Corporate Income Tax

Transcription

1 Corporate Income Tax Advance Materials for Lecture on Chapter 3 Property Dispositions UNC Charlotte MACC Program January 20, 2016

2 UNC Charlotte MACC Program Chapter 3. Advance Materials Page 1 Advance Handout for Chapter 3. In Chapter 3, we are going to cover pages 1-19 (skip pages 21-33), and cover 3 rules on pages 35 and 35. We will not cover the exhibits containing the reporting of these gains and losses on the tax forms. The second page of this document contains a graph for a business machine purchased at a cost of $400,000, on which depreciation of is claimed. Case 1 involves selling the asset (which has a book value of $300,000) for $200,000. Case 2 involves selling that asset for $400,000. Case 3 involves selling the asset for $430,000. The rest of the next page contains brief summaries of applicable rules from a maze of Internal Revenue Code sections. The instructor PowerPoint file for Chapter 3 has key sentences from the applicable code sections. The third page of this document has those rules presenting in paragraph form. I prepared this summary in an earlier semester, and students then asked me to prepare a summary of the summary. That is on page 4. Students often consider these rules to be pretty challenging or very challenging. I ask for your patience. In class, I will cover the graph, and the rules at the bottom of the page. I will also illustrate the application of those rules with sample problems. Students learn these rules by applying them in sample problems. The second page of this handout addresses the rules that are explained in pages 5 through 13 of the textbook. In the lecture, I will also explain the recapture rule described in your textbook under the caption: 1250 Depreciation Recapture for Real Property I will also explain the rules for unrecaptured 1250 gain found on pages 14 and 15 of the textbook. The section 1231 lookback rule on page 18 is important and will be explained. Skip textbook pages 21 through 33. You will not be responsible for that material. Then, I will cover the rules on pages 34, 35 and top of page 36. These rules that we cover in this chapter involve some aspect of taxation of capital gain and losses. As you study this material, I recommend that you keep good notes, because they will be very handy as you study for the CPA Exam. This is an important CPA Exam topic. When we get to page 12 of Chapter 5, the material on corporate capital losses should be a welcome review and not new material for you. Why Cover Rules for Corporations and Individuals? As you work through this material, you may wonder why we are covering both corporate and individual capital gain and loss rules. Here is the answer. Corporations file almost 7 million federal income tax returns each year (on some variation of Form 1120). Over two-thirds of those returns are for corporations that have elected to be taxed as Subchapter S corporations. S corporations tend to be smaller, with an average of about 2 shareholders per corporation. They are small, because they have a limit of 100 shareholders. They can be big-money corporations. They are not public companies, so we have a limited amount of public information about them. We learned from one court case that the New York Giants NFL football team was an S corporation. We learned from another court case that the Chicago Bulls (NBA) was also an S corporation. In a recent year, about 140,000 S corporation returns were filed by S corporations in North Carolina, and there were about 53,000 other corporate federal income tax returns filed in North Carolina. One advantage of an S corporation is the corporate losses flow through to owners, and the owners report the losses on their personal returns. Also, capital gains flow through to owners (who get low, long-term capital gains tax rates, while regular corporations apply their regular tax rates for all of their capital gains). A corporation does not use lower income tax rates for capital gains, but would like to treat a gain as a capital gain, if it has capital losses this year, or a carryover of capital losses from past years. In a recent year, S corporations in the U.S. reported short-term capital losses of $981,913,000 and long-term capital gains (after netting long-term capital losses) of $59,736,684,000. Flow-through capital gains and losses are taxed to the individual under individual tax rules, which are largely similar to corporate rules, except the lower long-term capital gains rates. C16-Chap-03-3-Advance handout for Chapter 3. Page 1 of 1

