orderly manner.21
Art, Beth, and Carlos form New Corporation. Art and Beth each transfer noncash property
worth $25,000 in exchange for one-third of the New stock. Carlos contributes $25,000 cash for
another one-third of the New stock. On January 10, Art and Carlos transfer their property and
cash, respectively. Beth transfers her property on March 3. Because all three transfers are part of
the same prearranged transaction, the transferors are deemed to be in control of the corpora-
tion immediately after the exchange. �
Section 351 does not require the transferors to retain control of the transferee corporation
for any specific length of time after the exchange. Control is required only “immediately after
the exchange.” The IRS has interpreted this phrase to mean that the transferors must not
have a prearranged plan to dispose of their stock outside the control group. If they do have
such a plan, they are not considered to be in control immediately after the exchange.22
Amir, Bill, and Carl form White Corporation. Each contributes to White appreciated property
worth $25,000 in exchange for one-third of White stock. Before the exchange, Amir arranges
to sell his stock to Dana as soon as he receives it. This prearranged plan implies that Amir, Bill,
and Carl do not have control immediately after the exchange because Bill and Carl own only
66.7% of the stock while Amir has disposed of his interest. Therefore, each must recognize gain
in the exchange. �
THE STOCK REQUIREMENT
Under Sec. 351, transferors who exchange property solely for transferee corporation
stock recognize no gain or loss if they control the corporation immediately after the
exchange. For this purpose, stock may be voting or nonvoting. On the other hand, non-
qualified preferred stock is treated as boot. Preferred stock generally has a preferred claim
to dividends and liquidating distributions. Such stock is nonqualified if
� The shareholder can require the corporation to redeem it,
� The corporation either is required to redeem the stock or is likely to exercise a right to
redeem it, or
� The dividend rate on the stock varies with interest rates, commodity prices, or other
similar indices.
These features render the preferred stock more like cash or debt than like equity. Thus, it
is treated as boot subject to the rules discussed below. In addition, stock rights or stock
warrants are not considered stock for purposes of Sec. 351.23
Topic Review C:2-1 summarizes the major requirements for a nontaxable exchange
under Sec. 351.
EFFECT OF SEC. 351 ON THE TRANSFERORS
If all Sec. 351 requirements are met, the transferors recognize no gain or loss on the
exchange of their property for stock in the transferee corporation. The receipt of property
other than stock does not necessarily render the entire transaction taxable. Rather, it
could result in the recognition of all or part of the transferors’ realized gain.
RECEIPT OF BOOT. If a transferor receives any money or property other than stock in
the transferee corporation, the additional money or property is considered to be boot.
Boot may include cash, notes, securities, or stock in another corporation. Upon receiving
boot, the transferor recognizes gain to the extent of the lesser of the transferor’s realized
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Topic Review C:2-1
Major Requirements of Sec. 351
1. The nonrecognition of gain or loss rule applies only to transfers of property in exchange for a corporation’s stock. It does
not apply to an exchange of services for stock.
2. The property transferors must be in control of the transferee corporation immediately after the exchange. Control means
ownership of at least 80% of the voting power and at least 80% of the total number of shares of all other classes of
stock. Stock disposed of after the exchange pursuant to a prearranged plan does not meet the “immediately after the
exchange” requirement.
3. The nonrecognition rule applies only to the gain realized in an exchange of property for stock. If the transferor receives
property other than stock, such property is considered to be boot. The transferor recognizes gain to the extent of the
lesser of the FMV of any boot received or the realized gain.
EXAMPLE C:2-24 �
ADDITIONAL
COMMENT
If multiple assets were aggre-
gated into one computation, any
built-in losses would be netted
against the gains. Such a result is
inappropriate because losses can-
not be recognized in a Sec. 351
transaction.
24 Sec. 351(b).
25 Section 1239 also may require some gain to be characterized as ordinary
income. Section 1250 ordinary depreciation recapture will not apply to real
property placed in service after 1986 because MACRS mandates straight-line
depreciation.
26 Secs. 1245(b)(3) and 1250(c)(3).
27 1968-1 C.B. 140, as amplified by Rev. Rul. 85-164, 1985-2 C.B. 117.
gain or the FMV of the boot property received.24 A transferor never recognizes a loss in
an exchange qualifying under Sec. 351 whether or not he or she receives boot.
The character of the recognized gain depends on the type of property transferred. For
example, if the shareholder transfers a capital asset such as stock in another corporation,
the recognized gain is capital in character. If the shareholder transfers Sec. 1231 property,
such as equipment or a building, the recognized gain is ordinary in character to the extent
of any depreciation recaptured under Sec. 1245 or 1250.25 Thus, depreciation is not
recaptured unless the transferor receives boot and recognizes a gain on the depreciated
property transferred.26 If the shareholder transfers inventory, the recognized gain is
entirely ordinary in character.
Pam, Rob, and Sam form East Corporation and transfer the following property:
Pam Machinery $10,000 $12,500 25 shares East stock
Rob Land 18,000 25,000 40 shares East stock and $5,000 East note
Sam Cash 17,500 17,500 35 shares East stock
The machinery and land are Sec. 1231 property and a capital asset, respectively. The
exchange meets the requirements of Sec. 351 except that, in addition to East stock, Rob
receives boot of $5,000 (the FMV of the note). Rob realizes a $7,000 ($25,000 � $18,000) gain,
of which he recognizes $5,000—the lesser of the $7,000 realized gain or the $5,000 boot
received. The gain is capital in character because the property transferred was a capital asset in
Rob’s hands. Pam realizes a $2,500 gain on her exchange of machinery. However, even though
Pam would have been required to recapture depreciation had she sold or exchanged the
machinery, she recognizes no gain because she received no boot. Sam neither realizes nor
recognizes gain on his cash purchase of East stock. �
COMPUTING GAIN WHEN SEVERAL ASSETS ARE TRANSFERRED. Revenue
Ruling 68-55 adopts a “separate properties approach” for computing gain or loss when a
shareholder transfers more than one asset to a corporation.27 Under this approach, the
gain or loss realized and recognized is computed separately for each property transferred.
The transferor is deemed to have received a proportionate share of stock, securities, and
boot in exchange for each property transferred, based on the assets’ relative FMVs.
Joan transfers two assets to newly formed North Corporation in a transaction qualifying in part
for tax-free treatment under Sec. 351. The total FMV of the assets is $100,000. The consideration
Consideration
ReceivedFMV
Transferor’s
Adj. BasisAssetTransferor
Corporate Formations and Capital Structure ▼ Corporations 2-17
EXAMPLE C:2-25 �
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2-18 Corporations ▼ Chapter 2
EXAMPLE C:2-26 �
ADDITIONAL
COMMENT
Because Sec. 351 is a deferral pro-
vision, any unrecognized gain
must be reflected in the basis of
the stock received by the trans-
feror shareholder and is accom-
plished by substituting the trans-
feror’s basis in the property given
up for the basis of the stock
received. This substituted basis
may be further adjusted by gain
recognized and boot received.
28 Sec. 358(a)(2). 29 Sec. 358(a)(1).
received by Joan consists of $90,000 of North stock and $10,000 of North notes. The following
data illustrate how Joan determines her realized and recognized gain under the procedure set
forth in Rev. Rul. 68-55.
Asset’s FMV $40,000 $60,000 $100,000
Percent of total FMV 40% 60% 100%
Consideration received in exchange for asset:
Stock (Stock � percent of total FMV) $36,000 $54,000 $ 90,000
Notes (Notes � percent of total FMV)
Total proceeds $40,000 $60,000 $100,000
Minus: Adjusted basis ) ) )
Realized gain (loss) ( )
Boot received $ 4,000 $ 6,000 $ 10,000
Recognized gain (loss) None $ 6,000 $ 6,000
Under the separate properties approach, the loss realized on the transfer of Asset 1 does not
offset the gain realized on the transfer of Asset 2. Therefore, Joan recognizes $6,000 of the total
$10,000 realized gain, even though she receives $10,000 of boot. Joan’s selling Asset 1 to North
so as to recognize the loss might be advisable. However, the Sec. 267 loss limitation rules may
apply to Joan if she is a controlling shareholder (see pages C:2-34 and C:2-35). �
COMPUTING A SHAREHOLDER’S BASIS.
Boot Property. A transferor’s basis in any boot property received is the property’s FMV.28
Stock. A shareholder computes his or her adjusted basis in stock received in a Sec. 351
exchange as follows:29
Adjusted basis of property transferred to the corporation
Plus: Any gain recognized by the transferor
Minus: FMV of boot received from the corporation
Money received from the corporation
Liabilities assumed by the corporation
Adjusted basis of stock received
Bob transfers a capital asset having a $50,000 adjusted basis and an $80,000 FMV to South
Corporation. He acquired the property two years earlier. Bob receives all 100 shares of South
stock, having a $70,000 FMV, plus a $10,000 90-day South note (boot property). Bob realizes a
$30,000 gain on the exchange, computed as follows:
FMV of stock received $70,000
Plus: FMV of 90-day note
Amount realized $80,000
Minus: Adjusted basis of property transferred )
Realized gain
Bob’s recognized gain is $10,000, i.e.,the lesser of the $30,000 realized gain or the $10,000
FMV of the boot property. This gain is long-term and capital in character. The Sec. 351 rules
effectively require Bob to defer $20,000 ($30,000 � $10,000) of his realized gain. Bob’s basis in
the South stock is $50,000, computed as follows:
Adjusted basis of property transferred $50,000
Plus: Gain recognized by Bob 10,000
Minus: FMV of boot received )
Adjusted basis of Bob’s stock �$50,000
(10,000
$30,000
(50,000
10,000
$ 10,000$35,000$25,000
(90,000(25,000(65,000
10,0006,0004,000
TotalAsset 2Asset 1
SELF-STUDY
QUESTION
What is an alternative method for
determining the basis of the
assets received by the transferor
shareholder? How is this method
applied to Bob in Example C:2-26?
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Prentice Hall’s Federal Taxation 2014 Corporations, Partnerships, Estates & Trusts, Twenty-Seventh Edition, by Kenneth E. Anderson, Thomas R. Pope, and
Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
EXAMPLE C:2-27 �
EXAMPLE C:2-28 �
STOP & THINK
30 Sec. 358(b)(1) and Reg. Sec. 1.358-2(b)(2).
31 Sec. 1223(1). Revenue Ruling 85-164 (1985-2 C.B. 117) provides that a
single share of stock may have two holding periods: a carryover holding
period for the portion of such share received in exchange for a capital asset or
Sec. 1231 property and a holding period that begins on the day after the
exchange for the portion of such share received for inventory or other prop-
erty. The split holding period is relevant only if the transferor sells the stock
received within one year of the transfer date.
If a transferor receives more than one class of qualified stock, his or her basis must be
allocated among the classes of stock according to their relative FMVs.30
Assume the same facts as in Example C:2-26 except Bob receives 100 shares of South common
stock with a $45,000 FMV, 50 shares of South qualified preferred stock with a $25,000 FMV, and
a 90-day South note with a $10,000 FMV. The total adjusted basis of the stock is $50,000
($50,000 basis of property transferred � $10,000 gain recognized � $10,000 FMV of boot
received). This basis must be allocated between the common and qualified preferred stock
according to their relative FMVs, as follows:
Basis of common stock � � $50,000 � $32,143
Basis of preferred stock � � $50,000 � $17,857
Bob’s basis in the note is its $10,000 FMV. �
TRANSFEROR’S HOLDING PERIOD. The transferor’s holding period for any stock
received in exchange for a capital asset or Sec. 1231 property includes the holding period
of the property transferred.31 If the transferor exchanged any other kind of property (e.g.,
inventory) for the stock, the transferor’s holding period for the stock begins on the day
after the exchange. Likewise, the holding period for boot property begins on the day after
the exchange.
Assume the same facts as in Example C:2-26. Bob’s holding period for the stock includes the
holding period of the capital asset transferred. His holding period for the note starts on the day
after the exchange. �
Question: The holding period for stock received in exchange for a capital asset or Sec.
1231 property includes the holding period of the transferred item. The holding period for
inventory or other assets begins on the day after the exchange. Why the difference?
Solution: Because stock received in a Sec. 351 exchange represents a “continuity of inter-
est” in the property transferred, logically the stock should not only be valued and charac-
terized in the same manner as the asset exchanged for the equity claim, but also accorded
the same tax attributes. Because the holding period of a capital asset is relevant in deter-
mining the character of gain or loss realized (i.e., long-term or short-term) on the asset’s
subsequent sale, stock received in a tax-free exchange of the asset should be accorded the
same holding period for the purpose of determining the character of gain or loss realized
on the stock’s subsequent sale. By the same token, because the holding period of a non-
capital asset is less relevant in determining the character of gain or loss realized on the
asset’s subsequent sale, stock received in a tax-free exchange of the asset need not be
accorded the same holding period for the purpose of determining the character of gain or
loss realized on the stock’s subsequent sale. Given the very nature of a noncapital asset,
this gain or loss generally is ordinary in character, in any event. Moreover, if stock
received in exchange for a noncapital asset were accorded a holding period that includes
that of the transferred property, a transferor could sell the stock in a short time to realize
a long-term capital gain, thereby converting ordinary income (potentially from the sale of
the noncapital asset) into capital gain from the sale of stock.
Topic Review C:2-2 summarizes the tax consequences of a Sec. 351 exchange to the
transferor(s) and the transferee corporation.
$25,000
$45,000 � $25,000
$45,000
$45,000 � $25,000
Corporate Formations and Capital Structure ▼ Corporations 2-19
ANSWER
The basis of all boot property is
its FMV, and the basis of stock
received is the stock’s FMV minus
any deferred gain or plus any
deferred loss. Bob’s stock basis
under the alternative method is
$50,000 ($70,000 FMV of stock �
$20,000 deferred gain).
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
2-20 Corporations ▼ Chapter 2
EXAMPLE C:2-29 �
EXAMPLE C:2-30 �
32 Sec. 1032.
TAX CONSEQUENCES TO TRANSFEREE
CORPORATION
A corporation that issues stock or debt for property or services is subject to various IRC
rules for determining the tax consequences of that exchange.
GAIN OR LOSS RECOGNIZED BY THE TRANSFEREE CORPORATION. Corpora-
tions recognize no gain or loss when they issue their own stock in exchange for property
or services.32 This result ensues whether or not Sec. 351 governs the exchange and
whether or not the corporation issues new stock or treasury stock.
West Corporation pays $10,000 to acquire 100 shares of its own stock from existing shareholders.
The next year, West reissues these 100 treasury shares for land having a $15,000 FMV. West real-
izes a $5,000 ($15,000 � $10,000) gain on the exchange but recognizes none of this gain. �
Corporations also recognize no gain or loss when they exchange their own debt instru-
ments for property or services. On the other hand, a corporation recognizes gain (but not
loss) if it transfers appreciated property to a transferor as part of a Sec. 351 exchange. The
amount and character of the gain are determined as though the property had been sold by
the corporation immediately before the transfer.
Alice, who owns 100% of Ace Corporation stock, transfers to Ace land having a $100,000 FMV
and a $60,000 adjusted basis. In exchange, Alice receives 75 additional shares of Ace common
stock having a $75,000 FMV, and Zero Corporation common stock having a $25,000 FMV. Ace’s
basis in the Zero stock, a capital asset, is $10,000. Alice realizes a $40,000 gain [($75,000 �
$25,000) � $60,000] on the land transfer, of which she recognizes $25,000 (i.e., the FMV of the
boot property received). In addition, Ace recognizes a $15,000 capital gain ($25,000 � $10,000)
upon transferring the Zero stock to Alice. �
TRANSFEREE CORPORATION’S BASIS FOR PROPERTY RECEIVED. A corpora-
tion that acquires property in exhange for its stock in a transaction that is taxable to the
transferor takes a current cost (i.e., its FMV) basis in the property. On the other hand, if
ADDITIONAL
COMMENT
The nonrecognition rule for cor-
porations that issue stock for
property applies whether or not
the transaction qualifies the
transferor shareholder for Sec.
351 treatment.
Topic Review C:2-2
Tax Consequences of a Sec. 351 Exchange
To Transferor(s):
1. Transferors recognize no gain or loss when they exchange property for stock. Exception: A transferor recognizes gain
equal to the lesser of the realized gain or the sum of any money received plus the FMV of any non-cash property
received. The character of the gain depends on the type of property transferred.
2. The basis of the stock received equals the adjusted basis of the property transferred plus any gain recognized by the
transferor minus the FMV of any boot property received minus any money received (including liabilities assumed or
acquired by the transferee corporation).
3. The holding period of stock received in exchange for capital assets or Sec. 1231 property includes the holding period of
the transferred property. The holding period of stock received in exchange for any other property begins on the day after
the exchange.
To Transferee Corporation:
1. A corporation recognizes no gain or loss when it exchanges its own stock for property or services.
2. The corporation’s basis in property received is the transferor’s basis plus any gain recognized by the transferor. However, if
the total adjusted basis of all transferred property exceeds the total FMV of the property, the total basis to the transferee
is limited to the property’s total FMV.
3. The corporation’s holding period for property received includes the transferor’s holding period.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
EXAMPLE C:2-31 �
33 Sec. 362. 34 Sec. 1223(2).
the exchange qualifies for nonrecognition treatment under Sec. 351 and is wholly or par-
tially tax-free to the transferor, the corporation’s basis in the property is computed as
follows:33
Transferor’s adjusted basis in property transferred to the corporation
Plus: Gain (if any) recognized by transferor
Minus: Reduction for loss property (if applicable)
Transferee corporation’s basis in property
The transferee corporation’s holding period for property acquired in a transaction sat-
isfying the Sec. 351 requirements includes the period during which the property was held
by the transferor.34 This general rule applies to all types of property without regard to
their character in the transferor’s hands or the amount of gain recognized by the trans-
feror. However, if the corporation reduces a property’s basis to its FMV under the loss
property limitation rule discussed below, the holding period will begin the day after the
exchange date because no part of the new basis references the transferor’s basis.
Top Corporation issues 100 shares of its stock for land having a $15,000 FMV. Tina, who trans-
ferred the land, had a $12,000 basis in the property. If the exchange satisfies the Sec. 351
requirements, Tina recognizes no gain on the exchange. Top’s basis in the land is $12,000, the
same as Tina’s. Top’s holding period includes Tina’s holding period. However, if the exchange
does not satisfy the Sec. 351 requirements, Tina recognizes $3,000 of gain. Top’s basis in the
land is its $15,000 acquisition cost, and its holding period begins on the day after the exchange
date. �
REDUCTION FOR LOSS PROPERTY. Section 362(e)(2) prevents shareholders from
generating double losses by transferring loss property to a corporation. The double loss
potential exists because the corporation would hold property with a built-in loss, and the
shareholders would hold stock with a built-in loss. Accordingly, if a corporation’s total
adjusted basis (including any increase for gain recognized by the shareholder) for all prop-
erties transferred by the shareholder exceeds the properties’ total FMV, the basis to the
corporation of the properties must be reduced by this excess. The reduction in basis is
allocated among the properties in proportion to their respective built-in losses. The limi-
tation applies on a shareholder-by-shareholder basis. In other words, the property values
and built-in losses of all shareholders are not aggregated.
John transfers the following assets to Pecan Corporation in exchange for all of Pecan’s stock
worth $26,000.
Inventory $ 5,000 $ 8,000
Equipment 15,000 11,000
Furniture
Total
Although the transaction meets the requirements of Sec. 351, the total basis of the assets
transferred ($29,000) exceeds their total FMV. Consequently, the total basis to Pecan is limited
to the assets’ FMV ($26,000). The $3,000 ($29,000 � $26,000) reduction in basis must be allo-
cated among the assets in proportion to their respective built-in losses as follows:
Equipment $4,000 $2,000
Furniture
Total $3,000$6,000
1,0002,000
Allocated
Reduction
Built-in
LossesAssets
$26,000$29,000
7,0009,000
FMV
Adjusted Basis
to JohnAssets
Corporate Formations and Capital Structure ▼ Corporations 2-21
ADDITIONAL
COMMENT
If a shareholder transfers built-in
gain property in a Sec. 351 trans-
action, the built-in gain actually is
duplicated. This duplication
occurs because the transferee cor-
poration assumes the potential
gain through its carryover basis in
the assets it receives, and the
transferor shareholder assumes
the potential gain through its
substituted basis in the transferee
corporation stock. A similar dupli-
cation occurs for built-in loss
property. This result reflects the
double taxation characteristic of
C corporations.
EXAMPLE C:2-32 �
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Thus, Pecan’s bases for the assets transferred by John are:
Inventory $ 5,000
Equipment ($15,000 � $2,000) 13,000
Furniture ($9,000 � $1,000)
Total
Because each property’s basis was not reduced to the property’s FMV, the holding period of
each property includes the transferor’s holding period. �
A corporation subject to the basis reduction rules described above can avoid this result
if the corporation and all its shareholders so elect. Under the election, the corporation
need not reduce the bases of the assets received, but the affected shareholder’s basis in
stock received for the property is reduced by the amount by which the corporation would
have reduced its basis absent the election.
Assume the same facts as in Example C:2-32 except John and Pecan elect not to reduce the
bases of the assets Pecan received. Under the election, John’s basis in his Pecan stock is reduced
to $26,000 ($29,000 � $3,000). �
A corporation and its shareholders can avoid the basis reduction rules altogether if
each shareholder transfers enough appreciated property to offset any built-in losses of
other property transferred. This avoidance opportunity exists because in making the com-
parison, each shareholder aggregates the adjusted bases and FMVs of his or her property
transferred.
Assume the same facts as in Example C:2-32 except the inventory’s FMV is $12,000. In this case,
total basis equals $29,000 and total FMV equals $30,000. Because total basis does not exceed
total FMV, the limitation does not apply. Consequently, the corporation takes a carryover basis
in each asset even though some assets have built-in losses. �
ASSUMPTION OF THE TRANSFEROR’S
LIABILITIES
When a shareholder transfers property to a controlled corporation, the corporation often
assumes the transferor’s liabilities. The question arises as to whether the transferee corpo-
ration’s assumption of liabilities is equivalent to a cash (boot) payment to the transferor. In
certain types of transactions, the transferee’s assumption of a transferor’s liability is treated
as a payment of cash to the transferor. For example, in a like-kind exchange, if a transferee
assumes a transferor’s liability, the transferor is treated as though he or she received a cash
payment equal to the amount of the liability assumed. By contrast, if a transaction satisfies
the Sec. 351 requirements, Sec. 357 provides relief from such treatment.
GENERAL RULE—SEC. 357(a). For the purpose of determining gain recognition, the
transferee corporation’s assumption of liabilities in a property transfer qualifying under
Sec. 351 is not considered equivalent to the transferor’s receipt of money. Consequently,
the transferee corporation’s assumption of liabilities does not result in the transferor’s rec-
ognizing part or all of his or her realized gain. For the purpose of calculating the trans-
feror’s stock basis, however, the transferee corporation’s assumption of liabilities is
treated as money received and thus decreases the transferor’s stock basis. Moreover, for
the purpose of calculating the transferor’s realized gain, the transferee corporation’s
assumption of liabilities is treated as part of the transferor’s amount realized.35
Roy and Eduardo transfer the following assets and liabilities to newly formed Palm
Corporation:
$26,000
8,000
2-22 Corporations ▼ Chapter 2
EXAMPLE C:2-33 �
EXAMPLE C:2-34 �
35 Sec. 358(d)(1).
EXAMPLE C:2-35 � ISB
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Roy Machinery $15,000 $32,000 50 shares Palm stock
Mortgage 8,000 — Assumed by Palm
Eduardo Cash 24,000 24,000 50 shares Palm stock
The transaction meets the requirements of Sec. 351. Roy’s recognized gain is determined as
follows:
FMV of stock received $24,000
Plus: Palm’s assumption of the mortgage liability
Amount realized $32,000
Minus: Basis of machinery )
Realized gain
Boot received
Recognized gain
Although Palm’s assumption of the mortgage liability increases Roy’s amount realized, Roy
recognizes none of his realized gain because the mortgage assumption is not considered to be
boot (i.e., a cash equivalent). Eduardo recognizes no gain because he transferred only cash.
Roy’s stock basis is $7,000 ($15,000 basis of property transferred � $8,000 liability assumed by
Palm). Eduardo’s stock basis is $24,000. �
The general rule of Sec. 357(a), however, has two exceptions. These exceptions, dis-
cussed below, relate to (1) transfers for the purpose of tax avoidance or without a bona
fide business purpose and (2) transfers where the liabilities assumed by the corporation
exceed the total basis of the property transferred.
TAX AVOIDANCE OR NO BONA FIDE BUSINESS PURPOSE—SEC. 357(b). All lia-
bilities assumed by a controlled corporation are considered to be money received by the
transferor, and therefore boot, if the principal purpose of the transfer of any portion of
such liabilities is tax avoidance or if the liability transfer has no bona fide business
purpose.
Liabilities the transfer of which might be considered to be motivated principally by tax
avoidance are those the transferor incurred shortly before the transfer. Thus, the most impor-
tant factor in determining whether a tax avoidance purpose exists may be the length of time
between the incurrence of the liability and its transfer to, or assumption by, the corporation.
The assumption of liabilities normally is considered to have a business purpose if the
transferor incurred the liabilities in the normal course of business or in the course of
acquiring business property. Examples of liabilities without a bona fide business purpose
and whose transfer would cause all liabilities transferred to be considered boot are per-
sonal obligations of the transferor, including a home mortgage or any other loans of a per-
sonal nature.
David owns land having a $100,000 FMV and a $60,000 adjusted basis. The land is not encum-
bered by any liabilities. To obtain cash for his personal use, David transfers the land to his
wholly owned corporation in exchange for additional stock and $25,000 cash. Because the cash
is considered to be boot, David must recognize $25,000 of gain. Assume instead that David
mortgages the land for $25,000 to obtain the needed cash. If shortly thereafter David transfers
the land and the mortgage to his corporation for additional stock, the $25,000 mortgage
assumed by the corporation will be considered to be boot because the transfer of the mort-
gage appears to have no bona fide business purpose. David’s recognized gain will be $25,000,
i.e., the lesser of the boot received ($25,000) or his realized gain ($40,000). This special liability
rule prevents David from obtaining cash without boot recognition. �
LIABILITIES IN EXCESS OF BASIS—SEC. 357(c). Under Sec. 357(c), if the total
amount of liabilities transferred to a controlled corporation exceeds the total adjusted
basis of all property transferred, the excess liability is taxed as a gain to the transferor.
$ –0–
$ –0–
$17,000
(15,000
8,000
Consideration
ReceivedFMV
Transferor’s
Adj. Basis
Asset/
LiabilityTransferor
Corporate Formations and Capital Structure ▼ Corporations 2-23
ADDITIONAL
COMMENT
If any of the assumed liabilities
are created for tax avoidance pur-
poses, all the assumed liabilities
are tainted.
ETHICAL POINT
Information about any transferor
liabilities assumed by the trans-
feree corporation must be
reported with the transferee and
transferor’s tax returns for the
year of transfer (see page C:2-36).
Where a client asks a tax practi-
tioner to ignore the fact that tax
avoidance is the primary purpose
for transferring a liability to a cor-
poration, the tax practitioner
must examine the ethical consid-
erations of continuing to prepare
returns and provide tax advice for
the client.
EXAMPLE C:2-36 �
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STOP & THINK
KEY POINT
Because of the “liabilities in
excess of basis” exception, many
cash basis transferor shareholders
might inadvertently create recog-
nized gain in a Sec. 351 transac-
tion. However, a special exception
exists that protects cash basis tax-
payers. This exception provides
that liabilities that would give rise
to a deduction when paid are not
treated as liabilities for purposes
of Sec. 357(c).
EXAMPLE C:2-38 �
36 Sec. 357(c)(3).
37 Sec. 358(d)(2).
2-24 Corporations ▼ Chapter 2
This rule applies regardless of whether the transferor realizes any gain or loss. The rationale
for the rule is that the transferor has received a benefit (in the form of a release from
liabilities) that exceeds his or her original investment in the transferred property.
Therefore, the transferor should be taxed on this benefit. The character of the recognized
gain depends on the type of property transferred to the corporation. The transferor’s basis
in any stock received is zero.
Judy transfers $10,000 cash and land, a capital asset, to Duke Corporation in exchange for all its
stock. At the time of the exchange, the land has a $70,000 adjusted basis and a $125,000 FMV.
Duke assumes a $100,000 mortgage on the land for a bona fide business purpose. Although
Judy receives no boot, Judy must recognize a $20,000 ($100,000 � $80,000) capital gain, the
amount by which the liabilities assumed by Duke exceed the basis of the land and the cash.
Judy’s basis in the Duke stock is zero, computed as follows:
Judy’s basis in the land transferred $ 70,000
Plus: Cash transferred 10,000
Gain recognized 20,000
Minus: Liabilities assumed by Duke )
Judy’s basis in the Duke stock
Note that, without the recognition of the $20,000 gain, Judy’s basis in the Duke stock would
be a negative $20,000 ($80,000 � $100,000). �
Question: What are the fundamental differences between the liability exceptions of Sec.
357(b) and Sec. 357(c)?
Solution: Section 357(b) treats all “tainted” liabilities as boot so that gain recognition is
the lesser of gain realized or the amount of boot. Excess liabilities under Sec. 357(c) are
not treated as boot; they require gain recognition whether or not the transferor realizes
any gain. Section 357(b) tends to be punitive in that the “tax avoidance” liabilities cause
all the “offending” shareholder’s transferred liabilities to be treated as boot even if the
transfer of some liabilities do not have a tax avoidance purpose. Section 357(c) is not
intended to be punitive. It recognizes that the shareholder has received an economic ben-
efit to the extent of excess liabilities, and it prevents the occurrence of a negative stock
basis. In short, Section 357(b) deters or punishes tax avoidance while Sec. 357(c) taxes an
economic gain.
LIABILITIES OF A CASH METHOD TAXPAYER—SEC. 357(c)(3). In a Sec. 351 tax-
free exchange, special problems arise when a taxpayer using the cash or hybrid method of
accounting transfers property and liabilities of an ongoing business to a corporation.36
Often, the principal assets transferred are accounts receivable having a zero basis.
Liabilities usually are transferred as well. Consequently, the amount of liabilities trans-
ferred may exceed the total basis (but not the FMV) of the property transferred.
Under the general rule of Sec. 357(c), the transferor recognizes gain equal to the amount
by which the liabilities assumed exceed the total basis of the property transferred. Section
357(c)(3), however, provides that, in applying the general rule, the term liabilities does not
include any amount that would give rise to a deduction when paid (e.g., accounts payable
of a cash basis taxpayer). These amounts also are not considered liabilities for the purpose
of determining the shareholder’s basis in stock received.37 Therefore, they generally do not
reduce this basis. However, if after all other adjustments the stock’s basis exceeds its FMV,
these liabilities could reduce stock basis, but not below the stock’s FMV.38
Tracy operates a cash basis accounting practice as a sole proprietorship. She transfers the assets
of her practice to Prime Corporation in exchange for all the Prime stock. The balance sheet for
the transferred practice is as follows:
$ –0–
(100,000
EXAMPLE C:2-37 �
38 Sec. 358(h)(1).
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Cash $ 5,000 $ 5,000
Furniture 5,000 8,000
Accounts receivable
Total
Accounts payable (deductible expenses) $ –0– $25,000
Note payable (on office furniture) 2,000 2,000
Owner’s equity
Total
If, for purposes of Sec. 357(c), the accounts payable were considered liabilities, the $27,000
of liabilities transferred (i.e., the $25,000 of accounts payable and the $2,000 note payable)
would exceed the $10,000 total basis of assets transferred, and Troy would recognize a $17,000
gain. Because paying the $25,000 of accounts payable gives rise to a deduction, however, they
are not considered liabilities for purposes of Sec. 357(c). On the other hand, the $2,000 note
payable is considered a liability for this purpose because paying it would not give rise to a
deduction. Thus, the total liabilities transferred to Prime amount to only $2,000. Because that
amount does not exceed the $10,000 total basis of the assets transferred, Tracy recognizes no
gain. Moreover, the accounts payable are not considered liabilities for purposes of computing
Tracy’s basis in her stock because the stock’s basis ($8,000) does not exceed its FMV ($36,000).
Thus, her basis in the Prime stock is $8,000 ($10,000 � $2,000). �
Topic Review C:2-3 summarizes the liability assumption and acquisition rules of
Sec. 357.
OTHER CONSIDERATIONS IN A SEC. 351
EXCHANGE
RECAPTURE OF DEPRECIATION. If a Sec. 351 exchange is completely nontaxable
(i.e., the transferor receives no boot), no depreciation is recaptured. Instead, the corpora-
tion inherits the entire amount of the transferor’s recapture potential. Where the trans-
feror recognizes some depreciation recapture as ordinary income (e.g., because of boot
recognition), the transferee inherits the remaining recapture potential. If the transferee
corporation subsequently disposes of the depreciated property, the corporation is subject
to recapture rules on depreciation it claimed subsequent to the transfer, plus the recapture
potential it inherited from the transferor.
Azeem transfers machinery having a $25,000 original cost, an $18,000 adjusted basis, and a
$35,000 FMV for all 100 shares of Wheel Corporation stock. Before the transfer, Azeem used
the machinery in his business and claimed $7,000 of depreciation. In the transfer, Azeem recap-
tures no depreciation, and Wheel inherits the $7,000 recapture potential. After claiming an
additional $2,000 of depreciation, Wheel has a $16,000 adjusted basis in the machinery. If
$63,000$10,000
36,0008,000
$63,000$10,000
50,000–0–
FMVAdjusted BasisAssets and Liabilities
Corporate Formations and Capital Structure ▼ Corporations 2-25
Topic Review C:2-3
Liability Assumption and Acquisition Rules of Sec. 357
1. General Rule (Sec. 357(a)): A transferee corporation’s assumption of liabilities in a Sec. 351 exchange is not treated as
boot by the shareholder for gain recognition purposes. On the other hand, the assumption of liabilities is treated as the
receipt of money for purposes of determining the transferor’s stock basis and amount realized.
2. Exception 1 (Sec. 357(b)): All liabilities assumed by a transferee corporation are considered to be money/boot received by
the transferor if the principal purpose of the transfer of any of the liabilities is tax avoidance or if no bona fide business
purpose exists for the transfer.
3. Exception 2 (Sec. 357(c)): If the total amount of liabilities assumed by a transferee corporation exceeds the total basis of
property transferred, the transferor recognizes the excess as gain.
4. Special Rule (Sec. 357(c)(3)): For purposes of Exception 2, the term liabilities for a transferor using a cash or hybrid
method of accounting does not include any amount that would give rise to a deduction when paid.
EXAMPLE C:2-39 �
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EXAMPLE C:2-41 �
39 Sec. 168(i)(7).
40 Prop. Reg. Secs. 1.168-5(b)(2)(i)(B), 1.168-5(b)(4)(i), and 1.168-5(b)(8).
41 Prop. Reg. Sec. 1.168-5(b)(7).
2-26 Corporations ▼ Chapter 2
EXAMPLE C:2-40 �
Wheel now sells the machinery for $33,000, it must recognize a $17,000 ($33,000 � $16,000)
gain. Of this gain, $9,000 is ordinary income recaptured under Sec. 1245. The remaining $8,000
is a Sec. 1231 gain. �
COMPUTING DEPRECIATION. When a shareholder transfers depreciable property to a
corporation in a nontaxable Sec. 351 exchange and the shareholder has not fully depreci-
ated the property, the corporation must use the depreciation method and recovery period
used by the transferor.39 For the year of the transfer, the depreciation must be allocated
between the transferor and the transferee corporation according to the number of months
each party held the property. The transferee corporation is assumed to have held the prop-
erty for the entire month in which the property was transferred.40
On June 10 of Year 1, Carla paid $6,000 for a computer (five-year property for MACRS pur-
poses), which she used in her sole proprietorship business. In Year 1, she claimed $1,200 (0.20 �
$6,000) of depreciation. She did not elect Sec. 179 expensing and did not claim any bonus
depreciation. On February 10 of Year 2, she transfers the computer and other sole proprietor-
ship assets to King Corporation in exchange for King stock. Because Sec. 351 applies, she recog-
nizes no gain or loss. King must use the same MACRS recovery period and method that Carla
used. Depreciation for Year 2 is $1,920 (0.32 � $6,000). That amount must be allocated
between Carla and King. The computer is considered to have been held by Carla for one month
and by King for 11 months (including the month of transfer). The Year 2 depreciation amounts
claimed by Carla and King are calculated as follows:
Carla $6,000 � 0.32 � 1/12 � $ 160
King Corporation $6,000 � 0.32 � 11/12 � $1,760
King’s basis in the computer is calculated as follows:
Original cost $6,000
Minus: Year 1 depreciation claimed by Carla (1,200)
Year 2 depreciation claimed by Carla )
Adjusted basis on transfer date
King’s depreciation for Year 2 and subsequent years is as follows:
Year 2 (as computed above) $1,760
Year 3 ($6,000 � 0.1920) 1,152
Year 4 ($6,000 � 0.1152) 691
Year 5 ($6,000 � 0.1152) 691
Year 6 ($6,000 � 0.0576)
Total �
If the transferee corporation’s basis in the depreciable property exceeds the transferor’s
basis (e.g., as a result of an upward adjustment to reflect gain recognized by the trans-
feror), the corporation treats the excess amount as newly purchased MACRS property
and uses the recovery period and method applicable to the class of property transferred.41
Assume the same facts as in Example C:2-40 except that, in addition to King stock, Carla
receives a King note. Consequently, she must recognize $1,000 of gain on the transfer of the
computer. King’s basis in the computer is calculated as follows:
Original cost $6,000
Depreciation claimed by Carla )
Adjusted basis on transfer date $4,640
Plus: Gain recognized by Carla
Basis to King on transfer date
The additional $1,000 of basis is depreciated as though it were separate, newly purchased five-
year MACRS property. Thus, King claims depreciation of $200 (0.20 � $1,000) on this portion of
$5,640
1,000
(1,360
$4,640
346
$4,640
(160
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Corporate Formations and Capital Structure ▼ Corporations 2-27
the basis in addition to the $1,760 of depreciation on the $4,640 carryover basis. Alternatively,
King could elect to expense the $1,000 “new” basis under Sec. 179. �
ASSIGNMENT OF INCOME DOCTRINE. The assignment of income doctrine holds
that income is taxable to the person who earned it and that it may not be assigned to
another person for tax purposes.42 The question arises as to whether the assignment of
income doctrine applies where a cash method taxpayer transfers uncollected accounts
receivable to a corporation in a Sec. 351 exchange. Specifically, who must recognize the
income when it is collected—the taxpayer who transferred the receivable or the corporation
that now owns and collects on the receivable? The IRS has ruled that the doctrine does not
apply in a Sec. 351 exchange if the taxpayer transfers substantially all the business assets
and liabilities, and a bona fide business purpose exists for the transfer. Instead, the accounts
receivable take a zero basis in the corporation’s hands, and the corporation includes their
value in its income when it collects on the receivables.43
For a bona fide business purpose, Ruth, a cash basis taxpayer, transfers all the assets and liabilities
of her legal practice to Legal Services Corporation in exchange for all of Legal Services stock. The
assets include $30,000 of accounts receivable that will generate earnings that Ruth has not
included in her gross income. Because Ruth transfers substantially all the business assets and lia-
bilities for a bona fide business purpose, the assignment of income doctrine does not apply to
the receivables transferred, and Legal Services takes a zero basis in the receivables. Subsequently,
Legal Services includes the value of the receivables in its income as it collects on them. �
The question of whether a transferee corporation can deduct the accounts payable
transferred to it in a nontaxable transfer has frequently been litigated.44 Most courts have
held that ordinarily expenses are deductible only by the party that incurred those liabilities
in the course of its trade or business. However, the IRS has ruled that in a nontaxable
exchange the transferee corporation may deduct the payments it makes to satisfy the trans-
ferred accounts payable even though they arose in the transferor’s business.45
ADDITIONAL
COMMENT
Currently, we have no clear guid-
ance on how the corporation
depreciates transferred property
that has a reduced basis under
the loss property limitation rule
discussed on page C:2-21. For
now, taxpayers probably should
rely on Prop. Reg. 1.168-2(d)(3),
which provides a method for cal-
culating depreciation when the
transferee’s basis is less than the
transferor’s basis.
EXAMPLE C:2-42 �
42 See, for example, Lucas v. Guy C. Earl, 8 AFTR 10287, 2 USTC ¶496
(USSC, 1930).
43 Rev. Rul. 80-198, 1980-2 C.B. 113.
44 See, for example, Wilford E. Thatcher v. CIR, 37 AFTR 2d 76-1068, 76-1
USTC ¶9324 (9th Cir., 1976), and John P. Bongiovanni v. CIR, 31 AFTR 2d
73-409, 73-1 USTC ¶9133 (2nd Cir., 1972).
CHOICE OF CAPITAL
STRUCTURE
45 Rev. Rul. 80-198, 1980-2 C.B. 113.
46 See, for example, Aqualane Shores, Inc. v. CIR, 4 AFTR 2d 5346, 59-2
USTC ¶9632 (5th Cir., 1959) and Sun Properties, Inc. v. U.S., 47 AFTR 273,
55-1 USTC ¶9261 (5th Cir., 1955).
When a corporation is formed, the way it is financed will determine its capital structure.
The corporation may obtain capital from shareholders, nonshareholders, and creditors.
In exchange for their capital, shareholders may receive common or preferred stock; non-
shareholders may receive benefits such as employment or special rates on products sold by
the corporation; and creditors may receive long- or short-term debt. As explained below,
each of these alternatives has tax advantages and disadvantages for the shareholders,
creditors, and corporation.
CHARACTERIZATION OF OBLIGATIONS
AS DEBT OR EQUITY
The deductibility of interest payments creates an incentive for corporations to incur as
much debt as possible. Because debt financing often resembles equity financing (e.g., pre-
ferred stock), the IRS and the courts have refused to accept the form of the security as
controlling.46 In some cases, debt obligations that possess equity characteristics have been
treated as common or preferred stock for tax purposes. In determining the appropriate
tax treatment, the courts have relied on a number of factors.
