This Document Contains Chapters 16 to 18 Chapter 16 Corporate Operations Learning Objectives 16-1. Describe the corporate income tax formula and discuss tax considerations relating to corporations’ accounting periods and accounting methods. 16-2. Identify common permanent and temporary book–tax differences and compute a corporation’s taxable income and associated income tax liability. 16-3. Describe a corporation’s tax return reporting and estimated tax payment obligations. Teaching Suggestions This chapter helps students understand how to compute corporate taxable income. The basic approach assumes that the corporation computes book income under GAAP accounting. The text highlights many book–tax adjustments that corporations make to book income in computing taxable income. The chapter points out that not all book–tax differences are the same. Some are permanent, and some are temporary. This has implications for reporting the differences (on the Schedule M-3), tracking the differences, and computing the corporation’s income tax provision. Many of the book–tax differences discussed early in the chapter relate to business income and deduction items and methods discussed in the “Business Income, Deductions, and Accounting Methods” chapter. Chapter 16 assumes that the students have already worked through the business chapter. Students may struggle with the following topics: • Corporations may report book–tax differences associated with reporting income from stock investments—how much income to report for books versus the amount of dividend received. • Accounting for nonqualified stock options. • Deductions allowed in determining a corporation’s NOL for the year. • Deductions allowed in determining the 10 percent of taxable income limit for the charitable contribution limitation. • The limitation on the dividends-received deduction and the allowable deductions in determining DRD modified taxable income. • The instructor may want to focus on problems that don’t involve complicated deduction sequencing (that is, focus on 10 percent of taxable income before the charitable contribution but don’t worry about the DRD and capital loss carrybacks). • The annualized income method for determining estimated tax payment requirements. The comprehensive problems are very useful for the students to help them see the big picture. The 2019 tax forms reflect tax reform for calendar-year taxpayers. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 Research Planning Tax Forms DQ16-1 5 min. Medium X DQ16-2 5 min. Medium X DQ16-3 10 min. Medium X DQ16-4 10 min. Medium X DQ16-5 5 min. Medium X DQ16-6 5 min. Medium X DQ16-7 5 min. Medium X DQ16-8 5 min. Medium X DQ16-9 5 min. Medium X DQ16-10 10 min. Medium X DQ16-11 10 min. Medium X DQ16-12 10 min. Medium X DQ16-13 10 min. Medium X DQ16-14 10 min. Medium X DQ16-15 10 min. Medium X DQ16-16 10 min. Medium X DQ16-17 5 min. Easy X DQ16-18 5 min. Medium X DQ16-19 5 min. Medium X DQ16-20 10 min. Hard X DQ16-21 10 min. Hard X DQ16-22 10 min. Hard X DQ16-23 10 min. Hard X DQ16-24 10 min. Hard X DQ16-25 10 min. Hard X DQ16-26 10 min. Hard X DQ16-27 10 min. Hard X DQ 16-28 5 min. Easy X DQ16-29 10 min. Hard X DQ16-30 10 min. Hard X DQ16-31 15 min. Hard X DQ16-32 10 min. Medium X P16-33 10 min. Easy X P16-34 20 min. Medium X P16-35 20 min. Medium X P16-36 10 min. Medium X P16-37 20 min. Medium X P16-38 15 min. Medium X P16-39 15 min. Medium X P16-40 30 min. Medium X P16-41 25 min. Medium X P16-42 30 min. Medium X P16-43 25 min. Medium X P16-44 20 min. Medium X P16-45 15 min. Hard X P16-46 15 min. Medium X P16-47 10 min. Medium X P16-48 15 min. Hard X P16-49 20 min. Medium X P16-50 20 min. Medium X P16-51 15 min. Medium X P16-52 45 min. Hard X X P16-53 35 min. Medium X X P16-54 30 min. Medium X P16-55 25 min. Medium X P16-56 5 min. Easy X P16-57 20 min. Medium X P16-58 15 min. Medium X P16-59 25 min. Medium X P16-60 25 min. Medium X X P16-61 20 min. Medium X CP16-62 30 min. Medium CP16-63 35 min. Medium CP16-64 60 min. Hard X CP16-65 60 min. Hard X Lecture Notes 1) Corporate Taxable Income Formula a) Refer to Exhibit 16-1 for Corporate and Individual Tax Formulas. b) The corporate tax formula is similar to the individual tax formula, but corporations don’t get a deduction for qualified business income and don’t itemize deductions. c) Accounting periods and methods i) Corporations with annual average gross receipts of $26 million or less over the three prior tax years (or a shorter period for new corporations) can elect to use the cash method. 2) Computing Corporate Taxable Income a) To compute taxable income, corporations generally start with book (financial reporting) income before tax and then make adjustments for book–tax differences to reconcile to the tax return numbers. b) Book–tax differences i) Favorable (unfavorable) book–tax differences decrease (increase) taxable income relative to book income. ii) Permanent book–tax differences arise in one year and never reverse (they affect either the financial statement or the tax return, but not both). iii) Temporary book–tax differences arise in one year and reverse in a subsequent year (they affect both the financial statement and the tax return, but in different periods). iv) Common permanent book–tax differences (1) Refer to Exhibit 16-2 for Common Permanent Book–Tax Differences Associated with Items Discussed in the Business Income, Deductions, and Accounting Methods Chapter. (2) Federal income tax expense (a) Corporations deduct federal income tax expense (referred to as the “provision for income taxes”) in determining net book income. (b) Corporations do not deduct their federal income tax expense in computing taxable income. (c) The amount of federal income tax expense corporations deduct for book purposes is treated as permanent book–tax difference on Schedule M-3 (although it does not technically meet the accounting definition of a permanent difference). v) Common temporary book–tax differences (1) Corporations experience temporary book–tax differences because the accounting methods they apply to determine certain items of income and expense for financial reporting purposes differ from those they use for tax purposes. (2) Unlike permanent book–tax differences, temporary book–tax differences balance out over time so that corporations eventually recognize the same amount of income or deduction for the particular item. (3) Refer to Exhibit 16-3 for Common Temporary Book–Tax Differences Associated with Items Discussed in Other Chapters. (4) Dividends and stock ownership related (a) For tax purposes, corporations receiving dividends include the dividends in gross income. (b) For financial reporting purposes, accounting for the dividend (and investment in the corporation) depends on the level of ownership in the distributing corporation. (c) The general rules for such investments are summarized as follows: (i) If the receiving corporation owns less than 20 percent of the stock of the distributing corporation, the receiving corporation usually includes a dividend in income when accrued. The dividend does not create a book–tax difference in gross income. Beginning in 2018, unrealized gain or loss associated with the stock is reported in the income statement along with the associated tax expense or benefit (ASC 321). This unrealized gain or loss creates a temporary book–tax difference because this gain or loss is not recognized for tax purposes until the stock is sold and the difference will completely reverse. (ii) If the receiving corporation owns at least 20 percent but not more than 50 percent of the distributing corporation’s stock, the receiving corporation usually includes a pro rata portion of the distributing corporation’s earnings in its income and does not include the dividend in its income (the equity method of accounting under ASC 323). The book–tax difference is the difference between the dividend and the pro rata share of the investee’s earnings. (iii) If the receiving corporation owns more than 50 percent of the distributing corporation’s stock, the receiving corporation and the distributing corporation consolidate their financial reporting and the dividend is eliminated (ASC 810). For tax purposes, corporations cannot elect to file a consolidated tax return until stock ownership reaches 80 percent. (Accounting for the book–tax difference is beyond the scope of this text.) (5) Goodwill acquired in an acquisition (a) When a corporation acquires the assets of another corporation in a cash (taxable) transaction and it allocates part of the purchase price to goodwill, the corporation is allowed to amortize this purchased goodwill on a straight-line basis over 15 years (180 months) for tax purposes. (b) For book purposes, corporations acquiring the assets of another business typically allocate part of the purchase price to goodwill. (c) In