Tax strategies for corporations.
You have to be familiar with the existing tax structure in order to make sound financial decisions. Ignoring relevant tax aspects will cause an overstatement in estimated income. As a result, an investment alternative may be chosen that does not sufficiently generate the needed return for the risk exposure taken.
If a company is operating internationally, it has the additional problem of applying tax laws of foreign countries. Tax Strategies and Planning
It is necessary to analyze the tax consequences of alternative approaches in decision making. Income and expenses have to be shifted into tax years that will result in the least tax. You must be up-to-date with the changes in the tax law as it affects the business.
Corporate taxes should be deferred when there will be a lower tax bracket in a future year, the firm lacks the funds to meet the present tax requirement, the business earns a return on the funds for another year that would have had to been paid to the federal and local taxing authorities, tax payment will be in "cheaper" dollars, and there may eventually be no tax payment required (e.g., new tax law).
In tax planning, properly time the receipt of income and the payment of expenses to minimize the tax payment. A good tax strategy is to receive income in a year it will be taxed at a lower rate. For example, if you expect tax rates to drop next year, you can reduce the tax obligation by deferring income to next year. Try to convert income to less taxed sources. Also, pay tax-deductible expenses in a year in which you will receive the most benefit. For example, accelerate deductions in the current year if you anticipate lower tax rates next period. Further, accelerate expenses which will no longer be deductible or will be restricted in the future.
The company may donate appreciated property instead of cash. By donating appreciated property to a charity, the business can deduct the full market value and avoid paying tax on the gain.
In some cases, a company can use one method of accounting for books and another method for tax. This is referred to as inter-period income tax allocation because the temporary difference eventually reverses. The company should lower tax in the earlier years due to the time value of money by using the method for tax that results in less taxable income initially relative to book income. For example, taxes can be reduced in the initial years by using modified ACRS depreciation rather than straight line depreciation for tangible assets. Another example is using the completed contract method for tax and percentage of completion method for books.
The company should try to obtain tax-exempt income. Thus, tax-free income is worth much more than taxable income. You can determine the equivalent taxable return as follows:
Equivalent = Tax Free Return
Tax Return 1 - Marginal Tax Rate
Interest earned on municipal bonds is not subject to federal tax and is exempt from tax of the state in which the bond was issued. Of course, the market value of the bond changes with changes in the "going" interest rate.
Example: A municipal bond pays an interest rate of 6%. Your tax rate is 34%. The equivalent rate on a taxable instrument is:
.06 = .06 = 9.1 % ___ ___ 1-.34 .66
Corporate taxable income is of two types:
* Capital gains or losses on the sale of capital assets. Capital assets (e.g., real estate, securities) are assets not bought and sold in the ordinary course of a company's business. Under certain circumstances, capital gains and losses receive special tax treatment.
* Ordinary income (income other than capital gains or losses).
80% of the dividends received by a company from a taxable domestic corporation are exempt from taxation. Thus, the maximum rate on dividend is 6.8% (20% x 34%). Further, if the company receiving the dividends owns 80% or more of the other company's stock, it may deduct 100% of the dividends. However, if the company owns less than 20% of the distributing company, the deduction is 70%.
The rates used in computing a company's total tax obligation are referred to as the marginal tax rates, which indicate the rate applicable for the next dollar of income. In addition to the marginal tax rate, the effective or average tax rate is the one applicable to all taxable income. It is computed as follows:
Effective Total tax liability = ___________________ Tax Rate Taxable income
The maximum federal tax rate for companies is 34%. In addition, companies have state and local income taxes that are typically based on federal taxable income. As a result, the effective tax rate a company pays is higher than 34%.
The federal income tax rate is graduated meaning that as additional profits are earned the percentage tax liability on the incremental earnings increases.
The federal corporate tax rates follow:
Taxable Income Tax Rate $50,000 or less 15 % $50,001 - $75,000 25 Over $75,000 34
And there is an additional 59% tax on taxable income between $100,000 and $335,000.
Example: Your company's taxable income is $160,000. The tax obligation is:
15% x $50,000 $7,500 25% x $25,000 6,250 34% x $85,000 28,900 5% x $60,000 3,000 _______ $45,650
Because the company is concerned with the tax obligation if there is additional profitability, the marginal tax rate is considered when making managerial decisions.
It is necessary to be familiar with which expenses are tax deductible so proper planning may be made.
Business meal and entertainment expenses are 80% deductible. The meal must have a direct relationship to carrying out the company's business. Business must be discussed before, during and after a meal. A corporate representative must be present at the meal. The meal or beverage cannot be lavish or extravagant." Transportation to and from the restaurant is 100% deductible. However, parking at a sports arena is only 80% deductible.