OBJECTIVE 5
Explain the tax
implications of alternative
capital structures
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Congress enacted Sec. 385 to establish a workable standard for determining whether a
security is debt or equity. Section 385 provides that the following factors be considered in
the determination:
� Whether there is a written unconditional promise to pay on demand or on a specified
date a certain sum of money in return for adequate consideration in the form of
money or money’s worth, in addition to an unconditional promise to pay a fixed rate
of interest
� Whether the debt is subordinate to, or preferred over, other indebtedness of the corpo-
ration
� The ratio of corporate debt to equity
� Whether the debt is convertible into stock of the corporation
� The relationship between holdings of stock in the corporation and holdings of the
interest in question47
DEBT CAPITAL
Various provisions govern the tax treatment of (1) the issuance of debt; (2) the payment of
interest on debt; and (3) the extinguishment, retirement, or worthlessness of debt. The tax
implications of each of these events are examined below.
ISSUANCE OF DEBT. If a transferor transfers appreciated property in exchange for
stock, the transfer will be nontaxable, provided the Sec. 351 requirements have been
met. On the other hand, if the transferor transfers appreciated property in exchange for
corporate debt as part of a Sec. 351 exchange, the FMV of the debt received will be
treated as boot, possibly leading to gain recognition.
PAYMENT OF INTEREST. Interest paid on indebtedness is deductible by the corpora-
tion in deriving its taxable income.48 Moreover, a corporation is not subject to the invest-
ment interest deduction limitation applicable to individual taxpayers. By contrast, the
corporation cannot deduct dividends paid on equity securities.
If a corporation issues a debt instrument at a discount, Sec. 1272 requires the holder to
amortize the original issue discount over the term of the obligation and treat the accrual
as interest income. The debtor corporation amortizes the original issue discount over the
term of the obligation and treats the accrual as an additional cost of borrowing.49 If the
corporation repurchases the debt instrument for more than the issue price (plus any orig-
inal issue discount deducted as interest), the corporation deducts the excess of the pur-
chase price over the issue price (adjusted for any amortization of original issue discount)
as interest expense.50
Under Sec. 171, if a corporation issues a debt instrument at a premium, the holder may
elect to amortize the premium over the term of the obligation and treat the accrual as a
reduction in interest income earned on the obligation. For the debtor corporation, the
premium reduces the amount of deductible interest.51 If the corporation repurchases the
debt instrument at a price greater than the issue price (minus any premium treated as
income), the corporation deducts the excess of the purchase price over the issue price
(adjusted for any amortization of premium) as interest expense.52
EXTINGUISHMENT OF DEBT. Generally, the retirement of debt is not a taxable
event. Thus, a debtor corporation’s extinguishing an obligation at face value does not
result in the creditor’s recognizing gain or loss. However, amounts received by the holder
2-28 Corporations ▼ Chapter 2
SELF-STUDY
QUESTION
From a tax perspective, why is the
distinction between debt and
equity important?
ANSWER
Interest paid with respect to a
debt instrument is deductible by
the payor corporation. Dividends
paid with respect to an equity
instrument are not deductible by
the payor corporation. Thus, the
determination of whether an
instrument is debt or equity can
provide different results to the
payor corporation. Different
results apply to the payee as well.
Qualified dividends are subject to
the applicable capital gains tax
rate while interest is ordinary
income.
HISTORICAL NOTE
The Treasury Department at one
time issued proposed and final
regulations covering Sec. 385.
These regulations were the sub-
ject of so much criticism that the
Treasury Department eventually
withdrew them. Section 385,
however, makes it clear that
Congress wants the Treasury
Department to make further
attempts at clarifying the debt-
equity issue. So far, the Treasury
Department has issued no “new”
proposed or final regulations.
47 See also O.H. Kruse Grain & Milling v. CIR, 5 AFTR 2d 1544, 60-2 USTC
¶9490 (9th Cir., 1960), which lists additional factors that the courts might
consider.
48 Sec. 163(a).
49 Sec. 163(e).
50 Reg. Sec. 1.163-7(c).
51 Reg. Sec. 1.163-12.
52 Reg. Sec. 1.163-7(c).
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Corporate Formations and Capital Structure ▼ Corporations 2-29
ADDITIONAL
COMMENT
Even though debt often is
thought of as a preferred instru-
ment because of the deductibility
of the interest paid, the debt
must be repaid at its maturity,
whereas stock has no specified
maturity date. Also, interest usu-
ally must be paid at regular inter-
vals, whereas dividends do not
have to be declared if sufficient
funds are not available to pay
them or if the corporation needs
to retain funds for operations or
growth.
SELF-STUDY
QUESTION
Does the transferee corporation
recognize gain on the receipt of
appreciated property from a
shareholder?
ANSWER
No. A corporation does not recog-
nize gain when it receives prop-
erty from its shareholders,
whether or not it exchanges its
own stock. However, the transfer
must qualify as a Sec. 351
exchange or the transaction will
be taxable to the shareholders.
of a debt instrument (e.g., note, bond, or debenture) at the time of its retirement are
deemed to be “in exchange for” the obligation. Thus, if the obligation is a capital asset in
the holder’s hands, the holder must recognize a capital gain or loss if the amount received
differs from its face value or adjusted basis, unless the difference is due to original issue
or market discount.
Titan Corporation issues a ten-year note at its $1,000 face amount. On the date of issuance, Rick
purchases the note for $1,000. Because of a decline in interest rates, Titan calls the note at a
price of $1,050 payable to each note holder. Rick reports the premium as a $50 capital gain, and
Titan deducts as interest expense total premiums paid to all its note holders. �
Table C:2-2 presents a comparison of the tax advantages and disadvantages of a cor-
poration’s using debt in its capital structure.
EQUITY CAPITAL
Corporations can raise equity capital through the issuance of various types of stock.
Some corporations issue only a single class of stock, whereas others issue numerous
classes of stock. Reasons for the use of multiple classes of stock include
� Permitting nonfamily employees of family owned corporations to obtain an equity
interest in the business while keeping voting control in the hands of family members
� Financing a closely held corporation through the issuance of preferred stock to an
outside investor, while leaving voting control in the hands of existing common stock-
holders.
Table C:2-3 lists some of the major tax advantages and disadvantages of using common
and preferred stock in a corporation’s capital structure.
CAPITAL CONTRIBUTIONS BY SHAREHOLDERS
A corporation recognizes no income when it receives cash or noncash property as a capi-
tal contribution from a shareholder.53 If the shareholders make voluntary pro rata pay-
ments to a corporation but do not receive any additional stock, the payments are treated
as additional consideration for the stock already owned.54 The shareholders’ respective
bases in their stock are increased by the amount of cash contributed, plus the basis of
any noncash property contributed, plus any gain recognized by the shareholders. The
EXAMPLE C:2-43 �
� TABLE C:2-2
Tax Advantages and Disadvantages of Using Debt in a Corporation’s Capital
Structure
Advantages:
1. A corporation can deduct interest paid on a debt obligation.
2. Shareholders do not recognize income in a debt retirement as they would in a stock redemption.
Disadvantages:
1. If at the time the corporation is formed or later when a shareholder makes a capital contribution,
the shareholder receives a debt instrument in exchange for property, the debt is treated as boot,
and the shareholder recognizes gain to the extent of the lesser of the boot’s FMV or the realized
gain.
2. If debt becomes worthless or is sold at less than its face value, the loss generally is a nonbusiness
bad debt (treated as a short-term capital loss) or a capital loss. Section 1244 ordinary loss
treatment applies only to stock (see pages C:2-32 and C:2-33).
53 Sec. 118(a). 54 Reg. Sec. 1.118-1.
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� TABLE C:2-3
Tax Advantages and Disadvantages of Using Equity in a Corporation’s Capital
Structure
Advantages:
1. A 70%, 80%, or 100% dividends-received deduction is available to a corporate shareholder who
receives dividends. A similar deduction is not available for the receipt of interest (see Chapter C:3).
2. A shareholder can receive common and preferred stock in a tax-free corporate formation under
Sec. 351 or a nontaxable reorganization under Sec. 368 without recognizing gain (see Chapters
C:2 and C:7, respectively). Receipt of debt securities in each of these two types of transactions
generally results in the shareholder’s recognizing gain.
3. Common and preferred stock can be distributed tax-free to the corporation’s shareholders as a
stock dividend. Some common and preferred stock distributions, however, may be taxable as
dividends under Sec. 305(b). Distributions of debt obligations generally are taxable as a dividend
(see Chapter C:4).
4. Common or preferred stock that the shareholder sells or exchanges or that becomes worthless is
eligible for ordinary loss treatment, subject to limitations, under Sec. 1244 (see pages C:2-32
and C:2-33). The loss recognized on similar transactions involving debt securities generally is
treated as capital in character.
5. Section 1202 excludes 50% of capital gains realized on the sale or exchange of qualified small
business (C) corporation stock that has been held for more than five years. For qualified stock
acquired after February 17, 2009 and before September 28, 2010, the exclusion is 75%,
and for qualified stock acquired after September 27, 2010 and before January 1, 2014, the
exclusion is 100%.
6. Qualified dividends are taxed at the applicable capital gains rate.
Disadvantages:
1. Dividends are not deductible in determining a corporation’s taxable income.
2. Redemption of common or preferred stock generally is taxable to the shareholders as a
dividend. Under the general rule, none of the redemption distribution offsets the shareholder’s
basis for the stock investment. Redemption of common and preferred stock is eligible for
exchange treatment only in situations specified in Secs. 302 and 303 (see Chapter C:4).
3. Preferred stock issued to a shareholder as a dividend may be treated as Sec. 306 stock. Sale,
exchange, or redemption of such stock can result in the recognition of ordinary income instead
of capital gain (see Chapter C:4). This ordinary income is taxed as a “deemed dividend” at the
applicable capital gains rate.
2-30 Corporations ▼ Chapter 2
TYPICAL
MISCONCEPTION
The characteristics of preferred
stock can be similar to those of a
debt security. Often, a regular div-
idend is required at a stated rate,
much like what would be
required with respect to a debt
obligation. The holder of pre-
ferred stock, like a debt holder,
may have preferred liquidation
rights over holders of common
stock. Also, preferred stock is not
required to possess voting rights.
However, differences remain. A
corporation can deduct its inter-
est expense but not dividends.
Interest income is ordinary
income to shareholders, but
qualified dividends are subject
to the applicable capital gains tax
rate.
EXAMPLE C:2-44 �
corporation’s basis in any property received as a capital contribution from a shareholder
equals the shareholder’s basis, plus any gain recognized by the shareholder.55 Normally,
the shareholders recognize no gain when they transfer property to a controlled corpora-
tion as a capital contribution.
Dot and Fred each own 50% of the stock in Trail Corporation, and each has a $50,000 basis in
that stock. Later, as a voluntary contribution to Trail’s capital, Dot contributes $40,000 in cash
and Fred contributes property having a $25,000 basis and a $40,000 FMV. As a result of the con-
tributions, Trail recognizes no income. Dot’s basis in her stock is increased to $90,000 ($50,000 �
$40,000), and Fred’s basis in his stock is increased to $75,000 ($50,000 � $25,000). Trail’s basis in
the property contributed by Fred is $25,000—the same as Fred’s basis in the property. �
If a shareholder-lender gratuitously forgives corporate debt, the debt forgiveness might
be treated as a capital contribution equal to the principal amount of the forgiven debt. A
determination of whether debt forgiveness is a capital contribution is based on the facts
and circumstances surrounding the event.
55 Sec. 362(a).
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Your corporate client wants to issue 100-year
bonds. The corporation’s CEO reads The Wall
Street Journal regularly and has observed that
similar bonds have been issued by several companies,
including several Fortune 500 companies. He touts
the fact that the interest rate on these bonds is slightly
more than that for 30-year U.S. Treasury bonds. In addi-
tion, he expresses the belief that interest on the bonds
would be deductible, whereas dividends on preferred or
common stock would be nondeductible. You are concerned
that the IRS might treat the bonds as equity because of
their extraordinarily long term. If the IRS does treat the
bonds as such, it might recharacterize the “interest” as
dividends and deny your client an interest deduction.
What advice would you give the client now regarding
the bond issue? What advice would you give it when it
prepares its tax return after the new bonds have been
issued?
Corporate Formations and Capital Structure ▼ Corporations 2-31
WHAT WOULD YOU DO IN THIS SITUATION?
BOOK-TO-TAX
ACCOUNTING
COMPARISON
The IRC requires capital contribu-
tions of property other than
money made by a nonshareholder
to be reported at a zero basis.
Financial accounting rules, how-
ever, require donated capital to
be reported at the FMV of the
asset on the financial accounting
books. Neither set of rules
requires the property’s value to
be included in income.
CAPITAL CONTRIBUTIONS BY
NONSHAREHOLDERS
Nonshareholders sometimes contribute capital to a corporation in the form of cash or
other property. For example, a city government might contribute land to a corporation
to induce the corporation to locate within the city and provide jobs for citizens of the
municipality. Such contributions are excluded from the corporation’s gross income if the
money or property contributed is neither a payment for goods or services nor a subsidy
to induce the corporation to limit production.56
If a nonshareholder contributes noncash property to a corporation, the corporation’s
basis in such property is zero.57 The zero basis precludes the corporation from claiming
either a depreciation deduction or capital recovery offset with respect to the contributed
property.
If a nonshareholder contributes cash, the basis of any property acquired with the cash
during a 12-month period beginning on the day the corporation received the contribution
is reduced by the cash amount. This rule limits the corporation’s deduction to the amount
of funds it invested in the property. The amount of any cash received from nonsharehold-
ers that the corporation did not spend to purchase property during the 12-month period
reduces the basis of any noncash property held by the corporation on the last day of the
12-month period.58
The basis reduction applies to the corporation’s property in the following order:
1. Depreciable property
2. Amortizable property
3. Depletable property
4. All other property
In the sequence of these downward adjustments, however, a property’s basis may not be
reduced below zero.
To induce the company to locate in the municipality, the City of San Antonio contributes to
Circle Corporation $100,000 in cash and a tract of land having a $500,000 FMV. Because of a
downturn in Circle’s business, the company spends only $70,000 of the contributed funds over
a 12-month period. Circle recognizes no income as a result of the contribution. Circle’s bases in
the land and other property purchased with the contributed funds are zero. The basis of Circle’s
remaining assets, starting with its depreciable property, must be reduced by the $30,000
($100,000 � $70,000) contributed but not spent. �
EXAMPLE C:2-45 �
56 Reg. Sec. 1.118-1.
57 Sec. 362(c)(1).
58 Sec. 362(c)(2).
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TYPICAL
MISCONCEPTION
Probably the most difficult aspect
of deducting a loss on a worthless
security is establishing that the
security is actually worthless. A
mere decline in value is not suffi-
cient to create a loss. The burden
of proof of establishing total
worthlessness rests with the
taxpayer.
SELF-STUDY
QUESTION
Why would a shareholder want
his or her stock to qualify as Sec.
1244 stock?
ANSWER
Section 1244 is a provision that
may help the taxpayer but that
can never hurt. If the Sec. 1244
requirements are satisfied, the
individual shareholders of a small
business corporation may treat
losses from the sale or worthless-
ness of their stock as ordinary
rather than capital losses. If the
Sec. 1244 requirements are not
satisfied, such losses generally are
capital losses.
EXAMPLE C:2-46 �
59 Sec. 165(g).
2-32 Corporations ▼ Chapter 2
Investors who purchase stock in, or lend money to, a corporation usually want to earn a
profit and recover their investment. Some investments, however, do not offer an adequate
return on capital, and an investor may lose part or all of the investment. In this event, the
securities evidencing the investment become worthless. This section examines the tax con-
sequences of stock or debt securities becoming worthless.
SECURITIES
A debt or equity security that becomes worthless results in a capital loss for the investor as
of the last day of the tax year in which the security becomes worthless. For purposes of
this rule, the term security includes (1) a share of stock in a corporation; (2) a right to sub-
scribe for, or the right to receive, a share of stock in a corporation; or (3) a bond, deben-
ture, note, or other evidence of indebtedness with interest coupons or in registered form
issued by a corporation.59
In some situations, investors recognize an ordinary loss when a security becomes
worthless. Investors who contribute capital, either in the form of equity or debt to a cor-
poration that later fails, generally prefer ordinary losses because such losses are deductible
against ordinary income. Ordinary losses that generate an NOL can be carried back two
years or forward up to 20 years. In general, ordinary loss treatment is available in the
following circumstances:
� Securities that are noncapital assets. An ordinary loss occurs when a security that is a
noncapital asset in the hands of the taxpayer is sold or exchanged or becomes totally
worthless. Securities in this category include those held as inventory by a securities dealer.
� Affiliated corporations. A domestic corporation can claim an ordinary loss for any
affiliated corporation’s security that becomes worthless during the tax year. The
domestic corporation must own at least 80% of the total voting power of all classes of
stock entitled to vote, and at least 80% of each class of nonvoting stock (other than
stock limited and preferred as to dividends). At least 90% of the aggregate gross
receipts of the loss corporation for all tax years must have been derived from nonpas-
sive income sources.
� Section 1244 stock. Section 1244 permits a shareholder to claim an ordinary loss if
qualifying stock issued by a small business corporation is sold or exchanged or
becomes worthless. This treatment is available only to an individual who was issued
the qualifying stock or who was a partner in a partnership at the time the partnership
acquired the qualifying stock. In the latter case, the partner’s distributive share of part-
nership losses includes the loss sustained by the partnership on such stock. Ordinary
loss treatment is not available for stock inherited, received as a gift, or purchased from
another shareholder. The ordinary loss is limited to $50,000 per year (or $100,000 if
the taxpayer is married and files a joint return). Losses exceeding the dollar ceiling in
any given year are considered capital in character.
For $175,000, Tammy and her husband Cole purchased 25% of Minor Corporation’s initial
offering of a single class of stock. Minor is a small business corporation, and the Minor stock sat-
isfies all Sec. 1244 requirements. On September 1 of the current year, Minor filed for bank-
ruptcy. Two years later, the bankruptcy court notifies shareholders that the Minor stock is
worthless. In that year, Tammy and Cole can deduct $100,000 of their initial investment as an
ordinary loss. The remaining $75,000 loss is treated as capital in character. �
If a corporation issues Sec. 1244 stock for property whose adjusted basis exceeds its
FMV immediately before the exchange, the stock’s basis is reduced to the property’s FMV
for the purpose of determining the ordinary loss amount.
OBJECTIVE 6
Determine the tax
consequences of
worthless stock or debt
obligations
WORTHLESSNESS OF STOCK
OR DEBT OBLIGATIONS
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EXAMPLE C:2-47 � In a Sec. 351 nontaxable exchange, Penny transfers to Small Corporation property having a
$40,000 adjusted basis and a $32,000 FMV for 100 shares of Sec. 1244 stock. Ordinarily, Penny’s
basis in the stock would be $40,000. However, for Sec. 1244 purposes, her stock basis is the
property’s FMV, or $32,000. If Penny sells the stock for $10,000, her recognized loss is $30,000
($10,000 � $40,000). Her ordinary loss under Sec. 1244 is $22,000 ($10,000 � $32,000 Sec. 1244
basis). The remaining $8,000 loss is treated as capital in character. (Note also that, under Sec.
362(e)(2), Small would reduce its basis in the transferred property to its $32,000 FMV.) �
Section 1244 loss treatment requires no special election. Investors, however, should be
aware that, if they fail to satisfy certain requirements, ordinary loss treatment will be
unavailable, and their loss will be treated as capital in character. The requirements are as
follows:
� The issuing corporation must be a small business corporation at the time it issues the
stock. A small business corporation is a corporation that receives in the aggregate $1
million or less in money or noncash property (other than stock and securities) in
exchange for its stock.60
� The issuing corporation must have derived more than 50% of its aggregate gross
receipts from “active” sources (i.e., other than royalties, rents, dividends, interest,
annuities, and gains on sales of stock and securities) during the five most recent tax
years ending before the date on which the shareholder sells or exchanges the stock or
the stock becomes worthless.
If a shareholder contributes additional cash or property to a corporation after acquir-
ing Sec. 1244 stock, the amount of ordinary loss recognized on the sale, exchange, or
worthlessness of the Sec. 1244 stock is limited to the shareholder’s capital contribution at
the time the corporation issued the stock.
UNSECURED DEBT OBLIGATIONS
In addition to holding an equity interest, shareholders may lend funds to the corporation.
The type of loss allowed if the corporation does not repay the borrowed funds depends on
the nature of the loan or advance.
If the unpaid loan was not evidenced by a security (i.e., an unsecured debt obligation),
it is considered to be either business or nonbusiness bad debt. Nonbusiness bad debts are
treated less favorably than business bad debts. Under Sec. 166, nonbusiness bad debts are
deductible as short-term capital losses (up to the $3,000 annual limit for net capital
losses) when they become totally worthless. Business bad debts are deductible as ordinary
losses without limitation when they become either partially or totally worthless. The IRS
generally treats a loan made by a shareholder to a corporation in connection with his or
her stock investment as nonbusiness in character.61 It is understandable why a share-
holder might attempt to rebut this presumption with the argument that a business pur-
pose exists for the loan.
An advance in connection with the shareholder’s trade or business, such as a loan to
protect the shareholder’s employment at the corporation, may be treated as an ordinary
loss under the business bad debt rules. Regulation Sec. 1.166-5(b) states that whether a
bad debt is business or nonbusiness related depends on the taxpayer’s motive for making
the advance. The debt is business related if the necessary relationship between the loss and
the conduct of the taxpayer’s trade or business exists at the time the debt was incurred,
acquired, or became worthless.
In U.S. v. Edna Generes, the U.S. Supreme Court held that where multiple motives
exist for advancing funds to a corporation, such as where a shareholder-employee
advances funds to protect his or her employment, determining whether the advance is
business or nonbusiness related must be based on the “dominant motivation” for the
Corporate Formations and Capital Structure ▼ Corporations 2-33
60 Regulation Sec. 1.1244(c)-2 provides special rules for designating which
shares of stock are eligible for Sec. 1244 treatment when the corporation has
issued more than $1 million of stock.
61 Here, it is assumed that the loan is not considered to be an additional
capital contribution. In such a case, the Sec. 165 worthless security rules
apply instead of the Sec. 166 bad debt rules.
TAX STRATEGY TIP
If a shareholder contributes addi-
tional money or property to an
existing corporation, he or she
should be sure to receive addi-
tional stock in the exchange so
that it will qualify for Sec. 1244
treatment if all requirements are
met. If the shareholder does not
receive additional stock, the
increased basis of existing stock
resulting from the capital contri-
bution will not qualify for Sec.
1244 treatment.
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ADDITIONAL
COMMENT
For the act of lending money to a
corporation to be considered the
taxpayer’s trade or business, the
taxpayer must show that he or
she was individually in the busi-
ness of seeking out, promoting,
organizing, and financing busi-
ness ventures. Ronald L. Farring-
ton v. CIR, 65 AFTR 2d 90-616,
90-1 USTC ¶50,125
(DC Okla., 1990).
62 29 AFTR 2d 72-609, 72-1 USTC ¶9259 (USSC, 1972).
TAX PLANNING
CONSIDERATIONS
63 Reg. Sec. 1.166-8(a).
AVOIDING SEC. 351
Section 351 is not an elective provision. If its conditions are met, a corporate formation is
tax-free, even if the taxpayer does not want it to be. Most often, taxpayers desire Sec. 351
treatment because it allows them to defer gains when transferring appreciated property to
a corporation. In some cases, however, shareholders find such treatment disadvantageous
because they would like to recognize gain or loss on the property transferred.
AVOIDING NONRECOGNITION OF LOSSES UNDER SEC. 351. If a shareholder
transfers to a corporation property that has declined in value, the shareholder may want
to recognize the loss so it can offset income from other sources. The shareholder can rec-
ognize the loss only if the Sec. 351 nonrecognition rules and the Sec. 267 related party
rules do not apply to the exchange.
Avoiding Sec. 351 treatment requires that one or more of its requirements not be met.
The simplest way to accomplish this objective is to ensure that the transferors of property
do not receive 80% of the voting stock.
2-34 Corporations ▼ Chapter 2
KEY POINT
In many closely held corporations,
the shareholders are also employ-
ees. Thus, when a shareholder-
employee makes a loan to the
corporation, a question arises
whether the loan is being made
in the individual’s capacity as an
employee or a shareholder. The
distinction is important because
an employee loan that is worth-
less is entitled to ordinary loss
treatment, whereas a shareholder
loan that is worthless is treated as
a nonbusiness bad debt (short-
term capital loss).
EXAMPLE C:2-48 �
advance.62 If the advance is only “significantly motivated” by considerations relating to
the taxpayer’s trade or business, such motivation will not establish a proximate relation-
ship between the bad debt and the taxpayer’s trade or business. Therefore, it may result in
a nonbusiness bad debt characterization. On the other hand, if the advance is “domi-
nantly motivated” by considerations relating to the taxpayer’s trade or business, such
motivation usually is sufficient to establish such a proximate relationship. Therefore, it
may result in a business bad debt characterization.
Factors deemed important in determining the character of bad debt include the tax-
payer’s equity in the corporation relative to compensation paid by the corporation. For
example, a modest salary paid by the corporation relative to substantial stockholdings in
the corporation suggests an investment motive for the advance. Conversely, a substantial
salary paid by the corporation relative to modest stockholdings suggests a business motive
for the advance. The business motive at issue is the protection of the employee-lender’s
employment because the advance may help save the business from failing. Reasonable
minds may differ on what is substantial and what is modest, and monetary stakes often are
high in these cases. Consequently, the determination frequently involves litigation.
Top Corporation employs Mary as its legal counsel. It pays Mary an annual salary of $100,000. In
March of the current year, Mary advances the corporation $50,000 to assist it financially. In
October of the current year, Top declares bankruptcy and liquidates. In the liquidation, Mary
and other investors receive 10 cents on every dollar advanced. If Mary can show that her
advance was dominantly motivated by a desire to preserve her employment, her $45,000
($50,000 � 0.90) loss will be treated as business bad debt, ordinary in character, and fully
deductible in the current year. On the other hand, if Mary shows that the advance was only
significantly motivated by a desire to preserve her employment, her $45,000 loss will be treated
as nonbusiness bad debt, capital in character, and deductible in this year and in subsequent
years only to the extent of $3,000 in excess of any capital gains she recognizes. �
A loss sustained by a shareholder who guarantees a loan made by a third party to the
corporation generally is treated as a nonbusiness bad debt. The loss can be claimed only
to the extent the shareholder actually pays the third party and is unable to recover the
payment from the debtor corporation.63 Occasionally, the IRS treats the amount of a
shareholder advance as additional paid-in capital. In such circumstances, any worthless
security loss the shareholder claims for his or her equity investment may be increased by
this amount.
OBJECTIVE 7
Identify tax planning
opportunities in corporate
formations
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SELF-STUDY
QUESTION
Which tax provisions may poten-
tially limit a transferor share-
holder from recognizing a loss on
the transfer of property to a
corporation?
ANSWER
Such transfer cannot be to a con-
trolled corporation, or Sec. 351
will defer the loss. Even if Sec. 351
can be avoided, losses on sales
between a corporation and a
more-than-50% shareholder are
disallowed under Sec. 267. Thus,
to recognize a loss on the sale of
property, such shareholder must,
directly or indirectly, own 50% or
less of the transferee corpora-
tion’s stock.
EXAMPLE C:2-49 �
Corporate Formations and Capital Structure ▼ Corporations 2-35
Even if a shareholder avoids Sec. 351 treatment, he or she still may not be able to rec-
ognize the losses because of the Sec. 267 related party loss rules. Under Sec. 267(a)(1), if
the shareholder owns more than 50% of the corporation’s stock, directly or indirectly,
he or she is a related party and therefore cannot recognize loss on an exchange of prop-
erty for the corporation’s stock or other property. If the transferors of property receive
less than 80% of the corporation’s voting stock and if the transferor of loss property
does not own more than 50% of the stock, the transferor of loss property may recognize
the loss.
Lynn owns property having a $100,000 basis and a $60,000 FMV. If Lynn transfers the property
to White Corporation in a nontaxable exchange under Sec. 351, she will not recognize a loss,
which will be deferred until she sells her White stock. If the Sec. 351 requirements are not met,
she will recognize a $40,000 loss in the year she transfers the property. If Lynn receives 50% of
the White stock in exchange for her property, Cathy, an unrelated individual, receives 25% of
the stock in exchange for $30,000 cash, and John, another unrelated individual, receives the
remaining 25% for services performed, the Sec. 351 control requirement will not be met
because the transferors of property receive less than 80% of the White stock. Moreover, Lynn
will not be a related party under Sec. 267 because she will not own more than 50% of the stock
either directly or indirectly. Therefore, Lynn will recognize a $40,000 loss on the exchange. �
AVOIDING NONRECOGNITION OF GAIN UNDER SEC. 351. Sometimes a trans-
feror would like to recognize gain when he or she transfers appreciated property to a cor-
poration so the transferee corporation can get a stepped-up basis in the transferred prop-
erty. Some other reasons for recognizing gain are as follows:
� If the transferor’s gain is capital in character, he or she can offset this gain with capital
losses from other transactions.
� Individual long-term capital gains are taxed at the applicable capital gains rate, which
may be lower than the 35% top tax rate applicable to corporate-level capital gains.
� The corporation’s marginal tax rate may be higher than a noncorporate transferor’s
marginal tax rate. In such case, it might be beneficial for the transferor to recognize
gain so the corporation can get a stepped-up basis in the property. A stepped-up basis
would either reduce the corporation’s gain when it later sells the property or allow the
corporation to claim greater depreciation deductions when it uses the property.
A transferor who does not wish to recognize gain on the transfer of appreciated prop-
erty to a corporation can avoid Sec. 351 treatment through one of the following planning
techniques:
� The transferor can sell the property to the controlled corporation for cash.
� The transferor can sell the property to the controlled corporation for cash and debt.
This transaction involves relatively less cash than the previous transaction. However,
the sale may be treated as a nontaxable exchange if the IRS recharacterizes the debt as
equity.64
� The transferor can sell the property to a third party for cash and have the third party
contribute the property to the corporation for stock.
� The transferor can have the corporation distribute sufficient boot property so that,
even if Sec. 351 applies to the transaction, he or she will recognize gain.
� The transferors can fail one or more of the Sec. 351 tests. For example, if the transfer-
ors do not own 80% of the voting stock immediately after the exchange, the Sec. 351
control requirement will not have been met, and they will recognize gain.
� To trigger gain recognition under Sec. 357(b) or (c), the transferors may transfer to the
corporation either debt that exceeds the basis of all property transferred or debt that
lacks a business purpose.
ADDITIONAL
COMMENT
Any potential built-in gain on
property transferred to the trans-
feree corporation is duplicated
because such gain may be recog-
nized at the corporate level and
at the shareholder level. This dou-
ble taxation may be another rea-
son for avoiding the nonrecogni-
tion of gain under Sec. 351.
64 See, for example, Aqualane Shores, Inc. v. CIR, 4 AFTR 2d 5346, 59-2
USTC ¶9632 (5th Cir., 1959) and Sun Properties, Inc. v. U.S., 47 AFTR 273,
55-1 USTC ¶9261 (5th Cir., 1955).
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COMPLIANCE AND
PROCEDURAL
CONSIDERATIONS
ADDITIONAL
COMMENT
The required information pro-
vided to the IRS by both the
transferor-shareholders and the
transferee corporation should be
consistent. For example, the FMVs
assigned to the stock and other
properties included in the
exchange should be the same for
both sides of the transaction.
65 Reg. Sec. 1.351-3.
REPORTING REQUIREMENTS UNDER SEC. 351
A taxpayer who receives stock or other property in a Sec. 351 exchange must attach a
statement to his or her tax return for the period encompassing the date of the exchange.65
The statement must include all facts pertinent to the exchange, including:
� A description of the property transferred and its adjusted basis to the transferor
� A description of the stock received in the exchange, including its type, number of
shares, and FMV
� A description of any other securities received in the exchange, including principal
amount, terms, and FMV
� The amount of money received
� A description of any other property received, including its FMV
� A statement of the liabilities transferred to the corporation, including the nature of
the liabilities, when and why they were incurred, and the business reason for their
transfer
The transferee corporation must attach a statement to its tax return for the year in
which the exchange took place. The statement must include
� A complete description of all property received from the transferors
� The transferors’ adjusted bases in the property
� A description of the stock issued to the transferors
� A description of any other securities issued to the transferors
� The amount of money distributed to the transferors
� A description of any other property distributed to the transferors
� Information regarding the transferor’s liabilities assumed by the corporation
2-36 Corporations ▼ Chapter 2
EXAMPLE C:2-50 � Ten years ago, Jaime purchased land as an investment for $100,000. The land is now
worth $500,000. Jaime plans to transfer the land to Bell Corporation in exchange for all
its stock. Bell will subdivide the land and sell individual tracts. Its gain on the land sales
will be ordinary income. Jaime has realized a large capital loss in the current year and
would like to recognize capital gain on the transfer of the land to Bell. One way for Jaime
to accomplish this objective is to transfer the land to Bell in exchange for all the Bell stock
plus a note for $400,000. Because the note is boot, Jaime will recognize $400,000 of gain
even though Sec. 351 applies to the exchange. However, if the note is due in a subse-
quent year, Jaime’s gain will be deferred until collection unless she elects out of the
installment method. �
OBJECTIVE 8
Comply with procedural
rules for corporate
formations
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Corporate Formations and Capital Structure ▼ Corporations 2-37
C:2-1 What entities or business forms are available for a
new enterprise? Explain the advantages and dis-
advantages of each.
C:2-2 Alice and Bill plan to go into business together. In
the first two or three years, they anticipate losses,
which they would like to use to offset income
from other sources. They also are concerned
about exposing their personal assets to business
liabilities. Advise Alice and Bill as to what busi-
ness form would best meet their needs.
C:2-3 Bruce and Bob organize Black LLC on May 10 of
the current year. What is the entity’s default tax
classification? Are any alternative classification(s)
available? If so, (1) how do Bruce and Bob elect
the alternative classification(s) and (2) what are
the tax consequences of doing so?
C:2-4 John and Wilbur form White Corporation on
May 3 of the current year. What is the entity’s
default tax classification? Are any alternative
classification(s) available? If so, (1) how do
John and Wilbur elect the alternative classifica-
tion(s) and (2) what are the tax consequences of
doing so?
C:2-5 Barbara organizes Blue LLC on May 17 of the cur-
rent year. What is the entity’s default tax classifica-
tion? Are any alternative classification(s) available?
If so, (1) how does Barbara elect the alternative
classification(s) and (2) what are the tax conse-
quences of doing so?
C:2-6 Debate the following proposition: All corporate
formation transactions should be taxable events.
C:2-7 What are the tax consequences for the transferor
and transferee when property is transferred to a
newly created corporation in an exchange quali-
fying as nontaxable under Sec. 351?
C:2-8 What items are considered to be property for pur-
poses of Sec. 351(a)? What items are not consid-
ered to be property?
C:2-9 How is “control” defined for purposes of Sec.
351(a)?
C:2-10 Explain how the IRS has interpreted the phrase
“in control immediately after the exchange” for
purposes of a Sec. 351 exchange.
C:2-11 John and Mary each exchange property worth
$50,000 for 100 shares of New Corporation
stock. Peter exchanges services for 98 shares of
New stock and $1,000 in cash for two shares of
New stock. Are the Sec. 351 requirements met?
Explain why or why not. What advice would you
give the shareholders?
PR O B L E M M A T E R I A L S
DISCUSSION QUESTIONS
C:2-12 Does Sec. 351 require shareholders to receive
stock equal in value to the property transferred?
Suppose Fred and Susan each transfer property
worth $50,000 to Spade Corporation. In ex-
change, Fred receives 25 shares of Spade stock
and Susan receives 75 shares. Are the Sec. 351
requirements met? Explain the tax consequences
of the exchange.
C:2-13 Does Sec. 351 apply to property transfers to an
existing corporation? Suppose Carl and Lynn
each own 50 shares of North Corporation stock.
Carl transfers property worth $50,000 to North
for an additional 25 shares. Does Sec. 351 apply?
Explain why or why not. If not, what can be done
to qualify the transaction for Sec. 351 treatment?
C:2-14 How are a transferor’s basis and holding period
determined for stock and other property (boot)
received in a Sec. 351 exchange? How does the
transferee corporation’s assumption of liabilities
affect the transferor’s basis in the stock?
C:2-15 Under what circumstances is a corporation’s
assumption of liabilities considered boot in a Sec.
351 exchange?
C:2-16 What factor(s) would the IRS likely consider to
determine whether the transfer of a liability to a
corporation in a Sec. 351 exchange was moti-
vated by a business purpose?
C:2-17 Mark transfers all the property of his sole propri-
etorship to newly formed Utah Corporation in
exchange for all the Utah stock. Mark has claimed
depreciation on some of the property. Under what
circumstances is Mark required to recapture
previously claimed depreciation deductions? How
is the depreciation deduction for the year of trans-
fer calculated? What are the tax consequences if
Utah sells the depreciable property?
C:2-18 How does the assignment of income doctrine
apply to a Sec. 351 exchange?
C:2-19 What factors did Congress mandate to be consid-
ered in determining whether indebtedness is clas-
sified as debt or equity for tax purposes?
C:2-20 What are the advantages and disadvantages of
using debt in a firm’s capital structure?
C:2-21 What are the advantages of Sec. 1244 loss treat-
ment when a stock investment becomes worthless?
What conditions must be met to qualify for this
treatment?
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2-38 Corporations ▼ Chapter 2
C:2-22 What are the advantages of business bad debt
treatment when a shareholder’s loan or advance
to a corporation cannot be repaid? What must
the debtholder show to claim a business bad debt
deduction?
C:2-23 Why might shareholders avoid Sec. 351 treat-
ment? Explain three ways they can accomplish
this end.
C:2-24 What are the Sec. 351 reporting requirements?
ISSUE IDENTIFICATION QUESTIONS
C:2-25 Peter Jones has owned all 100 shares of Trenton Corporation stock for the past five years.
This year, Mary Smith contributes property with a $50,000 basis and an $80,000 FMV
for 80 newly issued Trenton shares. At the same time, Peter contributes $15,000 in cash
for 15 newly issued Trenton shares. What tax issues regarding the exchanges should Mary
and Peter consider?
C:2-26 Carl contributes equipment with a $50,000 adjusted basis and an $80,000 FMV to Cook
Corporation for 50 of its 100 shares of stock. His son, Carl Jr., contributes $20,000 cash
for the remaining 50 Cook shares. What tax issues regarding the exchanges should Carl
and his son consider?
C:2-27 Several years ago, Bill acquired 100 shares of Bold Corporation stock directly from the
corporation for $100,000 in cash. This year, he sold the stock to Sam for $35,000. What
tax issues regarding the stock sale should Bill consider?
PROBLEMS
C:2-28 Organizational Forms Available. Lucia, a single taxpayer, operates a florist business. She
is considering either continuing the business as a sole proprietorship or reorganizing it as
a either a C corporation or an S corporation. Her goal is to withdraw $20,000 of profits
from the business annually while minimizing her total tax liability. She expects the busi-
ness to generate annually $50,000 of taxable income before considering a deductible
salary expense (see below). Which business form(s) can best achieve Lucia’s goals?
Remember that a shareholder is taxed on S corporation income whether withdrawn or
not and is not taxed on the actual withdrawals or distributions. Assume that a C corpora-
tion would be in the 15% corporate tax bracket, that Lucia is in the 25% individual
tax bracket for ordinary income, and that Lucia is taxed at 15% on dividend income.
When considering either corporate option, perform the analysis first by treating any
withdrawals as deductible salary payments of the corporation. Then do the analysis by
treating them as nondeductible dividends or distributions. Ignore employment taxes.
C:2-29 Transfer of Property and Services to a Controlled Corporation. In 2013, Dick, Evan, and
Fran form Triton Corporation. Dick contributes land (a capital asset) having a $50,000
FMV in exchange for 50 shares of Triton stock. He purchased the land in 2011 for
$60,000. Evan contributes machinery (Sec. 1231 property purchased in 2010) having a
$45,000 adjusted basis and a $30,000 FMV in exchange for 30 shares of Triton stock.
Fran contributes services worth $20,000 in exchange for 20 shares of Triton stock.
a. What is the amount of Dick’s recognized gain or loss?
b. What is Dick’s basis in his Triton shares? When does his holding period begin?
c. What is the amount of Evan’s recognized gain or loss?
d. What is Evan’s basis in his Triton shares? When does his holding period begin?
e. How much income, if any, does Fran recognize?
f. What is Fran’s basis in her Triton shares? When does her holding period begin?
g. What is Triton’s basis in the land and the machinery? When does its holding period
begin? How does Triton treat the amount paid to Fran for her services?
C:2-30 Transfer of Property and Services to a Controlled Corporation. In 2013, Ed, Fran, and
George form Jet Corporation. Ed contributes land having a $35,000 FMV purchased
as an investment in 2009 for $15,000 in exchange for 35 shares of Jet stock. Fran
contributes machinery (Sec. 1231 property) purchased in 2009 and used in her business in
exchange for 35 shares of Jet stock. Immediately before the exchange, the machinery had
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
Corporate Formations and Capital Structure ▼ Corporations 2-39
a $45,000 adjusted basis and a $35,000 FMV. George contributes services worth $30,000
in exchange for 30 shares of Jet stock.
a. What is the amount of Ed’s recognized gain or loss?
b. What is Ed’s basis in his Jet shares? When does his holding period begin?
c. What is the amount of Fran’s recognized gain or loss?
d. What is Fran’s basis in her Jet shares? When does her holding period begin?
e. How much income, if any, does George recognize?
f. What is George’s basis in his Jet shares? When does his holding period begin?
g. What is Jet’s basis in the land and the machinery? When does its holding period begin?
How does Jet treat the amount paid to George for his services?
h. How would your answers to Parts a through g change if George instead contributed
$5,000 in cash and services worth $25,000 for his 30 shares of Jet stock?