asset acquisitions, the amount of goodwill corporations recognize for tax purposes is closer to the amount they recognize for book purposes. (d) Corporations recover the cost of goodwill for book purposes only when, and only to the extent that, the goodwill is impaired (private corporations can elect to amortize goodwill over 10 years for book purposes). (e) To determine the temporary book–tax difference associated with purchased goodwill, corporations need only compare the amount of goodwill they amortize for tax purposes with the goodwill impairment expense for book purposes. (i) If the tax amortization exceeds the book impairment expense, corporations report favorable book–tax differences for goodwill. (ii) If the book impairment expense exceeds the goodwill tax amortization, corporations report unfavorable book–tax differences for goodwill. vi) Corporate-specific deductions and associated book–tax differences (1) Stock options (a) For tax purposes, the tax treatment to the corporation (and the employees) depends on whether the options are incentive stock options (ISOs) (less common, more administrative requirements for the corporation to qualify) or nonqualified stock options (NQOs) (more common, options that don’t qualify as ISOs). (b) Corporations issuing incentive stock options never deduct any compensation expense associated with the options for tax purposes. (c) For nonqualified options, corporations deduct the difference between the fair market value of the stock and the exercise price of the option (the bargain element) as employee compensation in the year in which employees exercise the stock options. (d) Under ASC 718, corporations are required to expense the options based on an estimate of the value of the options at the time they were issued over the vesting period of the stock. Book–tax differences associated with these options may be permanent, temporary, or both. (e) The permanent difference is recognized in the year the stock options are exercised. (f) For incentive stock options, the amount of the permanent difference is the estimated value of the stock that is amortized over the vesting period during the year. (i) The book–tax difference associated with incentive stock options is always unfavorable. (g) Nonqualified options may generate permanent and/or temporary book–tax differences. (h) Corporations initially recognize temporary book–tax differences associated with stock options for the value of options amortized over the vesting period during the year but are not exercised during that year. (i) This initial temporary difference is always unfavorable because the corporation deducts the value of the unexercised options that are amortized over the vesting during the year for book purposes but not for tax purposes. This book–tax difference completely reverses (favorable) when employees actually exercise the stock options. (j) The amount of the permanent difference is the difference between the estimated value of the stock options exercised minus the bargain element of the stock options exercised during the year. (k) If the estimated value of stock options exercised exceeds the bargain element of the stock options exercised, the permanent book–tax difference is unfavorable; otherwise it is favorable. (l) The permanent book–tax difference is recognized in the year the options are exercised. (m) Refer to Exhibit 16-5 for Book and Tax Treatment of Stock Options. (2) Net capital losses (a) Corporations are not allowed to deduct net capital losses in a given year. (b) Net capital losses are carried back three years and forward five years to offset net capital gains in those years. (c) Net capital losses are deductible for book purposes in the year incurred. (d) A net capital loss creates an unfavorable book–tax difference in the year the net capital loss occurs. An NCL carryover creates a favorable book–tax difference in the year recognized on the tax return. (3) Net operating losses (a) NOLs arising in tax years beginning after 12/31/17 are carried forward indefinitely and can offset up to 80 percent of taxable income in a future period; no carryback is allowed. (b) NOLs arising in tax years ending before 12/31/18 can be carried back two years (election) and carried forward 20 years and can offset 100 percent of taxable income in the carryover or carryback year. (4) Charitable contributions (a) For accrual-method corporations, deductible when accrued if approved by board of directors and paid within three and one-half months of year-end (April 15 for a calendar-year taxpayer) or within two and one-half months for corporations with a June 30 year end. (b) Deductions may not exceed 10 percent of charitable contribution limit modified taxable income. (c) Contributions in excess of 10 percent limit can be carried forward up to five years. (d) A corporation’s charitable contribution limit modified taxable income is its taxable income before deducting the following: (i) Any charitable contributions. (ii) The dividends-received deduction (DRD). (iii) Capital loss carrybacks. (5) Dividends-received deduction (dividend received from a domestic corporation) (a) Deduction percentage is 50 percent if a corporation owns less than 20 percent of the distributing corporation’s stock, 65 percent if a corporation owns at least 20 percent but less than 80 percent of the distributing corporation’s stock, and 100 percent if a corporation owns 80 percent or more of the distributing corporation’s stock. (i) Refer to Exhibit 16-6 for Stock Ownership and Dividends-Received Deduction Percentage. (b) The amount of the deduction generally is the lesser of the deduction percentage (50 percent, 65 percent, or 100 percent) based on ownership times the amount of the dividend, limited to the deduction percentage times DRD modified taxable income. (c) The limitation doesn’t apply if the full DRD creates or increases a corporation’s NOL. (d) The DRD creates a favorable permanent difference. (e) DRD modified taxable income (i) Dividend-receiving corporation’s taxable income before deducting the following: 1. DRD. 2. Any NOL deduction (carryover or carryback). 3. Capital loss carrybacks. (ii) The modified taxable income limitation does not apply if after deducting the full dividends-received deduction (dividend × DRD percentage) a corporation reports a current-year net operating loss. (iii) If the full dividends-received deduction either creates or increases a corporation’s net operating loss, the corporation is allowed to deduct the full dividends-received deduction even when the DRD limitation based on modified taxable income is lower. vii) Taxable income summary (1) Refer to Exhibit 16-7 for PCC Book–Tax Reconciliation Template. viii) Corporate income tax liability (1) When corporations determine their taxable income, they compute their tax liability using a flat 21 percent tax rate. 3) Compliance a) Corporations report taxable income on Form 1120. b) Corporations with total assets of less than $10 million report book–tax differences on Schedule M-1 of Form 1120. Otherwise, they are required to report book–tax differences on Schedule M-3. Corporations with total assets of less than $50 million are required to fill out Part I of Schedule M-3 but can elect not to fill out Schedule M-1 in place of Parts II and III. Note that the Schedule M-3 is much more detailed, with many more line items for book–tax differences than for the Schedule M-1. Also, Schedule M-3 requires taxpayers to report book–tax differences as permanent or temporary but Schedule M-1 does not. c) Refer to Exhibit 16-9 for Form 1120, Schedule M-1. d) Tax return due date is three and one-half months after year-end except for corporations with a June 30 year-end. The tax return due date for June 30 year-end is two and one-half months after year-end. i) Five-month extensions for filing the return (not paying taxes) are available (six months for a June 30 year-end corporation). e) An affiliated group may file a consolidated tax return. i) Corporations essentially are treated as a single entity for tax return purposes. f) Corporations pay expected annual tax liability through estimated tax payments. i) Installments due in 4th, 6th, 9th, and 12th months of their taxable year. g) Underpayment penalties if corporations don’t pay adequate estimated tax payments. h) Refer to Exhibit 16-10 for Estimated Taxable Income Computation under Annualized Income Method. i) Refer to Exhibit 16-11 for Estimated Taxable Income Computation under Annualized Income Method. Class Activities 1. Suggested class activities ○ Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problems 55 and 56 deal with deduction sequencing, problems 57 and 58 deal more with reconciling book and taxable income. Problem 58 gives students an income statement and has them reconcile book and taxable income). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (“what is taxable income?” or “what are taxes payable or taxes due?”) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Schedule M-3 research activity: Have students look up Schedule M-3 on the IRS website and have them point out the differences between Schedule M-1 and Schedule M-3. ○ Financial statement research activity: Have the students choose a publicly traded company and have them analyze the company’s 2018 and 2019 effective tax rate reconciliation, comparing the impact the 2017 TCJA had on 2018 and 2019 ETRs compared to 2017 and 2016. 2. Ethics discussion From page 16-25: Discussion points: This is a good example of Abraham Lincoln’s famous question: “If you call a tail a leg, how many legs does a dog have?” What constitutes a 100 percent deductible meal expense remains ambiguous, pending Treasury regulations on the new meals and entertainment limitations. What constitutes “mentoring” is not defined. One could label the morning get-togethers as “mentoring events,” but calling them such does not make them such. If the mentoring has some substance and is more than a few cursory remarks, there is some chance the cost of the doughnuts could be 100 percent deductible. Meeting the substantiation requirements to sustain any meal deduction would be very important. By the way, the answer to President Lincoln’s question is four, because calling a tail a leg doesn’t make it a leg. Chapter 17 Accounting for Income Taxes Learning Objectives 17-1. Describe the objectives of FASB ASC Topic 740, Income Taxes, and the income tax provision process. 17-2. Calculate the current and deferred income tax expense or benefit components of a company’s income tax provision. 17-3. Determine how to calculate a valuation allowance. 17-4. Explain how a company accounts for its uncertain income tax positions under FASB ASC Topic 740. 17-5. Describe how a company computes and discloses the components of its effective tax rate. Teaching Suggestions This chapter provides the basic framework for computing the federal income tax provision under ASC 740. This topic is extremely complex, and students can feel overwhelmed at first. It is best to concentrate on the basic concepts of the current income tax expense and the balance sheet approach to computing the deferred tax liability. The comprehensive problems help pull the computation of both components together. It is important to point out that most corporations do not keep formal tax balance sheets (although this is becoming a “best practice”), but rather roll forward the cumulative temporary differences (which some Big 4 accounting firms no longer allow as sufficient to audit the provision). Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 Research Planning Tax Forms DQ17-1 20 min. Medium X DQ17-2 20 min. Medium X DQ17-3 20 min. Medium X DQ17-4 20 min. Medium X DQ17-5 20 min. Medium X DQ17-6 20 min. Medium X DQ17-7 20 min. Medium X DQ17-8 20 min. Medium X DQ17-9 20 min. Medium X DQ17-10 20 min. Medium X DQ17-11 20 min. Medium X DQ17-12 10 min. Medium X DQ17-13 10 min. Medium X DQ17-14 10 min. Medium X DQ17-15 10 min. Medium X X DQ17-16 10 min. Medium X DQ17-17 25 min. Hard X DQ17-18 25 min. Hard X DQ17-19 25 min. Hard X DQ17-20 20 min. Hard X DQ17-21 20 min. Hard X DQ17-22 20 min. Hard X DQ17-23 20 min. Hard X DQ17-24 20 min. Hard X DQ17-25 20 min. Hard X DQ17-26 20 min. Hard X DQ17-27 20 min. Hard X DQ17-28 25 min. Hard X DQ17-29 25 min. Hard X DQ17-30 25 min. Hard X DQ17-31 25 min. Hard X DQ17-32 25 min. Hard X DQ17-33 25 min. Hard X DQ17-34 25 min. Hard X DQ17-35 25 min. Hard X DQ17-36 25 min. Hard X DQ17-37 25 min. Hard X P17-38 5 min. Easy X P17-39 5 min. Easy X P17-40 20 min. Medium X X P17-41 15 min. Medium X P17-42 15 min. Medium X P17-43 15 min. Medium X P17-44 15 min. Medium X P17-45 5 min. Easy X P17-46 5 min. Easy X P17-47 5 min. Easy X P17-48 5 min. Easy X P17-49 5 min. Easy X P17-50 5 min. Easy X P17-51 15 min. Medium X P17-52 5 min. Easy X P17-53 10 min. Medium X P17-54 20 min. Medium X P17-55 20 min. Medium X P17-56 20 min. Medium X P17-57 5 min. Easy X P17-58 10 min. Easy X P17-59 10 min. Easy X P17-60 10 min. Easy X P17-61 15 min. Medium X P17-62 5 min. Easy X P17-63 5 min. Easy X X P17-64 10 min. Easy X P17-65 10 min. Easy X P17-66 10 min. Easy X P17-67 15 min. Medium X P17-68 15 min. Easy X P17-69 15 min. Medium X X P17-70 15 min. Medium X P17-71 5 min. Easy X P17-72 10 min. Easy X P17-73 10 min. Easy X P17-74 10 min. Easy X P17-75 20 min. Medium X P17-76 10 min. Easy X CP17-77 30 min. Hard CP17-78 40 min. Hard CP17-79 40 min. Medium X CP17-80 40 min. Medium Lecture Notes 1) Accounting for Income Taxes and the Income Tax Provision Process a) Under GAAP, a company must include as part of its income statement a “provision” for the income tax expense or benefit that is associated with the pretax net income or loss reported on the income statement. b) The income tax provision includes not only current-year taxes payable or refundable, but also any changes to future income taxes payable or refundable that result from differences in the timing of when an item is reported on the tax return compared to the financial statement. c) The company records these future income taxes payable or refundable on its balance sheet as the amount the company expects to pay (deferred tax liability) or recover (deferred tax asset) in a future accounting period. d) Why is accounting for income taxes so complex? i) FASB ASC Topic 740, Accounting for Income Taxes (ASC 740), provides the general rules that apply to the computation of a company’s income tax provision. ii) The basic principles that underlie these rules are fairly straightforward, but the application of the rules themselves can be very complex. iii) Companies often prepare their financial statements (Form 10-K) much earlier than when they file their corresponding tax returns. iv) A company often must exercise a high degree of judgment in estimating its income tax return positions currently and in future years when a tax return position might be challenged by the tax authorities. v) After the tax return is filed, it may take five years or more before the tax return is audited by the IRS or other government authority and the final tax liability is determined (point out the Uncertain Tax Benefit schedule in Microsoft’s income tax footnote). e) Objectives of ASC 740 i) It applies only to income taxes levied by the U.S. federal government, U.S. state and local governments, and non-U.S. (“foreign”) governments. ii) The FASB defines an income tax as a tax based on income. This definition excludes property taxes, excise taxes, sales taxes, and value-added taxes. iii) Companies report no income taxes as expenses in the computation of their net income before taxes. iv) ASC 740 has two important objectives: (1) To “recognize the amount of income taxes payable or refundable in the current year” (referred to as the current tax liability or asset). (2) To “recognize deferred tax liabilities and assets for the (expected) future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns.” v) Both objectives relate to reporting a company’s income tax amounts on the balance sheet, not the income statement. vi) The FASB refers to this method as the “asset and liability approach” to accounting for income taxes. vii) The FASB chose this approach because it felt it is most consistent with the definitions in FASB Concepts Statement No. 6, Elements of Financial Statements, and produces the most useful and understandable information. viii) To compute the deferred tax liability or asset, a company must calculate the future tax effects attributable to temporary differences and tax carryforwards. ix) Temporary differences that are cumulatively favorable create deferred tax liabilities, while temporary differences that are cumulatively unfavorable create deferred tax assets. x) Work through Example 17-1. xi) Refer to Exhibit 17-1 for PCC Balance Sheet at 12/31/2019. xii) Refer to Exhibit 17-2 for PCC Deferred Tax Accounts at 12/31/2019. f) The income tax provision process i) Total income tax provision = Current income tax expense (benefit) + Deferred income tax expense (benefit) ii) There are seven steps in the computation of a company’s federal income tax provision: (1) Adjust pretax net income or loss for all permanent differences. (2) Identify all temporary differences and tax carryforward amounts. (3) Calculate the current income tax expense or benefit (refund). (4) Determine the ending balances in the balance sheet deferred tax asset and liability accounts. (5) Evaluate the need for a valuation allowance for gross deferred tax assets. (6) Calculate the deferred income tax expense or benefit. (7) Evaluate the need for an uncertain tax benefit reserve. 