Example: A customer was taken out to dinner and drinks and it cost $125. The business meal is limited in terms of tax deductibility to $100 (80% x $125). In addition, the taxi fare to the restaurant was $20. This is deductible in full.
Generally, food and entertainment-related employee benefits are fully deductible. Examples are company parties and subsidized cafeterias.
Promotional items for public distribution are fully deductible (e.g., samples).
Deductions for business gifts are limited to $2 5 per individual donee. Items clearly of an advertising nature which cost $4 or less do not figure in the 25 limitation.
Example: A company gave business gifts to 17 customers. These gifts, which were not of an advertising nature, had the following fair market values: 4 @ $10, 4 @ $25, 4 @ $50 and 5 @ $100. These gifts are deductible as business expenses for $365 computed as follows:
4 @ $10 $40 13 @ $25 325 Total 365
A charitable contribution made in cash or property is deductible limited to 10% of taxable income without taking into account:
1. The charitable contribution,
2. The dividends-received deduction,
3. Net operating loss carryback (if any), and
4. Capital loss carryback (if any). Any charitable contribution made in excess of the limitation may be carried over five succeeding years.
In general with life insurance, there are some circumstances in which a corporation may claim a deduction. These include "keyman" life insurance if the company is not the beneficiary and premiums paid for group-term policies where the corporation is not the beneficiary. As to group-term policies, any premiums for coverage in excess of $ 50,000 while deductible by the corporation are taxable income to the employee. "Key man" insurance premiums are deductible only if:
1 . The premium payments are an ordinary business expense as additional compensation and
2 . The total amount of all compensation for that person is not unreasonable.
The $50,000 group-term exclusion will not apply to a "key" employee if the plan discriminates as to eligibility and the type and amount of benefits provided.
Other deductible expenses include interest, professional fees (e.g., independent accountants, outside attorneys), casualty and theft losses and bad debts when a specific account is deemed uncollectible (direct write-off method). Non-deductible expenses include such areas as fines, penalties and illegal payments.
A company has the choice of depreciating tangible assets under the straight line method or modified accelerated cost recovery system (ACRS) method. The basis for determining depreciation is the cost of the asset and improvements. Apportionment of basis is required between depreciable and nondepreciable portions in a lump-sum acquisition.
ACRS depreciation lowers taxes in the early years of an asset's life, thus improving corporate cash flow and making funds available for investment. The faster the cash flow the greater the rate of return earned on the investment.
Under the modified ACRS provision of the tax law there are six different types of capital assets with stated lives (not necessarily useful lives for tax depreciation-purposes. These are shown in Table 1. Note that salvage value is ignored in calculating depreciation. In addition to the classes shown in Table 1 [omitted], there are two other classes which require the use of the straight-line method. The 27 -year class is for residential real estate (e,.g., apartment complexes) and the 31 -year class is for commercial real estate (e.g., office buildings and warehouses).
Each of the six classes in Table 1 [omitted] is depreciated over more than is the class itself This is because of a complicated formula in the tax law that mandates a half-year's depreciation beyond the class life to compensate for, in essence, one-half year's depreciation in the first year. Of course, total depreciation will be 1009o'. Depreciation rates are shown in Table 2 [omitted].
With regard to luxury autos, the depreciation limitation is as follows:
1st year $2,560 2nd year 4,100 3rd year 2,450 4th year and beyond 1,475
Election to Expense Certain Depreciable Assets Under ACRS
A company may elect to deduct certain assets as expenses rather than capitalizing and depreciating them under ACRS. This provision relates to personal property qualifying under ACRS and acquired for trade or business use. However, the maximum amount that may be expensed is 10,000 per year. The amount that may be expensed is reduced by the amount by which the cost of the property placed into service during the taxable year exceeds $200,000. For example, a company purchasing property of $206,000 during the year could expense at most $4,000 ($ 10,000 - $6,000). Assets costing $210,000 or more receive no immediate expensing benefit. The amount that may be expensed is further limited to the taxable income of the trade or business. Companies immediately expensing any amount must deduct that amount from the basis of the asset to arrive at the asset's depreciable cost.
Some intangible capital expenditures may be amortized for tax purposes. For instance, a new company's organization costs may be amortized over a period of not less than 60 months.
Capital Gains and Losses
A capital gain (or loss) is one that results from a sale of a capital asset. The gain or loss is the difference between selling price and cost. All other gains (or losses) are ordinary items. In general, capital assets are all assets except for business related assets. An example of a capital asset is stock. Examples of non-capital assets are inventories, receivables and depreciable items.