C:2-31 Control Requirement. In which of the following independent situations is the Sec. 351
control requirement met?
a. Olive transfers property to Quick Corporation for 75% of Quick stock, and Mary pro-
vides services to Quick for the remaining 25% of Quick stock.
b. Pete transfers property to Target Corporation for 60% of Target stock, and Robert
transfers property worth $15,000 and performs services worth $25,000 for the
remaining 40% of Target stock.
c. Herb and his wife, Wilma, each have owned 50 of the 100 outstanding shares of Vast
Corporation stock since it was formed three years ago. In the current year, their son,
Sam, transfers property to Vast for 50 newly issued shares of Vast stock.
d. Charles and Ruth develop a plan to form Tiny Corporation. On June 3 of this year,
Charles transfers property worth $50,000 for 50 shares of Tiny stock. On August 1,
Ruth transfers $50,000 cash for 50 shares of Tiny stock.
e. Assume the same facts as in Part d except that Charles has a prearranged plan to sell 30
of his shares to Sam on October 1.
C:2-32 Control Requirement. In which of the following unrelated exchanges is the Sec. 351 con-
trol requirement met? If the transaction does not meet the Sec. 351 requirements, suggest
ways in which the transaction can be structured so as to meet these requirements.
a. Fred exchanges property worth $50,000 and services worth $50,000 for 100 shares of
New Corporation stock. Greta exchanges $100,000 cash for the remaining 100 shares
of New stock.
b. Maureen exchanges property worth $2,000 and services worth $48,000 for 100 shares
of Gemini Corporation stock. Norman exchanges property worth $50,000 for the
remaining 100 shares of Gemini stock.
C:2-33 Control Requirement. Sam and Veronica own 300 and 200 shares, respectively, of
Poly-Electron Corporation stock, which represent all the shares outstanding. The current
market value per share is $25. Poly-Electron needs capital to expand its operations, and
Veronica is willing to contribute to Poly-Electron silver bullion against which the corpo-
ration can borrow operating funds. Veronica purchased the bullion 12 years ago, when its
cost was a fraction of its current market value. If Veronica wants to avoid recognizing a
gain upon transferring the bullion to the corporation, how many additional shares must
she receive in exchange for the bullion, and what value of silver bullion should she con-
tribute to Poly-Electron in exchange for additional shares? Hint: Veronica needs to
achieve 80% control of the corporation.
C:2-34 Sec. 351 Requirements. Al, Bob, and Carl form West Corporation and transfer the fol-
lowing items to West:
Al Patent –0– $25,000 1,000 common
Bob Cash $25,000 25,000 250 preferred
Carl Services –0– 7,500 300 common
The common stock has voting rights. The preferred stock does not.
a. Is the exchange nontaxable under Sec. 351? Explain the tax consequences of the
exchange to Al, Bob, Carl, and West.
Shares Received
by TransferorFMV
Transferor’s
BasisItemTransferor
Item Transferred
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2-40 Corporations ▼ Chapter 2
b. How would your answer to Part a change if Bob instead had received 200 shares of
common stock and 200 shares of preferred stock?
c. How would your answer to Part a change if Carl instead had contributed $800 cash as
well as services worth $6,700?
C:2-35 Incorporating a Sole Proprietorship. Tom incorporates his sole proprietorship as Total
Corporation and transfers its assets to Total in exchange for all 100 shares of Total stock
and four $10,000 interest-bearing notes. The stock has a $125,000 FMV. The notes
mature consecutively on the first four anniversaries of the incorporation date. The assets
transferred are as follows:
Cash $ 5,000 $ 5,000
Equipment $130,000
Minus: Accumulated depreciation ) 60,000 90,000
Building $100,000
Minus: Accumulated depreciation ) 51,000 40,000
Land
Total
a. What are the amounts and character of Tom’s recognized gains or losses?
b. What is Tom’s basis in the Total stock and notes?
c. What is Total’s basis in the property received from Tom?
C:2-36 Transfer to an Existing Corporation. For the last five years, Ann and Fred each have
owned 50 of the 100 outstanding shares of Zero Corporation stock. Ann transfers land
having a $10,000 basis and a $25,000 FMV to Zero for an additional 25 shares of Zero
stock. Fred transfers $1,000 cash to Zero for one additional share of Zero stock. What
amount of the gain or loss must Ann recognize on the exchange? If the transaction does
not meet the Sec. 351 requirements, suggest ways in which it can be structured so as to
meet these requirements.
C:2-37 Transfer to an Existing Corporation. For the last three years, Lucy and Marvin each
have owned 50 of the 100 outstanding shares of Lucky Corporation stock. Lucy transfers
property having an $8,000 basis and a $12,000 FMV to Lucky for an additional ten
shares of Lucky stock. How much gain or loss must Lucy recognize on the exchange? If
the transaction does not meet the Sec. 351 requirements, suggest ways in which it can be
structured so as to meet these requirements.
C:2-38 Disproportionate Receipt of Stock. Jerry transfers property with a $28,000 adjusted
basis and a $50,000 FMV to Texas Corporation for 75 shares of Texas stock. Frank,
Jerry’s father, transfers property with a $32,000 adjusted basis and a $50,000 FMV to
Texas for the remaining 25 shares of Texas stock.
a. What is the amount of each transferor’s recognized gain or loss?
b. What is Jerry’s basis in his Texas stock?
c. What is Frank’s basis in his Texas stock?
C:2-39 Sec. 351: Boot Property Received. Sara transfers land (a capital asset) having a $30,000
adjusted basis to Temple Corporation in a Sec. 351 exchange. In return, Sara receives the
following consideration:
100 shares of Temple common stock $100,000
50 shares of Temple qualified preferred stock 50,000
Temple note due in three years
Total
a. What are the amount and character of Sara’s recognized gain or loss?
b. What is Sara’s basis in her common stock, preferred stock, and note?
c. What is Temple’s basis in the land?
C:2-40 Receipt of Bonds for Property. Joe, Karen, and Larry form Gray Corporation. Joe con-
tributes land (a capital asset) having an $8,000 adjusted basis and a $15,000 FMV to
$170,000
20,000
FMVConsideration
$165,000$140,000
30,00024,000
(49,000
(70,000
FMV
Adjusted
BasisAssets
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Corporate Formations and Capital Structure ▼ Corporations 2-41
Gray in exchange for Gray ten-year notes having a $15,000 face value. Karen contributes
equipment (Sec. 1231 property) having an $18,000 adjusted basis and a $25,000 FMV
for 50 shares of Gray stock. She previously claimed $10,000 of depreciation on the equip-
ment. Larry contributes $25,000 cash for 50 shares of Gray stock.
a. What are the amount and character of Joe’s, Karen’s, and Larry’s recognized gains or
losses?
b. What basis do Joe, Karen, and Larry take in the stock or notes they receive?
c. What basis does Gray take in the land and equipment? What happens to the $10,000
of depreciation recapture potential on the equipment?
C:2-41 Transfer of Depreciable Property. Nora transfers to Needle Corporation depreciable
machinery originally costing $18,000 and now having a $15,000 adjusted basis. In
exchange, Nora receives all 100 shares of Needle stock having an $18,000 FMV and a
three-year Needle note having a $4,000 FMV.
a. What are the amount and character of Nora’s recognized gain or loss?
b. What are Nora’s bases in the Needle stock and note?
c. What is Needle’s basis in the machinery?
C:2-42 Transfer of Personal Liabilities. Jim owns 80% of Gold Corporation stock. He transfers
a business automobile to Gold in exchange for additional Gold stock worth $5,000 and
Gold’s assumption of both his $1,000 automobile debt and his $2,000 education loan.
The automobile originally cost Jim $12,000 and, on the transfer date, has a $4,500
adjusted basis and an $8,000 FMV.
a. What are the amount and character of Jim’s recognized gain or loss?
b. What is Jim’s basis in his additional Gold shares?
c. When does Jim’s holding period for the additional shares begin?
d. What basis does Gold take in the automobile?
C:2-43 Liabilities in Excess of Basis. Barbara transfers to Moore Corporation $10,000 cash and
machinery having a $15,000 basis and a $35,000 FMV in exchange for 50 shares of
Moore stock. The machinery was used in Barbara’s business, originally cost Barbara
$50,000, and is subject to a $28,000 liability, which Moore assumes. Sam exchanges
$17,000 cash for the remaining 50 shares of Moore stock.
a. What are the amount and character of Barbara’s recognized gain or loss?
b. What is Barbara’s basis in the Moore stock?
c. What is Moore’s basis in the machinery?
d. What are the amount and character of Sam’s recognized gain or loss?
e. What is Sam’s basis in the Moore stock?
f. When do Barbara and Sam’s holding periods for their stock begin?
g. How would your answers to Parts a through f change if Sam received $17,000 of
Moore stock for legal services (instead of cash)?
C:2-44 Transfer of Business Properties. Jerry transfers to Emerald Corporation property
having a $32,000 adjusted basis and a $50,000 FMV in exchange for all of Emerald’s
stock worth $15,000 and Emerald’s assumption of a $35,000 mortgage on the
property.
a. What is the amount of Jerry’s recognized gain or loss?
b. What is Jerry’s basis in the Emerald stock?
c. What is Emerald’s basis in the property?
d. How would your answers to Parts a through c change if the mortgage assumed by
Emerald were $15,000 and the Emerald stock were worth $35,000?
C:2-45 Incorporating a Cash Basis Proprietorship. Ted decides to incorporate his medical prac-
tice. He uses the cash method of accounting. On the date of incorporation, the practice
reports the following balance sheet:
Assets:
Cash $ 5,000 $ 5,000
Accounts receivable –0– 65,000
Equipment (net of $15,000 depreciation)
Total $110,000$40,000
40,00035,000
FMVBasis
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2-42 Corporations ▼ Chapter 2
Liabilities and Owner’s Equity:
Current liabilities $ –0– $ 35,000
Note payable on equipment 15,000 15,000
Owner’s equity
Total
All the current liabilities would be deductible by Ted if he paid them. Ted transfers all the
assets and liabilities to a professional corporation in exchange for all of its stock.
a. What are the amount and character of Ted’s recognized gain or loss?
b. What is Ted’s basis in the stock?
c. What is the corporation’s basis in the property?
d. Who recognizes income on the receivables upon their collection? Can the corporation
obtain a deduction for the liabilities when it pays them?
C:2-46 Transfer of Depreciable Property. On January 10, 2013, Mary transfers to Green
Corporation a machine purchased on March 3, 2010, for $100,000. On the transfer
date, the machine has a $60,000 adjusted basis and a $110,000 FMV. Mary receives all
100 shares of Green stock, worth $100,000, and a two-year Green note worth
$10,000.
a. What are the amount and character of Mary’s recognized gain or loss?
b. What is Mary’s basis in the stock and note? When does her holding period begin?
c. What are the amount and character of Green’s gain or loss?
d. What is Green’s basis in the machine? When does Green’s holding period begin?
C:2-47 Contribution to Capital by a Nonshareholder. The City of Omaha donates land worth
$500,000 to Ace Corporation to induce it to locate in Omaha and create an estimated
2,000 jobs for its citizens.
a. How much income, if any, must Ace report on the land contribution?
b. What basis does Ace take in the land?
c. Assume the same facts except the City of Omaha also donated to Ace $100,000 cash,
which the corporation used to pay a portion of the $250,000 cost of equipment that it
purchased six months later. How much income, if any, must Ace report on the cash con-
tribution? What basis does Ace take in the equipment?
C:2-48 Choice of Capital Structure. Kobe transfers $500,000 in cash to newly formed Bryant
Corporation for 100% of Bryant’s stock. In the first year of operations, Bryant’s taxable
income before any payments to Kobe is $120,000. What total amount of taxable income
must Kobe and Bryant each report in the following two scenarios?
a. Bryant pays a $70,000 dividend to Kobe.
b. Assume that when Bryant was formed, Kobe transferred his $500,000 to the corpora-
tion for $250,000 of Bryant stock and $250,000 in Bryant notes. The notes are
repayable in five annual installments of $50,000 plus 8% annual interest on the unpaid
balance. During the current year, Bryant gives Kobe $50,000 in repayment of the first
note plus $20,000 interest.
C:2-49 Worthless Stock or Securities. Tom and Vicki, husband and wife who file a joint return,
each purchase for $75,000 one-half the stock in Guest Corporation from Al. Tom is
employed full-time by Guest and earns $100,000 in annual salary. Because of Guest’s
financial difficulties, Tom and Vicki each lend Guest an additional $25,000. The $25,000
is secured by bonds and is repayable in five years, with interest accruing at the prevailing
market rate. Guest’s financial difficulties escalate, and it eventually declares bankruptcy.
Tom and Vicki receive nothing for their Guest stock or Guest bonds.
a. What are the amount and character of each shareholder’s loss on the worthless stock
and bonds?
b. How would your answer to Part a change if the liability were not secured by bonds?
c. How would your answer to Part a change if Tom and Vicki had purchased their stock
for $75,000 each at the time Guest was formed?
C:2-50 Worthless Stock. Duck Corporation is owned equally by Harry, Susan, and Big
Corporation. Harry and Susan are single. In 2005, Harry, Tom, and Big, the original
investors in Duck, each paid $125,000 for their Duck stock. Susan purchased her stock
from Tom in 2008 for $175,000. No adjustments to basis occur after the stock acquisi-
tion date. Duck encounters financial difficulties as a result of a lawsuit brought by a
customer who suffered personal injuries from using a defective product. Duck files for
$110,000$40,000
60,00025,000
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Corporate Formations and Capital Structure ▼ Corporations 2-43
bankruptcy, and uses all its assets to pay its creditors in 2013. What are the amount and
character of each shareholder’s loss?
C:2-51 Sale of Sec. 1244 Stock. Lois, who is single, transfers property with an $80,000 basis and
a $120,000 FMV to Water Corporation in exchange for all 100 shares of Water stock.
The shares qualify as Sec. 1244 stock. Two years later, Lois sells the shares for $28,000.
a. What are the amount and character of Lois’s recognized gain or loss?
b. How would your answer to Part a change if the FMV of the property were $70,000?
C:2-52 Transfer of Sec. 1244 Stock. Assume the same facts as in Problem C:2-51 except that
Lois gave the Water stock to her daughter, Sue, six months after she received it. The stock
had a $120,000 FMV when Lois acquired it and when she made the gift. Sue sold the
stock two years later for $28,000. How is the loss treated for tax purposes?
C:2-53 Avoiding Sec. 351 Treatment. Six years ago, Donna purchased land as an investment.
The land cost $150,000 and is now worth $480,000. Donna plans to transfer the
land to Development Corporation, which will subdivide it and sell individual tracts.
Development’s income on the land sales will be ordinary in character.
a. What are the tax consequences of the asset transfer and land sales if Donna contributes
the land to Development in exchange for all its stock?
b. In what alternative ways can the transaction be structured to achieve more favorable
tax results? Assume Donna’s marginal tax rate is 39.6%, and Development’s marginal
tax rate is 34%.
COMPREHENSIVE PROBLEMS
C:2-54 On March 1 of the current year, Alice, Bob, Carla, and Dick form Bear Corporation and
transfer the following items:
Alice Land $12,000 $30,000
Building 38,000 70,000 400
Mortgage on the land
and building 60,000 60,000
Bob Equipment 25,000 40,000 300
Carla Van 15,000 10,000 50
Dick Accounting services –0– 10,000 100
Alice purchased the land and building several years ago for $12,000 and $50,000, respec-
tively. Alice has claimed straight-line depreciation on the building. Bob also receives a
Bear note for $10,000 due in three years. The note bears interest at the prevailing market
rate. Bob purchased the equipment three years ago for $50,000. Carla also receives
$5,000 cash. Carla purchased the van two years ago for $20,000.
a. Does the transaction satisfy the requirements of Sec. 351?
b. What are the amount and character of the gains or losses recognized by Alice, Bob,
Carla, Dick, and Bear?
c. What is each shareholder’s basis in his or her Bear stock? When does the holding
period for the stock begin?
d. What is Bear’s basis in its property and services? When does the holding period for
each property begin?
C:2-55 On June 3 of the current year, Eric, Florence, and George form Wildcat Corporation and
transfer the following items:
Eric Land $200,000 $50,000 500
Florence Equipment –0– 25,000 250
George Legal services –0– 25,000 250
Number of
Common
Shares IssuedFMV
Basis to
TransferorAssetTransferor
Item Transferred
Number of
Common
Shares IssuedFMV
Basis to
TransferorAssetTransferor
Property Transferred
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2-44 Corporations ▼ Chapter 2
Eric purchased the land (a capital asset) five years ago for $200,000. Florence purchased
the equipment three years ago for $48,000. The equipment has been fully depreciated.
a. Does the transaction meet the requirements of Sec. 351?
b. What are the amount and character of the gains or losses recognized by Eric, Florence,
George, and Wildcat?
c. What is each shareholder’s basis in his or her Wildcat stock? When does the holding
period for the stock begin?
d. What is Wildcat’s basis in the land, equipment, and services? When does the holding
period for each property begin?
TAX STRATEGY PROBLEMS
C:2-56 Assume the same facts as in Problem C:2-55.
a. Under what circumstances is the tax result in Problem C:2-55 beneficial, and for which
shareholders? Are the shareholders likely to be pleased with the result?
b. If the shareholders decide that meeting the Sec. 351 requirements would generate a
greater tax benefit, how might they proceed?
C:2-57 Paula Green owns and operates the Green Thumb Nursery as a sole proprietorship. The
business has total assets with a $260,000 adjusted basis and a $500,000 FMV. Paula
wants to expand into the landscaping business. She views this expansion as risky and
therefore wants to incorporate so as not to put her personal assets at risk. Her friend,
Mary Brown, is willing to invest $250,000 in the enterprise.
Although Green Thumb has earned approximately $55,000 per year, Paula and
Mary expect that, when the landscaping business is launched, the new corporation will
incur annual losses of $50,000 for the next two years. They expect profits of at least
$80,000 annually, beginning in the third year. Paula and Mary earn approximately
$50,000 from other sources. They are considering the following alternative capital
structures and elections:
a. Green Thumb issues 50 shares of common stock to Paula and 25 shares of common
stock to Mary.
b. Green Thumb issues 50 shares of common stock to Paula and a $250,000 ten-year
note bearing interest at 8% to Mary.
c. Green Thumb issues 40 shares of common stock to Paula plus a $100,000 ten-year
note bearing interest at 6% and 15 shares of common stock to Mary, plus a $100,000
ten-year note bearing interest at 6%.
d. Green Thumb issues 50 shares of common stock to Paula and 25 shares of preferred
stock to Mary. The preferred stock is nonparticipating but pays a cumulative preferred
dividend at 8% of its $250,000 stated value.
What are the advantages and disadvantages of each of these alternatives? What consider-
ations are relevant for determining the best alternative?
C:2-58 Assume the same facts as in Problem C:2-57.
a. Given the nursery’s operating prospects, what business forms might Paula and Mary
consider and why?
b. In light of their proposed use of debt and equity, how might Paula and Mary structure
a partnership to achieve their various business and investment objectives?
CASE STUDY PROBLEMS
C:2-59 Bob Jones has a small repair shop that he has run for several years as a sole proprietor-
ship. The proprietorship uses the cash method of accounting and the calendar year as its
tax year. Bob needs additional capital for expansion and knows two people who might be
interested in investing in the business. One would like to work for the business. The other
would only invest.
Bob wants to know the tax consequences of incorporating the business. His business
assets include a building, equipment, accounts receivable, and cash. Liabilities include a
mortgage on the building and a few accounts payable, which are deductible when paid.
Assume that Bob’s ordinary tax rate is greater than 25%.
Required: Write a memorandum to Bob explaining the tax consequences of the incor-
poration. As part of your memorandum examine the possibility of having the corporation
issue common and preferred stock and debt for the shareholders’ property and money.
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Corporate Formations and Capital Structure ▼ Corporations 2-45
C:2-60 Eric Wright conducts a dry cleaning business as a sole proprietorship. The business oper-
ates in a building that Eric owns. Last year, Eric mortgaged for $150,000 the building and
the land on which the building sits. He used the money for a down payment on his per-
sonal residence and college expenses for his two children. He now wants to incorporate
his business and transfer the building and the mortgage to a new corporation, along with
other assets and some accounts payable. The amount of the unpaid mortgage balance will
not exceed Eric’s adjusted basis in the land and building at the time he transfers them to
the corporation. Eric is aware that Sec. 357(b) could impact the tax consequences of the
transaction because no bona fide business purpose exists for the mortgage transfer, which
the IRS might consider to have been for a tax avoidance purpose. However, Eric refuses to
acknowledge this possibility when you confront him. He maintains that many taxpayers
play the audit lottery and that, in the event of an audit, invoking this issue could be a
bargaining ploy.
Required: What information about the transaction must be provided with the trans-
feror and transferee’s tax returns for the year in which the transfer takes place? Discuss
the ethical issues raised by the AICPA’s Statements on Standards for Tax Services No. 1,
Tax Return Positions (which can be found in Appendix E) as it relates to this situation.
Should the tax practitioner act as an advocate for the client? Should the practitioner sign
the return?
TAX RESEARCH PROBLEMS
C:2-61 Anne and Michael own and operate a successful mattress business. They have decided to
take the business public. They contribute all the assets of the business to newly formed
Spring Corporation each in exchange for 20% of the stock. The remaining 60% is issued
to an underwriting company that will sell the stock to the public and charge 10% of the
sales proceeds as a commission. Prepare a memorandum for your tax manager explaining
whether or not this transaction meets the tax-free requirements of Sec. 351.
C:2-62 Bob and Carl transfer property to Stone Corporation for 90% and 10% of Stone stock,
respectively. Pursuant to a binding agreement concluded before the transfer, Bob sells half
of his stock to Carl. Prepare a memorandum for your tax manager explaining why the
exchange does or does not meet the Sec. 351 control requirement. Your manager has sug-
gested that, at a minimum, you consult the following authorities:
• IRC Sec. 351
• Reg. Sec. 1.351-1
C:2-63 In an exchange qualifying for Sec. 351 tax-free treatment, Greta receives 100 shares of
White Corporation stock plus a right to receive another 25 shares. The right is contingent
on the valuation of a patent contributed by Greta. Because the patent license is pending,
the patent cannot be valued for several months. Prepare a memorandum for your tax
manager explaining whether the underlying 25 shares are considered “stock” for pur-
poses of Sec. 351 and what tax consequences ensue from Greta’s receipt of the 100 shares
now and 25 shares later upon exercise of the right.
C:2-64 Your clients, Lisa and Matthew, are planning to form Lima Corporation. Lisa will con-
tribute $50,000 cash to Lima for 50 shares of its stock. Matthew will contribute land hav-
ing a $35,000 adjusted basis and a $50,000 FMV for 50 shares of Lima stock. Lima will
borrow additional capital from a bank and then will subdivide and sell the land. Prepare
a memorandum for your tax manager outlining the tax treatment of the corporate
formation. In your memorandum, compare tax and financial accounting for this transac-
tion. References:
• IRC Sec. 351
• Accounting Standards Codification (ASC) 845 (Nonmonetary Transactions), formerly
APB No. 29
C:2-65 John plans to transfer the assets and liabilities of his business to Newco in exchange for all
of Newco’s stock. The assets have a $250,000 basis and an $800,000 FMV. John also
plans to transfer $475,000 of business related liabilities to Newco. Under Sec. 357(c), can
John avoid recognizing a $175,000 gain (the excess of liabilities over the basis of assets
tranferred) by transferring a $175,000 personal promissory note along with the assets and
liabilities?
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2-46 Corporations ▼ Chapter 2
C:2-66 Six years ago, Leticia, Monica, and Nathaniel organized Lemona Corporation to develop
and sell computer software. Each individual contributed $10,000 to Lemona in exchange
for 1,000 shares of Lemona stock (for a total of 3,000 shares issued and outstanding).
The corporation also borrowed $250,000 from Venture Capital Associates to finance
operating costs and capital expenditures.
Because of intense competition, Lemona struggled in its early years of operation and
sustained chronic losses. This year, Leticia, who serves as Lemona’s president, decided to
seek additional funds to finance Lemona’s working capital.
Venture Capital Associates declined Leticia’s request for additional capital because of
the firm’s already high credit exposure to the software corporation. Hi-Tech Bank pro-
posed to lend Limona $100,000, but at a 10% premium over the prime rate. (Other soft-
ware manufacturers in the same market can borrow at a 3% premium.) Investment
Managers LLC proposed to inject $50,000 of equity capital into Lemona, but on the con-
dition that the investment firm be granted the right to elect five members to Lemona’s
board of directors. Discouraged by the “high cost” of external borrowing, Leticia turned
to Monica and Nathaniel.
She proposed to Monica and Nathaniel that each of the three original investors con-
tribute an additional $25,000 to Lemona, each in exchange for five 20-year debentures.
The debentures would be unsecured and subordinated to Venture Capital Associates debt.
Annual interest on the debentures would accrue at a floating 5% premium over the prime
rate. The right to receive interest payments would be cumulative; that is, each debenture
holder would be entitled to past and current interest payents before Lemona’s board could
declare a common stock dividend. The debentures would be both nontransferable and
noncallable.
Leticia, Monica, and Nathaniel have asked you, their tax accountant, to advise them
on the tax implications of the proposed financing arrangement. After researching the
issue, set forth your advice in a client letter. At a minimum, you should consult the follow-
ing authorities:
• IRC Sec. 385
• Rudolph A. Hardman, 60 AFTR 2d 87-5651, 82-7 USTC ¶9523 (9th Cir., 1987)
• Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ¶9438 (5th Cir.,
1967)
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3
3-1
LEARNING OBJECTIVES
After studying this chapter, you should be able to
1 Select tax years and accounting methods for C corporations
2 Calculate deductions particular to corporations and arrive at corporate
taxable income
3 Compute a corporation’s regular income tax liability
4 Recognize what a controlled group is and determine the tax
consequences of being a controlled group
5 Identify planning strategies to reduce taxes for corporations and their
shareholders
6 Comply with corporate tax filing requirements
7 Determine the financial statement implications of corporate federal
income taxes
C H A P T E R
THE
CORPORATE
INCOME TAX
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3-2 Corporations ▼ Chapter 3
CHAPTER OUTLINE
Corporate Elections…3-2
Determining a Corporation’s
Taxable Income…3-5
Computing a Corporation’s
Income Tax Liability…3-22
Controlled Groups of
Corporations…3-24
Tax Planning Considerations…3-31
Compliance and Procedural
Considerations…3-35
Financial Statement
Implications…3-43
OBJECTIVE 1
Select tax years and
accounting methods for
C corporations
KEY POINT
Whereas partnerships and S cor-
porations generally must adopt a
calendar year, C corporations
(other than personal service cor-
porations) have the flexibility of
adopting a fiscal year. The fiscal
year must end on the last day of
the month.
CORPORATE ELECTIONS
1 Sec. 7701(a)(4). Corporations that are not classified as domestic are for-
eign corporations. Foreign corporations are taxed like domestic corpora-
tions if they conduct a trade or business in the United States.
2 Sec. 441. Section 441 also permits accounting periods of either 52 or 53
weeks that always end on the same day of the week (such as Friday).
3 Sec. 443(a)(2).
Once formed, a corporation must make certain elections, such as selecting its tax year and
its accounting methods. The corporation makes these elections on its first tax return.
They are important and should be considered carefully because, once made, they gener-
ally can be changed only with permission from the Internal Revenue Service (IRS).
CHOOSING A CALENDAR OR FISCAL YEAR
A new corporation may elect to use either a calendar year or a fiscal year as its account-
ing period. The corporation’s tax year must be the same as the annual accounting period
used for financial accounting purposes. The corporation makes the election by filing its
first tax return for the selected period. A calendar year is a 12-month period ending on
December 31. A fiscal year is a 12-month period ending on the last day of any month
other than December. Examples of acceptable fiscal years are February 1, 2013, through
January 31, 2014, and October 1, 2013, through September 30, 2014. A fiscal year that
runs from September 16, 2013, through September 15, 2014, however, is not an accept-
able tax year because it does not end on the last day of the month. The IRS requires that
a corporation using an unacceptable tax year change to a calendar year.2
SHORT TAX PERIOD. A corporation’s first tax year might not cover a full 12-month
period. If, for example, a corporation begins business on March 10, 2013, and elects a fis-
cal year ending on September 30, its first tax year covers the period from March 10, 2013,
through September 30, 2013. Its second tax year covers the period from October 1, 2013,
through September 30, 2014. The corporation must file a short-period tax return for its
first tax year.3 From then on, its tax returns will cover a full 12-month period. The last
year of a corporation’s life, however, also may be a short period covering the period from
the beginning of the last tax year through the date the corporation ceases to exist.
RESTRICTIONS ON ADOPTING A TAX YEAR. A corporation may be subject to
restrictions in its choice of a tax year. For example, an S corporation generally must use a
calendar year (see Chapter C:11), and members of an affiliated group filing a consolidated
return must use the same tax year as the group’s parent corporation (see Chapter C:8).
A personal service corporation (PSC) generally must use a calendar year as its tax year.
This restriction prevents a personal service corporation with, for example, a January 31
year-end from distributing a large portion of its income earned during the February
through December portion of 2013 to its calendar year shareholder-employees in January
A corporation is a separate taxpaying entity that must file an annual tax return even if it
has no income or loss for the year. This chapter covers the tax rules for domestic corpora-
tions (i.e., corporations incorporated in one of the 50 states or under federal law) and
other entities taxed as domestic corporations under the check-the-box regulations.1 It
explains the rules for determining a corporation’s taxable income, loss, and tax liability
and for filing corporate tax returns. See Table C:3-1 for the general formula for determin-
ing the corporate tax liability. It also discusses the financial implications of federal income
taxes. Some of these implications appear briefly in the Book-to-Tax Accounting
Comparisons, and a more detailed discussion appears at the end of this chapter.
The corporations discussed in this chapter are sometimes referred to as regular or C
corporations because Subchapter C of the Internal Revenue Code (IRC) dictates much of
their tax treatment. Corporations that have a special tax status include S corporations (see
Chapter C:11) and affiliated groups of corporations that file consolidated returns (see
Chapter C:8). A comparison of the tax treatments of C corporations, partnerships, and S
corporations appears in Appendix F.
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The Corporate Income Tax ▼ Corporations 3-3
� TABLE C:3-1
General Rules for Determining the Corporate Tax Liability
Income Tax
Gross income
Minus: Deductions and losses
Taxable income before special deductions
Minus: Special deductions
Taxable income
Times: Corporate tax rates
Regular tax before credits and other taxes
Minus: Foreign tax credit and possessions tax credit
Regular tax
Minus: Other tax credits
Plus: Recapture of previously claimed tax credits
Alternative Minimum Tax (AMT)
Taxable income before NOL deduction
Plus or minus: Adjustments to taxable income
Plus: Tax preference items
Minus: Alternative tax NOL deduction
Alternative minimum taxable income
Minus: Statutory exemption
Tax base
Times: 20% tax rate
Tentative minimum tax before credits
Minus: AMT foreign tax credit
Tentative minimum tax
Minus: Regular (income) tax
(if greater than zero)
(See Table C:5-1)
Alternative minimum tax
Income (regular) tax liability
Income (regular) tax liability
Plus: Alternative minimum tax
Special taxes (if applicable):
Accumulated earnings tax
Personal holding company tax
Total tax liability
Minus: Estimated tax payments
Net tax due (or refund)
2014, thereby deferring income largely earned in 2013 to 2014. For this purpose, the IRC
defines a PSC as a corporation whose principal activity is the performance of personal
services by its employee-owners who own more than 10% of the stock (by value) on any
day of the year.4
A PSC, however, may adopt a fiscal tax year if it can establish a business purpose for
such a year. For example, it may be able to establish a natural business year and use that
year as its tax year.5 Deferral of income by shareholders is not an acceptable business
purpose. Even when no business purpose exists, a new PSC may elect to use a September
30, October 31, or November 30 year-end if it meets minimum distribution requirements
to employee-owners during the deferral period.6 If it fails to meet these distribution
requirements, the PSC may have to defer to its next fiscal year the deduction for amounts
paid to employee-owners.7
4 Sec. 441(i).
5 The natural business year rule requires that the year-end used for tax pur-
poses coincide with the end of the taxpayer’s peak business period. (See the
partnership and S corporation chapters and Rev. Proc. 2006-46, 2006-2
C.B. 859, for a further explanation of this exception.)
6 Sec. 444.
7 Sec. 280H.
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EXAMPLE C:3-1 �
BOOK-TO-TAX
ACCOUNTING
COMPARISON
Treasury Regulations literally
require taxpayers to use the same
overall accounting method for
book and tax purposes. However,
the courts have allowed different
methods if the taxpayer main-
tains adequate reconciling work-
papers. The IRS has adopted the
courts’ position on this issue.
Alice and Bob form Cole Corporation with each shareholder owning 50% of its stock. Alice and
Bob use the calendar year as their tax year. Alice and Bob are both active in the business and are
the corporation’s primary employees. The new corporation performs engineering services for
the automotive industry. Cole must use a calendar year as its tax year unless it qualifies for a fis-
cal year based on a business purpose exception. Alternatively, it may adopt a fiscal year ending
on September 30, October 31, or November 30, provided it complies with certain minimum dis-
tribution requirements. �
CHANGING THE ANNUAL ACCOUNTING PERIOD. A corporation that desires to
change its annual accounting period must obtain the prior approval of the IRS unless
Treasury Regulations specifically authorized the change or IRS procedures allow an auto-
matic change. A change in accounting period usually results in a short period running
from the end of the old annual accounting period to the beginning of the new accounting
period. A corporation must request approval of an accounting period change by filing
Form 1128 (Application for Change in Annual Accounting Period) on or before the fif-
teenth day of the third calendar month following the close of the short period. The IRS
usually will approve a request for change if a substantial business purpose exists for the
change and if the taxpayer agrees to the IRS’s prescribed terms, conditions, and adjust-
ments necessary to prevent any substantial distortion of income. A substantial distortion
of income includes, for example, a change that causes the “deferral of a substantial por-
tion of the taxpayer’s income, or shifting of a substantial portion of deductions, from one
taxable year to another.”8
Under IRS administrative procedures, a corporation may change its annual accounting
period without prior IRS approval if it meets the following conditions:
� The corporation files a short-period tax return for the year of change and annualizes
its income when computing its tax for the short period.
� The corporation files full 12-month returns for subsequent years ending on the new
year-end.
� The corporation closes its books as of the last day of the short-period and subse-
quently computes its income and keeps its books using the new tax year.
� If the corporation generates an NOL or capital loss in the short period, it may not
carry back the losses but must carry them over to future years. However, if the loss is
$50,000 or less, the corporation may carry it back.
� The corporation must not have changed its accounting period within the previous 48
months (with some exceptions).
� The corporation must not have an interest in a pass-through entity as of the end of the
short period (with some exceptions).
� The corporation is not an S corporation, personal service corporation, tax-exempt
organization, or other specialized corporation.9
ACCOUNTING METHODS
A new corporation must select the overall accounting method it will use for tax purposes.
The method chosen must be indicated on the corporation’s initial return. The three possi-
ble accounting methods are: accrual, cash, and hybrid.10
ACCRUAL METHOD. Under the accrual method, a corporation reports income in the
year it earns the income and reports expenses in the year it incurs the expenses. A corpora-
tion must use the accrual method unless it qualifies under one of the following exceptions:
� It qualifies as a family farming corporation.11
3-4 Corporations ▼ Chapter 3
8 Reg. Sec. 1.442-1(b)(3). Also see Rev. Proc. 2002-39, 2002-1 C.B. 1046.
9 Rev. Proc. 2006-45, 2006-2 C.B. 851. For automatic change procedures for
S corporations and personal service corporations, see Rev. Proc. 2006-46,
2006-2 C.B. 859.
10 Sec. 446.
11 Sec. 448. Certain family farming corporations having gross receipts of less
than $25 million may use the cash method of accounting. Section 447
requires farming corporations with gross receipts over $25 million to use the
accrual method of accounting.
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� It qualifies as a personal service corporation, which is a corporation substantially all of
whose activities involve the performance of services in the fields of health, law, engi-
neering, architecture, accounting, actuarial science, performing arts, or consulting;
and substantially all of whose stock is held by current (or retired) employees perform-
ing the services listed above, their estates, or (for two years only) persons who inher-
ited their stock from such employees.12
� It meets a $5 million gross receipts test for all prior tax years beginning after December
31, 1985. A corporation meets this test for any prior tax year if its average gross
receipts for the three-year period ending with that prior tax year do not exceed $5 mil-
lion. If the corporation was not in existence for the entire three-year period, the period
during which the corporation was in existence may be used.
� It has elected S corporation status.
If a corporation meets one of the exceptions listed above, it may use either the accrual
method or one of the following two methods.
CASH METHOD. Under the cash method, a corporation reports income when it actu-
ally or constructively receives the income and reports expenses when it pays them.
Corporations in service industries such as engineering, medicine, law, and accounting gen-
erally use this method because they prefer to defer recognition until they actually receive
the income. This method may not be used if inventories are a material income-producing
factor. In such case, the corporation must use either the accrual method or the hybrid
method of accounting.
HYBRID METHOD. Under the hybrid method, a corporation uses the accrual method
of accounting for sales, cost of goods sold, inventories, accounts receivable, and accounts
payable, and uses the cash method of accounting for all other income and expense items.
Small businesses with inventories (e.g., retail stores) often use this method. Although they
must use the accrual method of accounting for sales-related income and expense items,
they often find the cash method less burdensome to use for other income and expense
items, such as utilities, rents, salaries, and taxes.
ADDITIONAL
COMMENT
Whereas partnerships and S cor-
porations are generally allowed
to be cash method taxpayers,
most C corporations must use the
accrual method of accounting.
This restriction can prove incon-
venient for many small corpora-
tions (with more than $5 million
of gross receipts) that would
rather use the less complicated
cash method of accounting.
Each year, C corporations must determine their corporate income (or regular) tax liability.
In addition to the income tax, a C corporation may owe the corporate alternative mini-
mum tax and possibly either the accumulated earnings tax or the personal holding com-
pany tax. A corporation’s total tax liability equals the sum of its regular income tax liabil-
ity plus any additional taxes that it owes.
This chapter explains how to compute a corporation’s income (or regular) tax liability.
Chapter C:5 explains the computation of the corporate alternative minimum tax, per-
sonal holding company tax, and accumulated earnings tax.
DETERMINING A
CORPORATION’S TAXABLE
INCOME
12 The personal service corporation definition for the tax year election [Sec.
441(i)] is different from the personal service corporation definition for the
cash accounting method election [Sec. 448].
The Corporate Income Tax ▼ Corporations 3-5
OBJECTIVE 2
Calculate deductions
particular to corporations
and arrive at corporate
taxable income
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3-6 Corporations ▼ Chapter 3
1. Gross income: Generally, the same gross income definition applies to individuals and corporations. Certain exclusions
are available to individuals but not to corporations (e.g, fringe benefits); other exclusions are available to corporations
but not to individuals (e.g., capital contributions).
2. Deductions: Individuals have above-the-line deductions (for AGI), itemized deductions (from AGI), and personal exemp-
tions. Corporations do not compute AGI, and their deductions are presumed to be ordinary and necessary business
expenses.
3. Charitable contributions: Individuals are limited to 50% of AGI (30% for capital gain property). Corporations are
limited to 10% of taxable income computed without regard to the dividends-received deductions, the U.S. production
activities deduction, NOL and capital loss carrybacks, and the contribution deduction itself. Individuals deduct a contribu-
tion only in the year they pay it. Accrual basis corporations may deduct contributions in the year of accrual if the board
of directors authorizes the contribution by year-end, and the corporation pays it by the fifteenth day of the third month
of the next year.
4. Depreciation on Sec. 1250 property: Individuals generally do not recapture depreciation under the MACRS rules
because straight-line depreciation applies to real property. Corporations must recapture 20% of the amount that would
be recaptured under Sec. 1245. Individuals are subject to a 25% (and possibly 28.8%) tax rate on unrecaptured Sec.
1250 gains. Corporations are not subject to this rate.
5. Net capital gains: After 2012, the applicable capital gains tax rate for net capital gains and qualified dividends of noncor-
porate taxpayers is 0% for taxpayers in tax brackets of 15% and below, 15% for taxpayers in the 25% through 35% tax
brackets, and 20% for taxpayers in the 39.6% tax bracket. Also, 25% and 28% rates apply for gains on certain types of
property. In addition, an incremental 3.8% rate applies to net investment income for taxpayers whose modified AGI
exceeds $200,000 ($250,000 for married filing jointly). Net investment income includes, among other things, interest, divi-
dends, annuities, royalties, rents, and net gains from the disposition of property not used in a trade or business, all reduced
by deductions allocable to such income or gains. Corporate capital gains are taxed at the regular corporate tax rates.
6. Capital losses: Individuals can deduct up to $3,000 of net capital losses to offset ordinary income. Individual capital
losses carry over indefinitely. Corporations cannot offset any ordinary income with capital losses. However, capital losses
carry back three years and forward five years and offset capital gains in those years.
7. Dividends-received deduction: This deduction is not available to individuals. Corporations receive a 70%, 80%, or
100% special deduction depending on the percentage of stock ownership.
8. NOLs: Individuals must make many adjustments to arrive at the NOL they are allowed to carry back or forward. A
corporation’s NOL is simply the excess of its deductions over its income for the year. The NOL carries back two years
(or an extended period if applicable) and forward 20 years for individuals and corporations, or the taxpayer can elect to
forgo the carryback and only carry the NOL forward.
9. For individuals, the U.S. production activities deduction is based on the lesser of qualified production activities income or
AGI. For corporations, the deduction is based on the lesser of qualified production activities income or taxable income.
10. Tax rates: Individual’s ordinary tax rates range from 10% to 39.6% (in 2013). Corporate tax rates range from 15% to
39%.
11. AMT: Individual AMT rates are 26% or 28%. The corporate AMT rate is 20%. Corporations are subject to a special
AMTI adjustment, called adjusted current earnings (ACE), that does not apply to individuals.
12. Passive Losses: Passive loss rules apply to individuals, partners, S corporation shareholders, closely held C corporations,
and personal service corporations. They do not apply to widely held C corporations.
13. Casualty losses: Casualty losses are deductible in full by a corporation because all corporate casualty losses are
considered to be business related. Moreover, they are not reduced by a $100 offset, nor are they restricted to losses
exceeding 10% of AGI, as are an individual’s nonbusiness casualty losses.
FIGURE C:3-1 � DIFFERENCES BETWEEN INDIVIDUAL AND CORPORATE TAXATION
Like an individual, a corporation is a taxpaying entity with gross income and deduc-
tions. However, a number of differences arise between individual and corporate taxation
as summarized in Figure C:3-1. This section of the text expands on some of these items
and discusses other tax aspects particular to corporations.