2) Calculating a Company’s Income Tax Provision a) Step 1: Adjust pretax net income for all permanent differences i) A company does not take permanent differences into account in computing its deferred tax assets and liabilities (and consequently, the deferred component of its income tax provision). ii) Permanent differences enter into the company’s computation of taxable income, and thus affect the current tax expense or benefit, either increasing or decreasing it. iii) Permanent differences usually affect a company’s effective tax rate (income tax provision/pretax net income) and appear as part of the company’s reconciliation of its effective tax rate with its statutory U.S. tax rate (21 percent). iv) Refer to Exhibit 17-3 for PCC Book–Tax Reconciliation Template for 2020. v) Refer to Exhibit 17-4 for Common Permanent Differences. vi) Work through Examples 17-2 and 17-3. b) Step 2: Identify all temporary differences and tax carryforward amounts i) ASC 740-10-20 Glossary defines a temporary difference as “A difference between the tax basis of an asset or liability . . . and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively.” ii) Temporary differences commonly arise due to four instances: (1) Revenues or gains that are taxable after they are recognized in financial income. (2) Expenses or losses that are deductible after they are recognized in financial income. (3) Revenues or gains that are taxable before they are recognized in financial income. (4) Expenses or losses that are deductible before they are recognized in financial income. iii) Refer to Exhibit 17-5 for Common Temporary Differences. iv) Identifying taxable and deductible temporary differences (1) Taxable temporary difference (a) A temporary difference that initially is favorable (that is, an item that decreases taxable income relative to book income when the book–tax difference arises) gives rise to a taxable temporary difference. (b) Taxable temporary differences generally arise when: (i) Revenues or gains are taxable after they are recognized in net income. (ii) Expenses or losses are deductible on the tax return before they reduce net income. (c) From a balance sheet perspective, a taxable temporary difference generally arises when the financial reporting basis of an asset exceeds its corresponding tax basis or the financial reporting basis of a liability is less than its corresponding tax basis. (d) The future tax cost associated with a taxable temporary difference is recorded on the balance sheet as a deferred tax liability. (2) Deductible temporary difference (a) A temporary difference that initially is unfavorable (that is, an item that increases taxable income relative to book income when the book–tax difference arises) gives rise to a deductible temporary difference. (b) The future tax benefit associated with a deductible temporary difference is recorded on the balance sheet as a deferred tax asset. (c) Deductible temporary differences generally arise when: (i) Revenues or gains are taxable before they are recognized in net income. (ii) Expenses or losses are deductible on the tax return after they reduce net income. (d) From a balance sheet perspective, a deductible temporary difference generally causes the financial reporting basis of an asset to be less than its corresponding tax basis or the financial reporting basis of a liability to exceed its corresponding tax basis. (e) Work through Example 17-4. c) Step 3: Compute the current income tax expense or benefit i) The computation of the current portion of a company’s tax provision appears to be straightforward. ii) To be sure, the major component of a company’s current income tax expense or benefit is the income tax liability or refund from its current-year operations. iii) The computation of a company’s current income tax expense or benefit rarely reflects the actual taxes paid on the company’s current-year tax returns. iv) The current income tax expense or benefit includes the current year addition to the uncertain tax benefit balance and any current year tax payments from prior year tax returns on audit. v) Work through Example 17-5. d) Step 4: Determine the ending balances in the balance sheet deferred tax asset and liability accounts i) Identify current-year changes in taxable and deductible temporary differences. ii) Determine ending balances in each deferred tax asset and liability balance sheet account. iii) Identify carryovers (net operating loss, capital loss, charitable contributions) not on the balance sheet. iv) The current-year deferred income tax expense or benefit is the difference between the deferred tax asset and liability balances at the beginning of the year to the end of the year as well as changes in tax carryovers. v) Work through Examples 17-6, 17-7, 17-8, and 17-9. 3) Determining Whether a Valuation Allowance is Needed a) Step 5: Evaluate the need for a valuation allowance for gross deferred tax assets i) Determining the need for a valuation allowance (1) A valuation allowance is required if it is more likely than not that some or all of the deferred tax asset will not be realized in the future. (2) Companies usually disclose the amount of the valuation allowance in the income tax footnote to the financial statements. (3) ASC 740 identifies four sources of potential future taxable income, two of which are objective and two of which are subjective (that is, determined by management judgment). (4) The objective sources (a) Future reversals of existing taxable temporary differences (i) Existing taxable (favorable) temporary differences provide taxable income when they are recovered in a future period. (ii) If the reversing taxable temporary differences provide sufficient future taxable income to absorb the reversing deductible temporary differences, the company does not record a valuation allowance against the deferred tax asset. (b) Taxable income in prior carryback year(s) (i) The company does not record a valuation allowance if the tax benefit from the realization of a deferred income tax asset can be carried back to a prior year that has sufficient taxable income (or capital gain net income in the case of a net capital loss carryback) to absorb the realized tax benefit. (5) The subjective sources (a) Expected future taxable income exclusive of reversing temporary differences and carryforwards (i) ASC 740 allows a company to consider taxable income it expects to earn in future periods in determining whether a valuation allowance is necessary. (ii) The company might support its predictions of future taxable income with evidence of existing contracts or a sales backlog that will produce enough taxable income to realize the deferred tax asset when it reverses. (b) Tax planning strategies (i) To support the realization of a deferred tax asset involves the company’s ability and willingness to employ tax strategies in those future periods to create the taxable income needed to absorb the deferred tax asset. (ii) ASC 740 allows a company to consider actions it might take to create sufficient taxable income to absorb a deferred tax asset, provided such actions: 1. Are prudent and feasible; 2. Are actions an enterprise would take only to prevent an operating loss or tax credit carryforward from expiring unused; 3. Would result in realization of the deferred tax assets. (iii) Tax planning strategies could include: 1. Sale and leaseback of operating assets 2. Changing inventory accounting methods (for example, from LIFO to FIFO) 3. Refraining from making voluntary contributions to the company pension plan 4. Electing to capitalize certain expenditures (e.g., research and development costs) rather than deduct them currently 5. Sale of noncore assets 6. Converting tax-exempt investments into taxable investments 7. Electing the alternative depreciation system (straight line instead of declining balance). ii) Negative evidence that a valuation allowance is needed (1) Includes: (a) Cumulative (book) losses in recent years (b) A history of net operating (capital) losses and credits expiring unused (c) An expectation of losses in the near future (d) Unsettled circumstances that, if resolved unfavorably, will result in losses from continuing operations in future years iii) Work through Examples 17-10, 17-11, and 17-12. b) Step 6: Calculate the deferred income tax expense or benefit i) There is a straightforward “back-of-the-envelope” method of verifying the ASC 740 approach to calculating PCC’s total tax provision. ii) Under the assumption that all temporary differences will appear on a tax return in a current or future period, the total tax provision should reflect the tax that ultimately will be paid on pretax net income adjusted for permanent differences. iii) The total income tax provision should equal the company’s tax rate times its book equivalent of taxable income. iv) Work through Examples 17-13 and 17-14. 