Unlike the case with individuals, corporations cannot deduct a net capital loss from ordinary income in the year sustained. The net capital loss is carried over as a short-term loss and is offset against the net capital gains. Any capital loss that exceeds capital gains is carried back to the three years preceding the year of loss and, if not completely absorbed, is then carried forward for up to five years succeeding the loss year.
Capital gains and losses are classified as long-term or short-term. A long-term capital gain is a capital asset held for more than six months that is sold for a selling price in excess of cost. The highest tax rate on capital gains is 34%.
Example: A company sells securities it owns resulting in a capital gain of $180,000. The tax on the capital gain assuming the company is in the maximum tax bracket is $61,200 ($180,000 x 34%).
Operating Loss Carryback and Carryforward
If a company has an operating loss, the loss may be applied against income in other years. The loss can be carried back three years and then forward for 15 years. (Capital losses can be carried forward for five years.) Note that the taxpayer must first apply the loss against the taxable income in the three prior years. If the loss is not completely absorbed by the profits in these three years, it may be carried forward to each of the 15 following years. At that time, any loss remaining may no longer be used as a tax deduction. To illustrate, a 19X5 operating loss may be used to recover, in whole or in part, the taxes paid during 19X2, 19X3 and 19X4. If any part of the loss remains, this amount may be used to reduce taxable income, if any, during the 15-year period of 19X6 through 20X0.
With regard to company-sponsored pension and retirement plans, employees must vest 100% after five years of service. Employees are eligible for full retirement benefits at age 65. The pension plan must cover at least 40% of all employees or a minimum of 50 employees.
The maximum annual salary reduction allowed for an employee to a 401(k) plan is the lesser of 25% of compensation or $7,000 subject to inflation indexing using the consumer price index. But the $7,000 limit is reduced dollar for dollar for salary-reduction contributions to other retirement arrangements. Loans are allowed from 401(k) plans.
The ceiling on the amount a company could contribute to an employee profit sharing or other defined contribution plan is $30,000. Also, for every dollar the employee contributes to the plan there is a reduction of $1 to the amount the company can contribute.
Example: Employee X puts $6,000 in the co-sponsored pension plan. The most the company could contribute is $24,000 ($30,000 - $6,000).
The maximum annual benefit an employee can receive from a pension plan is $90,000 plus an inflation adjustment.
Foreign Tax Credit
A credit is permitted for income taxes paid to a foreign country. However, the foreign tax credit cannot be used to reduce the U.S. tax liability on income from U.S. sources. The allowable credit is calculated as follows:
Foreign Tax Credit Foreign x U.S. Liability Source Income.
Example: In 19X8, a company had worldwide taxable income of $675,000 and a tentative U.S. income tax of $270,000. The company's taxable income from business operations in Country X was $300,000, and foreign income taxes charged were $135,000 stated in U.S. dollars. The credit for foreign income taxes that can be claimed on the U.S. tax return for 19X8 is:
Foreign Tax Credit = 300,000 x $270,000 = 120,000 675,000
Administrative Tax Aspects
The corporate tax return must be filed on or before March 15 following the close of the calendar year unless an extension is requested. An automatic six-month extension is given. Companies must estimate their taxable income for the current year and if reporting on a calendar year basis, pay one-fourth of the estimated tax on April 15, june 15, September 15 and December 15 of that year. The estimated taxes paid must be at least 199% of the tax paid last year or 90% of the actual tax liability for the current year. If not, penalties will be charged for underpayments.
There is a penalty if a company improperly accumulates earnings for the purpose of enabling stockholders to avoid paying their personal income tax.
An S Corporation is one having 35 or less stockholders and only on class of stock. It is allowed to be taxed like a partnership. Corporate income is passed through to the stockholders' individual returns. Income is taxed as direct earnings to the stockholders regardless of whether it is actually received by them. Stockholders obtain all the benefits of a company but escape double taxation typically associated with the distribution of corporate profits. Stockholders are taxed only once at their tax rates. But certain tax advantages that companies obtain do not go to S corporations. For example, there is a limitation on retirement and fringe benefits paid to stockholders. An S corporation is advantageous because the maximum tax rate to individuals is lower (generally 289o) than the company's (generally 34%)
Corporate tax planning is needed to minimize the tax liability. The strategy depends on whether tax rates are expected to increase or decrease in future years. The accountant must also be familiar with tax requirements concerning sources of income and deductible amounts. Special areas of concern relate to tax credits as well as loss carrybacks and carryforwards.
Joel G. Siegel, PhD, CPA, is an accounting consultant and professor of accounting at Queens College of the City University of New York.
Peter Chiu, JD, is a financial consultant and professor of accounting at Queens College of the City University of New York.
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|Author:||Siegel, Joel G.; Chiu, Peter|
|Publication:||The National Public Accountant|
|Date:||Jan 1, 1991|
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