SALES AND EXCHANGES OF PROPERTY
Sales and exchanges of property generally are treated the same way for corporations as
for an individual. However, special rules apply to capital gains and losses, and corpora-
tions are subject to an additional 20% depreciation recapture rule under Sec. 291 on sales
of Sec. 1250 property.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
The Corporate Income Tax ▼ Corporations 3-7
EXAMPLE C:3-2 �
EXAMPLE C:3-3 �
CAPITAL GAINS AND LOSSES. A corporation has a capital gain or loss if it sells or
exchanges a capital asset. As with individuals, a corporation must net all its capital gains
and losses to obtain its net capital gain or loss position.
Net Capital Gain. A corporation includes all its net capital gains (net long-term capital
gains in excess of net short-term capital losses) for the tax year in gross income. Unlike
with individuals, a corporation’s capital gains receive no special tax treatment and are
taxed in the same manner as any other ordinary income item.
Beta Corporation has a net capital gain of $40,000, gross profits on sales of $110,000, and
deductible expenses of $28,000. Beta’s gross income is $150,000 ($40,000 � $110,000). Its tax-
able income is $122,000 ($150,000 � $28,000). The $40,000 of net capital gain receives no spe-
cial treatment and is taxed using the regular corporate tax rates described below. �
Net Capital Losses. If a corporation incurs a net capital loss, it cannot deduct the net
loss in the current year. A corporation’s capital losses can offset only capital gains. They
never can offset the corporation’s ordinary income.
A corporation must carry back a net capital loss as a short-term capital loss to the
three previous tax years and offset capital gains in the earliest year possible (i.e., the losses
carry back to the third previous year first). If the loss is not totally absorbed as a carry-
back, the remainder carries over as a short-term capital loss for five years. Any unused
capital losses remaining at the end of the carryover period expire.
In 2013, East Corporation reports gross profits of $150,000, deductible expenses of $28,000, and
a net capital loss of $10,000. East reported the following capital gain net income (excess of
gains from sales or exchanges of capital assets over losses from such sales or exchanges) during
2010 through 2012:
2010 $6,000
2011 –0–
2012 3,000
East has gross income of $150,000 and taxable income of $122,000 ($150,000 � $28,000) for
2013. East also has a $10,000 net capital loss that carries back to 2010 first and offsets the
$6,000 capital gain net income reported in that year. East receives a refund for the taxes paid in
2010 on the $6,000 of capital gains. The $4,000 ($10,000 � $6,000) remainder of the loss carry-
back carries to 2012 and offsets East’s $3,000 capital gain net income reported in that year. East
still has a $1,000 net capital loss carryover to 2014. �
SEC. 291: TAX BENEFIT RECAPTURE RULE. If a taxpayer sells Sec. 1250 property at
a gain, Sec. 1250 requires that the taxpayer report the recognized gain as ordinary income
to the extent the depreciation taken exceeds the depreciation that would have been
allowed had the taxpayer used the straight-line method. This ordinary income is known
as Sec. 1250 depreciation recapture. For individuals, any remaining gain is characterized
as a combination of unrecaptured Sec. 1250 gain and Sec. 1231 gain. Corporations, how-
ever, must recapture as ordinary income an amount equal to 20% of the ordinary income
that would have been recognized had the property been Sec. 1245 property instead of Sec.
1250 property.
Texas Corporation purchased residential real estate several years ago for $125,000, of which
$25,000 was allocated to the land and $100,000 to the building. Texas took straight-line MACRS
depreciation deductions of $10,606 on the building during the period it held the building. In
December of the current year, Texas sells the property for $155,000, of which $45,000 is allo-
cated to the land and $110,000 to the building. Texas has a $20,000 ($45,000 � $25,000) gain on
the land sale, all of which is Sec. 1231 gain. This gain is not affected by Sec. 291 because land is
not Sec. 1250 property. Texas has a $20,606 [$110,000 sales price � ($100,000 original cost �
$10,606 depreciation)] gain on the sale of the building. If Texas were an individual taxpayer,
$10,606 would be an unrecaptured Sec. 1250 gain subject to a 25% tax rate, and the remaining
Capital
Gain Net IncomeYear
EXAMPLE C:3-4 �
ADDITIONAL
COMMENT
Under the modified accelerated
cost recovery system (MACRS),
Sec. 1250 depreciation recapture
seldom, if ever, occurs for individ-
uals because MACRS requires
straight-line depreciation for Sec.
1250 property. Nevertheless, indi-
viduals would be subject to the
25% tax rate on unrecaptured
Sec. 1250 gains.
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3-8 Corporations ▼ Chapter 3
$10,000 would be a Sec. 1231 gain. However, a corporate taxpayer reports $2,121 of gain as
ordinary income. These amounts are summarized below:
Amount of gain:
Sales price $45,000 $110,000 $155,000
Minus: Adjusted basis ) ) )
Recognized gain
Character of gain:
Ordinary income $ –0– $ 2,121a $ 2,121
Sec. 1231 gain
Recognized gain
a0.20 � lesser of $10,606 depreciation claimed or $20,606 recognized gain. �
BUSINESS EXPENSES
Corporations are allowed deductions for ordinary and necessary business expenses, includ-
ing salaries paid to officers and other employees of the corporation, rent, repairs, insurance
premiums, advertising, interest, taxes, losses on sales of inventory or other property, bad
debts, and depreciation. No deductions are allowed, however, for interest on amounts bor-
rowed to purchase tax-exempt securities, illegal bribes or kickbacks, fines or penalties
imposed by a government, or insurance premiums incurred to insure the lives of officers
and employees when the corporation is the beneficiary.
ORGANIZATIONAL EXPENDITURES. When formed, a corporation may incur some
organizational expenditures such as legal fees and accounting fees incident to the incorpo-
ration process. These expenditures normally must be capitalized. Nevertheless, under Sec.
248, a corporation may elect to deduct the first $5,000 of organizational expenditures.
However, the corporation must reduce the $5,000 by the amount by which cumulative
organizational expenditures exceed $50,000 although the $5,000 cannot be reduced below
zero. The corporation can amortize the remaining organizational expenditures over a 180-
month period beginning in the month it begins business.
Sigma Corporation incorporates on January 10 of the current year, and begins business on
March 3. Sigma elects a September 30 year-end. Thus, it conducts business for seven months
during its first tax year. During the period January 10 through September 30, Sigma incurs
$52,000 of organizational expenditures. Because these expenditures exceed $50,000, Sigma
must reduce the first $5,000 by $2,000 ($52,000 � $50,000), leaving a $3,000 deduction.
Sigma amortizes the remaining $49,000 ($52,000 � $3,000) over 180 months beginning in
March of its first year. This portion of the deduction equals $1,906 ($49,000/180 � 7 months).
Accordingly, its total first-year deduction is $4,906 ($3,000 � $1,906). �
$ 40,606$ 20,606$20,000
38,48518,48520,000
$ 40,606$ 20,606$20,000
(114,394(89,394(25,000
TotalBuildingLand
WHAT WOULD YOU DO IN THIS SITUATION?
You are a CPA with a medium-size accounting
firm. One of your corporate clients is an electri-
cal contractor in New York City. The client is
successful and had $10 million of sales last year. The
contracts involve private and government electrical
work. Among the corporation’s expenses are $400,000
of kickbacks paid to people working for general contrac-
tors who award electrical subcontracts to the corpora-
tion, and $100,000 of payments to individuals in the
electricians’ union. Technically, these payments are ille-
gal. However, your client says that everyone in this busi-
ness needs to pay kickbacks to obtain contracts and to
have enough electricians to finish the projects in a
timely manner. He maintains that it is impossible to stay
in business without making these payments. In prepar-
ing its tax return, your client wants you to deduct these
expenses. What is your opinion concerning the client’s
request?
EXAMPLE C:3-5 �
ADDITIONAL
COMMENT
Section 291 results in the recap-
ture, as ordinary income, of up
to 20% of the gain on sales of
Sec. 1250 property. This recapture
requirement reduces the amount
of net Sec.1231 gains that can be
offset by corporate capital losses.
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The Corporate Income Tax ▼ Corporations 3-9
BOOK-TO-TAX
ACCOUNTING
COMPARISON
Most corporations amortize orga-
nizational expenditures for tax
purposes over the specified
period. For financial accounting
purposes, they are expensed
currently under ASC 720-15. Thus,
the differential treatment creates
a deferred tax asset.
EXAMPLE C:3-6 �
For organizational expenditures paid or incurred after August 16, 2011, a corporation
is deemed to have made the Sec. 248 election for the tax year the corporation begins busi-
ness.13 A corporation also can apply the amortization provisions for expenditures made
after October 22, 2004, provided the statute of limitations is still open for the particular
year. If the corporation chooses to forgo the deemed election, it can elect to capitalize the
expenditures (without amortization) on a timely filed tax return for the tax year the cor-
poration begins business. Either election, to amortize or capitalize, is irrevocable and
applies to all organizational expenditures of the corporation.
A corporation begins business when it starts the business operations for which it was
organized. Merely coming into existence is not sufficient. For example, obtaining a corpo-
rate charter does not in itself establish the beginning of business. However, acquiring
assets necessary for operating the business may be sufficient.
Organizational expenditures include expenditures (1) incident to the corporation’s cre-
ation; (2) chargeable to the corporation’s capital account; and (3) of a character that, if
expended incident to the creation of a corporation having a limited life, would be amorti-
zable over that life.
Specific organizational expenditures include
� Legal services incident to the corporation’s organization (e.g., drafting the corporate
charter and bylaws, minutes of organizational meetings, and terms of original stock
certificates)
� Accounting services necessary to create the corporation
� Expenses of temporary directors and of organizational meetings of directors and
stockholders
� Fees paid to the state of incorporation14
Organizational expenditures do not include expenditures connected with issuing or
selling the corporation’s stock or other securities (e.g., commissions, professional fees,
and printing costs) and expenditures related to the transfer of assets to the corporation.
Omega Corporation incorporates on July 12 of the current year, starts business operations on
August 10, and elects a tax year ending on September 30. Omega incurs the following expendi-
tures while organizing the corporation:
June 10 Legal expenses to draft charter $ 2,000
July 17 Commission to stockbroker for issuing and selling stock 40,000
July 18 Accounting fees to set up corporate books 2,400
July 20 Temporary directors’ fees 1,000
August 25 Directors’ fees 1,500
Omega’s first tax year begins July 12 and ends on September 30. Omega has organizational
expenditures of $5,400 ($2,000 � $2,400 � $1,000). The commission for selling the Omega stock
is treated as a reduction in the amount of Omega’s paid-in capital. Omega deducts the direc-
tors’ fees incurred in August as a trade or business expense under Sec. 162 because Omega had
begun business operations by that date. Assuming a deemed election to amortize its organiza-
tional expenditures, Omega can deduct $5,000 in its first tax year and amortize the remaining
$400 over 180 months. Thus, its first year deduction is $5,004 [$5,000 � ($400/180) � 2 months].
The following table summarizes the classification of expenditures:
June 10 Legal $ 2,000 $2,000
July 17 Commission 40,000 $40,000
July 18 Accounting 2,400 2,400
July 20 Temporary directors’ fees 1,000 1,000
August 25 Directors’ fees
Total �$1,500$40,000$5,400$46,900
$1,5001,500
BusinessCapitalOrganizationalAmountExpenditureDate
Type of Expenditure
AmountType of ExpenditureDate
13 Reg. Sec. 1.248-1(c) and 1(f). 14 Reg. Sec. 1.248-1(b)(2).
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3-10 Corporations ▼ Chapter 3
STOP & THINK
EXAMPLE C:3-7 �
START-UP EXPENDITURES. A distinction must be made between a corporation’s orga-
nizational expenditures and its start-up expenditures. Start-up expenditures are ordinary
and necessary business expenses paid or incurred by an individual or corporate taxpayer
� To investigate the creation or acquisition of an active trade or business
� To create an active trade or business
� To conduct an activity engaged in for profit or the production of income before the
time the activity becomes an active trade or business
Examples of start-up expenditures include the costs for a survey of potential markets; an
analysis of available facilities; advertisements relating to opening the business; the training
of employees; travel and other expenses for securing prospective distributors, suppliers, or
customers; and the hiring of management personnel and outside consultants. The expendi-
tures must be such that, if incurred in connection with the operation of an existing active
trade or business, they would be allowable as a deduction in the year paid or incurred.
Under Sec. 195, a corporation may elect to deduct the first $5,000 of start-up expendi-
tures. However, this amount is reduced (but not below zero) by the amount by which the
cumulative start-up expenditures exceed $50,000. The corporation can amortize the remain-
ing start-up expenditures over a 180-month period beginning in the month it begins business.
For start-up expenditures paid or incurred after August 16, 2011, a corporation is
deemed to have made the Sec. 195 election for the tax year the business to which the
expenditures relate begins.15 A corporation also can apply the amortization provisions for
expenditures made after October 22, 2004, provided the statute of limitations is still open
for the particular year. If the corporation chooses to forgo the deemed election, it can elect
to capitalize the expenditures (without amortization) on a timely filed tax return for the
tax year the business to which the expenditures relate begins. Either election, to amortize
or capitalize, is irrevocable and applies to all start-up expenditures related to the business.
Question: What is the difference between an organizational expenditure and a start-up
expenditure?
Solution: Organizational expenditures are outlays made in forming a corporation, such
as fees paid to the state of incorporation for the corporate chapter and fees paid to an
attorney to draft the documents needed to form the corporation. Start-up expenditures
are outlays that otherwise would be deductible as ordinary and necessary business
expenses but that are capitalized because they were incurred prior to the start of the cor-
poration’s business activities.
A corporation may elect to deduct the first $5,000 of organizational expenditures and
the first $5,000 of start-up expenditures. The corporation can amortize the remainder of
each set of expenditures over 180 months. Like a corporation, a partnership can deduct
and amortize its organizational and start-up expenditures. A sole proprietorship may incur
start-up expenditures, but sole proprietorships do not incur organizational expenditures.
LIMITATION ON DEDUCTIONS FOR ACCRUED COMPENSATION. If a corporation
accrues an obligation to pay compensation, the corporation must make the payment within
21⁄2 months after the close of its tax year. Otherwise, the deduction cannot be taken until the
year of payment.16 The reason is that, if a payment is delayed beyond 21⁄2 months, the IRS
treats it as a deferred compensation plan. Deferred compensation cannot be deducted until
the year the corporation pays it and the recipient includes the payment in income.17
On December 10 of the current year, Bell Corporation, a calendar year taxpayer, accrues an obli-
gation for a $100,000 bonus to Marge, a sales representative who has had an outstanding year.
Marge owns no Bell stock. Bell must make the payment by March 15 of next year. Otherwise, Bell
Corporation cannot deduct the $100,000 in its current year tax return but must wait until the
year it pays the bonus. �
BOOK-TO-TAX
ACCOUNTING
COMPARISON
For tax purposes, a corporation
amortizes start-up expenditures
over 180 months (after the initial
deduction). ASC 915 holds that
the financial accounting practices
and reporting standards used for
development stage businesses
should be no different for an
established business. The two
different sets of rules can lead to
different reporting for tax and
book purposes.
15 Reg. Sec. 1.195-1(b) and 1(d).
16 Temp. Reg. Sec. 1.404(b)-1T.
17 Sec. 404(b).
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The Corporate Income Tax ▼ Corporations 3-11
EXAMPLE C:3-8 �
18 Sec. 170(a). 19 Sec. 170(e).
CHARITABLE CONTRIBUTIONS. The treatment of charitable contributions by indi-
vidual and corporate taxpayers differs in three ways: the timing of the deduction, the
amount of the deduction permitted for the contribution of certain noncash property, and
the maximum deduction permitted in any given year.
Timing of the Deduction. Corporations may deduct contributions to qualified charitable
organizations. Generally, the contribution must have been paid during the year (not just
pledged) for a deduction to be allowed for a given year. A special rule, however, applies to
corporations using the accrual method of accounting (corporations using the cash or
hybrid methods of accounting are not eligible).18 These corporations may elect to treat
part or all of a charitable contribution as having been made in the year it accrued (instead
of the year paid) if
� The board of directors authorizes the contribution in the year it accrued
� The corporation pays the contribution on or before the fifteenth day of the third
month following the end of the accrual year.
The corporation makes the election by deducting the contribution in its tax return for the
accrual year and by attaching a copy of the board of director’s resolution to the return.
Any portion of the contribution for which the corporation does not make the election is
deducted in the year paid.
Echo Corporation is a calendar year taxpayer using the accrual method of accounting. In the cur-
rent year, its board of directors authorizes a $10,000 contribution to the Girl Scouts. Echo pays the
contribution on March 10 of next year. Echo may elect to treat part or all of the contribution as
having been paid in the current year. If the corporation pays the contribution after March 15 of
next year, it may not deduct the contribution in the current year but may deduct it next year. �
Deducting Contributions of Nonmonetary Property. If a taxpayer donates money to a
qualified charitable organization, the amount of the charitable contribution deduction
equals the amount of money donated. If the taxpayer donates property, the amount of the
charitable contribution deduction generally equals the property’s fair market value
(FMV). However, special rules apply to donations of appreciated nonmonetary property
known as ordinary income property and capital gain property.19
In this context, ordinary income property is property whose sale would have resulted in
a gain other than a long-term capital gain (i.e., ordinary income or short-term capital
gain). Examples of ordinary income property include investment property held for one
year or less, inventory property, and property subject to depreciation recapture under
Secs. 1245 and 1250. The deduction allowed for a donation of such property is limited to
the property’s FMV minus the amount of ordinary income or short-term capital gain the
corporation would have recognized had it sold the property.
In three special cases, a corporation may deduct the donated property’s adjusted basis
plus one-half of the excess of the property’s FMV over its adjusted basis (not to exceed
twice the property’s adjusted basis). This special rule applies to inventory if
1. The use of the property is related to the donee’s exempt function, and it is used solely
for the care of the ill, the needy, or infants;
2. The property is not transferred to the donee in exchange for money, other property, or
services; and
3. The donor receives a statement from the charitable organization stating that condi-
tions (1) and (2) will be complied with.
A similar rule applies to contributions of scientific research property if the corporation
created the property and contributed it to a college, university, or tax-exempt scientific
research organization for its use within two years of creating the property.
King Corporation donates inventory having a $26,000 adjusted basis and a $40,000 FMV to a
qualified public charity. A $33,000 [$26,000 � (0.50 � $14,000)] deduction is allowed for the
TAX STRATEGY TIP
The tax laws do not require a cor-
poration to recognize a gain
when it contributes appreciated
property to a charitable organiza-
tion. Thus, except for inventory
and limited other properties, a
corporation can deduct the FMV
of its donation without having to
recognize any appreciation in its
gross income. On the other hand,
a decline in the value of donated
property is not deductible. Thus,
the corporation should sell the
loss property to recognize the loss
and then donate the sales pro-
ceeds to the chariable organiza-
tion.
EXAMPLE C:3-9 �
ADDITIONAL
COMMENT
Through 2013, a similar rule
also applies to contributions of
“apparently wholesome food.”
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3-12 Corporations ▼ Chapter 3
20 Sec. 170(e)(5). The restriction on contributions of appreciated property to
private nonoperating foundations does not apply to contributions of stock for
which market quotations are readily available.
contribution of the inventory if the charitable organization will use the inventory for the care
of the ill, needy, or infants, or if the donee is an educational institution or research organiza-
tion that will use the scientific research property for research or experimentation. Otherwise,
the deduction is limited to the property’s $26,000 adjusted basis. If instead the inventory’s FMV
is $100,000 and the donation meets either of the two sets of requirements outlined above, the
charitable contribution deduction is limited to $52,000, the lesser of the property’s adjusted
basis plus one-half of the appreciation [$63,000 � $26,000 � (0.50 � $74,000)] or twice the
property’s adjusted basis ($52,000 � $26,000 � 2). �
When a corporation donates appreciated property whose sale would result in long-term
capital gain (also known as capital gain property) to a charitable organization, the amount
of the contribution deduction generally equals the property’s FMV. However, special
restrictions apply if
� The corporation donates a patent, copyright, trademark, trade name, trade secret,
know-how, certain software, or other similar property;
� 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; or
� A corporation donates appreciated property to certain private nonoperating founda-
tions.20
In these cases, the amount of the corporation’s contribution is limited to the property’s
FMV minus the long-term capital gain that would have resulted from the property’s sale.
Fox Corporation donates artwork to the MacNay Museum. The artwork, purchased two years
earlier for $15,000, is worth $38,000 on the date Fox donates it. At the time of the donation,
the museum’s directors intend to sell the work to raise funds to conduct museum activities.
Fox’s deduction for the gift is limited to $15,000. If the museum plans to display the artwork to
the public, the entire $38,000 deduction is permitted. Fox can avoid losing a portion of its char-
itable contribution deduction by, as a condition of the donation, placing restrictions on the sale
or use of the property. �
Substantiation Requirements. Section 170(f)(11) imposes substantiation requirements for
noncash charitable contributions. If the corporation does not comply, it will lose the char-
itable contribution deduction. The requirements are as follows:
� If the contribution deduction exceeds $500, the corporation must include with its tax
return a description of the property and any other information required by Treasury
Regulations.
� If the contribution deduction exceeds $5,000, the corporation must obtain a qualified
appraisal and include with its tax return any information and appraisal required by
Treasury Regulations.
� If the contribution deduction exceeds $500,000, the corporation must attach a quali-
fied appraisal to the tax return.
The second and third requirements, however, do not apply to contributions of cash; pub-
licly traded securities; inventory; or certain motor vehicles, boats, or aircraft the donee
organization sells without any intervening use or material improvement. With regard to
these vehicles, the donor corporation’s deduction is limited to the amount of gross pro-
ceeds the donee organization receives on the sale.
Maximum Deduction Permitted. A limit applies to the amount of charitable contribu-
tions a corporation can deduct in a given year. The limit is calculated differently for cor-
porations than for individuals. Contribution deductions by corporations are limited to
10% of adjusted taxable income. Adjusted taxable income is the corporation’s taxable
income computed without regard to any of the following amounts:
EXAMPLE C:3-10 �
ADDITIONAL
COMMENT
The $500, $5,000, and $500,000
thresholds apply on an aggregate
basis for similar property donated
to one or more donees.
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
The Corporate Income Tax ▼ Corporations 3-13
BOOK-TO-TAX
ACCOUNTING
COMPARISON
For financial accounting purposes,
all charitable contributions can be
claimed as an expense without
regard to the amount of profits
reported. For tax purposes, how-
ever, the charitable contribution
deduction may be limited. Thus,
the charitable contribution carry-
over for tax purposes creates a
deferred tax asset, possibly sub-
ject to a valuation allowance.
EXAMPLE C:3-11 �
21 Sec. 170(b)(2). 22 Sec. 170(d)(2).
� The charitable contribution deduction
� An NOL carryback
� A capital loss carryback
� The dividends-received deduction21
� The U.S. production activities deduction
Contributions that exceed the 10% limit are not deductible in the current year. Instead,
they carry forward to the next five tax years. Any excess contributions not deducted
within those five years expire. The corporation may deduct excess contributions in the
carryover year only after it deducts any contributions made in that year. The total chari-
table contribution deduction (including any deduction for contribution carryovers) is lim-
ited to 10% of the corporation’s adjusted taxable income in the carryover year.22
Golf Corporation reports the following results in Year 1 and Year 2:
Adjusted taxable income $200,000 $300,000
Charitable contributions 35,000 25,000
Golf’s Year 1 contribution deduction is limited to $20,000 (0.10 � $200,000). Golf has a
$15,000 ($35,000 � $20,000) contribution carryover to Year 2. The Year 2 contribution deduc-
tion is limited to $30,000 (0.10 � $300,000). Golf’s deduction for Year 2 is composed of the
$25,000 donated in Year 2 and $5,000 of the Year 1 carryover. The remaining $10,000 carryover
from Year 1 carries over to the next four years. �
Topic Review C:3-1 summarizes the basic corporate charitable contribution deduction
rules.
Year 2Year 1
Topic Review C:3-1
Corporate Charitable Contribution Rules
1. Timing of the contribution deduction
a. General rule: A deduction is allowed for contributions paid during the year.
b. Accrual method corporations can accrue contributions approved by their board of directors prior to the end of the
accrual year and paid within 21⁄2 months of that year-end.
2. Amount of the contribution deduction
a. General rule: A deduction is allowed for the amount of money and the FMV of other property donated.
b. Exceptions for ordinary income property:
1. If donated property would result in ordinary income or short-term capital gain if sold, the deduction is limited to
the property’s FMV minus this potential ordinary income or short-term capital gain. Thus, for gain property the
deduction equals the property’s cost or adjusted basis.
2. Special rule: For donations of (1) inventory used for the care of the ill, needy, or infants, (2) apparently wholesome
food, or (3) scientific research property or computer technology and equipment to certain educational institutions,
a corporate donor may deduct the property’s basis plus one-half of the excess of the property’s FMV over its
adjusted basis. The deduction may not exceed twice the property’s adjusted basis.
c. Exceptions for capital gain property: If the corporation donates tangible personal property to a charitable organization
for a use unrelated to its tax-exempt purpose, or the corporation donates appreciated property to a private
nonoperating foundation, the corporation’s contribution is limited to the property’s FMV minus the long-term capital
gain that would result if the corporation sold the property.
3. Limitation on contribution deduction
a. The contribution deduction is limited to 10% of the corporation’s taxable income computed without regard to the
charitable contribution deduction, any NOL or capital loss carryback, the dividends-received deduction, and the U.S
production activities deduction.
b. Excess contributions carry forward for a five-year period.
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3-14 Corporations ▼ Chapter 3
SPECIAL DEDUCTIONS
C corporations are allowed three special deductions: the U.S. production activities deduc-
tion, the dividends-received deduction, and the NOL deduction.
U.S. PRODUCTION ACTIVITIES DEDUCTION. Section 199 allows a U.S. production
activities deduction equal to 9% times the lesser of (1) qualified production activities
income for the year or (2) taxable income before the U.S. production activities deduction.
The deduction, however, cannot exceed 50% of the corporation’s W-2 wages allocable to
qualifying U.S. production activities for the year.
Qualified production activities income is the taxpayer’s domestic production gross
receipts less the following amounts:
� Cost of goods sold allocable to these receipts;
� Other deductions, expenses, and losses directly allocable to these receipts; and
� A ratable portion of other deductions, expenses, and losses not directly allocable to
these receipts or to other classes of income.
Domestic production gross receipts include receipts from the following taxpayer activities:
� The lease, rental, license, sale, exchange, or other disposition of (1) qualified produc-
tion property (tangible property, computer software, and sound recordings) manufac-
tured, produced, grown, or extracted in whole or significant part within the United
States; (2) qualified film production; or (3) electricity, natural gas, or potable water
produced within the United States
� Construction performed in the United States
� Engineering or architectural services performed in the United States for construction
projects in the United States
Domestic production gross receipts, however, do not include receipts from the sale of food
and beverages the taxpayer prepares at a retail establishment and do not apply to the
transmission of electricity, natural gas, or potable water.
The U.S. production activities deduction has the effect of reducing a corporation’s mar-
ginal tax rate on qualifying taxable income. For example, a 9% deduction for a corporation
in the 35% tax bracket decreases the corporation’s marginal tax rate by about 3% (0.09 �
35% � 3.15%).
Gamma Corporation earns domestic production gross receipts of $1 million and incurs allo-
cable expenses of $400,000. Thus, its qualified production activities income is $600,000. In
addition, Gamma has $200,000 of income from other sources, resulting in taxable income
of $800,000 before the U.S. production activities deduction. Its U.S. production activities
deduction, therefore, is $54,000 ($600,000 � 0.09), and its taxable income is $746,000
($800,000 � $54,000). �
Assume the same facts as in Example C:3-12 except Gamma has $100,000 of losses from other
sources rather than $200,000 of other income, resulting in taxable income of $500,000 before
the U.S. production activities deduction. In this case, its U.S. production activities deduction is
$45,000 ($500,000 � 0.09), and its taxable income is $455,000 ($500,000 � $45,000). �
DIVIDENDS-RECEIVED DEDUCTION. A corporation must include in its gross
income any dividends received on stock it owns in another corporation. As described in
Chapter C:2, the taxation of dividend payments to a shareholder generally results in dou-
ble taxation. When a distributing corporation pays a dividend to a corporate shareholder
and the recipient corporation subsequently distributes these earnings to its shareholders,
potential triple taxation of the earnings can result.
EXAMPLE C:3-12 �
EXAMPLE C:3-13 �
ADDITIONAL
COMMENT
In addition to providing a benefit,
the U.S. production activities
deduction will increase a corpora-
tion’s compliance costs because of
the time necessary to determine
what income and deductions per-
tain to U.S. production activities.
BOOK-TO-TAX
ACCOUNTING
COMPARISON
The U.S. production activities
deduction is not expensed for
financial accounting purposes.
Thus, it creates a permanent dif-
ference that affects the corpor-
tion’s effective tax rate but not its
deferred taxes.
ADDITIONAL
COMMENT
While discussed in this text under
special deductions, the U.S. pro-
duction activities deduction actu-
ally appears before Line 28 on
Form 1120. This deduction also is
referred to as the domestic
production activities deduction or
the manufacturing deduction.
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The Corporate Income Tax ▼ Corporations 3-15
23 Secs. 243(a) and (c). 24 Sec. 246(b).
Adobe Corporation owns stock in Bell Corporation. Bell reports taxable income of $100,000 and
pays federal income taxes on its income. Bell distributes its after-tax income to its shareholders.
The dividend Adobe receives from Bell must be included in its gross income and, to the extent it
reports a profit for the year, Adobe will pay taxes on the dividend. Adobe distributes its remain-
ing after-tax income to its shareholders. The shareholders must include Adobe’s dividends in
their gross income and pay federal income taxes on the distribution. Thus, Bell’s income in this
example potentially is taxed three times. �
To partially mitigate the effects of multiple taxation, corporations are allowed a divi-
dends-received deduction for dividends received from other domestic corporations and
from certain foreign corporations.
General Rule for Dividends-Received Deduction. Corporations that own less than 20%
of the distributing corporation’s stock may deduct 70% of the dividends received. If the
shareholder corporation owns 20% or more of the distributing corporation’s stock (both
voting power and value) but less than 80% of such stock, it may deduct 80% of the divi-
dends received.23
Hale Corporation reports the following results in the current year:
Gross income from operations $300,000
Dividends from 15%-owned domestic corporation 100,000
Operating expenses 280,000
Gross income from operations and expenses both pertain to qualified production activities,
so Hale’s qualified production activities income is $20,000 ($300,000 � $280,000). Hale’s divi-
dends-received deduction is $70,000 (0.70 � $100,000). Thus, Hale’s taxable income is com-
puted as follows:
Gross income $400,000
Minus: Operating expenses )
Taxable income before special deductions $120,000
Minus: Dividends-received deduction )
Taxable income before the U.S. production activites deduction $ 50,000
Minus: U.S. production activities deduction ($20,000 � 0.09) )
Taxable income �
Limitation on Dividends-Received Deduction. In the case of dividends received from
corporations that are less than 20% owned, the deduction is limited to the lesser of 70% of
dividends received or 70% of taxable income computed without regard to any NOL deduc-
tion, any capital loss carryback, the dividends-received deduction itself, or the U.S. production
activities deduction.24 In the case of dividends received from a 20% or more owned corpora-
tion, the dividends-received deduction is limited to the lesser of 80% of dividends received or
80% of taxable income computed without regard to the same deductions.
Assume the same facts as in Example C:3-15 except Hale Corporation’s operating expenses for
the year are $310,000 and that qualified production activities income is zero (or negative).
Thus, the corporation cannot claim the U.S. production activities deduction. Hale’s taxable
income before the dividends-received deduction is $90,000 ($300,000 � $100,000 � $310,000).
The dividends-received deduction is limited to the lesser of 70% of dividends received ($70,000
� $100,000 � 0.70) or 70% of taxable income before the dividends-received deduction
($63,000 � $90,000 � 0.70). Thus, the dividends-received deduction is $63,000. Hale’s taxable
income is $27,000 ($90,000 � $63,000). �
A corporation that receives dividends eligible for both the 80% dividends-received deduc-
tion and the 70% dividends-received deduction must compute the 80% dividends-
received deduction first and then reduce taxable income by the aggregate amount of divi-
dends eligible for the 80% deduction before computing the 70% deduction.
$ 48,200
(1,800
(70,000
(280,000
EXAMPLE C:3-14 �
EXAMPLE C:3-15 �
BOOK-TO-TAX
ACCOUNTING
COMPARISON
A corporation includes dividends
in its financial accounting income
but does not subtract a dividends-
received deduction in determin-
ing its book net income. Thus, the
dividends-received deduction cre-
ates a permanent difference that
affects the corporation’s effective
tax rate but not its deferred
taxes.
EXAMPLE C:3-16 �
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Assume the same facts as in Example C:3-16 except Hale Corporation receives $75,000 of the div-
idends from a 25%-owned corporation and the remaining $25,000 from a 15%-owned corpora-
tion. The tentative dividends-received deduction from the 25%-owned corporation is $60,000
($75,000 � 0.80), which is less than the $72,000 ($90,000 � 0.80) limitation. Thus, Hale can deduct
the entire $60,000. The tentative dividends-received deduction from the 15%-owned corpora-
tion is $17,500 ($25,000 � .70). The limitation, however, is $10,500 [($90,000 � $75,000) � 0.70].
Note that, in computing this limitation, Hale reduces its taxable income by the entire $75,000 div-
idend received from the 25%-owned corporation. Thus, Hale can deduct only $10,500 of the
$17,500 amount. Hale’s taxable income is $19,500 ($90,000 � $60,000 � $10,500). �
Exception to the Limitation. The taxable income limitation on the dividends-received
deduction does not apply if the tentative dividends-received deduction creates or increases
an NOL for the year.
Assume the same facts as in Example C:3-16 except Hale Corporation’s operating expenses for
the year are $331,000. Hale’s taxable income before the dividends-received deduction is
$69,000 ($300,000 � $100,000 � $331,000). The tentative dividends-received deduction is
$70,000 ($100,000 � 0.70). Hale’s dividends-received deduction is not restricted by the limita-
tion of 70% of taxable income before the dividends-received deduction because, after taking
into account the tentative $70,000 dividends-received deduction, the corporation has a $1,000
($69,000 � $70,000) NOL for the year. If Hale’s operating expenses were $410,000 instead of
$331,000, it would have a $10,000 NOL before the dividends-received deduction ($300,000 �
$100,000 � $410,000). Again, the dividends-received deduction is not restricted by the limi-
tation because it increases the NOL. In this case, the corporation has an $80,000 [$(10,000) �
$70,000] NOL for the year. �
The following table compares the results of Examples C:3-15, C:3-16, and C:3-18:
Gross income $400,000 $400,000 $400,000 $400,000
Minus: Operating expenses
Taxable income (NOL) before
special deductions $120,000 $ 90,000 $ 69,000 $(10,000)
Minus: Dividends-received
deduction (70,000) (63,000) (70,000) (70,000)
U.S. production
activities deduction
Taxable income (NOL)
Of these three examples, the only case where the dividends-received deduction does not equal
the full 70% of the $100,000 dividend is Example C:3-16. In that case, the deduction is lim-
ited to $63,000 because taxable income before special deductions is less than the $100,000
dividend and because the full $70,000 deduction would not create an NOL. The special
exception to the dividends-received deduction can create interesting situations. For example,
the additional $21,000 of deductions incurred in Example C:3-18 (as compared to Example
C:3-16) resulted in a $28,000 reduction in taxable income. Corporate taxpayers should be
aware of these rules and consider deferring income or recognizing expenses to ensure being
able to deduct the full 70% or 80% dividends-received deduction. If the taxable income lim-
itation applies, the corporation loses the unused dividends-received deduction.
Members of an Affilliated Group. Members of an affiliated group of corporations can
claim a 100% dividends-received deduction with respect to dividends received from other
group members.25 A group of corporations is affiliated if a parent corporation owns at least
80% of the stock (both voting power and value) of at least one subsidiary corporation, and
at least 80% of the stock (both voting power and value) of each other corporation is owned
by other group members. The 100% dividends-received deduction is not subject to a taxable
income limitation and is taken before the 80% or 70% dividends-received deduction.26
$(80,000)$ (1,000)$ 27,000$ 48,200
–0––0––0–(1,800)
(410,000)(331,000)(310,000)(280,000)
Example C:3-18Example C:3-16Example C:3-15
3-16 Corporations ▼ Chapter 3
EXAMPLE C:3-18 �
ADDITIONAL
COMMENT
When the dividends-received
deduction creates (or increases)
an NOL, the corporation gets the
full benefit of the deduction
because it can carry back or carry
forward the NOL.
TAX STRATEGY TIP
A corporation can avoid the
dividends-received deduction
limitation either by (1) increasing
its taxable income before the
dividends-received deduction so
the limitation exceeds the
tentative dividends-received
deduction or (2) decreasing its
taxable income before the
dividends-received deduction so
the tentative dividends-received
deduction creates an NOL.
EXAMPLE C:3-17 �
ADDITIONAL
COMMENT
If the affiliated group files a con-
solidated tax return, the recipient
of the dividend does not claim the
100% dividends received deduc-
tion because the intercompany
dividend gets eliminated in the
consolidation (see Chapter C:8).
25 Sec. 243(a)(3). 26 Secs. 243(b)(5) and 1504.
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Hardy Corporation reports the following results for the current year:
Gross income from operations $520,000
Dividend received from an 80%-owned affiliated corporation 100,000
Dividend received from a 20%-owned corporation 250,000
Operating expenses 550,000
Hardy does not file a consolidated tax return with the 80%-owned affiliate. Because Hardy’s
qualified production activities income is negative, it cannot claim the U.S. production activities
deduction. Hardy’s taxable income before any dividends-received deduction is $320,000
($520,000 � $100,000 � $250,000 � $550,000). Hardy can deduct the entire dividend received
from the 80%-owned affiliate without limitation. The tentative dividends-received deduction
from the 20%-owned corporation is $200,000 ($250,000 � 0.80). The limitation, however, is
$176,000 [($320,000 � $100,000) � 0.80]. Note that, in computing this limitation, Hardy first
reduces its taxable income by the $100,000 dividend received from the 80%-owned affiliate.
Thus, Hardy can deduct only $176,000 of the $200,000 amount. Hardy’s taxable income is
$44,000 ($320,000 � $100,000 � $176,000). �
Dividends Received from Foreign Corporations. The dividends-received deduction
applies primarily to dividends received from domestic corporations. The dividends-
received deduction does not apply to dividends received from a foreign corporation
because the U.S. Government does not tax its income. Thus, that income is not subject to
the multiple taxation illustrated above.27
Stock Held 45 Days or Less. A corporation may not claim a dividends-received deduc-
tion 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 with respect to the dividend.28
This rule prevents a corporation from claiming a dividends-received deduction if it pur-
chases stock shortly before an ex-dividend date and sells the stock shortly thereafter. (The
ex-dividend date is the first day on which a purchaser of stock is not entitled to a previ-
ously declared dividend.) Absent this rule, such a purchase and sale would allow the cor-
poration to receive dividends at a low tax rate—a maximum of a 10.5% [(100% � 70%)
� 0.35] effective tax rate—and to recognize a capital loss on the sale of stock that could
offset capital gains taxed at a 35% corporate tax rate.
Theta Corporation purchases 100 shares of Maine Corporation’s stock for $100,000 one day
before Maine’s ex-dividend date. Theta receives a $5,000 dividend on the stock and then sells
the stock for $95,000 shortly after the dividend payment date. Because the stock is worth
$100,000 immediately before the $5,000 dividend payment, its value drops to $95,000
($100,000 � $5,000) immediately after the dividend. The sale results in a $5,000 ($100,000 �
$95,000) capital loss that may offset a $5,000 capital gain. Assuming a 35% corporate tax rate,
the following table summarizes the profit (loss) to Theta with and without the 45-day rule.
Dividends $5,000 $5,000
Minus: 35% tax on dividend )a )
Dividend (after taxes)
Capital loss $5,000 $5,000
Minus: 35% tax savings on loss ) )
Net loss on stock
Dividend (after taxes) $4,475 $3,250
Minus: Net loss on stockb ) )
Net profit (loss)
a[$5,000 � (0.70 � $5,000)] � 0.35 � $525
bThis example assumes the corporation has capital gains against which to deduct this capital loss.
$ –0–$1,225
(3,250(3,250
$3,250$3,250
(1,750(1,750
$3,250$4,475
(1,750(525
If Deduction Is
Not Allowed
If Deduction Is
Allowed
The Corporate Income Tax ▼ Corporations 3-17
27 Sec. 245. A limited dividends-received deduction is allowed on dividends
received from a foreign corporation that earns income by conducting a trade
or business in the United States and, therefore, is subject to U.S. taxes.
28 Sec. 246(c)(1).
ADDITIONAL
COMMENT
Stock purchased on which a divi-
dend has been declared has an
increased value. This value will
drop when the corporation pays
the dividend. If the dividend is eli-
gible for a dividends-received
deduction and the drop in value
also creates a capital loss, corpo-
rate shareholders could use this
event as a tax planning device. To
avoid this result, no dividends-
received deduction is available for
stock held 45 days or less.
EXAMPLE C:3-19 �
EXAMPLE C:3-20 �
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3-18 Corporations ▼ Chapter 3
EXAMPLE C:3-22 �
29 Sec. 246A.
30 Sec. 172(c).
31 Various other carryback and carryover periods have applied in past years.
The profit is not available if Theta sells the stock shortly after receiving the dividend
because Theta must hold the Maine stock for at least 46 days to obtain the dividends-
received deduction. �
Debt-Financed Stock. The dividends-received deduction is not allowed to the extent the
corporation borrows money to acquire the dividend paying stock.29 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.
Palmer Corporation, whose marginal tax rate is 35%, borrows $100,000 at a 10% interest rate
to purchase 30% of Sun Corporation’s stock. The Sun stock pays an $8,000 annual dividend. If a
dividends-received deduction were allowed for this investment, Palmer would have a net profit
of $940 annually on owning the Sun stock even though the dividend received is less than the
interest paid. The following table summarizes the profit (loss) to Palmer with and without the
debt-financing rule.