4) Accounting for Uncertainty in Income Tax Positions a) Step 7: Evaluate the need for an uncertain tax benefit reserve b) Application of ASC 740 to uncertain tax positions i) ASC 740-10 applies to all tax positions that are accounted for under ASC 740 (that is, issues dealing with income taxes). ii) ASC 740-10 requires a two-step process in determining if a tax benefit can be recognized in the financial statements. (1) Step 1: Recognition (a) A company determines if it is more likely than not that its tax position on a particular account will be sustained on IRS examination based on its technical merits. (2) Step 2: Measurement (a) A company determines the amount it expects to be able to recognize. (b) The measurement process requires the company to make a cumulative probability assessment of all likely outcomes of the audit and litigation process. (c) The company recognizes the amount that has a greater than 50 percent probability of being sustained on examination and subsequent litigation. (d) The amount not recognized is recorded as a liability on the balance sheet. iii) Work through Examples 17-15, 17-16, and 17-17. c) Subsequent events i) ASC 740-10 requires a company to monitor subsequent events that might change the company’s assessment that a tax position will be sustained on audit and litigation. d) Interest and penalties i) ASC 740-10 requires a company to accrue interest and any applicable penalties on liabilities it establishes for potential future tax obligations. ii) They can be treated as part of the company’s income tax expense and income tax payable or can be recognized as interest or penalties separate from the income tax expense. iii) ASC 740-10 only requires that the company apply its election consistently from period to period, creating the potential for diversity in practice. e) Disclosures of uncertain tax positions i) One of the most controversial aspects of ASC 740-10 is its expansion of the disclosure requirements related to liabilities recorded due to uncertain tax positions. ii) ASC 740-10-50-15 requires the company to roll forward all unrecognized tax benefits on a worldwide aggregated basis. iii) Specific line items must disclose: (1) The gross amounts of increases and decreases in liabilities related to uncertain tax positions as a result of tax positions taken during a prior period. (2) The gross amounts of increases and decreases in liabilities related to uncertain tax positions as a result of tax positions taken during the current period. (3) The amounts of decreases in liabilities related to uncertain tax positions relating to settlements with taxing authorities. (4) Reductions in liabilities related to uncertain tax positions as a result of a lapse of the applicable statute of limitations. f) Schedule UTP (uncertain tax position) statement 5) Financial Statement Disclosure and Computing a Corporation’s Effective Tax Rate a) Balance sheet classification i) ASC 740 requires publicly traded and privately held companies to classify all deferred tax assets and liabilities on their balance sheets as noncurrent. b) Income tax footnote disclosure i) ASC 740 mandates that a company disclose the components of the net deferred tax assets and liabilities reported on its balance sheet and the total valuation allowance recognized for deferred tax assets. ii) Publicly traded companies must disclose the approximate “tax effect” of each type of temporary difference and carryforward that gives rise to a significant portion of the net deferred tax liabilities and deferred tax assets. iii) Privately held companies only need to disclose the types of significant temporary differences without disclosing the tax effects of each type. iv) ASC 740 does not define the term significant, although the SEC requires a publicly traded company to disclose separately the components of its total deferred tax assets and liabilities that are 5 percent or more of the total balance. v) Refer to Exhibit 17-7 for PCC’s Income Tax Note to Its Financial Statements. vi) ASC 740 also requires publicly traded companies to disclose the significant components of their income tax provision (expense or benefit) attributable to continuing operations in either the financial statements or a note thereto. vii) These components include the: (1) Current tax expense or benefit, (2) Deferred tax expense or benefit, (3) Benefits of operating loss carryforwards, (4) Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates, and (5) Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in management’s judgment about the realizability of the recognized deferred tax assets. c) Computation and reconciliation of the income tax provision with a company’s hypothetical tax provision i) ASC 740 requires a company to reconcile its: (1) Reported income tax provision attributable to continuing operations with (2) The amount of income tax expense that would result from applying its U.S. statutory tax rate to its pretax net income or loss from continuing operations. ii) A company can present the reconciliation in terms of tax rates, comparing its statutory tax rate with its effective tax rate. iii) ASC 740 requires a publicly traded company to disclose the estimated amount and nature of each significant reconciling item, which the SEC defines as an amount equal to or greater than 5 percent of the hypothetical provision. iv) The SEC requires no publicly traded companies to disclose the nature of significant reconciling items but not the reconciling amount. v) Work through Example 17-18. d) Importance of a corporation’s effective tax rate i) The effective tax rate often serves as a benchmark for companies in the same industry. ii) Nonrecurring events can sometimes have a significant impact on the effective tax rate. iii) To mitigate the impact of such aberrational events, companies and their investors may use a different measure of effective tax rate that backs out one-time and nonrecurring events. iv) This effective tax rate is referred to as the company’s structural tax rate. v) The structural effective tax rate often is viewed as more representative of the company’s effective tax rate from its normal (recurring) operations. vi) Analysts often compute a company’s cash tax rate in their evaluation of the company’s tax status. vii) As the name implies, the cash tax rate excludes deferred taxes. e) Interim period effective tax rates i) ASC 740-270-30-6 states that “at the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year” and apply this rate to the income reported in the quarterly statement. ii) A company must reconsider its estimate of the annual rate each quarter. iii) When the estimate changes, the company must adjust the cumulative tax provision for the year-to-date earnings to reflect the new expected annual rate. iv) The adjusting amount becomes the company’s income tax provision for the quarter. 6) FASB Projects Related to Accounting for Income Taxes a) The FASB has been deliberating making “simplification” changes to disclosures related to uncertain tax benefits and to expanding disclosures in other areas. b) The FASB has discussed and decided to increase the disclosure related to a company’s international operations and valuation allowances. c) With respect to international operations, the FASB decided to require entities to disclose taxes paid as either domestic (U.S.) or foreign and reporting income before taxes by individual countries that are significant in relation to total income before taxes. d) The FASB also wants increased disclosure regarding the nature and amounts of the valuation allowance recorded and released during the reporting period. e) The board also decided to require all entities to disclose the rate reconciliation currently required only for public companies. f) No formal accounting statement updates have been issued on these topics to date. 7) Conclusion Class Activities 1. Suggested class activities ○ Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (the final problem provides a comprehensive work paper approach to computing the income tax provision). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (“what is taxable income?” or “what are taxes payable or taxes due?”) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Research the impact of the Tax Cuts and Jobs Act on a corporation’s financial statement: • The TCJA reduced the corporate tax rate from 35 percent to 21 percent. This reduction required companies to revalue their U.S. deferred tax assets and liabilities to reflect the new rate. • Have your students (individually or in teams) choose a company and research the impact of the TCJA on the company’s balance sheet and income statement. Did the company have a net DTL or DTA balance? Did the revaluation cause the income statement provision to increase (write down DTAs) or decrease (write down DTLs)? • Have the students analyze the ETR reconciliation of their chosen company for 2018. Compare the ETR for 2018 with the ETR for 2017 (with the discrete items related to the TCJA excluded) and 2016. How has the TCJA affected the company’s ETR for 2018 compared to 2017 and 2016? 