Primary considerations in deciding whether or not to incorporate

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Presented by Paystrubmakr.com      By John Wolf and Tom Collen CPA

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There are two primary considerations in deciding whether or not to incorporate,

limited liability and tax benefits. With few exceptions, tax benefits will emerge as

the most important aspect of the decision to incorporate. The tax structure of the

corporation, as well as the effective use of the various fringe benefit, plans available will determine the actual amount of tax savings realized.

Tax Tables

Income tax rates were dramatically impacted by OBRA ’93, with the result that

since 1993, the top corporate income tax rate is less than the top individual income tax rate. This development has made the subchapter S election appear less attractive to many closely held corporations

Old Law

Before the TRA ’86, there were five rates of taxation, which were graduated

in taxable income increments of $25,000, with the lowest rate being 15% and

the highest being 46%:

Taxable Income

$25,000 and Under

$25,001 to $50,000

$50,001 to $75,000

$75,001 to $100,000

Tax Rates

15%

18%

30%

40%

1-23O over $100,000 46%  Surtax

In addition to these rates, a surtax was imposed on all corporations with taxable incomes in excess of $1,000,000. This surtax was equal to the lesser of

5% of all such excess income or $20,250. The effect of the surtax was to impose a flat tax at the maximum rate of 46% on all taxable income.

Reform Act of 1986

Under TRA 86, the corporate rates were lowered considerably. The top corporate rate was 34%, that represented a 12% reduction.

Phantom Bracket: Additionally, the 5% surtax was replaced with a phantom bracket of 39% on all income over $100,000 but less than $335,000.

Above $335,000, the graduated rates no longer applied, and instead, a flat 34% tax rate was imposed on all taxable income.

As a result, corporate taxable income is currently subject to a set of graduated

rates: 15%, 25%, 34%, and 35% 1, with the lower rates applying to firms with lower taxable incomes.

Since smaller firms tend to have lower profits, small firms benefit more often

from the 15% and 25% rates. And since large firms earn the bulk of corporate income, most corporate income is subject to either the 34% or 35% rate.

The benefits of the lower rates are phased out and during the phase-out range,

marginal tax rates are higher because of an additional dollar of income not

only has a direct tax rate but also reduces the benefit of lower rates.

Current Rates

OBRA ’93 increased the top individual rate to 39.6%, but only raised the top corporate rate by one point to 35% on corporations with taxable income in ex-

cess of $10 million. Corporations with taxable income in excess of $15 million

pay an additional tax equal to the lesser of:

(1) 3% of the excess, or

(2) $200,000.

This increase in tax recaptures the benefits of the 34% rate in a manner analogous to the recapture of the benefits of the 15% and 25% rates. Here is how the

current rates look in tabular form:

Taxable Income

Less than $50,000

Tax Rate 15%

There is a 38% rate designed to offset the earlier lower rates and essentially establish a flat 35%

the rate for higher-income corporations.

1-24$50,001 to $75,000

$75,001 to $100,000

$100,001 to $335,000

$335,001 to $10,000,000

$10,000,000 to $15,000,000

$15,000,000 to $18,333,333

Over $18,333,333

25%

34%

39%

34%

35%

38%

35% Flat Rate

The maximum corporate rate is now equal to the current 35% maximum individual rate. That will impact the decision of whether to incorporate or use the S corporation election. However, remember there are many other factors to

be weighed before deciding to incorporate or to revoke any S elec voluntarily already made. Especially with the latter course of action, a taxpayer would

have to wait five years before having the option to re-elect S status again.

Domestic Production Activities

Corporations are taxed at lower rates on income from certain local production activities. This rate reduction is affected by the allowance of a deduction equal to a percentage of qualifying domestic production activities income. The deduction is equal to 9% of the income from manufacturing, construction, and certain other specified activities (§199).

Capital Gains

In contrast to the treatment of capital gains in the individual income tax, no separate rate structure exists for corporate capital gains. Thus, the maximum

rate of tax on the net capital gains of a corporation is 35%. A corporation

may not deduct the number of capital losses in excess of capital gains for any taxable year. Disallowed capital losses may be carried back three years or carried forward five years.

Tax Return & Filing

After 2015, “C” corporations must file a federal tax return by the 15th day of the 4th (not 3 rd ) month after their taxable year ends, using Form 1120.

Affiliated Group

Domestic corporations that are affiliated through 80% or more corporate ownership may elect to file a consolidated return instead of filing separate

returns. Corporations filing a consolidated return are treated as a single corporation; thus, the losses of one corporation can offset the income

(and thus reduce the otherwise applicable tax) of other affiliated corporations.

Alternative Minimum Tax

Before TRA ’86, corporations could be subjected to the add-on minimum tax.