Dividends $ 8,000 $ 8,000
Minus: 35% tax on dividend )a )
Dividend (after taxes)
Interest paid $10,000 $10,000
Minus: 35% tax savings on deduction ) )
Net cost of borrowing
Dividend (after taxes) $ 7,440 $ 5,200
Minus: Net cost of borrowing ) )
Net profit (loss) )
a[$8,000 � ($8,000 � 0.80)] � 0.35 � $560
This example illustrates how the rule disallowing the dividends-received deduction on debt-
financed stock prevents corporations from making an after-tax profit by borrowing funds to
purchase stocks paying dividends that are less than the cost of the borrowing. �
NET OPERATING LOSSES (NOLs). If a corporation’s deductions exceed its gross
income for the year, the corporation has a net operating loss (NOL). The NOL is the
amount by which the corporation’s deductions (including any dividends-received deduc-
tion) exceed its gross income.30 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.
However, unlike an individual’s NOL, no other adjustments are required to compute a
corporation’s NOL. If the corporation has an NOL, it also would not be allowed a U.S.
production activities deduction because it has no positive taxable income.
A corporation’s NOL carries back two years and carries over 20 years. It carries to the
earliest of the two preceding years first and offsets taxable income reported in that year. If
the loss cannot be used in that year, it carries to the immediately preceding year, and then
to the next 20 years in chronological order. The corporation may elect to forgo the carry-
back period entirely and instead carry over the entire loss to the next 20 years.31
In 2013, Gray Corporation, a calendar year taxpayer, has gross income of $150,000 (including
$100,000 from operations and $50,000 in dividends from a 30%-owned domestic corporation)
and $180,000 of expenses. Gray has a $70,000 [$150,000 � $180,000 � (0.80 � $50,000)] NOL.
The NOL carries back to 2011 unless Gray elects to forego the carryback period. If Gray had
$(1,300$ 940
(6,500(6,500
$6,500$ 6,500
(3,500(3,500
$5,200$ 7,440
(2,800(560
If Deduction Is
Not Allowed
If Deduction Is
Allowed
EXAMPLE C:3-21 �
REAL-WORLD
EXAMPLE
Although sound in theory, the
debt-financed stock limitation
may be difficult to apply in prac-
tice. This difficulty became partic-
ularly apparent in a district court
case, OBH, Inc. v. U.S., 96 AFTR 2d,
2005-6801, 2005-2 USTC ¶50,627
(DC NB, 2005), where the IRS
failed to establish that a corpora-
tion’s debt proceeds were directly
traceable to the acquisition of
dividend paying stock.
ADDITIONAL
COMMENT
Borrowing money with deductible
interest to purchase a tax-advan-
taged asset, such as stock eligible
for the dividends-received deduc-
tion, is an example of “tax arbi-
trage.” Many provisions in the
IRC, such as the limits on debt-
financial stock, are aimed at cur-
tailing tax arbitrage transactions.
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The Corporate Income Tax ▼ Corporations 3-19
$20,000 of taxable income in 2011, $20,000 of Gray’s 2013 NOL offsets that income. Gray
receives a refund of all taxes paid in 2011. Gray carries the remaining $50,000 of the 2013 NOL
to 2012. Any of the NOL not used in 2012 carries over to 2014 �
A corporation might elect not to carry an NOL back because its income was taxed at
a low marginal tax rate in the carryback period and the corporation anticipates income
being taxed at a higher marginal tax rate in later years or because it used tax credit carry-
overs in the earlier year that were about to expire. The corporation must make this elec-
tion for the entire carryback by the due date (including extensions) for filing the return for
the year in which the corporation incurred the NOL. The corporation makes the election
by checking a box on Form 1120 when it files the return. Once made for a tax year, the
election is irrevocable.32 However, if the corporation incurs an NOL in another year, the
decision as to whether that NOL should be carried back is a separate decision. In other
words, each year’s NOL is treated separately and is subject to a separate election.
To obtain a refund due to carrying an NOL back to a preceding year, a corporation
files Form 1139 (Corporation Application for a Tentative Refund) if one year or less has
elapsed since the year in which the NOL occurred. If a longer period has elapsed, the cor-
poration files Form 1120X (Amended U.S. Corporation Income Tax Return).
THE SEQUENCING OF THE DEDUCTION CALCULATIONS. The rules for charita-
ble contributions, dividends-received, NOL, and U.S. production activities deductions
require that these deductions be calculated in the following sequence:
1. All deductions other than the charitable contributions deduction, the dividends-
received deduction, the NOL deduction, and the U.S. production activities deduction
2. The charitable contributions deduction
3. The dividends-received deduction
4. The NOL deduction
5. The U.S. production activities deduction
As stated previously, the charitable contributions deduction is limited to 10% of taxable
income before the charitable contributions deduction, any NOL or capital loss carryback, the
dividends-received deduction, or the U.S. production activities deduction, but after any NOL
carryover deduction. Once the corporation determines its charitable contributions deduction,
it adds back any NOL carryover deduction and subtracts the charitable contributions deduc-
tion before computing the dividends-received deduction. The corporation then subtracts the
NOL deduction, if any, before determining its U.S. production activities deduction.
East Corporation reports the following results for the current year:
Gross income from operations $150,000
Dividends from 30%-owned domestic corporation 100,000
Operating expenses 100,000
Charitable contributions 35,000
In addition, East has $50,000 of qualified production activities income in the current year
and a $40,000 NOL carryover from the previous year. East’s charitable contributions deduction
is computed as follows:
Gross income from operations $150,000
Plus: Dividends
Gross income $250,000
Minus: Operating expenses (100,000)
NOL carryover )
Base for charitable contributions limitation (adjusted taxable income)
East’s charitable contributions deduction is limited to $11,000 ($110,000 � 0.10). The
$11,000 limitation means that East has a $24,000 ($35,000 � $11,000) excess contribution that
carries over for five years. East Corporation computes its taxable income as follows:
$110,000
(40,000
100,000
32 Sec. 172(b)(3)(C).
BOOK-TO-TAX
ACCOUNTING
COMPARISON
An NOL carryover for tax pur-
poses creates a deferred tax asset,
possibly subject to a valuation
allowance.
EXAMPLE C:3-23 �
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
3-20 Corporations ▼ Chapter 3
STOP & THINK
Gross income $250,000
Minus: Operating expenses (100,000)
Charitable contributions deduction )
Taxable income before special deductions $139,000
Minus: Dividends-received deduction ($100,000 � 0.80) (80,000)
NOL carryover deduction )
Taxable income before the U.S. production activities deduction $ 19,000
Minus: U.S. production activities deduction ($19,000 � 0.09) )
Taxable income �
Note that, if an NOL carries back from a later year, it is not taken into account in
computing a corporation’s charitable contributions limitation. In other words, the contri-
bution deduction remains the same as in the year of the original return.
Assume the same facts as in Example C:3-23, except the facts pertain to a prior year, and East
carries back a $40,000 NOL to that year. East’s base for calculation of the charitable contribu-
tions limitation was computed as follows when it filed the original prior year return:
Gross income from operations $150,000
Plus: Dividends
Gross income $250,000
Minus: Operating expenses )
Adjusted taxable income
East’s charitable contributions deduction was limited to $15,000 ($150,000 � 0.10). The
$15,000 limitation means that East had a $20,000 ($35,000 � $15,000) contribution carryover
from the prior year. East Corporation computes its taxable income after the NOL carryback as
follows:
Gross income ($150,000 � $100,000) $250,000
Minus: Operating expenses (100,000)
Charitable contributions deduction )
Taxable income before special deductions $135,000
Minus: Dividends-received deduction ($100,000 � 0.80) (80,000)
NOL carryback deduction )
Taxable income before the U.S. production activities deduction $ 15,000
Minus: U.S. production activities deduction ($15,000 � 0.09) )
Taxable income as recomputed
Thus, East’s prior year charitable contributions deduction remains the same as originally
claimed. �
Question: Why does a corporation’s NOL or capital loss carryback not affect its
charitable contributions deduction, but yet the corporation must take into account an
NOL or capital loss carryover when calculating its charitable contribution limitation?
Solution: A carryback affects a tax return already filed in a prior year. If a carryback had
to be taken into account when calculating the charitable contribution deduction limita-
tion in the prior year, it might change the amount of the allowable charitable contribu-
tion. This change in turn might affect other items such as the carryback year’s dividends-
received deduction and some later years’ deductions as well. For example, assume Alpha
Corporation has a $10,000 NOL in 2013 that it carries back to 2011. If the NOL were
permitted to reduce Alpha’s allowable charitable contribution for 2011 by $1,000,
Alpha’s dividends-received deduction for 2011 and its charitable contribution deductions
for 2012 as well might change.
To avoid these complications, the law states that carrybacks are not taken into account in
calculating the charitable contribution deduction limitation. Also, in the prior year, manage-
ment made its charitable contribution decisions without knowledge of future NOLs. Altering
the result of those prior decisions with future events might be unfair.
$ 13,650
(1,350
(40,000
(15,000
$150,000
(100,000
100,000
$ 17,290
(1,710
(40,000
(11,000
ADDITIONAL
COMMENT
These computations in the carry-
back year are done on an
amended return or an application
for refund.
EXAMPLE C:3-24 �
ADDITIONAL
COMMENT
The U.S. production activities
deduction is last in the ordering
of deductions because it is lim-
ited to taxable income after all
other deductions. However, on
the corporate tax return, it
appears after the charitable con-
tributions deduction but before
the dividends-received and NOL
deductions. Specifically, it
appears on Form 1120, Line 25,
before Line 28.
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EXAMPLE C:3-25 �
33 Sec. 267(b)(2).
34 Sec. 267(e)(3).
35 Sec. 267(d).
EXCEPTIONS FOR CLOSELY HELD
CORPORATIONS
Congress has placed limits on certain transactions to prevent abuse in situations where a
corporation is closely held. Some of these restrictions are explained below.
TRANSACTIONS BETWEEN A CORPORATION AND ITS SHAREHOLDERS.
Special rules apply to transactions between a corporation and a controlling shareholder.
Section 1239 may convert a capital gain realized on the sale of depreciable property
between a corporation and a controlling shareholder into ordinary income. Section
267(a)(1) denies a deduction for losses realized on property sales between a corporation
and a controlling shareholder. Section 267(a)(2) defers a deduction for accrued expenses
and interest on certain transactions involving a corporation and a controlling shareholder.
In all three of the preceding situations, a controlling shareholder is one who owns
more than 50% (in value) of the corporation’s stock.33 In determining whether a share-
holder owns more than 50% of a corporation’s stock, certain constructive stock owner-
ship rules apply.34 Under these rules, a shareholder is considered to own not only his or
her own stock, but stock owned by family members (e.g., brothers, sisters, spouse, ances-
tors, and lineal descendants) and entities in which the shareholder has an ownership or
beneficial interest (e.g., corporations, partnerships, trusts, and estates).
Gains on Sale or Exchange Transactions. If a controlling shareholder sells depreciable
property to a controlled corporation (or vice versa) and the property is depreciable in the
purchaser’s hands, any gain on the sale is treated as ordinary income under Sec. 1239(a).
Ann owns all of Cape Corporation’s stock. Ann sells a building to Cape and recognizes a $25,000
gain, which usually would be Sec. 1231 gain or unrecaptured Sec. 1250 gain taxed (in 2013) at
the applicable capital gains rates. However, because Ann owns more than 50% of the Cape
stock and the building is a depreciable property in Cape’s hands, Sec. 1239 requires that Ann
recognize the entire $25,000 gain as ordinary income. �
Losses on Sale or Exchange Transactions. Section 267(a)(1) denies a deduction for
losses realized on a sale of property by a corporation to a controlling shareholder or on a
sale of property by the controlling shareholder to the corporation. If the purchaser later
sells the property to another party at a gain, that seller recognizes gain only to the extent
it exceeds the previously disallowed loss.35 Should the purchaser instead sell the property
at a loss, the previously disallowed loss is never recognized.
Quattros Corporation sells an automobile to Juan, its sole shareholder, for $6,500. The corpora-
tion’s adjusted basis for the automobile is $8,000. Quattros realizes a $1,500 ($6,500 � $8,000)
loss on the sale. Section 267(a)(1), however, disallows the loss to the corporation. If Juan later
sells the auto for $8,500, he realizes a $2,000 ($8,500 � $6,500) gain. He recognizes only $500 of
that gain, the amount by which his $2,000 gain exceeds the $1,500 loss previously disallowed to
Quattros. If Juan instead sells the auto for $7,500, he realizes a $1,000 ($7,500 � $6,500) gain
but recognizes no gain or loss. The previously disallowed loss reduces the gain to zero but may
not create a loss. Finally, if Juan instead sells the auto for $4,000, he realizes and may be able to
recognize a $2,500 ($4,000 � $6,500) loss. However, the $1,500 loss previously disallowed to
Quattros is permanently lost. �
Corporation and Controlling Shareholder Using Different Accounting Methods.
Section 267(a)(2) defers a deduction for accrued expenses or interest owed by a corpora-
tion to a controlling shareholder or by a controlling shareholder to a corporation when
the two parties use different accounting methods and the payee thereby includes the
amount in gross income later than when the payer accrues the deduction. Under this rule,
accrued expenses or interest owed by a corporation to a controlling shareholder may not
be deducted until the shareholder includes the payment in gross income.
The Corporate Income Tax ▼ Corporations 3-21
BOOK-TO-TAX
ACCOUNTING
COMPARISON
The denial of deductions for losses
involving related party transac-
tions is unique to the tax area.
Financial accounting rules contain
no such disallowance provision.
EXAMPLE C:3-26 �
KEY POINT
Section 267(a)(2) is primarily
aimed at the situation involving
an accrual method corporation
that accrues compensation to a
cash method shareholder-
employee. This provision forces a
matching of the income and
expense recognition by deferring
the deduction to the year the
shareholder recognizes the
income.
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� TABLE C:3-2
Computation of the Corporate Regular (Income) Tax Liability
Taxable income
Regular tax liability
Regular tax
Minus: General business credit (Sec. 38)
Minimum tax credit (Sec. 53)
Other allowed credits
Income (regular) tax liability
Plus: Recapture of previously claimed tax credits
Minus: Foreign tax credit (Sec. 27)
Times: Income tax rates
3-22 Corporations ▼ Chapter 3
Hill Corporation uses the accrual method of accounting. Hill’s sole shareholder, Ruth, uses the
cash method of accounting. Both taxpayers use the calendar year as their tax year. The corpora-
tion accrues a $25,000 interest payment to Ruth on December 20 of the current year. Hill makes
the payment on March 20 of next year. Hill, however, cannot deduct the interest in the current
year but must wait until Ruth reports the income next year. Thus, the expense and income are
matched. �
LOSS LIMITATION RULES
At-Risk Rules. If five or fewer shareholders own more than 50% (in value) of a C corpo-
ration’s outstanding stock at any time during the last half of the corporation’s tax year, the
corporation is subject to the at-risk rules.36 In such case, the corporation can deduct
losses pertaining to an activity only to the extent the corporation is at risk for that activ-
ity at year-end. Any losses not deductible because of the at-risk rules must be carried over
and deducted in a succeeding year when the corporation’s risk with respect to the activity
increases. (See Chapter C:9 for additional discussion of the at-risk rules.)
Passive Activity Limitation Rules. Personal service corporations (PSCs) and closely held
C corporations (those subject to the at-risk rules described above) also may be subject to
the passive activity limitations.37 If a PSC does not meet the material participation require-
ments, its net passive losses and credits must be carried over to a year when it has passive
income. In the case of closely held C corporations that do not meet material participation
requirements, passive losses and credits are allowed to offset the corporation’s net active
income but not its portfolio income (i.e., interest, dividends, annuities, royalties, and cap-
ital gains on the sale of investment property).38
36 Sec. 465(a).
37 Secs. 469(a)(2)(B) and (C).
38 Sec. 469(e)(2).
EXAMPLE C:3-27 �
OBJECTIVE 3
Compute a corporation’s
regular income tax liability
Once a corporation determines its taxable income, it then must compute its tax liability
for the year. Table C:3-2 outlines the steps for computing a corporation’s regular (income)
tax liability. This section explains the steps involved in arriving at a corporation’s income
tax liability in detail.
COMPUTING A
CORPORATION’S INCOME TAX
LIABILITY
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REAL-WORLD
EXAMPLE
In 2011, the IRS collected
$243 billion from corporations,
which was 10% of the
$2.41 trillion collected by
the IRS. This percentage is
down from 11.9% in 2010.
EXAMPLE C:3-28 �
The Corporate Income Tax ▼ Corporations 3-23
GENERAL RULES
All C corporations (other than members of controlled groups of corporations and per-
sonal service corporations) use the same tax rate schedule to compute their regular tax lia-
bility. The following table shows these rates, which also are reproduced on the inside back
cover of this textbook.
$ –0– $ 50,000 15% $ –0–
50,000 75,000 $ 7,500 � 25% 50,000
75,000 100,000 13,750 � 34% 75,000
100,000 335,000 22,250 � 39% 100,000
335,000 10,000,000 113,900 � 34% 335,000
10,000,000 15,000,000 3,400,000 � 35% 10,000,000
15,000,000 18,333,333 5,150,000 � 38% 15,000,000
18,333,333 — 6,416,667 � 35% 18,333,333
Copper Corporation reports taxable income of $100,000. Copper’s regular tax liability is com-
puted as follows:
Tax on first $50,000: 0.15 � $50,000 � $7,500
Tax on second $25,000: 0.25 � 25,000 � 6,250
Tax on remaining $25,000: 0.34 � 25,000 �
Regular tax liability
This tax liability also can be determined from the above tax rate schedule. �
If taxable income exceeds $100,000, a 5% surcharge applies to the corporation’s taxable
income exceeding $100,000. The surcharge phases out the lower graduated tax rates that
apply to the first $75,000 of taxable income for corporations earning between $100,000
and $335,000 of taxable income. The maximum surcharge is $11,750 [($335,000 �
$100,000) � 0.05]. The above tax rate schedule incorporates the 5% surcharge by impos-
ing a 39% (34% � 5%) rate on taxable income from $100,000 to $335,000.
Delta Corporation reports taxable income of $200,000. Delta’s regular tax liability is computed
as follows:
Tax on first $50,000: 0.15 � $ 50,000 � $ 7,500
Tax on next $25,000: 0.25 � 25,000 � 6,250
Tax on remaining $125,000: 0.34 � 125,000 � 42,500
Surcharge (income over $100,000): 0.05 � 100,000 �
Regular tax liability
Alternatively, from the above tax rate schedule, the tax is $22,250 � [0.39 � ($200,000 �
$100,000)] � $61,250. �
If taxable income is at least $335,000 but less than $10 million, the corporation pays a flat
34% tax rate on all of its taxable income. A corporation whose income is at least $10 mil-
lion but less than $15 million pays $3.4 million plus 35% of the income above $10 million.
Elgin Corporation reports taxable income of $350,000. Elgin’s regular tax liability is $119,000
(0.34 � $350,000). If Elgin’s taxable income is instead $12 million, its tax liability is $4.1 million
[$3,400,000 � (0.35 � $2,000,000)]. �
If a corporation’s taxable income exceeds $15 million, a 3% surcharge applies to the
corporation’s taxable income exceeding $15 million (but not exceeding $18,333,333).
The surcharge phases out the one percentage point lower rate (34% vs. 35%) that applies
to the first $10 million of taxable income. The maximum surcharge is $100,000
[($18,333,333 � $15,000,000) � 0.03]. The above tax rate schedule incorporates the 3%
$61,250
5,000
$22,250
8,500
Of the
Amount OverThe Tax IsBut Not OverTaxable Income Over
EXAMPLE C:3-29 �
EXAMPLE C:3-30 �
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OBJECTIVE 4
Recognize what a
controlled group is and
determine the tax
consequences of being
a controlled group
3-24 Corporations ▼ Chapter 3
surcharge by imposing a 38% (35% � 3%) rate on taxable income from $15 million to
$18,333,333. A corporation whose taxable income exceeds $18,333,333 pays a flat 35%
tax rate on all its taxable income.
Question: Planner Corporation has an opportunity to realize $50,000 of additional
income in either the current year or next year. Planner has some discretion as to the timing
of this additional income. Not counting the additional income, Planner’s current year
taxable income is $200,000, and it expects next year’s taxable income to be $500,000. In
what year should Planner recognize the additional $50,000?
Solution: Even though Planner’s current year taxable income is lower than next year’s
expected taxable income, Planner will have a lower marginal tax rate next year. The cur-
rent year’s marginal tax rate is 39% because Planner’s taxable income is in the 5% surtax
range (or 39% “bubble”). Next year’s taxable income is beyond the 39% bubble and is in
the flat 34% range. Thus, Planner can save $2,500 (0.05 � $50,000) in taxes by deferring
the $50,000 until next year.
PERSONAL SERVICE CORPORATIONS
Personal service corporations are denied the benefit of the graduated corporate tax rates.
Thus, all the income of personal service corporations is taxed at a flat 35% rate.
Section 448(d) defines a personal service corporation as a corporation that meets the
following two tests:
� Substantially all its activities involve the performance of services in the fields of health,
law, engineering, architecture, accounting, actuarial science, performing arts, and con-
sulting.
� Substantially all its stock (by value) is held directly or indirectly by employees per-
forming the services or retired employees who performed the services in the past, their
estates, or persons who hold stock in the corporation by reason of the death of an
employee or retired employee within the past two years.
This rule encourages employee-owners of personal service corporations either to with-
draw earnings from the corporation as deductible salary (rather than have the corpora-
tion retain them) or make an S election.
STOP & THINK
CONTROLLED GROUPS
OF CORPORATIONS
Special tax rules apply to corporations under common control to prevent them from avoid-
ing taxes that otherwise would be due. The rules apply to corporations that meet the defini-
tion of a controlled group. This section explains why special rules apply to controlled groups,
how the IRC defines controlled groups, and what special rules apply to controlled groups.
WHY SPECIAL RULES ARE NEEDED
Special controlled group rules prevent shareholders from using multiple corporations to
avoid having corporate income taxed at a 35% rate. If these rules were not in effect, the
owners of a corporation could allocate the corporation’s income among two or more cor-
porations and take advantage of the lower 15%, 25%, and 34% rates on the first $10
million of corporate income for each corporation.
The following example demonstrates how a group of shareholders could obtain a sig-
nificant tax advantage by dividing a business enterprise among several corporate entities.
Each corporation then could take advantage of the graduated corporate tax rates. To pre-
vent a group of shareholders from using multiple corporations to gain such tax advan-
tages, Congress enacted laws that limit the tax benefits of multiple corporations.39
39 Secs. 1561 and 1563.
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40 Sec. 1563(a)(1). Section 1563(d)(1) requires that certain attribution rules
apply to determine stock ownership for parent-subsidiary controlled groups.
If any person has an option to acquire stock, such stock is considered owned
by the person having the option. Section 1563(c) excludes certain types of
stock from the controlled group definition of stock.
EXAMPLE C:3-31 �
EXAMPLE C:3-32 �
Axle Corporation reports taxable income of $450,000. Axle’s regular tax liability on that income
is $153,000 (0.34 � $450,000). If Axle could divide its taxable income equally among six corpo-
rations ($75,000 apiece), each corporation’s federal income tax liability would be $13,750 [(0.15
� $50,000) � (0.25 � $25,000)], or an $82,500 total regular tax liability for all the corporations.
Thus, Axle could save $70,500 ($153,000 � $82,500) in federal income taxes. �
The law governing controlled corporations requires special treatment for two or more
corporations controlled by the same shareholder or group of shareholders. The most
important restrictions on a controlled group of corporations are that the group must
share the benefits of the progressive corporate tax rate schedule and pay a 5% surcharge
on the group’s taxable income exceeding $100,000, up to a maximum surcharge of
$11,750, and also pay a 3% surcharge on the group’s taxable income exceeding $15 mil-
lion, up to a maximum surcharge of $100,000.
White, Blue, Yellow, and Green Corporations belong to a controlled group. Each corporation
reports $100,000 of taxable income (a total of $400,000). Only one $50,000 amount is taxed at
15% and only one $25,000 amount is taxed at 25%. Furthermore, the group is subject to the
maximum $11,750 surcharge because its total taxable income exceeds $335,000. This sur-
charge is levied on the group member(s) that received the benefit of the 15 and 25% rates.
Therefore, the group’s total regular tax liability is $136,000 (0.34 � $400,000), as though one
corporation earned the entire $400,000. Each corporation would be allocated $34,000 of this
tax liability. �
WHAT IS A CONTROLLED GROUP?
A controlled group is comprised of two or more corporations owned directly or indi-
rectly by the same shareholder or group of shareholders. Controlled groups fall into
three categories: a parent-subsidiary controlled group, a brother-sister controlled group,
and a combined controlled group. Each of these groups is subject to the limitations
described above.
PARENT-SUBSIDIARY CONTROLLED GROUPS. In a parent-subsidiary controlled
group, one corporation (the parent corporation) must directly own at least 80% of the
voting power of all classes of voting stock, or 80% of the total value of all classes of
stock, of a second corporation (the subsidiary corporation).40 The group can contain
more than one subsidiary corporation. If the parent corporation, the subsidiary corpora-
tion, or any other members of the controlled group in total own at least 80% of the vot-
ing power of all classes of voting stock, or 80% of the total value of all classes of stock, of
another corporation, that other corporation also is included in the parent-subsidiary con-
trolled group.
Parent Corporation owns 80% of Axle Corporation’s single class of stock and 40% of Wheel
Corporation’s single class of stock. Axle also owns 40% of Wheel’s stock. (See Figure C:3-2.)
Parent, Axle, and Wheel are members of the same parent-subsidiary controlled group because
Parent directly owns 80% of Axle’s stock and therefore is its parent corporation, and Wheel’s
stock is 80% owned by Parent (40%) and Axle (40%).
If Parent and Axle together owned only 70% of Wheel’s stock and an unrelated shareholder
owned the remaining 30%, Wheel would not be included in the parent-subsidiary group. The
controlled group then would consist only of Parent and Axle. �
Beta Corporation owns 70% of Spectrum Corporation’s single class of stock and 60% of Red
Corporation’s single class of stock. Blue Corporation owns the remaining stock of Spectrum
(30%) and Red (40%). No combination of these corporations forms a parent-subsidiary group
because no corporation has direct stock ownership of at least 80% of any other corporation’s
stock. �
EXAMPLE C:3-33 �
The Corporate Income Tax ▼ Corporations 3-25
ADDITIONAL
COMMENT
For purposes of the Sec. 179
expense dollar limitation, a more-
than-50% threshold replaces the
at-least-80% threshold in defining
a parent-subsidiary controlled
group.
EXAMPLE C:3-34 �
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3-26 Corporations ▼ Chapter 3
41 Sec. 1563(a)(2). Section 1563(d)(2) requires that certain attribution rules
apply to determine stock ownership for brother-sister controlled groups. If
any person has an option to acquire stock, such stock is considered to be
owned by the person having the option. A proportionate amount of stock
owned by a partnership, estate, or trust is attributed to partners having an
interest of 5% or more in the capital or profits of the partnership or benefici-
aries having a 5% or more actuarial interest in the estate or trust. A propor-
tionate amount of stock owned by a corporation is attributed to shareholders
owning 5% or more in value of the corporate stock. Family attribution rules
also can cause an individual to be considered to own the stock of a spouse,
child, grandchild, parent, or grandparent.
BROTHER-SISTER CONTROLLED GROUPS. The IRC contains two definitions of a
brother-sister controlled group. This textbook will refer to them as the 50%-80% defini-
tion and the 50%-only definition. Under the 50%-80% definition, a group of two or
more corporations is a brother-sister controlled group if five or fewer individuals, trusts,
or estates meet both of the following conditions:
� More than 50% of the voting power of all classes of stock (or more than 50% of the
total value of the outstanding stock) of each corporation, taking into account only the
stock ownership that is common with respect to each corporation.41 A common own-
ership is the percentage of stock a shareholder owns that is common or identical in
each of the corporations. For example, if a shareholder owns 30% of New
Corporation and 70% of Old Corporation, his or her common ownership is 30%.
� At least 80% of the voting power of all classes of voting stock (or at least 80% of the
total value of the outstanding stock) of each corporation.
Thus, under the 50%-80% definition, the five or fewer shareholders not only must
have more than 50% common ownership in the corporations, they also must own at least
80% of the stock of each corporation in the brother-sister group. This definition is nar-
row because the shareholders must meet two tests.
The 50%-only definition, on the other hand, is broader than the 50%-80% definition
in that the five or fewer shareholders must satisfy only the 50% common ownership test
described above. Consequently, in situations where the 50%-only definition applies, more
corporations may be pulled into the controlled group than under the 50%-80% defini-
tion. Table C:3-3 on page C:3-29 indicates which definition applies to specific situations.
North and South Corporations have only one class of stock outstanding, owned by the follow-
ing individuals:
Walt 30% 70% 30%
Gail
Total 100% 100% 60%
Five or fewer individuals (Walt and Gail) together own at least 80% (actually 100%) of each
corporation’s stock, and the same individuals own more than 50% (actually 60%) of the corpo-
rations’ stock taking into account only their common ownership in each corporation. Because
30%30%70%
Common
OwnershipSouth Corp.North Corp.Shareholder
Stock Ownership Percentages
Parent
Corporation
Axle
Corporation
Wheel
Corporation
80%
40%
40%
FIGURE C:3-2 � PARENT-SUBSIDIARY CONTROLLED GROUP (EXAMPLE C:3-33)
EXAMPLE C:3-35 �
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The Corporate Income Tax ▼ Corporations 3-27
their ownership satisfies both tests, North and South are a brother-sister controlled group
under the 50%-80% definition. (See Figure C:3-3.) �
East and West Corporations have only one class of stock outstanding, owned by the following
individuals:
Javier 80% 25% 25%
Sara
Total 100% 100% 45%
Five or fewer individuals (Javier and Sara) together own at least 80% (actually 100%) of
each corporation’s stock. However, those same individuals own only 45% of the corporations’
stock taking into account only their common ownership. Because their ownership does not sat-
isfy the more-than-50% test, East and West are not a brother-sister controlled group under
either the 50%-80% or the 50%-only definition. Consequently, each corporation is taxed on its
own income without regard to the earnings of the other. �
An individual’s stock ownership can be counted for the 80% test only if that individ-
ual owns stock in each and every corporation in the controlled group.42
Long and Short Corporations each have only a single class of stock outstanding, owned by the
following individuals:
Al 50% 40% 40%
Beth 20% 60% 20%
Carol
Total 100% 100% 60%
Carol’s stock does not count for purposes of Long’s 80% stock ownership requirement
because she owns no stock in Short. Only Al’s and Beth’s stock holdings count, and together
they own only 70% of Long’s stock. Thus, the 80% test fails. Consequently, Long and Short are
not a brother-sister controlled group under the 50%-80% defintion, but they are a brother-
sister controlled group under the 50%-only definition. �
——30%
Common
OwnershipShort Corp.Long Corp.Shareholder
Stock Ownership Percentages
20%75%20%
Common
OwnershipWest Corp.East Corp.Shareholder
Stock Ownership Percentages
Walt
Gail
30%
30%
70
%
70%
North
Corporation
South
Corporation
FIGURE C:3-3 � BROTHER-SISTER CONTROLLED GROUP (EXAMPLE C:3-35)
EXAMPLE C:3-36 �
42 Reg. Sec. 1.1563-1(a)(3).
EXAMPLE C:3-37 �
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3-28 Corporations ▼ Chapter 3
COMBINED CONTROLLED GROUPS. A combined controlled group is comprised of
three or more corporations meeting the following criteria:
� Each corporation is a member of a parent-subsidiary controlled group or a brother-
sister controlled group
� At least one of the corporations is both the parent corporation of a parent-subsidiary
controlled group and a member of a brother-sister controlled group.43
Able, Best, and Coast Corporations each have a single class of stock outstanding, owned by the
following shareholders:
Art 50% 50% —
Barbara 50% 50% —
Able Corp. — — 100%
Able and Coast are a brother-sister controlled group under the 50%-80% definition
because Art’s and Barbara’s ownership satisfy both the 80% and 50% tests. Able and Best are a
parent-subsidiary controlled group because Able owns all of Best’s stock. Each of the three cor-
porations is a member of either the parent-subsidiary controlled group (Able and Best) or the
brother-sister controlled group (Able and Coast), and the parent corporation (Able) of the par-
ent-subsidiary controlled group also is a member of the brother-sister controlled group.
Therefore, Able, Best, and Coast Corporations are members of a combined controlled group.
(See Figure C:3-4.) �
APPLICATION OF THE CONTROLLED GROUP TEST
Controlled group status generally is tested on December 31. A corporation is included in
a controlled group if it is a group member on December 31 and has been a group member
on at least one-half of the days in its tax year that precede December 31. A corporation
that is not a group member on December 31, nevertheless, is considered a member for the
tax year if it has been a group member on at least one-half the days in its tax year that pre-
cede December 31. Corporations are excluded from the controlled group if they were
members for less than one-half the days in their tax year that precede December 31 or if
they retain certain special tax statuses such as being a tax-exempt corporation.
Best Corp.Coast Corp.Able Corp.Shareholder
Stock Ownership Percentages
43 Sec. 1563(a)(3).
Art Barbara
50%
50
%50%
50%
100%
Able
Corporation
Best
Corporation
Coast
Corporation
FIGURE C:3-4 � COMBINED CONTROLLED GROUP (EXAMPLE C:3-38)
EXAMPLE C:3-38 �
KEY POINT
The combined controlled group
definition does just what its name
implies: It combines a parent-
subsidiary controlled group and a
brother-sister controlled group.
Thus, instead of trying to apply
the controlled group rules to two
different groups, the combined
group definition eliminates the
issue by combining the groups
into one controlled group.
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The Corporate Income Tax ▼ Corporations 3-29
Ace and Copper Corporations are members of a parent-subsidiary controlled group of which
Ace is the common parent. Both corporations are calendar year taxpayers and have been group
members for the entire year. They do not file a consolidated return. Bell Corporation, which has
a fiscal year ending on August 31, becomes a group member on December 1 of the current
year. Although Bell is a group member on December 31 of the current year, it has been a group
member for less than half the days in its tax year that precede December 31—only 30 of 121
days starting on September 1. Therefore, Bell is not a member of the Ace-Copper controlled
group for its tax year beginning on September 1 of the current year. �
SPECIAL RULES APPLYING TO CONTROLLED
GROUPS
As discussed earlier, if two or more corporations are members of a controlled group, the
member corporations are limited to a total of $50,000 taxed at 15%, $25,000 being
taxed at 25%, and $9,925,000 million being taxed at 34%. For brother-sister corpora-
tions, the broader 50%-only definition applies for limiting the reduced tax rates.
In addition, a controlled group must apportion certain other items among its group mem-
bers, some of which are shown in Table C:3-3. For purposes of apportioning the Sec. 179
expense dollar limitation in a parent-subsidiary situation, the corporations are considered a
controlled group if the ownership percentage is more than 50% rather than at least 80%.44
In addition to the above restrictions, Sec. 267(a)(1) allows no deduction for any loss
on the sale or exchange of property between two members of the same controlled group,
with control defined as more than 50% rather than as at least 80%. However, in contrast
to losses between a corporation and controlling shareholder described earlier in this chap-
ter, a loss realized on a transaction between members of a controlled group is deferred
(instead of being disallowed). The original selling member recognizes the deferred loss
when the property sold or exchanged in the intragroup transaction is sold outside the con-
trolled group.
Section 267(a)(2) allows no deduction for certain accrued expenses or interest owed by
one member of a controlled group to another member of the same controlled group when the
two corporations use different accounting methods so that the payments would be reported in
different tax years. (See page C:3-21 for a detailed discussion of Sec. 267.) The Sec. 1239 rules
that convert capital gain into ordinary income on depreciable property sales between related
parties also apply to sales or exchanges involving two members of the same controlled group.
Sections 267 and 1239, however, provide special definitions of controlled groups that differ
somewhat from those described above. These details are beyond the scope of this textbook.
CONSOLIDATED TAX RETURNS
WHO CAN FILE A CONSOLIDATED RETURN. Some groups of related corporations
(i.e., affiliated groups) may elect to file a single income tax return called a consolidated
tax return. An affiliated group is one or more chains of includible corporations connected
through stock ownership with a common parent. In general, includible corporations are
those other than foreign corporations, certain insurance companies, tax-exempt organiza-
EXAMPLE C:3-39 �
TAX STRATEGY TIP
A controlled group of corpora-
tions should elect to apportion
the tax benefits in a manner that
maximizes the tax savings from
the tax benefits. See Tax Planning
Considerations later in this chap-
ter for details.
44 Secs. 179(d)(6) and (7).
TYPICAL
MISCONCEPTION
The definitions of a parent-
subsidiary controlled group and
an affiliated group are similar,
but not identical. For example,
the 80% stock ownership test for
controlled group purposes is satis-
fied if 80% of the voting power
or 80% of the FMV of a corpora-
tion’s stock is owned. For pur-
poses of an affiliated group, 80%
of both the voting power and the
FMV of a corporation’s stock must
be owned.
� TABLE C:3-3
Items that Must be Apportioned if a Controlled Group Exists
Brother-Sister Parent-Subsidiary
Item 50%-Only 50%–80% � 80% � 50%
Low-bracket tax rates x x x
AMT exemption x x x
Minimum accumulated earnings tax credit x x x
Section 179 expense limitation x x x
General business tax credit limitation x x
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3-30 Corporations ▼ Chapter 3
tions, S corporations, and a few other specially defined corporations. The required own-
ership criteria are as follows:
� The common parent must directly own stock with at least 80% of the voting power
and 80% of the value of at least one includible corporation.
� One or more group members must directly own stock with at least 80% of the voting
power and 80% of the value of each other corporation included in the affiliated group.45
Many parent-subsidiary controlled groups also qualify as affiliated groups and thus are
eligible to file a consolidated return in place of separate tax returns for each corporation. The
parent-subsidiary portion of a combined group also can file a consolidated tax return if it also
qualifies as an affiliated group. Brother-sister controlled groups, however, are not eligible to
file consolidated returns because the requisite parent-subsidiary relationship does not exist.
An affiliated group elects to file a consolidated tax return by filing Form 1120, which
includes all the income and expenses of each of its members. Each corporate member of
the affiliated group must consent to the original election. Thereafter, any new member of
the affiliated group must join in the consolidated return.
ADVANTAGES OF FILING A CONSOLIDATED RETURN. A consolidated return, in
effect, is one tax return for the entire affiliated group of corporations. The main advan-
tages of filing a consolidated return are
� Losses of one member of the group can offset profits of another member of the group.
� Capital losses of one member of the group can offset capital gains of another member
of the group.
� Profits or gains realized on intercompany transactions are deferred until a sale outside
the group occurs (i.e., if one member sells property to another member, the gain is post-
poned until the member sells the property to someone outside the affiliated group).
In contrast, if the group members file separate returns, members with NOLs or capital
losses must either carry back these losses to earlier years or carry them over to future
years rather than offset another member’s profits or gains.
Although the losses of one group member can offset the profits of another group member
when the group files a consolidated return, some important limitations apply to the use of a
member corporation’s NOL. These limitations prevent one corporation from purchasing
another corporation’s NOL carryovers to offset its own taxable income or purchasing a prof-
itable corporation to facilitate the use of its own NOL carryovers. (See Chapters C:7 and C:8.)
The following example illustrates the advantage of a consolidated return election.
Parent Corporation owns 100% of Subsidiary Corporation’s stock. Parent reports $110,000 of
taxable income, including a $10,000 capital gain. Subsidiary incurs a $100,000 NOL and a
$10,000 capital loss. If Parent and Subsidiary file separate returns, Parent has a $26,150 [$22,250
� 0.39 � ($110,000 � $100,000)] tax liability. Subsidiary has no tax liability but may be able to
use its $100,000 NOL and $10,000 capital loss to offset taxable income in other years. On the
other hand, if Parent and Subsidiary file a consolidated return, the group’s consolidated tax-
able income is zero and the group has no tax liability. By filing a consolidated return, the group
saves $26,150 in taxes for the year. �
DISADVANTAGES OF FILING A CONSOLIDATED RETURN. The main disadvan-
tages of a consolidated return election are
� The election is binding on all subsequent tax years unless the IRS grants permission to
discontinue filing consolidated returns or the affiliated group terminates.
� Losses on intercompany transactions are deferred until a sale outside the group takes place.
� One member’s Sec. 1231 loss offsets another member’s Sec. 1231 gain instead of being
reported as an ordinary loss.
� Losses of an unprofitable member of the group may reduce the deduction or credit
limitations of the group below what would be available had the members filed sepa-
rate tax returns.
BOOK-TO-TAX
ACCOUNTING
COMPARISON
The corporations included in a
consolidated tax return may differ
from those included in consoli-
dated financial statements. Page
1 of Schedule M-3 reconciles
financial statement worldwide
consolidated net income to finan-
cial statement net income (loss) of
corporations included in the con-
solidated tax return.
SELF-STUDY
QUESTION
What is probably the most com-
mon reason for making a consoli-
dated return election?
ANSWER
Filing consolidated returns allows
the group to offset losses of one
corporation against the profits of
other members of the group.
EXAMPLE C:3-40 �
45 Sec. 1504(a).
ADDITIONAL
COMMENT
Under Sec. 267 discussed earlier,
intercompany losses may be
deferred even if the corporations
file separate tax returns.
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The Corporate Income Tax ▼ Corporations 3-31
� The group may incur additional administrative costs in maintaining the records
needed to file a consolidated return.
Determining whether to make a consolidated tax return election is a complex decision
because of the various advantages and disadvantages and because the election is so diffi-
cult to revoke once made. Chapter C:8 provides detailed coverage of the consolidated
return rules.
TAX PLANNING
CONSIDERATIONS
COMPENSATION PLANNING FOR
SHAREHOLDER-EMPLOYEES
Compensation paid to a shareholder-employee in the form of salary has the advantage of
single taxation because, while taxable to the employee, salary is deductible by the corpo-
ration. Dividend payments, on the other hand, are taxed twice. The corporation is taxed
on its income when earned, and the shareholder is taxed on profits distributed as divi-
dends. Double taxation occurs because the corporation may not deduct dividend pay-
ments. The applicable capital gains tax rate on dividends, however, makes the difference
between salary and dividends less substantial than it would be if dividends were taxed at
ordinary rates.