2. Ethics discussion From page 17-25: Discussion points: • The issue in this case study involves the auditor’s duty to obtain sufficient “evidential matter” to render an opinion as to whether financial statements comply materially with GAAP. The issue as to how much evidence to obtain and to document with respect to tax accrual work papers is a “hot topic” because the IRS has a written policy that it will issue a summons for tax accrual/tax contingency work papers in certain circumstances. The summons can be directed at the taxpayer and/or the taxpayer’s auditor. The relevant professional standard that applies in this case is PCAOB AU Section 9326, Evidential Matter. In particular, paragraphs 20 and 21 state as follows: ○ . 20 Question—A client may have obtained the advice or opinion of an outside tax adviser related to the tax accrual or matters affecting it, including tax contingencies, and further may attempt to limit the auditor’s access to such advice or opinion, or limit the auditor’s documentation of such advice or opinion. This limitation on the auditor’s access may be proposed on the basis that such information is privileged. Can the auditor rely solely on the conclusions of third party tax advisers? What evidential matter should the auditor obtain and include in the audit documentation? ○ .21 Interpretation—As discussed in paragraphs .17 through .19 above, the auditor cannot accept a client’s or a third party’s analysis or opinion with respect to tax matters without careful consideration and application of the auditor’s tax expertise and knowledge about the client’s business. As a result of applying such knowledge to the facts, the auditor may encounter situations in which the auditor either disagrees with the position taken by the client, or its advisers, or does not have sufficient appropriate evidential matter to support his or her opinion. • The auditor must decide whether failure to read and document the opinion is a scope limitation to the audit, thus impairing his or her ability to render a judgment on whether the financial statements comply with GAAP. In practice, companies seeking to assert “work product privilege” on such an opinion will assert that the opinion was obtained as supplementary corroboration of their position and preclude the auditor from obtaining a copy. These are difficult judgments for the auditor to make. Chapter 18 Corporate Taxation: Nonliquidating Distributions Learning Objectives 18-1. Recognize the tax framework applying to property distributions from a corporation to a shareholder. 18-2. Compute a corporation’s earnings and profits and a shareholder’s dividend income. 18-3. Explain the taxation of stock distributions. 18-4. Discern the tax consequences of stock redemptions. 18-5. Describe the tax consequences of a partial liquidation to the corporation and its shareholders. Teaching Suggestions This chapter provides the basic framework for taxing distributions from a corporation to its shareholders in their capacity as shareholders. Renowned corporate tax experts Bittker and Eustice call this topic “wondrously complex.” The topics build from basic dividends to stock dividends to redemptions to partial liquidations. The most difficult part of the material is the computation of current earnings and profits and the impact on E&P from the distributions themselves. As the instructor, you should decide whether you want to go through the four different combinations of E&P balances (both positive, both negative, one positive and the other negative). As an alternative, you could also choose to focus on the “both positive” scenario and skip the other three possibilities. With stock redemptions, discuss the attribution rules, and make sure to focus on the family attribution rules that apply to closely held companies. Partial liquidations are very rare; you might decide to pass on the technical discussion. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 Research Planning Tax Form DQ18-1 15 min. Easy X DQ18-2 15 min. Easy X DQ18-3 15 min. Easy DQ18-4 15 min. Easy X DQ18-5 20 min. Medium X DQ18-6 20 min. Medium X DQ18-7 20 min. Medium X DQ18-8 20 min. Medium X DQ18-9 20 min. Medium X DQ18-10 20 min. Medium X DQ18-11 20 min. Medium X DQ18-12 20 min. Medium X DQ18-13 10 min. Medium X DQ18-14 10 min. Medium X DQ18-15 10 min. Medium X DQ18-16 10 min. Medium X DQ18-17 10 min. Medium X DQ18-18 10 min. Medium X DQ18-19 25 min. Medium X DQ18-20 25 min. Medium X DQ18-21 25 min. Medium X DQ18-22 20 min. Medium X DQ18-23 20 min. Medium X DQ18-24 20 min. Medium X DQ18-25 20 min. Medium X DQ18-26 20 min. Medium X DQ18-27 20 min. Medium X DQ18-28 20 min. Hard X DQ18-29 20 min. Hard X DQ18-30 25 min. Hard X DQ18-31 25 min. Medium X DQ18-32 20 min. Hard X P18-33 20 min. Easy X P18-34 15 min. Easy X P18-35 15 min. Easy X P18-36 10 min. Easy X P18-37 20 min. Medium X P18-38 20 min. Medium X P18-39 20 min. Medium X P18-40 20 min. Medium X P18-41 20 min. Medium X P18-42 20 min. Medium X P18-43 10 min. Medium X P18-44 15 min. Medium X P18-45 25 min. Hard X P18-46 25 min. Hard X P18-47 25 min. Hard X X X P18-48 25 min. Medium X P18-49 25 min. Medium X P18-50 20 min. Medium X P18-51 25 min. Medium X P18-52 25 min. Hard X P18-53 25 min. Hard X P18-54 25 min. Hard X X P18-55 25 min. Hard X P18-56 25 min. Hard X X P18-57 25 min. Hard X X P18-58 25 min. Hard X P18-59 25 min. Hard X X P18-60 25 min. Hard X X P18-61 20 min. Hard X P18-62 25 min. Medium X X P18-63 20 min. Medium X P18-64 10 min. Medium X X P18-65 10 min. Medium X P18-66 25 min. Medium X CP18-67 20 min. Medium CP18-68 20 min. Medium CP18-69 20 min. Medium X Lecture Notes 1) Taxation of Property Distributions a) If the tax law characterizes the distribution as a dividend, the corporation cannot deduct the amount paid in computing its taxable income. b) The shareholder is subject to tax on the gross amount of the dividend received. c) The nondeductibility of the distribution by the corporation, coupled with the taxation of the distribution to the shareholder, creates double taxation of the corporation’s income, first at the corporate level and then at the shareholder level. d) The double taxation of distributed corporate income is a fundamental principle of the U.S. income tax system, having been made part of the tax code in 1913. e) If the distribution can instead be characterized as salary, bonus, interest, or rent, the corporation usually can deduct the amount paid in computing its taxable income. 2) Determining the Dividend Amount from Earnings and Profits a) Overview i) When a corporation distributes property to shareholders in their capacity as shareholders, the tax consequences of the distribution to the shareholder can be summarized as follows: (1) The portion of the distribution that is a dividend is included in gross income. (2) The portion of the distribution that is not a dividend reduces the shareholder’s tax basis in the corporation’s stock (that is, it is a nontaxable return of capital). (3) The portion of the distribution that is not a dividend and is in excess of the shareholder’s stock tax basis is treated as gain from sale or exchange of the stock (capital gain). ii) Corporate distributions of “property” usually take the form of cash, but they can include debt and other tangible or intangible property. b) Dividends defined i) The tax law defines a dividend as any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P) account. ii) Congress intended earnings and profits to be a measure of the corporation’s economic earnings available for distribution to its shareholders. iii) The IRC requires a corporation to keep two separate E&P accounts (1) The current year (current earnings and profits) (2) Undistributed earnings and profits accumulated in all prior years (accumulated earnings and profits) iv) Current E&P not distributed to shareholders is added to accumulated E&P at the beginning of the next taxable year. v) Distributions cannot reduce earnings and profits below zero—deficits in E&P are only created by negative income. vi) A corporation that pays a distribution in excess of its total E&P must report the distribution on Form 5452 and include a calculation of its E&P balance to support the tax treatment. c) Computing earnings and profits i) Earnings and profits include taxable and nontaxable income, reflecting the fact that Congress intended E&P to represent a corporation’s economic income. ii) Shareholders may be taxed on distributions of income not subject to tax at the corporate level. iii) The corporation begins its computation of E&P