3 UNC Charlotte MACC Program Chapter 3. Advance Materials Page 2 Buy, Use and Sell Business Machine $430,000 Case 1 Case 2 Case 3 $400,000 Original cost $300,000 Basis after Depreciation $200,000 Original Cost = $ 400,000 Depreciation Book Value: Basis $300,000 Loss $200,000 Gain $400,000 Gain $130,000 $430,000 Buy Asset Use Asset Case 1 Case 2 Case 3 Held over 12 Months Indivduals can use preferential tax rates for long-term capital gains. Corporations cannot!!! Section 1001: gain or loss is computed by subtracting basis from amount realized (price). Chap. 3 instructor PowerPoints have key sentences from code sections mentioned below. Case 1. See Textbook Exhibit 3-4 on page 3-8 for another rule summary. Section 165: A taxpayer may deduct a loss. (Individuals have limits on loss deductions.) An individual taxpayer may only deduct three types of losses. Section 165 ( c). [Losses in: (1) trade or business, (2) transaction entered into for profit, and (3) a casualty loss.] If a loss is a capital loss, taxpayer must consider capital loss limits in Sections 1211 & Section 1211: Corporation may deduct capital losses, but only from capital gains. Section 1211: Individual may deduct capital losses only from capital gains, plus $3,000. Section 1212: Corporations can carry net capital losses back 3 years and forward 5 years. Section 1212: Individuals may carry net capital losses forward to future years - unlimited. Section 1221: A capital asset is any asset other than inventory, depreciable property, or real estate used in a trade or business -- and several items which are not relevant here. Solution: Loss in Case 1 is an ordinary loss for a corporation or an indivdual. (Sec def. above.) Case 2. See Textbook Exhibit 3-5 on page 3-10 for more on Section [Sec gives general rule, Sec gives an exception, Sec is an exception to 1231.] Section 1221 (above): The depreciable asset is not a capital asset, so this is not a true capital gain. Section 1231: Treat gains from sale of such assets as capital gains if taxpayer has a net gain from all sales of all such assets in the year. What opportunity for abuse does this provide? Solution: Sec provides that a gain from sale of depreciable personal property is ordinary income to the extent that the gain was caused by the company claiming depreciation (). "Recapture of depreciation" means reclassifying a gain as an "ordinary" gain, not Capital Gain. Case 3 Case involves a gain of $130,000, and the company has taken depreciation of. Solution: Sec carves out of the gain and treats it as ordinary income (of ). Solution: Sec controls the remaining gain. Individual or Corp. has L.T. capital gain of $30,000. C16-Chap-03-Summary-Example-of-Asset-Sales-2016