The tax was imposed at the rate of 15% of the amount by which tax preference items exceeded $10,000 or the regular corporate tax liability for the year, which-

ever was greater. TRA ’86 repealed the add-on minimum tax and replaced it with the Alternative

Minimum Tax (AMT). The tax is similar to the AMT, which is imposed on individuals. The current AMT rate is 20% of Alternative Minimum Taxable Income

(AMTI) that is more than the exemption amount of $40,000. This exemption amount is reduced by 25% of the amount by which AMTI exceeds $150,000 with

the result that when AMTI reaches $310,000, the benefit of the exemption amount is lost.

Computation

Alternative minimum taxable income is computed as follows: 

Regular Taxable Income (before NOL deduction)

Plus or Minus AMT Adjustments Under §56 Plus

Tax Preferences Under §57 Equals

Alternative Minimum Taxable Income (AMTI) before AMT NOL deduction Less

AMT NOL deduction (limited to 90%) Equals

Alternative Minimum Taxable Income (AMTI)

Less Exemption Amount

Equals. Alternative Minimum Tax Base

Multiplied by 20% (26% to 28% for individuals) Equals

AMT before AMT Foreign Tax Credit

Less AMT Foreign Tax Credit (possibly limited to 90%)

Equals

Tentative minimum tax

Less, Regular Tax Liability before Credits minus Regular Foreign Tax Credit

Equals Alternative Minimum Tax (§55(a); §55(b))

1-26Regular Tax Deduction – §55(c)

A corporation is subject to an alternative minimum tax that is payable, in addition to all other tax liabilities, to the extent that it exceeds the corporation’s regular income tax liability. Thus, in the calculation of alternative minimum tax, “regular tax” is deducted from “tentative minimum tax.” The regular tax is the

regular tax liability that is used for determining the limitation on various nonrefundable credits reduced by the regular (as opposed to the alternative minimum

tax) foreign tax credit and without including:

(1) The 5-year and 10-year averaging taxes on lump-sum distributions from a qualified retirement plan;

(2) Any investment credit recapture; or

(3) Any recapture of the low-income housing credit.

If a corporation pays the alternative minimum tax, the amount of the tax paid is

allowed as a credit against the regular tax in future years.

Tax Preferences & Adjustments

Alternative minimum taxable income is the corporation’s taxable income increased by the corporation’s tax preferences and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income re-

resulting from the regular tax treatment of those items. Any item that is treated

differently for alternative tax purposes than it is for regular tax purposes is termed a tax preference (§57) or an adjustment (§56; §55(b)(2)(A)). Adjustments

involve a substitution of a special AMT treatment of an item from the regular tax treatment, while a preference involves the addition of the difference between the special AMT treatment and the regular tax treatment.

Some adjustments can be negative (i.e., they result in alternative minimum taxable income that is less than taxable income). Tax preferences cannot be negative amounts. Some tax preferences and adjustments only apply to certain types of taxpayers.

Preferences & Adjustments for All Taxpayers

Depreciation

Note: The TRA ’97 has made regular and AMT depreciation the same in many cases.

Depletion

Mining Costs

Pollution Control Facilities

Incentive Stock Options

Intangible Drilling Costs

Long-term Contracts

Tax-Exempt Interest

Appreciated Charitable Contribution Property

Financial Institutions’ Bad Debts

Alternative Tax Net Operating Loss Deduction

Adjusted Basis of Certain Property

Preferences & Adjustments for Noncorporate Taxpayers & Some Corporations

Circulation Expenditures

Farm Losses

Passive Losses

Preferences & Adjustments for Corporations Only

Untaxed Book Income

Earnings & Profits

Blue Cross/Blue Shield Deduction

Merchant Marine Capital Construction Fund

Adjustments – §56

As the AMT formula shows, taxable income is increased by positive adjustments

and decreased by negative adjustments. Most positive adjustments arise because of timing differences between the AMT and the regular tax related to the Fdeferral of income or acceleration of deductions. When these timing differences reverse, negative adjustments are made.

Other adjustments are based on permanent differences between the AMT and the regular tax. These adjustments are similar to preferences and are always positive.

Business Untaxed Reported Profits (Pre-1990)

An additional positive adjustment is included in determining AMTI for those corporations whose taxable income differs from income used for financial accounting purposes. From 1987 through 1989, one-half of the excess of pretax adjusted net book income over AMTI was a positive adjustment.

Adjusted net book income refers to the net income or loss as shown on the taxpayer’s applicable financial statements, subject to several adjustments

(§56(f)(2)(A) & Temp. Reg. §1.56-IT(b)(2)(i)). This business untaxed reported profits adjustment is treated as a timing adjustment even if it related to a permanent exclusion. Since the business untaxed reported profits adjustment cannot be negative, AMTI is not reduced where adjusted net book income is less than AMTI.