Delta Corporation earns $500,000 and wishes to distribute $100,000 or as much of the $100,000
as possible to Mary, its sole shareholder and CEO. Mary’s ordinary tax rate is 39.6%, her capital
gains rate is 23.8% (including the 3.8% net investment tax rate), and the corporation’s
marginal tax rate is 34%. Ignoring payroll taxes, the following table compares salary and
dividend payments to Mary with respect to the $100,000 of partial earnings:
EXAMPLE C:3-41 �
OBJECTIVE 5
Identify planning
strategies to reduce
taxes for corporations
and their shareholders
1. Corporate earnings (partial) $100,000 $100,000
2. Minus: Salary deduction )
3. Corporate taxable income (partial) $ -0- $100,000
4. Times: Corporate tax rate
5. Corporate income tax (on partial income)
6. Dividend to Mary (Line 1 � Line 5) $100,000 $ 66,000
7. Times: Mary’s tax rate
8. Mary’s tax
9. Total tax (Line 5 � Line 8)
10. Overall tax rate (Line 9 � Line 1) 49.7%39.6%
$ 49,708$ 39,600
$ 15,708$ 39,600
0.2380.396
$ 34,000$ -0-
0.340.34
-0-(100,000
Dividend at Capital
Gains Tax RateSalary
Thus, in this situation, the double taxation due to paying nondeductible dividends instead of
deductible salary increases Mary’s overall tax rate from 39.6% to 49.7%. �
To avoid double taxation, some owners of closely held corporations prefer to be taxed
under the rules of Subchapter S (see Chapter C:11). Other owners of closely held corpora-
tions retain C corporation status to use the 15% and 25% marginal corporate tax rates
and to benefit from nontaxable fringe benefits such as health and accident insurance. These
fringe benefits are nontaxable to the employee and deductible by the corporation. For both
tax and nontax reasons, closely held corporations must determine the appropriate level of
earnings to be withdrawn from the business in the form of salary and fringe benefits and
the amount of earnings to be retained in the business.
ADVANTAGE OF SALARY PAYMENTS. If a corporation distributes all its profits as
deductible salary and fringe benefit payments, it will eliminate double taxation. However,
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3-32 Corporations ▼ Chapter 3
46 Sec. 162(m).
47 Sec. 1561(a).
� Regulation Sec. 1.162-7(a) requires salary or fringe benefit payments to be reasonable
in amount and to be paid for services rendered by the employee. If the IRS deems com-
pensation to be unreasonable, it may disallow the portion of the salary it deems unrea-
sonable while still requiring the employee to include all compensation in gross income
(see Chapter C:4). This disallowance will result in double taxation. The reasonable
compensation restriction primarily affects closely held corporations.
� A corporation may not deduct compensation paid to an executive of a publicly traded
corporation that exceeds $1 million. However, this limitation does not apply to com-
pensation paid to an executive other than the corporation’s top five officers, or to per-
formance-based compensation.46
� A corporation is a taxpaying entity independent of its owners. The first $75,000 of a
corporation’s earnings is taxed at 15% and 25% corporate tax rates. These rates are
lower than the marginal tax rate that may apply to an individual taxpayer and pro-
vides an incentive to retain some earnings in the corporation instead of paying them
out as salaries.
� A combined employee–employer Social Security tax rate of 15.3% generally applies
Employers and employees were each liable for 6.2% of old age security and disability insur-
ance tax, or a total of 12.4% on wages up to the salary cap ($110,100 in 2012; $113,700
in 2013). Employers and employees also are each liable for a 1.45% Medicare hospital
insurance tax, for a total of 2.9% of all wages. (However, see Additional Comment in the
margin.) In addition to these taxes, state and federal unemployment taxes may be imposed
on a portion of wages paid.
ADVANTAGE OF FRINGE BENEFITS. Fringe benefits provide two types of tax advan-
tages: a tax deferral or an exclusion. Qualified pension, profit-sharing, and stock bonus
plans provide a tax deferral; that is, the corporation’s contribution to such a plan is not tax-
able to the employees when the corporation makes the contribution. Instead, employees are
taxed on the benefits when they receive them. Other common fringe benefits, such as group
term life insurance, accident and health insurance, and disability insurance, are exempt
from tax altogether; that is, the employee never is taxed on the value of these fringe benefits.
Because the employee excludes the value of fringe benefits from gross income, the mar-
ginal individual tax rate applicable to these benefits is zero. Thus, conversion of salary
into a fringe benefit provides tax savings for the shareholder-employee equal to the
amount of the converted salary times the employee’s marginal tax rate, assuming the
shareholder-employee could not purchase the same fringe benefit and deduct its cost on
his or her individual tax return.
SPECIAL ELECTION TO ALLOCATE REDUCED
TAX RATE BENEFITS
A controlled group may elect to apportion the tax benefits of the 15%, 25%, and 34% tax
rates to the member corporations in any manner it chooses. If the corporations elect no spe-
cial apportionment plan, the $50,000, $25,000, and $9,925,000 amounts allocated to the
three reduced tax rate brackets are divided equally among all the corporations in the
group.47 If a controlled group has one or more group members that report little or no taxable
income, the group should elect special apportionment of the reduced tax benefits to obtain
the full tax savings resulting from the reduced rates. The following steps outline a set of pro-
cedures for apportioning tax rates for taxable income levels at or below $10 million.48
1. If aggregate positive taxable income is $100,000 or less, apportion the 15%, 25%, and
34% rates to members that have positive taxable income so as to maximize their benefit.
a. To avoid “wasting” low tax rates on loss members, elect special apportionment of
tax benefits.
TAX STRATEGY TIP
A fringe benefit probably is the
most cost effective form of com-
pensation because the amount of
the benefit is deductible by the
employer and never taxed to the
employee. Thus, where possible,
fringe benefits are an excellent
compensation planning tool. For
closely held corporations, how-
ever, the tax savings to share-
holder-employees are reduced
because the fringe benefit must
be offered to all employees with-
out discrimination.
ADDITIONAL
COMMENT
In 2011 and 2012, the employee’s
portion of the Social Security tax
rate was reduced from 6.2% to
4.2%. Congress did not extend
that reduction beyond 2012.
Beginning in 2013, an additional
0.9% for the Medicare hospital
insurance tax applies to the
employee’s portion of wages
exceeding $200,000 ($250,000 for
married filing jointly).
ADDITIONAL
COMMENT
Reasonableness of a salary pay-
ment is a question of fact to be
determined in each case. No for-
mula can be used to determine a
reasonable amount.
48 For the sake of simplicity, we do not extend the procedures to taxable
income exceeding $10 million but similar procedures apply.
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The Corporate Income Tax ▼ Corporations 3-33
EXAMPLE C:3-42 �
b. Summing the members’ taxes results in the same total tax as would occur by apply-
ing the corporate tax rate schedule to the group’s aggregate positive taxable income.
2. If aggregate positive taxable income is between $100,000 and $335,000, apportion the
15%, 25%, and 34% brackets as in Step 1 above. Follow the next steps to apportion
the 5% surtax.
a. Calculate the surtax as 5% times (aggregate positive taxable income � $100,000).
b. If the calculated surtax is $9,500 or less, apportion the calculated surtax in propor-
tion to the way the corporations apportioned the 15% bracket.
c. If the surtax is greater than $9,500 ($11,750 maximum), apportion the first $9,500
as in Step 2b, and apportion the excess in proportion to the way the corporations
apportioned the 25% bracket in Step 1 above.
d. Summing the members’ taxes results in the same total tax as would occur by apply-
ing the corporate tax rate schedule to the group’s aggregate positive taxable income.
3. If aggregate positive taxable income is from $335,000 to $10,000,000, the 15% and
25% tax brackets are fully phased out, so each member’s tax equals a flat 34% of its
taxable income, and the group’s total tax equals 34% of aggregate positive taxable
income.
North and South Corporations are members of a controlled group. The corporations file sepa-
rate tax returns for the current year and report the following results:
North $(25,000)
South 100,000
If they elect no special apportionment plan, North and South are limited to $25,000 each
taxed at a 15% rate and to $12,500 each taxed at a 25% rate. The tax liability for each corpora-
tion is determined as follows:
North
South 15% tax bracket: 0.15 � $25,000 $ 3,750
25% tax bracket: 0.25 � $12,500 3,125
34% tax bracket: 0.34 � $62,500
Subtotal for South Corporation
Total for North-South controlled group
If the corporations elect a special apportionment plan, the group may apportion the full
$50,000 and $25,000 amounts for each of the reduced tax rate brackets to South. The tax liabil-
ity for each corporation is determined as follows:
North
South 15% tax bracket: 0.15 � $50,000 $ 7,500
25% tax bracket: 0.25 � $25,000 6,250
34% tax bracket: 0.34 � $25,000
Subtotal for South Corporation
Total for North-South controlled group
By shifting the benefit of low tax brackets away from a corporation that cannot use it
(North) to a corporation that can (South), the special apportionment election reduces the total
tax liability for the North-South controlled group by $5,875 ($28,125 � $22,250). �
$22,250
$22,250
8,500
$ –0–
TaxCalculationCorporation
$28,125
$28,125
21,250
$ –0–
TaxCalculationCorporation
Taxable Income (NOL)Corporation
ADDITIONAL
COMMENT
This apportionment method for
the 5% surtax is one of two
possible methods available. It
apportions the surtax first to
the corporation using the
15% bracket and then to the
corporation using the 25%
bracket. Hence, it is referred
to as the FIFO method. The
other method is called the pro-
portionate method. See the
Additional Comment next to
Example C:3-43.
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If a controlled group’s total taxable income exceeds $100,000 ($15 million), a 5%
(3%) surcharge recaptures the benefits of the reduced tax rates. The component member
(or members) that took advantage of the lower tax rates pays this additional tax.
Alpha, Beta, and Gamma Corporations are members of a controlled group and report the fol-
lowing results:
Alpha $ 80,000
Beta (25,000)
Gamma 230,000
The group, which has aggregate taxable income of $310,000 ($80,00 � $230,000), elects
special apportionment. They apportion the 15% tax bracket to Alpha with the balance of
Alpha’s income taxed at 34% (before the surtax apportionment), and they apportion the 25%
tax bracket to Gamma with the balance of Gamma’s income taxed at 34% (before the surtax
apportionment). The surtax in this case is $10,500 (0.05 � ($310,000 � $100,000)). Using the
procedures outlined above, the members apportion $9,500 of the surtax to Alpha because that
corporation received the entire 15% tax bracket, and they apportion the remaining $1,000 sur-
tax to Gamma because that corporation received the entire 25% tax bracket. Accordingly, the
tax liability for each corporation is as follows:
Alpha:
Tax on $50,000 at 15% $ 7,500
Tax on $30,000 at 34% 10,200
Surtax
Total for Alpha $27,200
Beta –0–
Gamma:
Tax on $25,000 at 25% $ 6,250
Tax on $205,000 at 34% 69,700
Surtax
Total for Alpha
Total for the group
The total tax for the group is the same as if they applied the corporate tax rate schedule to
the $310,000 aggregate positive taxable income as follows: $22,250 � ($210,000 � 0.39) �
$104,150. �
Hill, Jet, and King Corporations are members of a controlled group and report the following
results:
Hill $300,000
Jet (50,000)
King 100,000
The group’s aggregate positive taxable income is $400,000 ($300,000 � $100,000), which
exceeds $335,000. Therefore, with special apportionment, Hill’s and King’s tax equals 34% of
each corporation’s taxable income as follows:
Hill ($300,000 � 0.34) $102,000
Jet –0–
King ($100,000 � 0.34)
Total for the group ($400,000 � 0.34) �
USING NOL CARRYOVERS AND CARRYBACKS
When a corporation incurs an NOL for the year, it has two choices:
� Carry the NOL back to the second and first preceding years in that order (assuming no
extended carryback period), and then forward to the succeeding 20 years in chrono-
logical order until the NOL is exhausted.
� Forgo any carryback and just carry the NOL forward to the 20 succeeding years.
$136,000
34,000
Taxable IncomeCorporation
$104,150
76,950
1,000
9,500
Taxable Income (Loss)Corporation
3-34 Corporations ▼ Chapter 3
TAX STRATEGY TIP
A corporation may want to elect
to forgo the NOL carryback when
tax credit carryovers are being
used in the earlier years. If the
NOLs are carried back, the tax
credits may expire. Thus, before
deciding to carry back NOLs, the
prior tax returns should be care-
fully examined to ensure that
expiring tax credits do not exist.
EXAMPLE C:3-44 �
EXAMPLE C:3-43 �
ADDITIONAL
COMMENT
If the group used the proportion-
ate method, the surtax would be
apportioned based on the relative
tax benefit of the lower brackets.
The tax benefit of the 15% bracket
is $9,500 [$50,000 � (0.34 � 0.15)],
and the tax benefit of the 25%
bracket is $2,250 [$25,000 �
(0.34 � 0.25)]. Thus, $8,489 of the
surtax would be allocated to
Alpha, calculated as $10,500 �
($9,500/$11,750), and $2,011
would be allocated to Gamma,
calculated as $10,500 �
($2,250/$11,750).
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A corporation might elect to forgo an NOL carryback if it would offset income at a low
tax rate, resulting in a small tax refund compared to a greater anticipated benefit if the
NOL instead were carried over to a high tax rate year.
Boyd Corporation, a calendar year taxpayer, incurs a $30,000 NOL in 2012. Boyd’s 2010 taxable
income was $50,000. If Boyd carries the NOL back to 2010, Boyd’s tax refund is computed as
follows:
Original tax on $50,000 (using 2010 rates) $7,500
Minus: Recomputed tax on $20,000
[($50,000 � $30,000) � 0.15] )
Tax refund
If Boyd anticipates taxable income (after reduction for any NOL carryovers) of $75,000 or
more in 2013, carrying over the NOL will result in the entire loss offsetting taxable income that
otherwise would be taxed at a 34% or higher marginal tax rate. The tax savings is computed as
follows:
Tax on $105,000 of expected taxable income $24,200
Minus: Tax on $75,000 ($105,000 � $30,000) )
Tax savings in 2013
Thus, if Boyd expects taxable income to be $105,000 in 2013, it might elect to forgo the NOL
carryback and obtain the additional $5,950 ($10,450 � $4,500) tax benefit. Of course, by carry-
ing the NOL over to 2013, Boyd loses the value of having the funds immediately available.
However, Boyd may use the NOL to reduce its estimated tax payments for 2013. If the corpora-
tion expects the NOL carryover benefit to occur at an appreciably distant point in the future,
the corporation would have to determine the benefit’s present value to make it comparable to
a refund from an NOL carryback. This example ignores the effect the NOL carryover has on the
U.S. production activities deduction in the carryover year. �
$10,450
(13,750
$4,500
(3,000
The Corporate Income Tax ▼ Corporations 3-35
EXAMPLE C:3-45 �
ETHICAL POINT
When tax practitioners take on a
new client, they should review
the client’s prior year tax returns
and tax elections for accuracy and
completeness. Tax matters arising
in the current year, such as an
NOL, can affect prior year tax
returns prepared by another tax
practitioner. Positions taken or
errors discovered in a prior year
return may have ethical conse-
quences for a practitioner who
takes on a new client.
49 Sec. 6655.
50 Rev. Rul. 92-54, 1992-2 C.B. 320.
51 Sec. 6655(c)(2). Fiscal year corporations must deposit their taxes on or
before the fifteenth day of the fourth, sixth, ninth, and twelfth month of their
tax year. If the fifteenth falls on a weekend or holiday, the payment is due on
the next business day. If April 15 falls on Sunday, April 16 also is a nonfiling
day because April 16 is Emancipation Day, which is a holiday in Washington,
D.C. In this case, a return will be due on April 17.
COMPLIANCE AND
PROCEDURAL CONSIDERATIONS
ESTIMATED TAXES
Every corporation that expects to owe more than $500 in tax for the current year must
pay four installments of estimated tax, each equal to 25% of its required annual pay-
ment.49 For corporations that are not large corporations (defined below), the required
annual payment is the lesser of 100% of the tax shown on the current year return or
100% of the tax shown on the preceding year return. A corporation may not base its
required estimated tax amount on the tax shown on the preceding year return if the pre-
ceding year tax return showed a zero tax liability.50 The estimated tax amount is the sum
of the corporation’s income tax and alternative minimum tax liabilities that exceeds its
tax credits. The amount of estimated tax due may be computed on Schedule 1120-W
(Estimated Tax for Corporations).
ESTIMATED TAX PAYMENT DATES. A calendar year corporation must deposit esti-
mated tax payments in a Federal Reserve bank or authorized commercial bank on or
before April 15, June 15, September 15, and December 15.51 This schedule differs from
that of an individual taxpayer. The final estimated tax installment for a calendar year cor-
poration is due in December of the tax year rather than in January of the following tax
year, as is the case for individual taxpayers. For a fiscal year corporation, the due dates are
the fifteenth day of the fourth, sixth, ninth, and twelfth months of the tax year.
OBJECTIVE 6
Comply with corporate tax
filing requirements
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3-36 Corporations ▼ Chapter 3
EXAMPLE C:3-46 �
TYPICAL
MISCONCEPTION
The easiest method of determin-
ing a corporation’s estimated tax
payments is to pay 100% of last
year’s tax liability. Unfortunately,
for “large corporations,” other
than for its first quarterly pay-
ment, last year’s tax liability is not
an acceptable method of deter-
mining the required estimated
tax payments. Also, last year’s tax
liability cannot be used if no tax
liability existed in the prior year
or if the corporation filed a short-
year return for the prior year.
EXAMPLE C:3-47 �
EXAMPLE C:3-48 �
Garden Corporation, a calendar year taxpayer, expects to report the following results for the
current year:
Regular tax $119,000
Alternative minimum tax 25,000
Garden’s current year estimated tax liability is $144,000 ($119,000 regular tax liability �
$25,000 AMT liability). Garden’s tax liability last year was $120,000. Assuming Garden is not a
large corporation, its required annual payment for the current year is $120,000, the lesser of its
prior year liability ($120,000) or its current year tax return liability ($144,000). Garden will not
incur a penalty if it deposits four equal installments of $30,000 ($120,000 � 4) on or before
April 15, June 15, September 15, and December 15 of the current year. �
Different estimated tax payment rules apply to large corporations. A large corpora-
tion’s required annual payment is 100% of the tax shown on the current year return. A
large corporation’s estimated tax payments cannot be based on the prior year’s tax liabil-
ity except the first installment. If a large corporation bases its first estimated tax install-
ment on the prior year’s liability, any shortfall between the required payment based on the
current year’s tax liability and the actual payment must be made up with the second
installment.52 A large corporation is one whose taxable income was $1 million or more in
any of its three immediately preceding tax years. Controlled groups of corporations must
allocate the $1 million amount among its group members.
Assume the same facts as in Example C:3-46 except Garden is a large corporation (i.e., it had
more than $1 million of taxable income in one of its prior three years). Garden can base its
first estimated tax payment on either 25% of its current year tax liability or 25% of last year’s
tax liability. Garden should elect to use its prior year tax liability as the basis for its first install-
ment because it can reduce the needed payment from $36,000 (0.25 � $144,000) to $30,000
(0.25 � $120,000). However, it must recapture the $6,000 ($36,000 � $30,000) shortfall when
it pays its second installment. Therefore, the total second installment is $42,000 ($36,000 sec-
ond installment � $6,000 recapture from first installment). The third and fourth installments
are $36,000 each. �
PENALITES FOR UNDERPAYMENT OF ESTIMATED TAX. The IRS will assess a
nondeductible penalty if a corporation does not deposit its required estimated tax install-
ment on or before the due date for that installment. The penalty is the underpayment rate
found in Sec. 6621 times the amount by which the installment due by a payment date
exceeds the payment actually made.53 The penalty accrues from the payment due date for
the installment until the earlier of the actual date of the payment or the due date for the
tax return (excluding extensions).
Globe Corporation is a calendar year taxpayer that reported a $100,000 tax liability for 2012.
Globe’s tax liability for 2011 was $125,000. It should have made estimated tax payments of
$25,000 ($100,000 ÷ 4) on or before April 17, June 15, September 17, and December 17, 2012
(the 15th and 16th fell on a weekend or holiday for some months). No penalty is assessed if
Globe deposited the requisite amounts on or before each of those dates. However, if Globe
deposited only $16,000 ($9,000 less than the required $25,000) on April 17, 2012, and did not
deposit the remaining $9,000 before the due date for the 2012 return, the corporation must
pay a penalty on the $9,000 underpayment for the period of time from April 17, 2012, through
March 15, 2013. If Globe deposits $34,000 on the second installment date (June 15, 2012), so
that it has paid a total of $50,000 by the second installment due date, the penalty runs only
from April 17, 2012, through June 15, 2012.
Now assume that Globe instead made the following estimated tax payments in 2012:
52 Sec. 6655(d)(2)(B). A revision to the required estimated tax payment
amount also may be needed if the corporation is basing its quarterly pay-
ments on the current year’s tax liability. Installments paid after the estimate of
the current year’s liability has been revised must take into account any short-
age or excess in previous installment payments resulting from the change in
the original estimate.
53 Sec. 6621. This interest rate is the short-term federal rate as determined by
the Secretary of the Treasury plus three percentage points. It is subject to
change every three months. The interest rate for large corporations is the
short-term federal rate plus five percentage points. This higher interest rate
begins 30 days after the issuance of either a 30-day or 90-day deficiency
notice.
KEY POINT
The amount of penalty depends
on three factors: the applicable
underpayment rate, the amount
of the underpayment, and the
amount of time that lapses until
the corporation makes the
payment.
ADDITIONAL
COMMENT
This illustration pertains to 2012
because tax forms for that year are
the latest available at the time this
textbook was published.
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The Corporate Income Tax ▼ Corporations 3-37
April 17 $16,000
June 15 16,000
September 17 21,000
December 17 35,000
Form 2220 in Appendix B calculates the underpayments and resultant penalty given this pat-
tern of payments. �
SPECIAL COMPUTATION METHODS. In lieu of the current year and prior year meth-
ods, corporations can use either of two special methods for calculating estimated tax
installments:
� The annualized income method
� The adjusted seasonal income method
The Annualized Income Method. This method is useful if a corporation’s income is
likely to increase a great deal toward the end of the year. It allows a corporation to base
its first and second quarterly estimated tax payments on its annualized taxable income for
the first three months of the year. The corporation then bases its third payment on its
annualized taxable income for the first six months of the year and its fourth payment on
annualized taxable income for the first nine months of the year. (Two other options for
the number of months used for each installment also are available.)
Erratic Corporation, a calendar year taxpayer, reports taxable income of: $10,000 in each of
January, February, and March; $20,000 in each of April, May, and June; and $50,000 in each of
the last six months of the current year. Erratic’s annualized taxable income and annualized tax
are calculated as follows:
Third month $ 30,000 12/3 $120,000 $ 30,050
Sixth month 90,000 12/6 180,000 53,450
Ninth month 240,000 12/9 320,000 108,050
Assuming Erratic uses the annualized method for all four estimated tax payments, its install-
ments will be as follows:
One $ 30,050 25% $ 7,513a $ 7,513
Two 30,050 50 7,512b 15,025
Three 53,450 75 25,063c 40,088
Four 108,050 100 67,962d 108,050
a$30,050 � 0.25
b($30,050 � 0.50) � $7,513
c($53,450 � 0.75) � $15,025
d($108,050 � 1.00) � $40,088 �
A corporation may use the annualized income method for an installment payment only
if it is less than the regular required installment (including the recapture described in the
next sentence). It must recapture any reduction in an earlier required installment resulting
from use of the annualized income method by increasing the amount of the next installment
that does not qualify for the annualized income method.
For small corporations, the sure way to avoid a penalty for the underpayment of esti-
mated tax is to base the current year’s estimated tax payments on 100% of last year’s tax.
This approach is not possible, however, for large corporations or for corporations that
owed no tax in the prior year or that filed a short period tax return for the prior year. This
approach also is not advisable if the corporation had a high tax liability in the prior year
and expects a low tax liability in the current year.
Cumulative
Installment
Installment
Amount
Applicable
Percentage
Annualized
Tax
Installment
Number
Tax on
Annualized
Taxable Income
Annualized
Taxable Income
Annualization
Factor
Cumulative
Taxable IncomeThrough
AmountDate
EXAMPLE C:3-49 �
TAX STRATEGY TIP
Both the “annualized income
exception” and the “adjusted sea-
sonal income exception” are com-
plicated computations. However,
due to the large amounts of
money involved in making corpo-
rate estimated tax payments
along with the possible underpay-
ment penalties, the time and
effort spent in determining the
least amount necessary for a
required estimated tax payment
are often worthwhile.
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54 Reg. Sec. 301.6651-1(c)(4).
55 Sec. 6012(a)(2).
56 Reg. Sec. 1.6012-2(a)(2).
Adjusted Seasonal Income Method. A corporation may base its installments on its
adjusted seasonal income. This method permits corporations that earn seasonal income to
annualize their income by assuming income earned in the current year is earned in the
same pattern as in preceding years. As in the case of the annualized income exception, a
corporation can use the seasonal income exception only if the resulting installment pay-
ment is less than the regular required installment. Once the exception no longer applies,
any savings resulting from its use for prior installments must be recaptured.
REPORTING THE UNDERPAYMENT. A corporation reports its underpayment of esti-
mated taxes and the amount of any penalty on Form 2220 (Underpayment of Estimated
Tax by Corporations). A completed Form 2220 using the facts from Example C:3-47
appears in Appendix B.
PAYING THE REMAINING TAX LIABILITY. A corporation must pay its remaining tax
liability for the year when it files its corporate tax return. An extension of time to file the
tax return, however, does not extend the time to pay the tax liability. If any tax remains
unpaid after the original due date for the tax return, the corporation must pay interest at
the underpayment rate prescribed by Sec. 6621 from the due date until the corporation
pays the tax. In addition to interest, the IRS assesses a penalty if the corporation does not
pay the tax on time and cannot show reasonable cause for the failure to pay. The IRS pre-
sumes that reasonable cause exists if the corporation requests an extension of time to file
its tax return and the amount of tax shown on the request for extension (Form 7004) or
the amount of tax paid by the original due date of the return is at least 90% of the corpo-
ration’s tax shown on its Form 1120.54 A discussion of the failure-to-pay penalty and the
interest calculation can be found in Chapter C:15.
Question: Why does the tax law permit a corporation to use special methods such as the
annualized income method to calculate its required estimated tax installments?
Solution: A large corporation whose income varies widely may not be able to estimate
its taxable income for the year until late in the year, and it is not allowed to base its esti-
mates on last year’s income. If, for example, a calendar year corporation earns income
of $100,000 per month during the first six months of its year, it might estimate its first
two installments on the assumption that it will earn a total taxable income of $1.2 mil-
lion for the year. But if its income unexpectedly increases to $500,000 per month in the
seventh month, it would need an annualized method to avoid an underpayment penalty
for the first two installments. Were it not for the ability to use the annualized method,
the corporation would have no way to avoid an underpayment penalty even though it
could not predict its taxable income for the year when it made the first two installment
payments.
REQUIREMENTS FOR FILING
AND PAYING TAXES
A corporation must file a tax return, Form 1120 (U.S. Corporation Income Tax Return),
even if it has no taxable income for the year.55 If the corporation did not exist for its entire
annual accounting period (either calendar year or fiscal year), it must file a short period
return for the part of the year it did exist. For tax purposes, a corporation’s existence ends
when it ceases business and dissolves, retaining no assets, even if state law treats the cor-
poration as continuing for purposes of winding up its affairs.56
A completed Form 1120 corporate income tax return appears in Appendix B. A
spreadsheet that converts book income into taxable income for the Johns and Lawrence
business enterprise (introduced in Chapter C:2) is presented with the C corporation tax
return.
STOP & THINK
3-38 Corporations ▼ Chapter 3
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The Corporate Income Tax ▼ Corporations 3-39
WHEN THE RETURN MUST BE FILED
Corporations must file their tax returns by the fifteenth day of the third month following
the close of their tax year.57 A corporation can obtain an automatic six-month extension to
file its tax return by filing Form 7004 (Application for Automatic Extension of Time to File
Certain Business Tax, Information, and Other Returns) by the original due date for the
return. Corporations that fail to file a timely tax return are subject to the failure-to-file
penalty. Chapter C:15 discusses this penalty in some detail.
Palmer Corporation’s fiscal tax year ends on September 30. Its corporate tax return for the
year ending September 30, 2013, is due on or before December 16, 2013 (December 15 falls
on a Sunday). If Palmer files Form 7004 by December 16, 2013, it can obtain an automatic
extension of time to file until June 16, 2014 (June 15 falls on a Sunday). Assuming Palmer
expects its 2013 tax liability to be $72,000 and it has paid $68,000 in estimated tax during the
year, it must pay the remaining $4,000 by December 16, 2013. A completed Form 7004
appears in Appendix B. �
Additional extensions beyond the automatic six-month period are not available. The
IRS can rescind the extension period by mailing a ten-day notice to the corporation before
the end of the six-month period.58
TAX RETURN SCHEDULES
SCHEDULE L (OF FORM 1120): THE BALANCE SHEET. Schedule L of Form 1120
requires a balance sheet showing the financial accounting results at the beginning and end
of the tax year.
RECONCILIATION SCHEDULES. The IRS also requires the reconciliation of the cor-
poration’s financial accounting income (also known as book income) and its taxable
income (before special deductions). Book income is calculated according to generally
accepted accounting principles (GAAP) including rules promulgated by the Financial
Accounting Standards Board (FASB). On the other hand, taxable income must be calcu-
lated using tax rules. Therefore, book income and taxable income usually differ.
Some small corporations that do not require audited statements keep their books on a
tax basis. For example, they may calculate depreciation for book purposes the same way
they do for tax purposes. Income tax expense for book purposes may simply reflect the
federal income tax liability. Most corporations, however, must use GAAP to calculate net
income per books. For such corporations, taxable income and book income may differ
significantly. The reconciliation of book income and taxable income provides the IRS
with information that helps it audit a corporation’s tax return.
For many corporations, the reconciliation must be provided on Schedule M-1 of Form
1120. Corporations with total assets of $10 million or more on the last day of the tax
year, however, must complete Schedule M-3 instead of Schedule M-1. This schedule pro-
vides the IRS with much more detailed information on differences between book income
and taxable income than does Schedule M-1. This additional transparency of corporate
transactions will increase the IRS’s ability to audit corporate tax returns. Form 1120 also
requires an analysis of unappropriated retained earnings on Schedule M-2.
BOOK-TAX DIFFERENCES. A corporation’s book income usually differs from its tax-
able income for a large number of transactions. Some of these differences are permanent.
Permanent differences arise because:
� Some book income is never taxed. Examples include:
1. Tax-exempt interest received on state and municipal obligations
2. Proceeds of life insurance carried by the corporation on the lives of key officers or
employees
� Some book expenses are never deductible for tax purposes. Examples include:
1. Expenses incurred in earning tax-exempt interest
BOOK-TO-TAX
ACCOUNTING
COMPARISON
Schedule L requires a financial
accounting (book) balance sheet
rather than a tax balance sheet.
BOOK-TO-TAX
ACCOUNTING
COMPARISON
The Internal Revenue Code and
related authorities determine the
treatment of items in the tax
return while Accounting
Standards Codification (ASC) 740
(Income Taxes) dictates the treat-
ment of tax items in the financial
statements.
57 Sec. 6072(b). 58 Reg. Sec. 1.6081-3.
EXAMPLE C:3-50 �
ADDITIONAL
COMMENT
The IRS will not assess a late pay-
ment penalty if the corporation
extends its due date and pays 90%
of its total tax liability by the
unextended due date and pays the
balance by the extended due date.
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2. Premiums paid for life insurance carried by the corporation on the lives of key offi-
cers or employees
3. Fines and expenses resulting from a violation of law
4. Disallowed travel and entertainment costs
5. Political contributions
6. Federal income taxes per books, which is based on GAAP (ASC 740)
� Some tax deductions are never taken for book purposes. Examples include:
1. The dividends-received deduction
2. The U.S. production activities deduction
3. Percentage depletion of natural resources in excess of their cost
Some of the differences are temporary. Temporary differences arise because:
� Some revenues or gains are recognized for book purposes in the current year but not
reported for tax purposes until later years. Examples include:
1. Installment sales reported in full for book purposes in the year of sale but reported
over a period of years using the installment method for tax purposes
2. Gains on involuntary conversions recognized currently for book purposes but
deferred for tax purposes
� Some revenues or gains are taxable before they are reported for book purposes. These
items are included in taxable income when received but are included in book income
as they accrue. Examples include:
1. Prepaid rent or interest income
2. Advance subscription revenue
� Some expenses or losses are deductible for tax purposes after they are recognized for
book purposes. Examples include:
1. Excess of capital losses over capital gains, which are expensed for book purposes
but carry back or over for tax purposes
2. Book depreciation in excess of tax depreciation
3. Charitable contributions exceeding the 10% of taxable income limitation, which
are currently expensed for book purposes but carry over for tax purposes
4. Bad debt accruals using the allowance method for book purposes and the direct
write-off method for tax purposes
5. Organizational and start-up expenditures, which are expensed currently for book
purposes but partially deducted and amortized for tax purposes
6. Product warranty liabilities expensed for book purposes when estimated but
deducted for tax purposes when the liability becomes fixed
7. Net operating losses (NOLs) that, for tax purposes, carry back two years (or
extended period if applicable) and carry over 20 years
� Some expenses or losses are deductible for tax purposes before they are recognized for
book purposes. Examples include:
1. Tax depreciation in excess of book depreciation
2. Prepaid expenses deducted on the tax return in the period paid but accrued over a
period of years for book purposes
For book purposes, temporary differences listed under the first and fourth bullets create
deferred tax liabilities while those listed under the second and third bullets create deferred
tax assets. The Financial Statement Implications section later in this chapter discusses the
financial accounting treatment of book-tax differences.
SCHEDULE M-1. The Schedule M-1 reconciliation of book to taxable income begins
with net income per books and ends with taxable income before special deductions, which
corresponds with Line 28 of Form 1120. Thus, some book-tax differences enumerated
above do not appear in the reconciliation, for example, the dividends-received deduction
and the net operating loss deduction.
The left side of Schedule M-1 contains items the corporation adds back to book
income. These items include the following categories:
� Federal income tax expense (per books)
� Excess of capital losses over capital gains
3-40 Corporations ▼ Chapter 3
SELF-STUDY
QUESTION
Why might the IRS be interested
in reviewing a corporation’s
Schedule M-1 or M-3?
ANSWER
Schedule M-1 or M-3 adjustments
reconcile book income to taxable
income. Thus, these schedules can
prove illuminating to an IRS agent
who is auditing a corporate
return. Because Schedule M-1 or
M-3 highlights each departure
from the financial accounting
rules, the schedules sometimes
help the IRS identify tax issues it
may want to examine further.
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The Corporate Income Tax ▼ Corporations 3-41
� Income subject to tax but not recorded on the books in the current year
� Expenses recorded on the books but not deductible for tax purposes in the current year
The right side of the schedule contains items the corporation deducts from book income.
These items include the following categories:
� Income recorded on the books in the current year that is not taxable in the current year
� Deductions or losses claimed in the tax return that do not reduce book income in the
current year
These categorizations, however, do not distinguish between permanent and temporary
differences as does Schedule M-3 discussed below. The following example illustrates a
Schedule M-1 reconciliation.
Valley Corporation reports the following items for book and tax purposes in its first year of
operations (Year 1):
Gross receipts $1,500,000 $1,500,000
MInus: Cost of goods sold ) )
Gross profit from operations $ 950,000 $950,000
Plus: Dividends from less than
20%-owned corporations 10,000 10,000
Tax-exempt income 3,000 –0– $ (3,000)
Prepaid rental income –0– 8,000 8,000
Minus: Operating expenses (300,000) (300,000)
Depreciation (60,000) (170,000) (110,000)
Bad debt expense (25,000) (16,000) 9,000
Business interest expense (75,000) (75,000)
Insurance premiums on life
for key employee
(Valley is the beneficiary) (2,800) –0– 2,800
Net capital loss disallowed for
tax purposes (12,000) –0– 12,000
U.S. production activities
deduction (rounded) (35,000) (35,000)
Net income before federal income taxes $ 488,200
Taxable income before special deductions $372,000
Minus: Federal income tax expense per books (151,640) –0– 151,640
Dividends-received deduction ) (7,000)
Net income per books / Taxable income
Federal tax liability ($365,000 � 0.34)
Effective tax rate ($151,640/$488,200)
Valley’s Schedule M-1 reconciliation appears in Figure C:3-5.59 �
SCHEDULE M-3. Schedule M-3 requires extensive detail in its reconciliation. Moreover,
the schedule has the corporation distinguish between its permanent and temporary differ-
ences. The schedule contains three parts. Part I adjusts worldwide income per books to
worldwide book income for only includible corporations. As described in Chapter C:8,
some corporations may be included in the financial statement consolidation that might be
excluded from the tax consolidated tax return. This resulting figure is then reconciled to
taxable income before special deductions (again Line 28 of Form 1120). Part II enumer-
ates the corporation’s income and loss items, and Part III enumerates the expense and
deduction items. The total items from Part III carry over to Part II for the final reconcilia-
tion. Both Parts II and III contain the following four columns: (a) book items, (b) tempo-
rary differences, (c) permanent differences, and (d) tax items.
31.06%
$124,100
$365,000$ 336,560
(7,000–0–
–0–
(550,000(550,000
DifferenceTaxBook
BOOK-TO-TAX
COMPARISON
Schedules M-1 and M-3 adjust-
ments highlight the fact that
financial accounting and tax
accounting differ in many ways. A
review of Schedule M-1 or M-3 is
an excellent way to compare the
financial accounting and tax
accounting differences in a corpo-
ration.
59 A worksheet for converting book income to taxable income for a sample
Form 1120 return is provided in Appendix B with that return.
EXAMPLE C:3-51 �
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Appendix B provides an example of Schedule M-3 using the data from Example C:3-51.
Valley Corporation in that example is too small to be required to use Schedule M-3
although it may elect to do so. Nevertheless, that data is used to allow for comparison of
Schedules M-1 and M-3. Note that Lines 1 and 2 of Schedule M-3, Part III, break the
$151,640 federal income tax expense into its current and deferred components. In this
example, the current expense ties to the current tax liability ($124,100), and the deferred
expense ties to the change in net deferred tax liabilities and assets arising from temporary
differences, specifically, depreciation, net capital loss, prepaid rent, and bad debt expense
[$27,540 � 0.34 � ($110,000 � $12,000 � $8,000 � $9,000)]. These temporary differ-
ences appear in Column b of Schedule M-3, Parts II and III.
SCHEDULE M-2 (OF FORM 1120). Schedule M-2 of Form 1120 requires an analysis of
changes in unappropriated retained earnings from the beginning of the year to the end of
the year. The schedule supplies the IRS with information regarding dividends paid during
the year and any special transactions that caused a change in retained earnings for the year.
Schedule M-2 starts with the balance in the unappropriated retained earnings account
at the beginning of the year. The following items, which must be added to the beginning
balance amount, are listed on the left side of the schedule:
� Net income per books
� Other increases (e.g., refund of federal income taxes paid in a prior year taken directly
to the retained earnings account instead of used to reduce federal income tax expense)
The following items, which must be deducted from the beginning balance amount, are
listed on the right side of the schedule:
� Dividends (e.g., cash or property)
� Other decreases (e.g., appropriation of retained earnings made during the tax year)
The result is the amount of unappropriated retained earnings at the end of the year.
In the current year, Beta Corporation reports net income and other capital account items as
follows:
Unappropriated retained earnings, January 1, current year $400,000
Net income 350,000
Federal income tax refund for capital loss carryback 15,000
Cash dividends paid in the current year 250,000
Unappropriated retained earnings, December 31, current year 515,000
Beta Corporation’s Schedule M-2 appears in Figure C:3-6. �
Topic Review C:3-2 summarizes the requirements for paying the taxes due and filing
the corporate tax return.
3-42 Corporations ▼ Chapter 3
336,560
151,640
12,000
8,000
11,800
520,000
Prepaid rent
Premiums on life insurance 2,800
Bad debt expense 9,000
3,000
3,000
110,000
U.S. prod. act. ded. 35,000
145,000
148,000
372,000
1 Net income (loss) per books . . . . .
2 Federal income tax per books . . . .
3 Excess of capital losses over capital gains
4 Income subject to tax not recorded on
books this year (itemize):
5 Expenses recorded on books this year not
deducted on this return (itemize):
a Depreciation . . . . $
b Charitable contributions $
c Travel and entertainment $
d Other (itemize):
6 Add lines 1 through 5 . . . . . . .
7 Income recorded on books this year
not included on this return (itemize):
a $Tax-exempt interest
b Other (itemize):
8 Deductions on this return not charged
against book income this year (itemize):
a Depreciation . . $
b Charitable contributions $
c Other (itemize):
9 Add lines 7 and 8 . . . . . . .
10 Income—line 6 less line 9 . . . .
FIGURE C:3-5 � VALLEY CORPORATION’S FORM 1120 SCHEDULE M-1 (EXAMPLE C:3-51)
BOOK-TO-TAX
ACCOUNTING
COMPARISON
Schedule M-2 requires an analysis
of a corporation’s retained earn-
ings. Retained earnings is a finan-
cial accounting number that has
little relevance to tax accounting.
A more relevant analysis for tax
purposes is one of current and
accumulated earnings and profits
(E&P). If a corporation distributes
more than its E&P, the excess is a
nondividend distribution. In this
case, the corporation must file
Form 5452, Corporate Report of
Nondividend Distributions,
which requires an analysis of
E&P along with other supporting
information.
EXAMPLE C:3-52 �
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The Corporate Income Tax ▼ Corporations 3-43
Federal tax refund
250,000
250,000
515,000
Schedule M-2 Analysis of Unappropriated Retained Earnings per Books
1 Balance at beginning of year . . . .
2 Net income (loss) per books . . . . .
3 Other increases (itemize):
4 Add lines 1, 2, and 3 . . . . . . .
5 Distributions: a Cash . . . .
b Stock . . . .
c Property . . .