4 UNC Charlotte MACC Program Chapter 3. Advance Materials Page 3 We Like Capital Gains and Hate Capital Losses Corporations may get no current tax benefit from losses (often incurred in recessions and depressions) if those losses are classified as capital losses. Capital loss deduction is limited to the amount of capital gains. Capital loss deductions for individuals are also limited. Congress was helpful, by stating in Section 1221 that land, buildings, equipment, etc. used in a business are not capital assets. This means that losses on those assets are fully deductible, because those losses are not capital losses. Of course corporations have a different view in good times when they are realizing gains on sale of such assets. They would like for those assets to be considered capital gains, so that capital gains can be offset by their accumulated capital loss carryovers from other years. [Classification as a capital assets is also significant when making an installment sale, or a charitable contribution of the property. Reg A- 1(c), Sec. 170(e), Sec. 453(i)] Individuals have essentially the same concerns, and in addition individuals use low tax rates on long-term capital gains. Corporation do not have low capital gains rates. Congress to the Rescue Congress went further to make both individuals and corporations happy, by saying you can have your cake and eat it too! [Be Patient; We have Section 1221 defining capital assets to exclude business property. Then Section 1231 making an exception to Section 1221 (by allowing capital gain treatment on sale or exchange of that property). Then we have sections 1245 (business personal property) and 1250 (generally depreciable business real estate) making exceptions to Section 1231 (which cause the some of the gain NOT to be capital gain after all).] Section 1231 says that you get to treat net gains from sale of this business property (buildings, land, equipment, etc.) as capital gains - if you have a net gain from all such sales. (This is an exception to Section 1221.) If you instead have a net loss from all sales of business property, you stay under Section 1221 which says such a loss is not a capital loss but rather an ordinary loss. Section 1231 does not apply in this case. A great loophole. A proprietorship (individual) buys a machine, uses it and sells it. Cost of Machine $400,000 Depreciation claimed 100,000 Book Value of machine 300,000 Savings - Deprec. ( 35% tax rate) 35,000 Machine is later sold for $400,000 The proprietorship sells the machine for $400,000 after one year. Selling price is $400,000. Book value is $300,000. The gain is. Section 1231 will cause this gain to be treated as a capital gain. Using a capital gains rate of 15%, the tax paid back to the government is only $15,000. Here, an individual taxpayer actually broke-even. However, the taxpayer saved $35,000 and then only had to repay $15,000 when the property was sold. The government lost $20,000. Congress fixed that loophole, by adding Section 1245, which says that any gain on the sale of depreciable business personal property (not real estate, except in rare cases) is ordinary income to the extent that prior depreciation is recaptured. This means in the case above, Section 1245 will cause any gain up to to be ordinary income. What happens if the machine is sold for $415,000? The gain is $115,000 [ ordinary gain (Section 1245) and $15,000 capital gain (Section 1231)]. If you sell the property at a loss, recapture is not an issue. If your selling price is between $300,000 and $400,000, all gain is treated as depreciation recapture. Recapture means that some gain which might otherwise be capital gain is reclassified as ordinary income. Congress was more generous with buildings. There is no recapture of depreciation on the sale of real estate under Section 1250 as long as the building was depreciated using the straight-line method. Only excess depreciation (amount exceeding straight-line amount) is recaptured. The law has only allowed straight-line depreciation for buildings since the mid-1980s. (Section 291 provides an exception for corporations see below.) Lets repeat the problem above, except assume the asset is a building (and is sold for $415,000). Since straight-line depreciation has been claimed, none of the past depreciation expense is recaptured. This means that the entire gain of $115,000 is capital gain. However, the past depreciation is called unrecaptured depreciation and the related gain is called Unrecaptured Section 1250 Gain. It is subject to a special capital gains rate of 25% under Section 1(h)(1)(D). [This is for individuals. Corporations do not have special capital gains rates.] That means that a gain of is taxed at 25% and the remaining gain is taxed at 15% tax rate. Additional Special Rules 1. There are special rules for netting gains and losses from casualty losses. 2. Section 291 provides that a corporation recaptures depreciation to the extent that its 1250 recapture (probably zero) would be higher if you used the rules under Section 1245.) Specifically, 20% of unrecaptured depreciation under section 1250 is recaptured if the taxpayer is a corporation. A corporation buys a building for $400,000 and claims (S/L) depreciation of on that building. Then it is sold for $415,000. Twenty percent of the unrecaptured depreciation under Section 1250 is recaptured under Section 291 only for corporations. Recaptured depreciation is $20, If you sell property on the installment basis and collect nothing in the year of sale, any depreciation recapture is recognized as if you sold the property for cash. See Section 453(i). 4. Section Look-Back Rules - Sec. 1231(c) recapture of net ordinary losses. C16-Chap-03-4-Depreciation-Recapture-Summary

5 RECAPTURE OF DEPRECIATION 1221 Depreciable property used in a trade or business, & real property used in a trade or business are not capital assets Capital gain treatment is given to sales, exchanges, or involuntary conversions of depreciable or real property used in a trade or business, if there is a net gain during the year from such sales. (Note rule on non-recaptured sec losses: when you take a 1231 loss, future 1231 gains may be ordinary income.) [Spoils plan to take 1231 losses in one year and 1231 gains in another year: 1245 would give ordinary losses in one year & capital gains in another year.] (Exception to Section 1231) Applies generally to depreciable personal property. Non-residential real property is also covered if accelerated depreciation is used (for very old buildings). All depreciation taken is recaptured (treated as ordinary gain) up to amount of gain on sale Generally applies to depreciable real estate. 291 Excess of: (1) actual depreciation over (2) S/L is recaptured. If S/L is taken, no depreciation is recaptured. (Rule, for individuals, on unrecaptured section 1250 gains: Gain up to unrecaptured depreciation had 25% tax rate.) An exception to Section Compare depreciation recaptured under sec with the depreciation that would be recaptured under 1245, if that applied. Then, 20% of the excess (of what would be recaptured under 1245 over actual 1250 recapture) is also recaptured. Sec. 291 only applies to corporations. C16-Chp-03-5-RECP-Asset Sales--Sec etc