In determining adjusted net book income, the following order of priority was used:

(1) Financial statements filed with the Securities and Exchange Commission,

(2) Certified audited financial statements prepared for nontax purposes,

(3) Financial statements that must be filed with any Federal or other governmental agency,

(4) Financial statements used for credit purposes,

(5) Financial statements provided to shareholders,

(6) Financial statements used for other substantial nontax purposes, and

(7) The corporation’s earnings and profits for the year.

After 1989, the use of pretax book income was replaced by a concept based on adjusted earnings and profits. However, even before 1990, corporations

had to use current adjusted earnings and earnings in determining business un-

taxed reported profits if it did not have any of the statements listed in 1 through 6 above.

ACE Adjustment (Post-1989)

Effective for the tax years start on 12/31/89, the business untaxed reported profits adjustment is replaced with adjusted current earnings (ACE)

adjustment. The ACE is tax-based and can be a negative amount. AMTI is increased by 75% of the excess of ACE over unadjusted AMTI. Or AMTI is

reduced by 75% of the excess of unadjusted AMTI over ACE. The negative

adjustment is limited to the aggregate of the positive adjustments under ACE for prior years reduced by the previously claimed negative adjustments. Thus,

the ordering of the timing differences is crucial because any lost negative adjustment is perpetual. Unadjusted AMTI is AMTI without the ACE adjustment of the AMT NOL (§56(g)(1) & (2)).

ACE should not be confused with current earnings and profits. Although

many items are treated the same, certain items that are deductible in computing revenues and profits (but are not deductible in calculating taxable income) generally are not deductible in computing ACE (e.g., Federal income

taxes).

The starting point for computing ACE is AMTI, which is defined as regular taxable income after AMT adjustments (other than the NOL and ACE adjustments) and tax preferences (§56(g)(3)). The resulting figure is then ad-

justed for the following items to determine ACE:

1. Depreciation: Effective for property placed in service after December 31, 1993, the depreciation component of the adjustment used in computing ACE is eliminated.

2. Exclusion Items: These are income items (net of related expenses) that are included in earnings and profits, but will never be included in the regular

taxable income of AMTI (except on liquidation or disposal of a business). An example would be interest income from tax-exempt bonds.

Exclusion expense items do not include fines and penalties, disallowed golden parachute payments, and the disallowed portion of meals and entertainment expenses.

3. Disallowed items: A deduction is not allowed in computing ACE if it is

never deductible in computing earnings and profits. Thus, the dividends

received deduction, and net operating loss deduction is not allowed.

However, since the starting point for ACE is AMTI before the NOL, no adjustment is necessary for NOL. An exception does allow the 100% dividends received deduction if the payor corporation and recipient corporation are not members of the same affiliated group and an 80% deduction

when a recipient corporation has at least 20% ownership of the payor corporation (§56(g)(4)(C)(i) & (ii)). The exception does not cover dividends received from corporations where the ownership percentage is less than 20%.

4. Miscellaneous Adjustments: The following adjustments, which are re-

quired for regular earnings and profits purposes, are necessary:

(a) Intangible drilling costs,

(b) Construction period carrying charges,

(c) Circulation expenditures,

(d) Mineral exploration and development cost,

(e) Organization expenditures,

(f) LIFO inventory adjustments,

(g) Installment sales, and

(i) Long-term contracts (§312(n)(1) through (6)).

Other special rules apply to disallowed losses on the exchange of debt pools,

acquisition expenses of life insurance companies, depletion, and certain ownership changes.

Small Businesses AMT Exclusion

The tax law imposes a minimum tax on an individual or a corporation to the extent

the taxpayer’s minimum tax liability exceeds its regular tax liability. The individual minimum tax is imposed at rates of 26% and 28% on alternative minimum taxable income above a phased-out exemption amount; the corporate minimum tax is imposed at a rate of 20% on alternative minimum taxable income over a phased-out $40,000 exemption amount. Alternative minimum taxable

income (“AMTI”) is the taxpayer’s taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a

manner that negates the deferral of income resulting from the regular tax treatment of those items. In the case of a corporation, in addition to the regular set of

adjustments and preferences, there is a second set of adjustments known as the

“adjusted current earnings” adjustment. However, for taxable years beginning

after 1997, the TRA ’97 repealed the corporate alternative minimum tax for

“small business corporations.”

Small Business Corporation

A corporation is a small business corporation for its first taxable years beginning after 1997 when it has average gross receipts of no greater than $5 mil-

lion for three consecutive taxable years beginning with the taxable year be-

ginning after December 31, 1994. A corporation that meets the $5 million test continues as a small business corporation so long as its average gross receipts do not exceed $7.5 million.

A corporation that subsequently earns more than $7.5 million of gross receipts becomes subject to the corporate alternative minimum tax, but only for

adjustments and references on transactions and investments entered into after the corporation loses its status as a small business corporation.

Transition Rule

Small businesses that had alternative minimum tax credit carryforwards on August 5, 1997, may utilize their credit to reduce their regular tax liability to

no less than 25% of the amount by which their regular debt exceeds $25,000.

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