6 Other decreases (itemize):
7 Add lines 5 and 6 . . . . . . .
8 Balance at end of year (line 4 less line 7) .
400,000
350,000
15,000
765,000
FIGURE C:3-6 � BETA CORPORATION’S FORM 1120 SCHEDULE M-2 (EXAMPLE C:3-52)
Topic Review C:3-2
Requirements for Paying Taxes Due and Filing
Tax Returns
1. Estimated Tax Requirement
a. Corporations that expect to owe more than $500 in tax for the current year must pay four installments of estimated
tax, each equal to 25% of its required annual payment.
b. Taxes for which estimated payments are required of a C corporation include regular tax and alternative minimum tax,
minus any tax credits.
c. If a corporation is not a large corporation, its required annual payment is the lesser of 100% of the tax shown on the
current year’s return or 100% of the tax shown on the preceding year’s return.
d. If a corporation is a large corporation, its required annual payment is 100% of the tax shown on the current year’s
return. Its first estimated tax payment may be based on the preceding year’s tax liability, but any shortfall must be
made up when the second installment is due.
e. Special rules apply if the corporation bases its estimated tax payments on the annualized income or adjusted seasonal
income method.
2. Filing Requirements
a. The corporate tax return is due by the fifteenth day of the third month after the end of the tax year.
b. A corporate taxpayer may request an automatic six-month extension to file its tax return (but not to pay its tax due).
FINANCIAL STATEMENT
IMPLICATIONS
The book-tax differences discussed on pages C:3-39 and C:3-40 have implications not
only for preparing the reconciliation Schedules M-1 and M-3 but also affect how a firm’s
financial statements present income taxes. Income taxes impact both the income state-
ment and balance sheet. For example, the tax section of the income statement might
appear as follows:
Net income before federal income taxes
Moreover, the income tax expense (also called the total tax provision) usually breaks
down into a current component and a deferred component. The current component ties
into the taxes payable for the current year, and the deferred component arises from book-
tax temporary differences. The income tax expense also can contain a state tax compo-
nent. For this textbook, however, we focus primarily on federal income taxes. Financial
statements usually publish details concerning its tax provision in a footnote to the finan-
cial statements. Temporary differences also create deferred tax liabilities and deferred tax
assets, which appear on the balance sheet.
The primary standard that dictates financial statement treatment is Accounting
Standards Codification (ASC) 740, issued by the Financial Accounting Standards Board
(FASB). This section first describes the basic principles of ASC 740 and then presents a com-
prehensive example to demonstrate its application.
Net income
Minus: Federal income tax expense
OBJECTIVE 7
Determine the financial
statement implications of
corporate federal income
taxes
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SCOPE, OBJECTIVES, AND PRINCIPLES
OF ASC 740
ASC 740 establishes principles of accounting for current income taxes and for deferred
taxes arising from temporary differences. Specifically, ASC 740 addresses the financial
statement consequences of the following events:
� Revenues, expenses, gains, or losses recognized for tax purposes in an earlier or later
year than recognized for financial statement purposes
� Other events that create differences between book and tax bases of assets and liabilities
� Operating loss and tax credit carrybacks or carryforwards
ASC 740 sets out two objectives: (1) to recognize current year taxes payable or refund-
able and (2) to recognize deferred tax liabilities and assets for the future tax consequences
of events recognized in a firm’s financial statements or tax return. To implement these
objectives, ASC 740 applies the following principles:
� Recognize a current tax liability or asset for taxes payable or refundable on current
year tax returns
� Recognize a deferred tax liability or asset for future tax effects attributable to tempo-
rary differences and carryforwards
� Measure current and deferred tax liabilities and assets using only enacted tax law, not
anticipated future changes
� Reduce deferred tax assets by the amount of tax benefits the firm does not expect to
realize, based on available evidence and adjusted via a valuation allowance
� Establish a liability for uncertain tax positions if necessary
Interestingly, the only comment ASC 740 makes about permanent differences is that
“[s]ome events do not have tax consequences. Certain revenues are exempt from taxation
and certain expenses are not deductible.” In this context, ASC 740 does not mention cer-
tain events that do have tax consequences but, nevertheless, create permanent differences,
for example, the dividends-received deduction and the U.S. production activities deduc-
tion. As we show later, permanent differences do not affect deferred taxes, but they do
impact the firm’s effective tax rate.
TEMPORARY DIFFERENCES
Similarly to the discussion on pages C:3-39 and C:3-40, the following lists describe events
that generate (1) taxable temporary differences and thus deferred tax liabilities and
(2) deductible temporary differences and thus deferred tax assets. Deferred tax liabilities
and assets appear on a firm’s balance sheet.
Taxable temporary differences and deferred tax liabilities occur when:
� Revenue or gains are recognized earlier for book purposes than for tax purposes
� Expenses or losses are deductible earlier for tax purposes than for book purposes
� Tax basis of an asset is less than its book basis
� Tax basis of a liability exceeds its book basis
Deductible temporary differences and deferred tax assets occur when:
� Revenue or gains are recognized earlier for tax purposes than for book purposes
� Expenses or losses are deductible earlier for book purposes than for tax purposes
� Tax basis of an asset exceeds its book basis
� Tax basis of a liability is less than its book basis
� Operating loss or tax credit carryforwards exist
DEFERRED TAX ASSETS AND THE
VALUATION ALLOWANCE
A deferred tax asset indicates that a firm will realize the tax benefit of an event some time
in the future. For example, if the firm generates a net operating loss in the current year
and, for tax purposes carries the loss forward, the firm will realize a tax benefit only if it
earns sufficient future income to use the carryover before it expires. If the firm likely will
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The Corporate Income Tax ▼ Corporations 3-45
not realize the entire tax benefit, it must record a valuation allowance to reflect the unre-
alizable portion. The valuation allowance is a contra-type account that reduces the
deferred tax asset.
Delta Corporation’s NOL carryover is $200,000, and it expects to realize (deduct) the entire car-
ryover at a 34% tax rate. Thus, Delta’s deferred tax asset is $68,000 ($200,000 � 0.34), and it
makes the following book journal entry:
Deferred tax asset 68,000
Federal income tax expense (benefit) 68,000
Consequently, the deferred tax asset reduces the income tax expense or creates an income tax
benefit.
If Delta determines that it likely will realize (deduct) only $150,000 of the NOL carryover, it
must record a $17,000 ($50,000 � 0.34) valuation allowance. Accordingly, Delta makes the fol-
lowing book journal entry:
Deferred tax asset 68,000
Valuation allowance 17,000
Federal income tax expense (benefit) 51,000 �
ASC 740 specifically states that a deferred tax asset must be reduced by a valuation
allowance if, based on the weight of evidence available, the firm more likely than not will
fail to realize the benefit of the deferred tax asset. For this purpose, the term more likely
than not means a greater than 50% likelihood. In assessing this likelihood, a firm must
consider both negative and positive evidence, where negative evidence leads toward estab-
lishing a valuation allowance while positive evidence helps avoid a valuation allowance.
ASC 740 lists several examples of each type of evidence. Examples of negative evidence
include the following items:
� Cumulative losses in recent years
� A history of expiring loss or credit carryforwards
� Expected losses in the near future
� Unfavorable contingencies with future adverse effects
� Short carryback or carryover periods that might limit realization of the deferred tax asset
Examples of positive evidence include the following items:
� Existing contracts or sales backlogs that will produce sufficient income to realize the
deferred tax asset
� Excess of appreciated asset value over tax basis (i.e., built-in gain) sufficient to realize
the deferred tax asset
� A strong earnings history aside from the event causing the deferred tax asset along
with evidence that the event is an aberration
In essence, a firm can realize (deduct) a deferred tax asset if it has sufficient taxable
income to offset the deduction. ASC 740 suggests the following potential sources of
such income:
� Future reversals of deferred tax liabilities
� Future taxable income other than reversing deferred tax liabilities
� Taxable income in carryback years assuming the tax law allows a carryback
� Taxable income from prudent and feasible tax planning strategies that a firm ordinar-
ily would not take but nevertheless would pursue to realize an otherwise expiring
deferred tax asset
ACCOUNTING FOR UNCERTAIN TAX POSITIONS
ASC 740 also prescribes acceptable accounting for uncertain tax positions. This standard
addresses the following basic situation: For tax purposes, a firm may take a position in
claiming a tax benefit that might not be sustained under IRS scrutiny. The FASB, however,
believes that, for determining the financial statement tax provision, such uncertain tax
positions either should not be recognized or should be recognized only partially.
EXAMPLE C:3-53 �
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In applying the tax position standard, a firm takes a two-step approach. First, the firm
determines whether the tax position has a more likely than not (greater than 50%) probabil-
ity of being sustained upon an IRS examination. This determination requires substantial
judgment and necessitates careful documentation for the financial statement audit and any
IRS examination. If the tax position does not exceed this threshold, the firm cannot recognize
the tax benefit for financial reporting purposes until one of the following three events occur:
� The position subsequently meets the more likely than not threshold.
� The firm favorably settles the tax issue with the IRS or in court.
� The statute of limitations on the transaction expires.
If the firm determines that a tax position meets the more like than not threshold, it
then must measure the amount of benefit it can recognize for financial reporting purposes.
This measure is the largest amount of tax benefit that exceeds a 50% probability of real-
ization upon settlement with the taxing authorities. Further details of this measurement
process and other procedures under the tax position standard become quite complex and
are beyond the scope of this textbook.
Lambda Corporation claims a $1 million deduction on its tax return, which provides a
$350,000 tax savings, assuming a 35% tax rate. After some analysis and judgment, manage-
ment determines the deduction has only a 45% chance of being allowed should the IRS
audit Lambda’s tax return. Assume for simplicity that Lambda has no deferred tax assets or
liabilities. Assume further that Lambda’s pretax book income and taxable income equal $20
million after taking the $1 million deduction. Thus, Lambda’s tax liability is $7 million. Under
the tax position standard, Lambda makes the following journal entry (ignoring potential
penalties and interest):
Federal income tax expense 7,350,000
Liability for unrecognized tax benefits 350,000
Federal income taxes payable 7,000,000
Suppose in a subsequent period Lambda negotiates a settlement with the IRS that allows
$200,000 of the deduction, and Lambda pays $280,000 tax on the $800,000 disallowed portion.
Ignoring penalties and interest, Lambda would make the following journal entry:
Liability for unrecognized tax benefits 350,000
Cash 280,000
Federal income tax expense 70,000 �
Assume the same facts as in Example C:3-54 except Lambda meets the more likely than not
threshold. Lambda then measures the benefit more than 50% likely to be realized as $600,000
of the $1 million deduction taken. Thus, Lambda may not recognize $400,000 in determining its
federal income tax expense for financial reporting purposes and, accordingly, makes the fol-
lowing journal entry:
Federal income tax expense 7,140,000
Liability for unrecognized tax benefits 140,000
Federal income taxes payable 7,000,000 �
BALANCE SHEET CLASSIFICATION
Deferred tax liabilities and assets must be classified as either current or noncurrent. If
related to another asset or liability, the classification is the same as the related asset. For
example, a deferred tax asset pertaining to a difference between book and tax bad debt
expense is current because it relates to accounts receivable. On the other hand, a deferred
tax liability pertaining to a difference between book and tax depreciation is noncurrent
because it relates to fixed assets. If a deferred tax liability or asset does not relate to a par-
ticular asset or liability, it is classified as current or noncurrent depending on its expected
reversal date. Once classified as current and noncurrent, all current deferred tax liabilities
and assets must be netted and presented as one amount. Similarly, all noncurrent deferred
tax liabilities and assets must be netted and presented as another amount.
3-46 Corporations ▼ Chapter 3
EXAMPLE C:3-54 �
EXAMPLE C:3-55 �
REAL-WORLD
EXAMPLE
The IRS has developed Schedule
UTP for inclusion in Form 1120.
This schedule requires certain
taxpayers to provide information
about their uncertain tax posi-
tions. The required information
will provide the IRS a road map
for auditing the tax return.
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The Corporate Income Tax ▼ Corporations 3-47
TAX PROVISION PROCESS
The following steps outline the approach used in this chapter to provide for income taxes
in the financial statements. This process addresses only federal income taxes.
1. Identify temporary differences by comparing the book and tax bases of assets and lia-
bilities, and identify tax carryforwards.
2. Prepare “roll forward” schedules of temporary differences that tabulate cumulative
differences and current-year changes.
3. In the roll forward schedules, apply the appropriate statutory tax rates to determine
the ending balances of deferred tax assets and liabilities.
4. Adjust deferred tax assets by a valuation allowance if necessary.
5. Adjust the income tax expense for uncertain tax positions if necessary.
6. Determine current federal income taxes payable, which, in many cases, also is the
current federal income tax expense for book purposes.
7. Determining the total federal income tax expense (benefit).
8. Prepare and record tax related journal entries.
9. Prepare a tax provision reconciliation.
10. Prepare the tax rate reconciliation.
11. Prepare financial statements.
In practice, various firms may use slightly different approaches. For this chapter, however,
the above steps provide a logical and systematic approach.
COMPREHENSIVE EXAMPLE – YEAR 1
To provide comprehensiveness, this example continues with the facts set forth in
Example C:3-51. Thus, when completed, the two examples together provide the finan-
cial statement implications of federal income taxes as well as the tax return reporting in
Schedules M-1 and M-3 for Year 1. We then continue the example with events occurring
in Year 2.
In addition to the facts stated in Example C:3-51, Valley reports the following book
and tax balance sheet items at the end of Year 1, prior to adjustment for tax related items.
Step 11 below presents the completed book balance sheet after making tax related journal
entries.
Assets:
Cash $ 230,200 $ 230,200
Accounts receivable 300,000 300,000
Minus: Allowance for bad debts )
Net accounts receivable $ 9,000
Investment in corporate stock 90,000 90,000
Investment in tax-exempt bonds 50,000 50,000
Inventory 500,000 500,000
Fixed assets 1,200,000 1,200,000
Minus: Accumulated depreciation ) )
Net fixed assets 110,000
Liabilities and stock equity:
Accounts payable 225,000 225,000
Unearned rental income 8,000 –0– 8,000
Long-term liabilities 930,000 930,000
Common stock 650,000 650,000
Steps 1 through 3.
The book and tax balance sheets above indicate the items where the book and tax bases dif-
fer, thereby indicating temporary differences. In addition, the facts from Example C:3-51
indicates a nondeductible net capital loss, which creates a carryforward.
1,030,0001,140,000
(170,000(60,000
300,000291,000
–0–(9,000
DifferenceTaxBook
ADDITIONAL
COMMENT
Determining the valuation
allowance and uncertain tax posi-
tion adjustments requires a great
deal of professional judgment.
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The following three roll forward schedules calculate the deferred tax assets and deferred
tax liability associated with these temporary differences. The beginning and ending balances
for the balance sheet items reflect the differences between the book and tax bases for these
assets and liabilities. In the first schedule, the deferred tax asset for the net accounts receivable
is current because it relates to a current asset. The deferred tax asset for the unearned rental
income is current because Valley expects to earn that income in the next year. In the second
schedule, the example assumes Valley does not expect to have sufficient capital gains to offset
the capital loss carryover until three years from now. Therefore, this deferred tax asset will
not reverse next year and is considered noncurrent. In the third schedule, the deferred tax
liability pertaining to fixed assets is noncurrent because it relates to a noncurrent asset.
Current deferred tax asset:
Net accounts receivable $ –0– $ 9,000 $ 9,000
Unearned rental income
Total $ –0–
8,0008,000–0–
ChangeEnd of Year 1Beg. of Year 1
3-48 Corporations ▼ Chapter 3
$ 17,000
Times: Tax rate
Current deferred tax asset
Noncurrent deferred tax asset:
Net capital loss $ –0– $ 12,000
Times: Tax rate
Noncurrent deferred tax asset
Noncurrent deferred tax liability:
Net fixed assets $ –0– $110,000
Times: Tax rate
Noncurrent deferred tax liability
The amounts in the change column also appear as book-tax differences in the book
and tax income schedules in Example C:3-51. In those schedules, the differences occur in
the related income or expense accounts, specifically, bad debt expense, prepaid rental
income, and depreciation.
One last aspect of these schedules needs mentioning. Specifically, the changes in the
deferred tax assets and liabilities also represent the deferred federal tax expense or benefit
for the current year. See Step 7 below.
Step 4.
Assuming evidence supports that Valley will realize the entire amount of its deferred tax
assets, Valley need not establish a valuation allowance.
Step 5.
Assume that Valley requires no adjustments for uncertain tax positions.
Step 6.
As provided in Example C:3-51, current federal income taxes payable is $124,100. In this
example, the current payable amount also is the current federal income tax expense for
book purposes. (The equality of the current payable amount and the federal income tax
expense may not occur, however, under some uncertain tax position situations and in
other special circumstances.)
$ 37,400$ 37,400$ –0–
0.340.34
$110,000
ChangeEnd of Year 1Beg. of Year 1
$ 4,080$ 4,080$ –0–
0.340.34
$ 12,000
ChangeEnd of Year 1Beg. of Year 1
$ 5,780$ 5,780$ –0–
0.340.34
$ 17,000
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The Corporate Income Tax ▼ Corporations 3-49
Step 7.
The net deferred federal tax expense from the roll forward schedules equals $27,540
($37,400 � $5,780 � $4,080). Therefore, the total federal income tax expense for this
year can be calculated as follows:
Current federal income tax expense $124,100
Deferred income tax expense
Total federal income tax expense
Step 8.
Given the amounts determined in previous steps, Valley makes the following book journal
entry:
Current federal income tax expense 124,100
Deferred federal income tax expense 27,540
Current deferred tax asset 5,780
Noncurrent deferred tax asset 4,080
Noncurrent deferred tax liability 37,400
Federal income taxes payable 124,100
Alternatively, Valley could make the following combined book journal entry:
Total federal income tax expense 151,640
Current deferred tax asset 5,780
Net noncurrent deferred tax liability (37,400 � 4,080) 33,320
Federal income taxes payable 124,100
Step 9.
As a cross check on the previous steps, Valley can prepare the following tax provision
reconciliation:
Net income before federal income taxes (FIT) $488,200
Permanent differences:
Nondeductible insurance premiums 2,800
Tax-exempt income (3,000)
U.S. production activities deduction (35,000)
Dividends-received deduction )
Net income after permanent differences $446,000
Temporary differences:
Unearned rental income 8,000
Net capital loss disallowed for tax 12,000
Net accounts receivable (bad debt expense) 9,000
Net fixed assets (depreciation) )
Taxable income
Assuming no enacted change in future tax rates, net income after permanent differ-
ences times the tax rate results in the total federal income tax expense. Specifically,
$446,000 � 0.34 � $151,640. Similarly, taxable income times the tax rate results in cur-
rent federal income taxes payable. Specifically, $365,000 � 0.34 � $124,100.
Step 10.
A firm’s effective tax rate is its income tax expense divided by its pretax book income.
Because the income tax expense is based on net income after adjustment for permanent
differences (see Step 9), these differences cause a firm’s effective tax rate to differ from the
statutory tax rate. In the footnotes to financial statements, firms reconcile the statutory
tax rate to their effective tax rate. Accordingly, Valley’s effective tax rate reconciliation is
as follows:
$365,000
(110,000
(7,000
$151,640
27,540
ADDITIONAL
COMMENT
This approach and the balance
sheet approach may not always
lead to the same result when
enacted tax rates change, under
some uncertain tax position
situations, and in other special
circumstances.
ADDITIONAL
COMMENT
Remember that we are looking
only at federal income taxes in
these examples. Foreign, state,
and local taxes also can affect a
firm’s effective tax rate.
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Statutory tax rate 34.00%
Nondeductible insurance premiums ($2,800/$488,200 � 34%) 0.20%
Tax-exempt income [($3,000)/$488,200 � 34%] (0.21)%
U.S. production activities deduction [($35,000)/$488,200 � 34%] (2.44)%
Dividends-received deduction [($7,000)/$488,200 � 34%]
Effective tax rate ($151,640/$488,200)
In practice, a firm would not disclose the detail shown here but would aggregate small
percentage amounts into an “other” category. Also, if the enacted future tax rate changes,
that change also would be reflected in this schedule.
Step 11.
At this point, Valley can complete its financial statements. The income statement appears
in Example C:3-51, but the tax portion is repeated here.
Partial income statement:
Net income before federal income taxes $488,200
Minus: Federal income tax expense )
Net income
Effective tax rate ($151,640/$488,200)
As shown in Step 7, the total federal income tax expense has two components as follows:
Current federal income tax expense $124,100
Deferred income tax expense
Total federal income tax expense
The book balance sheet for Year 1 is as follows:
Assets:
Cash $ 230,200
Accounts receivable $ 300,000
Minus: Allowance for bad debts ) 291,000
Investment in corporate stock 90,000
Investment in tax-exempt bond 50,000
Inventory 500,000
Current deferred tax asset 5,780
Fixed assets $1,200,000
Minus: Accumulated depreciation )
Total assets
Liabilities and equity:
Accounts payable $ 225,000
Unearned rental income 8,000
Federal income taxes payable 124,100
Noncurrent deferred liability ($37,400 � $4,080) 33,320
Long-term liabilities 930,000
Common stock 650,000
Retained earnings
Total liabilities and equity
COMPREHENSIVE EXAMPLE – YEAR 2
Valley reports the following book and tax balance sheet items at the end of Year 2, prior to
adjustment for tax related items. Pertinent to the temporary differences, in Year 2 Valley
earned the rental income that was prepaid in Year 1 and did not collect additional amounts.
It also adjusted its allowance for bad debts and claimed additional depreciation on fixed
assets. It did not recognize any capital gains to offset the capital loss carryover. Step 11
below presents the completed book balance sheet after making tax related journal entries.
$2,306,980
336,560
$2,306,980
1,140,000(60,000
(9,000
$151,640
27,540
31.06%
$336,560
(151,640
31.06%
(0.49)%
3-50 Corporations ▼ Chapter 3
ADDITIONAL
COMMENT
This example ignores estimated
tax payments, so that the entire
amount of federal income taxes
payable appears on the balance
sheet.
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The Corporate Income Tax ▼ Corporations 3-51
Assets:
Cash $ 318,800 $ 318,800
Accounts receivable 400,000 400,000
Allowance for bad debts )
Net accounts receivable $ 37,000
Investment in corporate stock 90,000 90,000
Investment in tax-exempt bonds 50,000 50,000
Inventory 600,000 600,000
Fixed assets 1,200,000 1,200,000
Accumulated depreciation ) )
Net fixed assets 285,000
Liabilities and stock equity:
Accounts payable 295,000 295,000
Unearned rental income –0– –0–
Long-term liabilities 530,000 530,000
Common stock 650,000 650,000
Valley also reports the following book income statement through net income before fed-
eral income taxes and tax return schedule through taxable income. The tax portion of the
book income statement appears in Step 11.
Gross receipts $2,000,000 $2,000,000
Minus: Cost of goods sold ) )
Gross profit from operations $1,300,000 $1,300,000
Plus: Dividends from less than
20%-owned corporations 15,000 15,000
Tax-exempt income 3,200 –0– $ (3,200)
Prepaid rental income 8,000 –0– (8,000)
Minus: Operating expenses (500,000) (500,000)
Depreciation (120,000) (295,000) (175,000)
Bad debt expense (40,000) (12,000) 28,000
Business interest expense (60,000) (60,000)
Insurance premiums on life
insurance for key employee
(Valley is the beneficiary) (3,500) –0– 3,500
U.S. production activities
deduction (rounded) –0– (39,000) (39,000)
Dividends-received deduction ) (10,500)
Net income before federal income taxes
Taxable income
Steps 1 through 3.
The book and tax balance sheets above indicate the items where the book and tax bases
differ, thereby indicating temporary differences. In addition, the net capital loss carryfor-
ward remains unused.
The following three roll forward schedules calculate the deferred tax assets and
deferred tax liability associated with these temporary differences. The beginning and end-
ing balances for the balance sheet items reflect the differences between the book and tax
bases for these assets and liabilities. In the first schedule, the net accounts receivable tem-
porary difference increases, and the unearned rental income item reverses. In the second
schedule, Valley has not realized the deferred tax asset because it recognized no capital
gains in Year 2. Therefore, this deferred tax asset has not yet reversed. In the third sched-
ule, the fixed asset temporary difference increases.
$ 398,500
$ 602,700
(10,500–0–
(700,000(700,000
DifferenceTaxBook
735,0001,020,000
(465,000(180,000
400,000363,000
–0–(37,000
DifferenceTaxBook
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Current deferred tax asset:
Net accounts receivable $ 9,000 $ 37,000 $ 28,000
Unearned rental income )(8,000–0–8,000
ChangeEnd of Year 2Beg. of Year 2
3-52 Corporations ▼ Chapter 3
Total $ 17,000 $ 37,000
Times: Tax rate
Current deferred tax asset
Noncurrent deferred tax asset:
Net capital loss $ 12,000 $ 12,000
Times: Tax rate
Noncurrent deferred tax asset
Noncurrent deferred tax liability:
Net fixed assets $110,000 $285,000
Times: Tax rate
Noncurrent deferred tax liability
The amounts in the change column also appear as book-tax differences in the above book
and tax income schedules. In those schedules, the differences occur in the related income or
expense accounts, specifically, bad debt expense, prepaid rental income, and depreciation.
As before, the changes in the deferred tax assets and liabilities also represent the
deferred federal tax expense or benefit for the current year. See Step 7 below.
Step 4.
Assuming evidence supports that Valley still will realize the entire amount of its deferred
tax assets, Valley need not establish a valuation allowance.
Step 5.
Assume again that Valley requires no adjustments for uncertain tax positions.
Step 6.
As provided in the schedule above, taxable income is $398,500. Therefore, current federal
income taxes payable is $135,490 ($398,500 � 0.34). In this example, the current payable
amount also is the current federal income tax expense for book purposes. (The equality of
the current payable amount and the federal income tax expense may not occur, however,
under some uncertain tax position situations and in other special circumstances.)
Step 7.
The net deferred federal tax expense from the roll forward schedules equals $52,700
($59,500 � $6,800). Therefore, the total federal income tax expense for this year can be
calculated as follows:
Current federal income tax expense $135,490
Deferred income tax expense
Total federal income tax expense
Step 8.
Given the amounts determined in previous steps, Valley makes the following book journal
entry:
Current federal income tax expense 135,490
Deferred federal income tax expense 52,700
Current deferred tax asset 6,800
Noncurrent deferred tax liability 59,500
Federal income taxes payable 135,490
$188,190
52,700
$ 59,500$ 96,900$ 37,400
0.340.34
$175,000
ChangeEnd of Year 2Beg. of Year 2
$ –0–$ 4,080$ 4,080
0.340.34
$ –0–
ChangeEnd of Year 2Beg. of Year 2
$ 6,800$ 12,580$ 5,780
0.340.34
$ 20,000
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The Corporate Income Tax ▼ Corporations 3-53
Alternatively, Valley could make the following combined book journal entry:
Total federal income tax expense 188,190
Current deferred tax asset 6,800
Noncurrent deferred tax liability 59,500
Federal income taxes payable 135,490
Step 9.
As a cross check on the previous steps, Valley can prepare the following tax provision
reconciliation:
Net income before federal income taxes (FIT) $602,700
Permanent differences:
Nondeductible insurance premiums 3,500
Tax-exempt income (3,200)
U.S. production activities deduction (39,000)
Dividends-received deduction )
Net income after permanent differences $553,500
Temporary differences:
Unearned rental income (8,000)
Net accounts receivable (bad debt expense) 28,000
Net fixed assets (depreciation) )
Taxable income
Assuming no enacted change in future tax rates, net income after permanent differ-
ences times the tax rate results in the total federal income tax expense. Specifically,
$553,500 � 0.34 � $188,190. Similarly, taxable income times the tax rate results in cur-
rent federal income taxes payable. Specifically, $398,500 � 0.34 � $135,490.
Step 10.
Valley’s Year 2 effective tax rate is its income tax expense divided by its pretax book
income, or $188,190/$602,700 � 31.23% (rounded up). Accordingly, Valley’s effective
tax rate reconciliation is as follows:
Statutory tax rate 34.00%
Nondeductible insurance premiums ($3,500/$602,700 � 34%) 0.20%
Tax-exempt income [($3,200)/$602,700 � 34%] (0.18)%
U.S. production activities deduction [($39,000)/$602,700 � 34%] (2.20)%
Dividends-received deduction [($10,500)/$602,700 � 34%]
Effective tax rate ($188,190/$602,700)
Step 11.
At this point, Valley can complete its financial statements. The first part of the income
statement appears in the schedule appearing before Steps 1 through 3, and the tax portion
is as follows:
Partial income statement:
Net income before federal income taxes $602,700
Minus: Federal income tax expense )
Net income
Effective tax rate ($188,190/$602,700)
As shown in Step 7, the federal income tax expense has two components as follows:
Current federal income tax expense $135,490
Deferred income tax expense ($59,500 � $6,800)
Total federal income tax expense $188,190
52,700
31.23%
$414,510
(188,190
31.23%
(0.59)%
$398,500
(175,000
(10,500
ADDITIONAL
COMMENT
This approach and the balance
sheet approach may not always
lead to the same result when
enacted tax rates change, under
some uncertain tax position
situations, and in other special
circumstances.
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The book balance sheet for Year 2 is as follows:
Assets:
Cash $ 318,800
Accounts receivable $ 400,000
Minus: Allowance for bad debts ) 363,000
Investment in corporate stock 90,000
Investment in tax-exempt bond 50,000
Inventory 600,000
Current deferred tax asset 12,580
Fixed assets $1,200,000
Minus: Accumulated depreciation )
Total assets
Liabilities and equity:
Accounts payable $ 295,000
Unearned rental income –0–
Federal income taxes payable 135,490
Noncurrent deferred liability ($96,900 � $4,080) 92,820
Long-term liabilities 530,000
Common stock 650,000
Retained earnings
Total liabilities and equity
OTHER TRANSACTIONS
Chapters C:5, C:7, C:8, and C:16 describe the financial statement implications of other
transactions, for example, the alternative minimum tax (Chapter C:5), corporate acquisitions
(Chapter C:7), intercompany transactions (Chapter C:8), and the foreign tax credit and
deferred foreign earnings (Chapter C:16). Also, Problem C:3-64 provides a comprehensive
tax return and financial accounting exercise.
$2,454,380
751,070
$2,454,380
1,020,000(180,000
(37,000
3-54 Corporations ▼ Chapter 3
PR O B L E M M A T E R I A L S
DISCUSSION QUESTIONS
C:3-1 High Corporation incorporates on May 1 and
begins business on May 10 of the current year.
What alternative tax years can High elect to
report its initial year’s income?
C:3-2 Port Corporation wants to change its tax year
from a calendar year to a fiscal year ending June
30. Port is a C corporation owned by 100 share-
holders, none of whom own more than 5% of the
stock. Can Port change its tax year? If so, how
can it accomplish the change?
C:3-3 Stan and Susan, two calendar year taxpayers, are
starting a new business to manufacture and sell
digital circuits. They intend to incorporate the
business with $600,000 of their own capital and
$2 million of equity capital obtained from other
investors. The company expects to incur organi-
zational and start-up expenditures of $100,000 in
the first year. Inventories are a material income-
producing factor. The company also expects to
incur losses of $500,000 in the first two years of
operations and substantial research and develop-
ment expenses during the first three years. The
company expects to break even in the third year
and be profitable at the end of the fourth year,
even though the nature of the digital circuit busi-
ness will require continual research and develop-
ment activities. What accounting methods and
tax elections must Stan and Susan consider in
their first year of operation? For each method and
election, explain the possible alternatives and the
advantages and disadvantages of each alternative.
C:3-4 Compare the tax treatment of capital gains and
losses by a corporation and by an individual.
C:3-5 What are organizational expenditures? How are
they treated for tax purposes?
C:3-6 What are start-up expenditures? How are they
treated for tax purposes?
ADDITIONAL
COMMENT
This example ignores estimated
tax payments, so the entire
amount of federal income taxes
payable appears on the balance
sheet.
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The Corporate Income Tax ▼ Corporations 3-55
ISSUE IDENTIFICATION QUESTIONS
C:3-28 X-Ray Corporation received a $100,000 dividend from Yancey Corporation this year.
X-Ray owns 10% of the Yancey’s single class of stock. What tax issues should X-Ray con-
sider with respect to its dividend income?
C:3-29 Williams Corporation sold a truck with an adjusted basis of $100,000 to Barbara for
$80,000. Barbara owns 25% of the Williams stock. What tax issues should Williams and
Barbara consider with respect to the sale/purchase?
C:3-30 You are the CPA who prepares the tax returns for Don, his wife, Mary, and their two cor-
porations. Don owns 100% of Pencil Corporation’s stock. Pencil’s current year taxable
income is $100,000. Mary owns 100% of Eraser Corporation’s stock. Eraser’s current
year taxable income is $150,000. Don and Mary file a joint federal income tax return.
What issues should Don and Mary consider with respect to the calculation of the three
tax return liabilities?
C:3-31 Rugby Corporation has a $50,000 NOL in the current year. Rugby’s taxable income in each
of the previous two years was $25,000. Rugby expects its taxable income for next year to
exceed $400,000. What issues should Rugby consider with respect to the use of the NOL?
C:3-7 Describe three ways in which the treatment of
charitable contributions by individual and corpo-
rate taxpayers differ.
C:3-8 Carver Corporation uses the accrual method of
accounting and the calendar year as its tax year. Its
board of directors authorizes a cash contribution
on November 3 of Year 1, that the corporation
pays on March 9 of Year 2. In what year(s) is it
deductible? What happens if the corporation does
not pay the contribution until April 20 of Year 2?
C:3-9 Zero Corporation contributes inventory (com-
puters) to State University for use in its mathe-
matics program. The computers have a $1,225
cost basis and an $2,800 FMV. How much is
Zero’s charitable contribution deduction for the
computers? (Ignore the 10% limit.)
C:3-10 Why are corporations allowed a dividends-
received deduction? What dividends qualify for
this special deduction?
C:3-11 Why is a dividends-received deduction disallowed
if the stock on which the corporation pays the
dividend is debt-financed?
C:3-12 Crane Corporation incurs a $75,000 NOL in the
current year. In which years can Crane use this
NOL if it makes no special elections? When
might a special election to forgo the carryback of
the NOL be beneficial for Crane?
C:3-13 What special restrictions apply to the deduction
of a loss realized on the sale of property between
a corporation and a shareholder who owns 60%
of the corporation’s stock? What restrictions
apply to the deduction of expenses accrued by a
corporation at year-end and owed to a cash
method shareholder who owns 60% of the cor-
poration’s stock?
C:3-14 Deer Corporation is a C corporation. Its taxable
income for the current year is $200,000. What is
Deer Corporation’s income tax liability for the
year?
C:3-15 Budget Corporation is a personal service corpora-
tion. Its taxable income for the current year is
$75,000. What is Budget’s income tax liability for
the year?
C:3-16 Describe the three types of controlled groups.
C:3-17 Why do special restrictions on using the progres-
sive corporate tax rates apply to controlled
groups of corporations? List five restrictions on
claiming multiple tax benefits that apply to con-
trolled groups of corporations.
C:3-18 What are the major advantages and disadvan-
tages of filing a consolidated tax return?
C:3-19 What are the tax advantages of substituting fringe
benefits for salary paid to a shareholder-employee?
C:3-20 Explain the tax consequences to both the corpo-
ration and a shareholder-employee if an IRS
agent determines that a portion of the compensa-
tion paid in a prior tax year exceeds a reasonable
compensation level.
C:3-21 What is the advantage of a special apportionment
plan for the benefits of the 15%, 25%, and 34%
tax rates to members of a controlled group?
C:3-22 What corporations must pay estimated taxes?
When are the estimated tax payments due?
C:3-23 What is a “large” corporation for purposes of the
estimated tax rules? What special rules apply to
such large corporations?
C:3-24 What penalties apply to the underpayment of
estimated taxes? The late payment of the remain-
ing tax liability?
C:3-25 Describe the situations in which a corporation
must file a tax return.
C:3-26 When is a corporate tax return due for a calen-
dar-year taxpayer? What extension(s) of time in
which to file the return are available?
C:3-27 List four types of differences that can cause a cor-
poration’s book income to differ from its taxable
income.
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PROBLEMS
C:3-32 Depreciation Recapture. Young Corporation purchased residential real estate several
year ago for $225,000, of which $25,000 was allocated to the land and $200,000 was
allocated to the building. Young took straight-line MACRS deductions of $30,000 dur-
ing the years it held the property. In the current year, Young sells the property for
$285,000, of which $60,000 is allocated to the land and $225,000 is allocated to the
building. What are the amount and character of Young’s recognized gain or loss on the
sale?
C:3-33 Depreciation Recapture, Sec. 1231, and Capital Gains and Losses. Gamma Corporation
sold the following property on March 3 of the current year:
Selling price
Cost $100,000 $200,000 $400,000 $190,000
Accumulated depreciation -0-(120,000)(125,000)-0-
$175,000$385,000$210,000$ 65,000
LandBuildingEquipmentSecurities
Adjusted basis
Gain (loss)
The corporation used the equipment, building, and land in its business and has held all
the property for more than one year. Aside from these transactions, Alpha had $720,000
of operating net income during the current year. Gamma has a $24,000 nonrecaptured
Sec. 1231 loss from prior years. Determine the character of the gains and losses, and cal-
culate the corporation’s taxable income. Ignore the U.S. production activities deduction.
C:3-34 Organizational and Start-up Expenditures. Delta Corporation incorporates on January
7, begins business on July 10, and elects to have its initial tax year end on October 31.
Delta incurs the following expenses between January and October related to its organiza-
tion during the current year:
January 30 Travel to investigate potential business site $2,000
May 15 Legal expenses to draft corporate charter 2,500
May 30 Commissions to stockbroker for issuing and selling stock 4,000
May 30 Temporary directors’ fees 2,500
June 1 Expense of transferring building to Delta 3,000
June 5 Accounting fees to set up corporate books 1,500
June 10 Training expenses for employees 5,000
June 15 Rent expense for June 1,000
July 15 Rent expense for July 1,000
a. What alternative treatments are available for Delta’s expenditures?
b. What amount of organizational expenditures can Delta Corporation deduct on its first
tax return for the fiscal year ending October 31?
c. What amount of start-up costs can Delta Corporation deduct on its first tax return?
C:3-35 Charitable Contribution of Property. Yellow Corporation donates the following prop-
erty to the State University:
• ABC Corporation stock purchased two years ago for $18,000. The stock, which trades
on a regional stock exchange, has a $25,000 FMV on the contribution date.
• Inventory with a $17,000 adjusted basis and a $22,000 FMV. State will use the inven-
tory for scientific research that qualifies under the special Sec. 170(e)(4) rules.
• An antique vase purchased two years ago for $10,000 and having an $18,000 FMV.
State University plans to sell the vase to obtain funds for educational purposes.
Yellow Corporation’s taxable income before any charitable contributions deduction,
NOL or capital loss carryback, or dividends-received deduction is $250,000.
a. What is Yellow Corporation’s charitable contributions deduction for the current year?
b. What is the amount of its charitable contributions carryover (if any)?
C:3-36 Charitable Contributions of Property. Blue Corporation donates the following property
to Johnson Elementary School:
AmountExpenditureDate
$(15,000)$105,000$135,000$ (35,000)
$190,000$280,000$ 75,000$100,000
3-56 Corporations ▼ Chapter 3
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The Corporate Income Tax ▼ Corporations 3-57
• XYZ Corporation stock purchased two years ago for $25,000. The stock has a
$19,000 FMV on the contribution date.
• ABC Corporation stock purchased three years ago for $2,000. The stock has a
$16,000 FMV on the contribution date.
• PQR Corporation stock purchased six months ago for $12,000. The stock has an
$18,000 FMV on the contribution date.
The school will sell the stock and use the proceeds to renovate a classroom to be used as
a computer laboratory. Blue’s taxable income before any charitable contribution deduc-
tion, dividends-received deduction, or NOL or capital loss carryback is $400,000.
a. What is Blue’s charitable contributions deduction for the current year?
b. What is Blue’s charitable contribution carryback or carryover (if any)? In what years
can it be used?
c. What would have been a better tax plan concerning the XYZ stock donation?
C:3-37 Charitable Contribution Deduction Limitation. Zeta Corporation reports the following
results for Year 1 and Year 2:
Adjusted taxable income $180,000 $125,000
Charitable contributions (cash) 20,000 12,000
The adjusted taxable income is before Zeta claims any charitable contributions deduc-
tion, NOL or capital loss carryback, dividends-received deduction, or U.S. production
activities deduction.
a. How much is Zeta’s charitable contributions deduction in Year 1? In Year 2?
b. What is Zeta’s contribution carryover to Year 3, if any?
C:3-38 Taxable Income Computation. Omega Corporation reports the following results for the
current year:
Gross profits on sales $120,000
Dividends from less-than-20%-owned domestic corporations 40,000
Operating expenses 100,000
Charitable contributions (cash) 11,000
a. What is Omega’s charitable contributions deduction for the current year and its chari-
table contributions carryover to next year, if any?
b. What is Omega’s taxable income for the current year, assuming qualified production
activities income is $20,000?
C:3-39 Dividends-Received Deduction. Theta Corporation reports the following results for the
current year:
Gross profits on sales $220,000
Dividends from less-than-20%-owned domestic corporations 100,000
Operating expenses 218,000
a. What is Theta’s taxable income for the current year, assuming qualified production
activities income is $2,000?
b. How would your answer to Part a change if Theta’s operating expenses are instead
$234,000, assuming qualified production activities income is zero or negative?
c. How would your answer to Part a change if Theta’s operating expenses are instead
$252,000, assuming qualified production activities income is zero or negative?
d. How would your answers to Parts a, b, and c change if Theta received $75,000 of the
dividends from a 20%-owned corporation and the remaining $25,000 from a less-
than-20%-owned corporation?
C:3-40 Stock Held 45 Days or Less. Beta Corporation purchased 100 shares of Gamma
Corporation common stock (less than 5% of the outstanding stock) two days before the
ex-dividend date for $200,000. Beta receives a $10,000 cash dividend from Gamma. Beta
sells the Gamma stock one week after purchasing it for $190,000. What are the tax con-
sequences of these three events?