with taxable income or loss. iv) It then makes adjustments required by the Internal Revenue Code (IRC) or the accompanying regulations and IRS rulings. These adjustments are: (1) Nontaxable income included in current E&P (a) The regulations state that “all income exempted by statute” must be added back to taxable income in computing E&P. (b) Common examples of tax-exempt income included in E&P are tax-exempt interest, tax-exempt life insurance proceeds, and the increase in cash surrender value of corporate-owned life insurance. (2) Deductible expenses that do not reduce current E&P (a) Deductions that are allowed in computing taxable income but disallowed in the computation of E&P generally are deductions that require no cash outlay by the corporation or are carryovers from a different tax year. (b) Examples include dividends received deduction, net capital loss carryovers from a different tax year, net operating loss carryovers from a different tax year, and charitable contribution carryovers from a prior tax year. (3) Nondeductible expenses that reduce current E&P (a) A corporation reduces its E&P for certain items that are not deductible in computing its taxable income but require a cash outflow. (b) Examples of such expenses are: (i) Federal income taxes paid or accrued (depending on the corporation’s method of accounting). (ii) Expenses incurred in earning tax-exempt income (such income is included in E&P). (iii) Current-year charitable contributions in excess of 10 percent of taxable income (there is no 10 percent limitation for E&P purposes). (iv) Premiums on life insurance contracts in excess of the increase in the policy’s cash surrender value. (v) Current-year net capital loss (there is no limit on capital losses for E&P purposes). (vi) Nondeductible portion of meals (generally 50%) and all entertainment expenses. (vii) Nondeductible lobbying expenses and political contributions. (viii) Penalties and fines. (4) Items requiring separate accounting methods for E&P purposes (a) A corporation using the accrual method for regular income tax purposes generally must use the accrual method for E&P purposes. (b) Some income deferred from inclusion in the computation of current-year taxable income must be included in the computation of current E&P in the year in which the transaction occurs. (c) Certain expenses currently deducted in the computation of taxable income are deferred in computing E&P. (d) Organizational expenditures, which can be deducted currently or amortized for income tax purposes, must be capitalized for E&P purposes. (e) Amounts expensed under §179 (first-year expensing) must be amortized over five years for E&P purposes. (f) Refer to Exhibit 18-1 for a Template for Computing Current Earnings and Profits. d) Ordering of E&P distributions i) A corporation must maintain two separate E&P accounts: current E&P and accumulated E&P. ii) Whether a distribution is characterized as a dividend depends on whether the balances in these accounts are positive or negative. iii) There are four possible scenarios. (1) Positive current E&P, positive accumulated E&P (a) Corporate distributions are deemed to be paid out of current E&P first. (b) If distributions exceed current E&P, the amount distributed out of current E&P is allocated pro rata to all of the distributions made during the year. (c) The ordering of distributions is necessary only when distributions exceed current E&P and either the identity of the shareholders receiving the distributions changes or a shareholder’s percentage ownership changes during the year. (2) Positive current E&P, negative accumulated E&P (a) Distributions deemed paid out of current E&P are taxable as dividends. (b) Distributions in excess of current E&P in this scenario would first be treated as nontaxable reductions in the shareholders’ tax basis in their stock. (c) Any excess received over their stock basis would be treated as a (capital) gain from sale of the stock. (3) Negative current E&P, positive accumulated E&P (a) When current E&P is negative, the tax status of a dividend is determined by total E&P on the date of the distribution. (b) This requires the corporation to prorate the negative current E&P to the distribution date and add it to accumulated E&P at the beginning of the year to determine total E&P at the distribution date. (c) Distributions in excess of total E&P in this scenario are treated as return of capital. Any excess over their stock basis would be treated as a capital gain. (4) Negative current E&P, negative accumulated E&P (a) None of the distribution is treated as a dividend. (b) Distributions in this scenario will be a return of capital. (c) Any excess over their stock basis would be treated as a capital gain. e) Distributions of noncash property to shareholders i) Amount distributed = Money received + Fair market value − Liabilities assumed by the shareholder on property received ii) As a general rule, a shareholder’s tax basis in noncash property received as a dividend equals the property’s fair market value. iii) The tax consequences to a corporation paying noncash property as a dividend (1) The IRC provides that taxable gains (but not losses) are recognized by a corporation on the distribution of noncash property as a dividend. (2) To the extent the fair market value of property distributed as a dividend exceeds the corporation’s tax basis in the property, the corporation recognizes a taxable gain on the distribution, which increases current E&P by virtue of the fact that it increases taxable income. (3) If the fair market value of the property distributed is less than the corporation’s tax basis in the property, the corporation does not recognize a deductible loss on the distribution. (4) E&P is reduced by the distributed property’s fair market value if the property is appreciated (gain is recognized) and by the property’s E&P basis if the property is depreciated (loss is not recognized). iv) Liabilities (1) If the property’s fair market value is less than the amount of the liability assumed, the property’s fair market value is deemed to be the amount of the liability assumed by the shareholder. (2) If the liability assumed is less than the property’s fair market value, the gain recognized on the distribution is the excess of the property’s fair market value over its tax basis (that is, the liability is ignored). v) Effect of noncash property distributions on E&P (1) In the case of appreciated property (noncash) distributions, current E&P is increased by the property’s E&P gain (FMV in excess of E&P basis) and reduced by tax on the taxable gain (regular tax). (2) When depreciated property (the property’s fair market value is less than the corporation’s E&P basis in the property) is distributed by the corporation, the corporation does not recognize the loss and no adjustment is made to current E&P. (3) In the case of appreciated property distributions, the corporation reduces accumulated E&P by the property’s FMV. (4) In the case of depreciated property distributions, the corporation reduces accumulated E&P by the property’s E&P basis. (5) When property subject to a liability is distributed, the corporation increases accumulated E&P by the liability assumed by the shareholders in the distribution. (6) A distribution of property can only reduce E&P to the extent E&P is positive. (7) A distribution cannot create negative E&P or increase already existing negative E&P that results from operations. 3) Stock Distributions a) Most stock distributions take the form of either a stock dividend or a stock split (a stock split has essentially the same result as a 100 percent stock dividend). b) Tax consequences to shareholders receiving a stock distribution c) Nontaxable stock distributions i) General rule, the stock distribution must meet two conditions: (1) It must be made with respect to the corporation’s common stock, and (2) It must be pro rata with respect to all shareholders (that is, the shareholders’ relative equity positions do not change as a result of the distribution). ii) The recipient of a nontaxable stock distribution allocates a portion of the tax basis from the stock on which the stock distribution was issued to the newly issued stock based on the relative fair market values (FMV) of the stock. iii) Adjusted basis of new stock on a per-share basis = Adjusted basis of “old stock”/Total shares of stock. This formula works when the total shares of stock are calculated after the dividend (old shares plus new shares) and when the dividend is made in shares of the same class of stock (identical market values). iv) The holding period of the new stock includes the holding period for which the shareholder held the old stock. v) Pro rata distributions generally are nontaxable. d) Taxable stock distributions i) Non-pro rata stock distributions usually are taxable as dividends. 