Elements of Corporate Taxation

One of the most common forms of organization to conduct business is a Corporation. Corporations are
usually chartered by a state and conferred many legal rights as an entity separate from its owners. This form
of an entity is characterized by the limited liability of its owners, the issuance of shares of easily transferable
stock, and existence as a going concern. As a separate legal entity, Corporation form of business structure
provides the owners with a more flexible way to manage their ownership structure. In addition, there are
different tax implications for corporations, although these can be both advantageous and disadvantageous.
In these respects, corporations differ from sole proprietorships and limited partnerships.
(http://www.investorwords.com/1140/corporation.html)

Taxation of Corporate entities can be a complex process which is dictated by the Internal Revenue Service
(IRS). Although the process and components of corporate taxation can be complex, the basic components
can be determined. The main components relating to corporate taxation can be seen from the following
formula:

Gross Income
- Deductions and Losses
- Any Special Deductions
= Taxable Income
X Applicable Tax Rate (Based on the Graduated Tax Scale)
= Corporate Tax Liability before any Applicable Credits

Total Tax Liability before Applicable Credits

- Any Foreign Tax Credits
- Other Credits
+ Credit Recapture
= Regular Tax Liability

Regular Tax Liability

+ AMT Tax Liability
+ Any Special Taxes Incurred
- Estimated Tax Payments
= Refund or Tax due (Pope, Anderson, and Kramer, 2011)

We will be examining each of the components of the above formula to better understand the overall taxation
formula and the process in general. (Pope el al, 2011)

Before discussing the taxation components applicable to corporations, an important point has to be covered.
When a corporation is being setup, due consideration has to be made on the selection of the tax year. A
corporation can select a calendar year, which a 12 month period ending on 31st December. Or it can select a
fiscal year, which is a 12 month period ending on the last day of any moth other than December. (Pope el al,
2011)

Once the tax year has been selected, it can only be changed with the permission of the Internal Revenue
Service (IRS).

Gross Income
The Gross income items that apply to a Corporate are similar to the items that apply to Individuals. But
there are certain exclusions that are available to individuals but not to Corporations, like Fringe benefits.
Vice versa, there are certain exclusions that are available to Corporations but not to individuals, like capital
contributions.

But in the case of Corporations, there is a major difference from individuals. The Gross Income of
Corporations is basically income from all sources which is shown as “Gross Receipts or sales” in IRS Form
1120. From this amount returns and allowances are deducted. From that amount Cost of goods sold is
deducted. Cost of goods sold has a separate schedule which is detailed in IRS Schedule A. Once cost of
goods sold is deducted, we arrive at the Gross profit.

Once the Gross profit has been determined, incomes from other sources are included. The other incomes
that are listed in IRS Form 1120 are dividends, interest, gross rents and royalties, capital gain, net gain or
loss and other income. The sum off all will result in the Total income.

Capital gain net income requires special attention. It is not simply deducting the purchase amount from the
sale amount. If a number of years had passed between the purchase and sale of the asset, then the simple
difference will always show a loss. When reporting the Capital gain net income, the depreciated value is to
be deducted from the sale amount. (Pope el al, 2011 & irs.gov)

Deductions and Losses

The deductions that form the reporting items in IRS Form 1120 are the business expenses that corporations
are allowed to deduct for ordinary and necessary business expenses. The listed items are compensation to
officers, salaries and wages, repairs and maintenance, bad debts, rents, interest etc.

There are exceptions to some of these deductions like interest. Deduction is not allowed for borrowings to
purchase tax exempted securities.

When a corporation is initially being setup, there would be expenses which are termed as organizational
expenses. These expenses are usually capitalized. But corporation are allowed to deduct organizational
expenses that exceed USD 50,000.00. But this deduction cannot reduce the excess amount over USD
50,000.00 to zero. After the first deduction, the remaining amount must be amortized over a 180 month
period.

On the IRS FORM 1120, the total of all the expenses and deductions results in the Total Deductions. (Pope
el al, 2011 & irs.gov)

Special Deductions

There are special deductions that also available to corporations. IRS allows deductions under “U.S.
production Activities Deductions”, “Dividends Received Deductions” and “Net Operating Loss (NOL)
Deduction”.

IRS allows deduction of US production activities that equal to a percentage times the lesser of (a) qualified
production activities income for the year or (b) taxable income before the US production activates
deduction. The deduction however cannot exceed fifty percent of the corporation’s W-2 wages allocable to
qualifying US production activates for the year.