C:3-41 Debt-financed Stock. Cheers Corporation purchased for $500,000 5,000 shares of Beer
Corporation common stock (less than 5% of the outstanding Beer stock) at the beginning
Year 2Year 1
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3-58 Corporations ▼ Chapter 3
of the current year. It used $400,000 of borrowed money and $100,000 of its own cash to
make this purchase. Cheers paid $50,000 of interest on the debt this year. Cheers received
a $40,000 cash dividend on the Beer stock on September 1 of the current year.
a. What amount can Cheers deduct for the interest paid on the loan?
b. What dividends-received deduction can Cheers claim with respect to the dividend?
C:3-42 Net Operating Loss Carrybacks and Carryovers. In 2013, Ace Corporation reports gross
income of $200,000 (including $150,000 of profit from its operations and $50,000 in
dividends from less-than-20%-owned domestic corporations) and $220,000 of operating
expenses. Ace’s 2011 taxable income (all ordinary income) was $75,000, on which it paid
taxes of $13,750.
a. What is Ace’s NOL for 2013?
b. What is the amount of Ace’s tax refund if Ace carries back the 2013 NOL to 2011?
c. Assume that Ace expects 2014’s taxable income to be $400,000. Ignore the U.S. pro-
duction activities deduction. What election could Ace make to increase the tax benefit
from its NOL? What is the dollar amount of the expected benefit (if any)? Assume a
10% discount rate as a measure of the time value of money.
C:3-43 Ordering of Deductions. Beta Corporation reports the following results for the current year:
Gross income from operations $180,000
Dividends from less-than-20%-owned domestic corporations 100,000
Operating expenses 150,000
Charitable contributions 20,000
In addition, Beta has a $50,000 NOL carryover from the preceding tax year, and its qual-
ified production activities income is $30,000.
a. What is Beta’s taxable income for the current year?
b. What carrybacks or carryovers are available to other tax years?
C:3-44 Sale to a Related Party. Union Corporation sells a truck for $18,000 to Jane, who owns
70% of its stock. The truck has a $24,000 adjusted basis on the sale date. Jane sells the truck
to an unrelated party, Mike, for $28,000 two years later after claiming $5,000 in depreciation.
a. What is Union’s realized and recognized gain or loss on selling the truck?
b. What is Jane’s realized and recognized gain or loss on selling the truck to Mike?
c. How would your answers to Part b change if Jane instead sold the truck for $10,000?
C:3-45 Payment to a Cash Basis Employee-Shareholder. Value Corporation is a calendar year
taxpayer that uses the accrual method of accounting. On December 10 of the current year,
Value accrues a bonus payment of $100,000 to Brett, its president and sole shareholder.
Brett is a calendar year taxpayer who uses the cash method of accounting.
a. When can Value deduct the bonus if it pays it to Brett on March 11 of next year? On
March 18 of next year?
b. How would your answers to Part a change if Brett were an employee of Value who
owns no stock in the corporation?
C:3-46 Capital Gains and Losses. Western Corporation reports the following results for the cur-
rent year:
Gross profits on sales $150,000
Long-term capital gain 8,000
Long-term capital loss 15,000
Short-term capital gain 10,000
Short-term capital loss 2,000
Operating expenses 61,000
a. What are Western’s taxable income and income tax liability for the current year,
assuming qualified production activities income is $89,000?
b. How would your answers to Part a change if Western’s short-term capital loss is
$5,000 instead of $2,000?
C:3-47 Corporate Taxable Income and Tax Liability. Alpha Corporation has been in business
for two years. It incurred the following items last year (Year 1):
Gross profits on sales $240,000
Operating expenses 100,000
Long-term capital gain 8,000
Short-term capital loss 12,000
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The Corporate Income Tax ▼ Corporations 3-59
Omega reported the following items this year (Year 2):
Gross profits on sales $600,000
Operating expenses 165,000
Long-term capital gain 10,000
Assume that qualified production activities income in each year equals gross profit minus
operating expenses. Compute Alpha’s taxable income and tax liability for Year 1 and Year 2.
C:3-48 Computing the Corporate Income Tax Liability. What is Beta Corporation’s income tax
liability assuming its taxable income is (a) $94,000, (b) $300,000, and (c) $600,000. How
would your answers change if Beta were a personal service corporation?
C:3-49 Computing the Corporate Income Tax Liability. Fawn Corporation, a C corporation,
paid no dividends and recognized no capital gains or losses in the current year. What is its
income tax liability assuming its taxable income for the year is
a. $50,000
b. $14,000,000
c. $18,000,000
d. $34,000,000
C:3-50 Computing Taxable Income and Income Tax Liability. Pace Corporation reports the fol-
lowing results for the current year:
Gross profit on sales $120,000
Long-term capital loss 10,000
Short-term capital loss 5,000
Dividends from 40%-owned domestic corporation 30,000
Operating expenses 65,000
Charitable contributions 10,000
a. What are Pace’s taxable income and income tax liability, assuming qualified produc-
tion activities income is $55,000?
b. What carrybacks and carryovers (if any) are available and to what years must they be
carried?
C:3-51 Computing Taxable Income and Income Tax Liability. Roper Corporation reports the
following results for the current year:
Gross profits on sales $80,000
Short-term capital gain 40,000
Long-term capital gain 25,000
Dividends from 25%-owned domestic corporation 15,000
NOL carryover from the preceding tax year 9,000
Operating expenses 45,000
What are Roper’s taxable income and income tax liability, assuming qualified production
activities income is $35,000?
C:3-52 Controlled Groups. Which of the following groups constitute controlled groups? (Any
stock not listed below is held by unrelated individuals each owning less than 1% of the
outstanding stock.) For brother-sister corporations, which definition applies?
a. Judy owns 100% of the single classes of stock of Hot and Ice Corporations.
b. Jones and Kane Corporations each have only a single class of stock outstanding. The
two controlling individual shareholders own the stock as follows:
Tom 60% 100%
Mary 40%
c. Link, Model, and Name Corporations each have a single class of stock outstanding.
The stock is owned as follows:
Link Corp. 80% 50%
Model Corp. 40%
Unrelated individuals 20% 10%
Name Corp.Model Corp.Shareholder
Stock Ownership Percentages
Kane Corp.Jones Corp.Shareholder
Stock Ownership Percentages
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3-60 Corporations ▼ Chapter 3
Link Corporation’s stock is widely held by over 1,000 shareholders, none of whom
owns directly or indirectly more than 1% of Link’s stock.
d. Oat, Peach, Rye, and Seed Corporations each have a single class of stock outstanding.
The stock is owned as follows:
Bob 100% 90%
Oat Corp. 80% 30%
Rye Corp. 60%
Unrelated individuals 10% 20% 10%
C:3-53 Controlled Groups of Corporations. Sally owns 100% of the outstanding stock of Eta,
Theta, Phi, and Gamma Corporations, each of which files a separate return for the cur-
rent year. During the current year, the corporations report taxable income as follows:
Eta $40,000
Theta (25,000)
Phi 50,000
Gamma 10,000
a. What is each corporation’s separate tax liability, assuming the corporations do not
elect a special apportionment plan for allocating the corporate tax rates?
b. What is each corporation’s separate tax liability, assuming the corporations make a
special election to apportion the reduced corporate tax rates in such a way that mini-
mizes the group’s total tax liability? Note: More than one plan can satisfy this goal.
c. How does the result in Part b change if Gamma’s income is $30,000 instead of $10,000?
C:3-54 Compensation Planning. Marilyn owns all of Bell Corporation’s stock. Bell is a C corpo-
ration and employs 40 people. Marilyn is married, has two dependent children, and files
a joint tax return with her husband. She projects that Bell will report $400,000 of pretax
profits for the current year. Marilyn is considering five salary levels as shown below.
Ignore the U.S. production activities deduction for this problem.
Tax Liability
$400,000 $ –0– $400,000
400,000 $100,000 300,000
400,000 200,000 200,000
400,000 300,000 100,000
400,000 400,000 –0–
a. Determine the total tax liability for Marilyn and Bell for each of the five proposed salary
levels. Assume no other income for Marilyn’s family, and assume that Marilyn and her
husband claim a combined itemized deduction and personal exemption of $30,000
regardless of AGI levels. Ignore employment taxes.
b. What recommendations can you make about a salary level for Marilyn that will mini-
mize the total tax liability? Assume salaries paid up to $400,000 are considered reason-
able compensation.
c. What is the possible disadvantage to Marilyn if Bell retains funds in the business and
distributes some of the accumulated earnings as a dividend in a later tax year?
C:3-55 Fringe Benefits. Refer to the facts in Problem C:3-54. Marilyn has read an article explain-
ing the advantages of paying nontaxable fringe benefits (premiums on group term life
insurance, accident and health insurance, etc.) and having deferred compensation plans
(e.g., qualified pension and profit-sharing plans). Provide Marilyn with information on the
tax savings associated with converting $3,000 of her salary into nontaxable fringe bene-
fits. What additional costs might Bell Corporation incur if it adopts a fringe benefit plan?
C:3-56 Estimated Tax Requirement. Zeta Corporation’s taxable income for 2012 was $1.5 million,
on which Zeta paid federal income taxes of $510,000. Zeta estimates calendar year 2013’s
taxable income to be $2 million, on which it will owe $680,000 in federal income taxes.
a. What are Zeta’s minimum quarterly estimated tax payments for 2013 to avoid an
underpayment penalty?
TotalBell CorporationMarilyn
Earnings Retained
by Bell Corporation
Salary
Paid to Marilyn
Total
Income
Taxable IncomeCorporation
Seed Corp.Rye Corp.Peach Corp.Oat Corp.Shareholder
Stock Ownership Percentages
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The Corporate Income Tax ▼ Corporations 3-61
b. When is Zeta’s 2013 tax return due?
c. When are any remaining taxes due? What amount of taxes are due when Zeta files its
return assuming Zeta timely pays estimated tax payments equal to the amount deter-
mined in Part a?
d. If Zeta obtains an extension to file, when is its tax return due? Will the extension per-
mit Zeta to delay making its final tax payments?
C:3-57 Filing the Tax Return and Paying the Tax Liability. Wright Corporation’s taxable
income for calendar years 2010, 2011, and 2012 was $120,000, $150,000, and
$100,000, respectively. Its total tax liability for 2012 was $22,250. Wright estimates that
its 2013 taxable income will be $500,000, on which it will owe federal income taxes of
$170,000. Assume Wright earns its 2013 taxable income evenly throughout the year.
a. What are Wright’s minimum quarterly estimated tax payments for 2013 to avoid an
underpayment penalty?
b. When is Wright’s 2013 tax return due?
c. When are any remaining taxes due? What amount of taxes are due when Wright files
its return assuming it timely paid estimated tax payments equal to the amount deter-
mined in Part a?
d. How would your answer to Part a change if Wright’s tax liability for 2012 had been
$200,000?
C:3-58 Converting Book Income to Taxable Income. The following income and expense
accounts appeared in the book accounting records of Rocket Corporation, an accrual
basis taxpayer, for the current calendar year.
Net sales $3,230,000
Dividends 10,000 (1)
Interest 18,000 (2)
Gain on sale of stock 9,000 (3)
Key-person life insurance proceeds 100,000
Cost of goods sold $2,000,000
Salaries and wages 500,000
Bad debts 13,000 (4)
Payroll taxes 62,000
Interest expense 12,000 (5)
Charitable contributions 50,000 (6)
Depreciation 70,000 (7)
Other expenses 40,000 (8)
Federal income taxes 166,000
Net income
Total
The following additional information applies.
1. Dividends were from Star Corporation, a 30%-owned domestic corporation.
2. Interest revenue consists of interest on corporate bonds, $15,000; and municipal
bonds, $3,000.
3. The stock is a capital asset held for three years prior to sale.
4. Rocket uses the specific writeoff method of accounting for bad debts.
5. Interest expense consists of $11,000 interest incurred on funds borrowed for working
capital and $1,000 interest on funds borrowed to purchase municipal bonds.
6. Rocket paid all contributions in cash during the current year to State University.
7. Rocket calculated depreciation per books using the straight-line method. For income
tax purposes, depreciation amounted to $95,000.
8. Other expenses include premiums of $5,000 on the key-person life insurance policy
covering Rocket’s president, who died in December.
9. Qualified production activities income is $300,000.
10. Rocket has a $90,000 NOL carryover from prior years.
Required:
a. Prepare a worksheet reconciling Rocket’s book income with its taxable income (before
special deductions). Six columns should be used—two (one debit and one credit) for
each of the following three major headings: book income, Schedule M-1 adjustments,
$3,367,000$3,367,000
454,000
CreditDebitAccount Title
Book Income
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3-62 Corporations ▼ Chapter 3
and taxable income. (See the sample worksheet with Form 1120 in Appendix B if you
need assistance).
b. Prepare a tax provision reconciliation as in Step 9 of the Tax Provision Process.
Assume a 34% corporate tax rate.
C:3-59 Reconciling Book Income and Taxable Income. Omega Corporation reports the follow-
ing results for the current year:
Net income per books (before federal income taxes) $738,000
Federal income tax expense per books (232,000)
Net income per books (after federal income taxes) $506,000
Tax-exempt interest income 10,000
Interest on loan to purchase tax-exempt bonds 7,000
MACRS depreciation exceeding book depreciation 40,000
Net capital loss 8,000
Insurance premium on life of corporate officer where Omega is the beneficiary 9,000
Excess charitable contributions carried over to next year 4,000
U.S. production activities deduction ($700.0000 � 0.09)* 63,000
*Assume that qualified production activities income is $700,000.
a. Prepare a reconciliation of Omega’s taxable income before special deductions with its
book income.
b. Prepare a tax provision reconciliation as in Step 9 of the Tax Provision Process.
C:3-60 Reconciling Unappropriated Retained Earnings. White Corporation’s financial accounting
records disclose the following results for the period ending December 31 of the current year:
Retained earnings balance on January 1 $246,500
Net income for year 259,574
Contingency reserve established on December 31 60,000
Cash dividend paid on July 23 23,000
What is White’s unappropriated retained earnings balance on December 31 of the current year?
C:3-61 Tax Reconciliation Process. Omega Corporation, a regular C corporation, presents you
with the following partial book income statement for the current year:
Sales $1,900,000
Cost of goods sold )
Gross profit $800,000
Operating expenses:
Depreciation $ 80,000
Interest expense 18,000
Warranty expense 12,000
Fines and penalties 10,000
Other business expenses )
Net operating income $460,000
Other income (losses):
Interest received on municipal bonds $ 1,000
Income on installment sale 9,000
Net losses on stock sales ) )
Net income before federal income taxes
Omega also provides the following partial balance sheet information:
Book Tax
Installment note receivable $ –0– $ 30,000 $ –0– $ 30,000
Minus: Unrecognized income
on note )
Net basis of note receivable –0– 30,000 –0– 21,000
Tax-exempt bonds 18,000 18,000 18,000 18,000
Current deferred asset 5,100 ? –0– –0–
Investment stocks 100,000 40,000 100,000 40,000
(9,000–0––0––0–
End of YearBeg. of YearEnd of YearBeg. of Year
$450,000
(10,000(20,000
(340,000220,000
(1,100,000
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The Corporate Income Tax ▼ Corporations 3-63
Fixed assets 400,000 400,000 400,000 400,000
Minus: Accumulated
depreciation ) ) ) )
Net basis of fixed assets 360,000 280,000 320,000 192,000
Liability for warranties –0– 12,000 –0– –0–
Noncurrent deferred tax liability 13,600 ? –0– –0–
You have gathered the following additional information:
1. Depreciation for tax purposes is $128,000.
2. Of the $18,000 interest expense, $2,000 is allocable to a loan used to purchase the
municipal bonds.
3. The warranty expense is an estimated amount for book purposes. Omega expects
actual claims on these warranties to be filed and paid next year.
4. Your research determines that the fines and penalties are not deductible for tax purposes.
5. In the current year, Omega sold property using the installment method as follows:
Selling price $30,000
Adjusted basis (21,000)
Gain $9,000
Omega obtains a $30,000 installment note receivable this year and will receive the
$30,000 sales proceeds next year. For book purposes, Omega recognizes the $9,000
gain in the current year. For tax purposes, Omega will recognize the $9,000 gain next
year when it receives the $30,000 sales proceeds.
6. Omega sold a significant portion of its stock portfolio in the current year. The
$20,000 net loss per books from these stock sales includes the following components:
Long-term capital gain $15,000
Long-term capital loss (38,000)
Short-term capital gain 3,000
Omega had no capital gains in prior years, so it cannot carry the net capital losses
back.
7. Omega does not expect to realize capital gains next year, but it does expect sufficient
capital gains within the next five years so that it can use the capital loss carryover
before it expires. Thus, Omega determines that it needs no valuation allowance.
8. Omega has a $15,000 net operating loss carryover from last year, which it then
expected to use in the next year (now the current year).
9. Qualified production activities income for the current year equals $300,000, which is
less than taxable income before the U.S. production activities deduction. The applicable
percentage is 9%.
10. Omega’s tax rate is 34% and will remain so in future years.
11. The beginning deferred tax asset pertains to the NOL carryover, and the beginning
deferred tax liability pertains to fixed assets. Other deferred tax assets and deferred
tax liabilities may arise in the current year.
12. Omega determines that it needs no adjustment for uncertain tax positions.
Required: Perform the tax provision process steps as outlined in the text. For Step 11, just
present partial income statement and balance sheet disclosures as allowed by the given facts.
C:3-62 Valuation Allowance. In the current year, Alpha Corporation generated $500,000 of
ordinary operating income and incurred a $20,000 capital loss on the sale of marketable
securities from its investment portfolio. Alpha expects to generate $500,000 of ordinary
operating income in each of the next five years. Alpha incurred no capital gains in its pre-
vious three years, so it must carry over the $20,000 capital loss for up to five years. Alpha
estimates that its remaining marketable securities would produce a $12,000 capital gain if
sold. Thus, Alpha determines that, more likely than not, the corporation will not realize
(deduct) $8,000 of the current year capital loss. Alpha has no other book-tax differences
and is subject to a 34% tax rate.
Required:
a. Determine Alpha’s deferred tax asset and valuation allowance for the current year.
b. Determine Alpha’s current federal income tax expense, deferred federal income tax
expense (benefit), total federal income tax expense, and federal income taxes payable.
(208,000(80,000(120,000(40,000
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3-64 Corporations ▼ Chapter 3
c. Prepare the journal entry necessary to record the above amounts.
d. Prepare a tax provision reconciliation and effective tax rate reconciliation for the
current year.
C:3-63 Uncertain Tax Positions. In the current year, Kappa Corporation earned $1 million of net
income before federal income taxes. This amount of book income includes a $100,000
expense for what the company considers an ordinary and necessary business expense.
Kappa also deducted the entire $100,000 for tax purposes. In assessing the expense for its
tax provision, Kappa determines that it has a more-likely-than-not probability of sustain-
ing some portion of the deduction upon an IRS examination. However, some uncertainty
remains as to whether the entire amount is deductible. Any amount ultimately disallowed
by the IRS would be a permanent disallowance and not merely a temporary item that
could be amortized over time. Upon further analysis, Kappa measures the benefit that is
more than 50% likely to be realized as $70,000. Thus, Kappa may not recognize $30,000
of the expense in determining its federal income tax provision. In addition, Kappa has a
$25,000 temporary difference that decreases its taxable income to $975,000 and
increases its deferred tax liability.
Required:
a. Determine Kappa’s liability for unrecognized tax benefits, total federal income tax
expense, deferred federal income tax expense, current federal income tax expense,
increase in deferred tax liability, and federal income taxes payable.
b. Prepare the journal entry necessary to record the current year tax provision.
COMPREHENSIVE PROBLEM
C:3-64 Jackson Corporation prepared the following book income statement for its year ended
December 31, 2013:
Sales $950,000
Minus: Cost of goods sold )
Gross profit $500,000
Plus: Dividends received on Invest Corporation stock $ 3,000
Gain on sale of Invest Corporation stock
Total dividends and gain 33,000
Minus: Depreciation ($7,500 � $52,000) $ 59,500
Bad debt expense 22,000
Other operating expenses 105,500
Loss on sale of Equipment 1
Total expenses and loss )
Net income per books before taxes $276,000
Minus: Federal income tax expense )
Net income per books
Information on equipment depreciation and sale:
Equipment 1:
• Acquired March 3, 2011 for $180,000
• For books: 12-year life; straight-line depreciation
• Sold February 17, 2013 for $80,000
Sales price $ 80,000
Cost $180,000
Minus: Depreciation for 2011 (1⁄2 year) $ 7,500
Depreciation for 2012 ($180,000/12) 15,000
Depreciation for 2013 (1⁄2 year)
Total book depreciation )
Book value at time of sale )
Book loss on sale of Equipment 1 )
• For tax: Seven-year MACRS property for which the corporation made no Sec. 179
election in the acquisition year and elected out of bonus depreciation.
$(70,000
(150,000
(30,000
7,500
$186,000
(90,000
(257,000
70,000
30,000
(450,000
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The Corporate Income Tax ▼ Corporations 3-65
Equipment 2:
• Acquired February 16, 2012 for $624,000
• For books: 12-year life; straight-line depreciation
• Book depreciation in 2013: $624,000/12 � $52,000
• For tax: Seven-year MACRS property for which the corporation made the Sec. 179
election in 2012 but elected out of bonus depreciation.
Other information:
• Under the direct writeoff method, Jackson deducts $15,000 of bad debts for tax
purposes.
• Jackson has a $40,000 NOL carryover and a $6,000 capital loss carryover from last year.
• Jackson purchased the Invest Corporation stock (less than 20% owned) on June 21,
2011, for $25,000 and sold the stock on December 23, 2013, for $55,000.
• Jackson Corporation has qualified production activities income of $120,000.
Required:
a. For 2013, calculate Jackson’s tax depreciation deduction for Equipment 1 and
Equipment 2, and determine the tax loss on the sale of Equipment 1.
b. For 2013, calculate Jackson’s taxable income and tax liability.
c. Prepare a schedule reconciling net income per books to taxable income before special
deductions (Form 1120, line 28).
TAX STRATEGY PROBLEM
C:3-65 Mike Barton owns Barton Products, Inc. The corporation has 30 employees. Barton
Corporation expects $800,000 of net income before taxes in 2013. Mike is married and
files a joint return with his wife, Elaine, who has no earnings of her own. They have one
dependent son, Robert, who is 16 years old. Mike and Elaine have no other income and
do not itemize. Mike’s salary is $180,000 per year (already deducted in computing Barton
Corporation’s $500,000 net income). Assume that variations in salaries will not affect the
U.S. production activities deduction already reflected in taxable income.
a. Should Mike increase his salary from Barton by $50,000 to reduce the overall tax bur-
den to himself and Barton Products? Because of the Social Security cap, the corpora-
tion and Mike each would incur a 1.45% payroll tax with the corporate portion being
deductible.
b. Should Barton employ Mike’s wife Elaine for $50,000 rather than increase Mike’s
salary? Take into consideration employment taxes as well as federal income taxes.
Note, that Elaine’s salary would be well below the Social Security cap, so that she and
the corporation each would incur the full amount of payroll taxes with the corporate
portion being deductible. Both Elaine’s and the corporation’s portion is 7.65%.
TAX FORM/RETURN PREPARATION PROBLEMS
C:3-66 Melodic Musical Sales, Inc. is located at 5500 Fourth Avenue, City, ST 98765. The cor-
poration uses the calendar year and accrual basis for both book and tax purposes. It is
engaged in the sale of musical instruments with an employer identification number (EIN)
of XX-2014012. The company incorporated on December 31, 2008, and began business
on January 2, 2009. Table C:3-4 contains balance sheet information at January 1, 2012,
and December 31, 2012. Table C:3-5 presents an income statement for 2012. These
schedules are presented on a book basis. Other information follows the tables.
Estimated Tax Payments (Form 2220):
The corporation deposited estimated tax payments as follows:
April 17, 2012 $110,000
June 15, 2012 221,000
September 17, 2012 265,000
December 17, 2012
Total
Some dates are the 17th because the 15th and 16th fall on a weekend or holiday. Taxable
income in 2011 was $1.5 million, and the 2011 tax was $510,000. The corporation
$861,000
265,000
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3-66 Corporations ▼ Chapter 3
earned its 2012 taxable income evenly throughout the year. Therefore, it does not use the
annualization or seasonal methods.
Inventory and Cost of Goods Sold (Form 1125-A):
The corporation uses the periodic inventory method and prices its inventory using the
lower of FIFO cost or market. Only beginning inventory, ending inventory, and purchases
should be reflected on Form 1125-A. No other costs or expenses are allocated to cost of
goods sold. Note: the corporation is exempt from the uniform capitalization (UNICAP)
rules because average gross income for the previous three years was less than $10 million.
Line 9 (a) Check (ii)
(b), (c) & (d) Not applicable
(e) & (f) No
Compensation of Officers (Form 1125-E):
Mary Travis XXX-XX-XXXX 100% 50% $277,500
John Willis XXX-XX-XXXX 100% 25% 170,000
Chris Parker XXX-XX-XXXX 100% 25%
Total
Bad Debts:
For tax purposes, the corporation uses the direct writeoff method of deducting bad debts.
For book purposes, the corporation uses an allowance for doubtful accounts. During 2012,
the corporation charged $38,000 to the allowance account, such amount representing actual
writeoffs for 2012.
$617,500
170,000
(f)(d)(c)(b)(a)
� TABLE C:3-4
Melodic Musical Sales, Inc.—Book Balance Sheet Information
January 1, 2012 December 31, 2012
Account Debit Credit Debit Credit
Cash $ 193,116 $ 226,823
Accounts receivable 441,180 513,000
Allowance for doubtful accounts $ 22,059 $ 25,650
Inventory 2,375,000 3,325,000
Investment in corporate stock 265,000 110,000
Investment in municipal bonds 32,000 32,000
Net current deferred tax asset 10,220 8,721
Cash surrender value of insurance policy 42,000 54,000
Land 300,000 300,000
Buildings 1,400,000 1,400,000
Accumulated depreciation—Buildings 70,000 98,000
Equipment 960,000 2,640,000
Accumulated depreciation—Equipment 160,000 249,333
Trucks 250,000 250,000
Accumulated depreciation—Trucks 75,000 125,000
Accounts payable 300,000 270,000
Notes payable (short-term) 610,000 488,000
Accrued payroll taxes 14,250 17,812
Accrued state income taxes 8,550 14,250
Accrued federal income taxes 116,693
Bonds payable (long-term) 2,000,000 2,300,000
Net noncurrent deferred tax liability 158,657 284,588
Capital stock—Common 950,000 950,000
Retain earnings—Unappropriated
Totals $8,859,544$8,859,544$6,268,516$6,268,516
3,920,2181,900,000
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The Corporate Income Tax ▼ Corporations 3-67
Additional Information (Schedule K):
1 b Accrual 8 Do not check box
2 a 451140 9 Fill in the correct amount
b Retail sales 10 3
c Musical instruments 11 Do not check box
3 No 12 Not applicable
4 a No 13–14 No
b Yes; omit Schedule G
5 a No 15a No
b No b Not applicable
6-7 No 16–18 No
Organizational Expenditures:
The corporation incurred $11,000 of organizational expenditures on January 2, 2009.
For book purposes, the corporation expensed the entire expenditure. For tax purposes,
the corporation elected under Sec. 248 to deduct $5,000 in 2009 and amortize the
remaining $6,000 amount over 180 months, with a full month’s amortization taken for
January 2009. The corporation reports this amortization in Part VI of Form 4562 and
includes it in “Other Deductions” on Form 1120, Line 26.
� TABLE C:3-5
Melodic Musical Sales, Inc.—Book Income Statement 2012
Sales $ 9,500,000
Returns )
Net sales $ 9,262,500
Beginning inventory $2,375,000
Purchases 5,225,000
Ending inventory )
Cost of goods sold )
Gross profit $ 4,987,500
Expenses:
Amortization $ –0–
Depreciation 231,333
Repairs 19,760
General ins. 52,250
Net premium-Off. life ins. 42,750
Officer’s compensation 617,500
Other salaries 380,000
Utilities 68,400
Advertising 45,600
Legal and accounting fees 47,500
Charitable contributions 28,500
Payroll taxes 59,375
Interest expense 199,500
Bad debt expense
Total expenses (1,834,059)
Gain on sale of equipment 104,000
Interest on municipal bonds 4,750
Net gain on stock sales 18,000
Dividend income
Net income before income taxes $ 3,291,591
Federal income tax expense (1,105,123)
State income tax expense )
Net income $ 2,115,218
(71,250
11,400
41,591
(4,275,000
(3,325,000
(237,500
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Capital Gains and Losses:
The corporation sold 100 shares of PDQ Corp. common stock on October 8, 2012, for
$105,000. The corporation acquired the stock on December 15, 2011, for $75,000. The
corporation also sold 75 shares of JSB Corp. common stock on June 18, 2012, for $68,000.
The corporation acquired this stock on September 18, 2010, for $80,000. The corporation
has an $8,000 capital loss carryover from 2011.
Fixed Assets and Depreciation:
For book purposes: The corporation uses straight-line depreciation over the useful lives of
assets as follows: Store building, 50 years; Equipment, 15 years (old) and ten years (new);
and Trucks, five years. The corporation takes a half-year’s depreciation in the year of
acquisition and the year of disposition and assumes no salvage value. The book financial
statements in Tables C:3-4 and C:3-5 reflect these calculations.
For tax purposes: All assets are MACRS property as follows: Store building, 39-year nonres-
idential real property; equipment, seven-year property; and trucks, five-year property. The
corporation acquired the store building for $1.4 million and placed it in service on January 2,
2009. The corporation acquired two pieces of equipment for $320,000 (Equipment 1) and
$640,000 (Equipment 2) and placed them in service on January 2, 2009. The corporation
acquired the trucks for $250,000 and placed them in service on July 18, 2010. The trucks are
not listed property and are not subject to the limitation on luxury automobiles. The corpora-
tion did not make the expensing election under Sec. 179 or take bonus depreciation on any
property acquired before 2012. Accumulated tax depreciation through December 31, 2011,
on these properties is as follows:
Store building $106,246
Equipment 1 180,064
Equipment 2 360,128
Trucks 130,000
On October 16, 2012, the corporation sold for $325,000 Equipment 1 that originally
cost 320,000 on January 2, 2009. The corporation had no Sec. 1231 losses from prior years.
In a separate transaction on October 17, 2012, the corporation acquired and placed in
service a piece of equipment costing $2 million. Assume these two transactions do not qual-
ify as a like-kind exchange under Reg. Sec. 1.1031(k)-1(a). The new equipment is seven-year
property. The corporation made the Sec. 179 expensing election with regard to the new
equipment but elected out of bonus depreciation. Where applicable, use published IRS depre-
ciation tables to compute 2012 depreciation (reproduced in Appendix C of this text).
Other Information:
• The corporation’s activities do not qualify for the U.S. production activities deduction.
• Ignore the AMT and accumulated earnings tax.
• The corporation received dividends (see Income Statement in Table C:3-5) from tax-
able, domestic corporations, the stock of which Melodic Musical Sales, Inc. owns less
than 20%.
• The corporation paid $95,000 in cash dividends to its shareholders during the year
and charged the payment directly to retained earnings.
• The state income tax in Table C:3-5 is the exact amount of such taxes incurred during
the year.
• The corporation is not entitled any credits.
• Ignore the financial statement impact of any underpayment penalties incurred on the
tax return.
Required: Prepare the 2012 corporate tax return for Melodic Musical Sales, Inc. along
with any necessary supporting schedules.
Optional: Prepare both Schedule M-3 (but omit Schedule B) and Schedule M-1 even
though the IRS does not require both Schedule M-1 and Schedule M-3.
Note to Instructor: See solution in the Instructor’s Guide for other optional information
to provide to students.
3-68 Corporations ▼ Chapter 3
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Timothy J. Rupert. Published by Prentice Hall. Copyright © 2014 by Pearson Education, Inc.
The Corporate Income Tax ▼ Corporations 3-69
C:3-67 Permtemp Corporation formed in 2011 and, for that year, reported the following book
income statement and balance sheet, excluding the federal income tax expense, deferred
tax assets, and deferred tax liabilities:
Sales $20,000,000
Cost of goods sold )
Gross profit $ 5,000,000
Dividend income 50,000
Tax-exempt interest income
Total income $ 5,065,000
Expenses:
Depreciation $ 800,000
Bad debts 400,000
Charitable contributions 100,000
Interest 475,000
Meals and entertainment 45,000
Other
Total expenses )
Net loss before federal income taxes )
Cash $ 500,000
Accounts receivable $ 2,000,000
Allowance for doubtful accounts ) 1,750,000
Inventory 4,000,000
Fixed assets $10,000,000
Accumulated depreciation ) 9,200,000
Investment in corporate stock 1,000,000
Investment in tax-exempt bonds
Total assets
Accounts payable $2,610,000
Long-term debt 8,500,000
Common stock 6,000,000
Retained earnings )
Total liabilities and equity
Additional information for 2011:
• The investment in corporate stock is comprised of less-than-20%-owned corporations.
• Depreciation for tax purposes is $1.4 million under MACRS.
• Bad debt expense for tax purposes is $150,000 under the direct writeoff method.
• Limitations to charitable contribution deductions and meals and entertainment
expenses must be tested and applied if necessary.
• Qualified production activities income is zero.
Required for 2011:
a. Prepare page 1 of the 2011 Form 1120, computing the corporation’s NOL.
b. Determine the corporation’s deferred tax asset and deferred tax liability situation, and
then complete the income statement and balance sheet to reflect proper GAAP
accounting under ASC 740. Use the balance sheet information to prepare Schedule L of
the 2011 Form 1120.
c. Prepare the 2011 Schedule M-3 for Form 1120.
d. Prepare a schedule that reconciles the corporation’s effective tax rate to the statutory
34% tax rate.
Note: For 2011 forms, go to forms and publications, previous years, at the IRS website,
www.irs.gov.
$16,500,000
(610,000
$16,500,000
50,000
(800,000
(250,000
$ (610,000
(5,675,000
3,855,000
15,000
(15,000,000
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For 2012, Permtemp reported the following book income statement and balance sheet,
excluding the federal income tax expense, deferred tax assets, and deferred tax liabilities:
Sales $33,000,000
Cost of goods sold )
Gross profit $11,000,000
Dividend income 55,000
Tax-exempt interest income
Total income $11,070,000
Expenses:
Depreciation $ 800,000
Bad debts 625,000
Charitable contributions 40,000
Interest 455,000
Meals and entertainment 60,000
Other
Total expenses )
Net income before federal income taxes
Cash $ 2,125,000
Accounts receivable $ 3,300,000
Allowance for doubtful accounts ) 2,850,000
Inventory 6,000,000
Fixed assets $10,000,000
Accumulated depreciation ) 8,400,000
Investment in corporate stock 1,000,000
Investment in tax-exempt bonds
Total assets
Accounts payable $ 2,120,000
Long-term debt 8,500,000
Common stock 6,000,000
Retained earnings
Additional information for 2012:
• Depreciation for tax purposes is $2.45 million under MACRS.
• Bad debt expense for tax purposes is $425,000 under the direct writeoff method.
• Qualified production activities income is $3 million.
Required for 2012:
a. Prepare page 1 of the 2012 Form 1120, computing the corporation’s taxable income
and tax liability.
b. Determine the corporation’s deferred tax asset and deferred tax liability situation, and
then complete the income statement and balance sheet to reflect proper GAAP
accounting ASC 740. Use the balance sheet information to prepare Schedule L of the
2012 Form 1120.
c. Prepare the 2012 Schedule M-3 for Form 1120.
d. Prepare a schedule that reconciles the corporation’s effective tax rate to the statutory
34% tax rate.
CASE STUDY PROBLEMS
C:3-68 Marquette Corporation, a tax client since its creation three years ago, has requested that
you prepare a memorandum explaining its estimated tax requirements for the current
year. The corporation is in the fabricated steel business. Its earnings have been growing
each year. Marquette’s taxable income for the last three tax years has been $500,000, $1.5
million, and $2.5 million, respectively. The Chief Financial Officer expects its taxable
income in the current year to be approximately $3 million.
Required: Prepare a one-page client memorandum explaining Marquette’s estimated
tax requirements for the current year, providing the necessary supporting authorities.
$20,425,000
3,805,000
$20,425,000
50,000
(1,600,000
(450,000
$ 4,415,000
(6,655,000
4,675,000
15,000
(22,000,000
3-70 Corporations ▼ Chapter 3
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The Corporate Income Tax ▼ Corporations 3-71
C:3-69 Susan Smith accepted a new corporate client, Winter Park Corporation. One of Susan’s
tax managers conducted a review of Winter Park’s prior year tax returns. The review
revealed that an NOL for a prior tax year was incorrectly computed, resulting in an over-
statement of NOL carrybacks and carryovers to prior tax years. Apply the Statements on
Standards for Tax Services (SSTSs) to the following situtations. The SSTSs are in
Appendix E of this text.
a. Assume the incorrect NOL calculation does not affect the current year’s tax liability.
What recommendations (if any) should Susan make to the new client? See SSTS No. 6.
b. Assume the IRS is currently auditing a prior year. What are Susan’s responsibilities in
this situation? See SSTS No. 6.
c. Assume the NOL carryover is being carried to the current year, and Winter Park does
not want to file amended tax returns to correct the error. What should Susan do in this
situation? See SSTS No. 1.
C:3-70 The Chief Executive Officer of a client of your public accounting firm saw the following
advertisement in a financial newspaper:
DONATIONS WANTED
The Center for Restoration of Waters
A Nonprofit Research and Educational Organization
Needs Donations—Autos, Boats, Real Estate, Etc.
ALL DONATIONS ARE TAX-DEDUCTIBLE
Prepare a memorandum to your client Phil Nickelson explaining how the federal income
tax laws regarding donations of cash, automobiles, boats, and real estate apply to corpo-
rate taxpayers.
TAX RESEARCH PROBLEMS
C:3-71 Wicker Corporation made estimated tax payments of $6,000 in Year 1. On March 12 of
Year 2, it filed its Year 1 tax return showing a $20,000 tax liability, and it paid the $14,000
balance at that time. On April 20 of Year 2, it discovers an error and files an amended
return for Year 1 showing a reduced tax liability of $8,000. Prepare a memorandum for
your tax manager explaining whether Wicker can base its estimated tax payments for Year
2 on the amended $8,000 tax liability for Year 1, or whether it must use the $20,000 tax
liability reported on its original Year 1 return. Your manager has suggested that, at a min-
imum, you consult the following resources:
• IRC Sec. 6655(d)(1)
• Rev. Rul. 86-58, 1986-1 C.B. 365
C:3-72 Alice, Bill, and Charles each received an equal number of shares when they formed King
Corporation a number of years ago. King has used the cash method of accounting since
its inception. Alice, Bill, and Charles, the shareholder-employees, operate King as an
environmental engineering firm with 57 additional employees. King had gross receipts of
$4.3 million last year. Gross receipts have grown by about 15% in each of the last three
years and were just under $5 million in the current year. The owners expect the 15%
growth rate to continue for at least five more years. Outstanding accounts receivable
average about $600,000 at the end of each month. Forty-four employees (including
Alice, Bill, and Charles) actively engage in providing engineering services on a full-time
basis. The remaining 16 employees serve in a clerical and support capacity (secretarial
staff, accountants, etc.). Bill has read about special restrictions on the use of the cash
method of accounting and requests information from you about the impact these rules
might have on King’s continued use of that method. Prepare a memorandum for your tax
manager addressing the following issues: (1) If the corporation changes to the accrual
method of accounting, what adjustments must it make? (2) Would an S election relieve
King from having to make a change? (3) If the S election relieves King from having to
make a change, what factors should enter into the decision about whether King should
make an S election?
Your manager has suggested that, at a minimum, you should consult the following
resources:
• IRC Secs. 446 and 448
• Temp. Reg. Sec. 1.448-1T
• H. Rept. No. 99-841, 99th Cong., 2d Sess., pp. 285–289 (1986)I
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3-72 Corporations ▼ Chapter 3
C:3-73 James Bowen owns 100% of Bowen Corporation stock. Bowen is a calendar year, accrual
method taxpayer. During the current year, Bowen made three charitable contributions:
State University Bates Corporation stock $110,000
Red Cross Cash 5,000
Girl Scouts Pledge to pay cash 25,000
Bowen purchased the Bates stock three years ago for $30,000. Bowen holds a 28% inter-
est, which it accounts for under GAAP using the equity method of accounting. The cur-
rent carrying value for the Bates stock for book purposes is $47,300. Bowen will pay the
pledge to the Girl Scouts by check on March 3 of next year. Bowen’s taxable income for
the current year before the charitable contributions deduction, dividends-received deduc-
tion, NOL deduction, and U.S. production activities deduction is $600,000. Your tax
manager has asked you to prepare a memorandum explaining how these transactions are
to be treated for tax purposes and for accounting purposes. Your manager has suggested
that, at a minimum, you should consult the following resources:
• IRC Sec. 170
• Accounting Standards Codification (ASC) 720
C:3-74 Production Corporation owns 70% of Manufacturing Corporation’s common stock and
Rita Howard owns the remaining 30%. Each corporation operates and sells its product
within the United States, and the corporations engaged in no intercompany transactions.
Production’s Chief Financial Officer (CFO) presents you with the following information
pertaining to current year operations:
Gross profit on sales $500,000 $225,000
Minus: Operating expenses ) )
Qualified production activities income $300,000 $125,000
Plus: Dividends received from
20%-owned corporations 20,000 -0-
Minus: Dividends-received deduction (16,000) -0-
NOL carryover deduction )
Taxable income before the U.S.
production activities deduction
Operating expenses include W-2 wages allocable to U.S. production activities of $75,000
and $35,000 for Production and Manufacturing, respectively. Given this information, the
CFO asks you to determine each corporation’s qualified production activities deduction.
The applicable deduction percentage is 9%. At a minimum, you should consult the fol-
lowing resources:
• IRC Sec. 199
• Reg. Sec. 1.199-7
$110,000$304,000
(15,000-0-
(100,000(200,000
Manufacturing
Corporation
Production
Corporation
FMV of PropertyProperty DonatedDonee
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