4) Stock Redemptions a) The form of a stock redemption i) The tax law defines redemption as an acquisition by a corporation of its stock from a shareholder in exchange for property, whether or not the stock so acquired is canceled, retired, or held as treasury stock. ii) Stock redemptions take the form of an exchange; that is, the shareholders exchange their stock in the corporation for property, usually cash. iii) The IRC attempts to provide both “bright line” and subjective tests to distinguish when redemption should be treated as an exchange or a potential dividend. iv) Corporate shareholders generally have more incentive for dividend treatment. v) Dividends from domestic corporations are eligible for the dividends received deduction (usually 50 percent or 65 percent), whereas a capital gain is taxed at the corporation’s tax rate. vi) A corporation might prefer exchange treatment if the redemption results in a loss, if the corporation has capital loss carryovers, or if its stock tax basis as a percentage of the redemption price exceeds the dividends received deduction ratio. b) Redemptions that reduce a shareholder’s ownership interest i) The IRC allows a shareholder to treat redemption as an exchange if the transaction meets one of three change-in-stock-ownership tests. ii) Redemptions that are substantially disproportionate (1) A redemption will be treated as an exchange if the redemption is “substantially disproportionate with respect to the shareholder.” (2) A shareholder meets this requirement by satisfying three mechanical (“bright line”) stock ownership tests: (a) Immediately after the exchange, the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote. (b) The shareholder’s percentage ownership of voting stock after the redemption is less than 80 percent of his or her percentage ownership before the redemption. (c) The shareholder’s percentage ownership of the aggregate fair market value of the corporation’s common stock (voting and nonvoting) after the redemption is less than 80 percent of his or her percentage ownership before the redemption. (3) Family attribution (4) Attribution from entities to owners or beneficiaries (5) Attribution from owners or beneficiaries to entities (6) Option attribution iii) Complete redemption of the stock owned by the shareholder (1) This test seems redundant with the substantially disproportionate test discussed previously; after all, a complete redemption automatically satisfies the 50 percent and 80 percent tests. (2) The difference relates to the application of the family attribution rules that apply to this form of redemption. (3) The stock attribution rules previously discussed also apply to a complete redemption. (4) The shareholder has no interest in the corporation immediately after the exchange as a “shareholder, employee, director, officer or consultant.” These relations to the corporation are referred to as prohibited interests. (5) The shareholder does not acquire a prohibited interest within 10 years after the redemption, unless by inheritance (this is known as the 10-year look-forward rule). (6) The shareholder must agree to notify the IRS district director within 30 days if he or she acquires a prohibited interest within 10 years after the redemption. iv) Redemptions that are not essentially equivalent to a dividend (1) To satisfy this requirement, the IRS or the court must conclude that there has been a “meaningful” reduction in the shareholder’s ownership interest in the corporation as a result of the redemption. (2) The application of this test is often uncertain. v) Tax consequences to the distributing corporation (1) The corporation distributing property to shareholders in redemption generally recognizes gain on distributions of appreciated property but is not permitted to recognize loss on distribution of property with a fair market value less than its tax basis. (2) If the shareholder treats the redemption as a dividend, the corporation reduces its E&P by the cash distributed and the greater of the fair market value or the adjusted basis of other property distributed. (3) If the shareholder treats the redemption as an exchange, the corporation reduces E&P at the date of distribution by the percentage of stock redeemed (that is, if 60 percent of the stock is redeemed, E&P is reduced by 60 percent), not to exceed the fair market value of the property distributed. (4) The distributing corporation reduces its E&P by any dividend distributions made during the year before reducing its E&P for redemptions treated as exchanges. vi) Trends in stock redemptions by publicly traded corporations (1) Publicly traded corporations viewed stock redemptions as a tax-efficient means to return cash to their shareholders. (2) Redemptions allow shareholders to “declare their own dividends” by voluntarily selling shares back to the corporation. (3) Individuals have a tax incentive to participate in redemption because gain recognized as a result of the redemption usually is capital gain. (4) Losses produced by the buyback generally can be deducted against capital gains. 5) Partial Liquidations a) Noncorporate shareholders receive exchange treatment. b) Corporate shareholders determine their tax consequences using the change-in-stock-ownership rules that apply to stock redemptions. 6) Conclusion 7) Summary 8) Key Terms Class Activities 1. Directions from the IRS? The IRS sometimes publishes Revenue Rulings or Revenue Procedures to provide guidance about how to apply various subjective tax rules. However, additional guidance is sometimes available in unofficial IRS publications, such as PLRs. In these publications, the IRS takes special care to redact information that identifies taxpayers. Unfortunately, the IRS sometimes also redacts information that taxpayers might find helpful. For example, in PLR 201918009, the IRS ruled that a corporation's redemption of a shareholder's stock was not essentially equivalent to a dividend. Whether a redemption is essentially equivalent to a dividend is a question of fact, and depends on the circumstances of each case. A redemption distribution is not essentially equivalent to a dividend if it results in a meaningful reduction in the redeemed shareholder's proportionate interest in the distributing corporation. Apparently, the Service wanted to avoid giving specific guidance about what size of reduction the IRS would find “meaningful” because the facts only stated that the redemption reduced shareholder's stock ownership from “H% to I%”! 2. Real-world examples: Visteon Visteon Corporation is a global technology company that designs, engineers and manufactures innovative cockpit electronics and connected car solutions for the world’s major vehicle manufacturers. During 2008 and 2009, weakened economic conditions triggered a global economic recession that severely impacted the automotive sector. Visteon filed voluntary petitions for reorganization relief in 2009, and the company has been profitable since it emerged from bankruptcy in 2010. Visteon had two technology-focused core businesses: vehicle cockpit electronics and thermal energy management. The company’s vehicle cockpit electronics product line includes audio systems, infotainment systems, driver information systems, and electronic control modules. In order to focus its operations on automotive cockpit electronics, Visteon sold a subsidiary at a pretax gain of approximately $2.3 billion. The sale was completed on June 9, 2015, and Visteon's net cash proceeds from the sale were approximately $2.7 billion. Visteon then announced a plan to return $2.5 billion–$2.75 billion of cash to its shareholders through a series of actions including a special distribution. Ultimately, Visteon actually distributed approximately $1.75 billion on January 22, 2016. Is there a tax reason why Visteon might have delayed the distribution from 2015 until 2016? One possibility is that Visteon had a large deficit in its accumulated E&P at the beginning of 2015 from prior losses. However, the gain on the sale of the subsidiary created significant 2015 current E&P. Recall that distributions are dividends to the extent of current E&P even when there is a deficit in accumulated E&P. If true, then Visteon’s special distribution in 2015 would have been characterized entirely as a dividend to its shareholders. However, by waiting until 2016 to make the distribution, it is possible that a significant portion of the distribution was treated as a nontaxable return of capital to shareholders instead of a taxable dividend. This is because Visteon' available E&P (beginning of year accumulated E&P plus current E&P) was significantly less than the distribution amount. Instructor Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
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