IRS allows deduction of deduction of dividends that a corporation receives. The dividends the corporation
receive are included under the reported income. This is taxed. When the corporation distributed dividends to
its shareholders, there is double taxation. Including the taxation of the dividend income received there is
triple taxation. To overcome this, IRS allows deduction of the dividends that a corporation received from
other corporations.
Another deduction that is allowable for corporation is Net Operating Loss deduction. A corporation in a
particular year may have a situation where its deductions exceed its gross income. In such cases there is a
Net Operating Loss (NOL). The NOL deductibility can be carried back for 2 years and carried forward for
20 years. A corporation may elect to not carry back and instead only carry forward NOL because the carry
back period may had been taxed at a lower marginal tax rate and the corporation anticipates higher marginal
tax rates in the future. (Pope el al, 2011 & irs.gov)

Taxable Income

As per the tax formula, after a corporation deducts from Gross Income the allowed deductions and losses
including special deductions, it arrives at the Taxable Income. It is to this amount that the tax rate is applied.
The applicable tax rate is as per the tax rate schedule released by the IRS. As per the tax rate schedule for
2010, the rates range from 15 percent to 35 percent for taxable income ranging from USD 0.00 till
50,000.00 and for taxable income above USD 18,333,333.00

When the applicable tax rate from the tax rate schedule is applied to the Taxable Income, we arrive at the
“Total Tax Liability before Applicable Credits”. (Pope el al, 2011 & irs.gov)

Tax Credits and Tax Recaptures

After arriving at the Total tax Liability before applicable credits, a corporation has to complete Schedule J
of the IRS Form 1120. In this form the corporation has to first of all check if the corporation is member of a
controlled group. A Controlled group is a group of two or more corporations directly or indirectly owned by
the same shareholders or group of shareholders. If the corporation declares it is member of a controlled
group, then it has to complete IRS 1220 Schedule O.

This is required by the IRS to prevent corporations that could have taxable income above USD
18,333,333.00 where it is taxed 35 percent to distribute the income among its group to reduce the marginal
tax rate.

There are various credits that can be deducted from “Total Tax Liability before Applicable Credits”. One of
them is foreign tax credit. Corporations that have foreign operations usually are taxed by the foreign
government for the income generated in their jurisdiction. When that income is also reported in the United
States, there is a possibility of double taxation. In order to mitigate double taxation, a corporation is required
to complete Form 1118 to claim the credit. But this foreign tax credit has some limits and restrictions.

Another credit that a corporation can claim is the General business credit. This credit is claimed by
completing IRS Form 3800. This contains a list of various items that total to the general business credit.
This is primarily to promote certain activities that involve the environment and other aspects.

There are credits that a corporation can claim. They are “Qualified Plug-in Electric and Electric Vehicle
Credit” reported on Form 8834, “Credit from prior year minimum tax” reported on form 8827 and “Bond
credits” reported on Form 8912. All these credits are deducted from “Total Tax Liability before Applicable
Credits” to arrive at the Regular Tax Liability. (Pope el al, 2011 & irs.gov)

Regular Tax Liability

After arriving at the Regular Tax Liability, other taxes that a corporation has incurred are included. These
other taxes are reported to the IRS in forms 4255, 87611, 8697, 8866, 8902 and any other taxes that have
been incurred.
Once the other taxes incurred have been added to the Regular tax liability, estimated tax payments are
deducted. Estimated tax payments are payments that corporations pay periodically if they expect to pay
more than USD 500.00 in taxes for the current year.

After completing all the above, the corporation is finally at the “Tax Due” if the amount is a positive amount
or a “Refund” if it is a negative amount.

We have covered all the major components of the corporate taxation formula from determination of the
Gross income to finally arriving at the tax due or refund. This is a simplified explanation of the corporate
taxation process. It is normally a more complex process involving many different forms and deeper
understanding of the requirements and the application of the requirements. Corporations would be better to
use the services of a qualified accountant and a tax expert to ascertain the best course of action and
addressing the reporting requirements for its entity. (Pope el al, 2011 & irs.gov)

References:

• Prentice Hall’s Federal Taxation 2011 (Thomas R. Pope, Kenneth E. Anderson, John L. Kramer)

• http://www.investorwords.com/1140/corporation.html

• www.irs.gov/pub/irs-pdf/f1120.pdf

• www.irs.gov/pub/irs-pdf/i1120.pdf

• http://www.irs.gov/instructions/i1120/index.html