Becker CPA Review Regulation 3 Class Notes

REGULATION 3 CLASS NOTES

This lecture focuses mainly on all aspects of C corporations, depreciation, MACRS and S corporations.
According to the AICPA's Content Specification Outline these items and the items on partnerships,
estates and trusts in R4 should make up between 22% and 28% of your Regulation examination.
C CORPORATIONS, DEPRECIATION, AND MACRS
I.

II.

C CORPORATION FORMATION
A.

Shareholder General Rule No Gain or Loss Recognized if property exchanged for

80% control or if no boot is involved. Adjusted basis in stock = Adjusted basis (NBV) of
property transferred to the corporation plus any gain recognized by the shareholder.

B.

Corporation General Rule No Gain or Loss Recognized. Corporation's basis in the

property contributed is the greater of the shareholder's basis in the property or the debt
assumed.

C CORPORATION - OPERATIONS
A.

This is the most heavily tested area of the exam for corporations.

B.

Book vs. Tax Income Schedule M-1 on page 4 of Form 1120 is where book income is
reconciled to taxable income. There are many different items of income and expense that
are treated differently for GAAP and tax rules. You need to have an understanding of how
this reconciliation is performed.

C.

Form 1120 Familiarize yourself with the form and the different schedules.

D.

Form M-3 A more detailed version of the M-1. It actually shows which items are
permanent differences between book and tax and which are temporary. An example of a
permanent difference is the 50% tax deductibility of meals and entertainment. An example
of a temporary difference is the difference between tax and book depreciation because the
difference between these two items will eventually reverse.

E.

Domestic Production Deduction allows a business to deduct a specific percentage of

their qualified production activities income (QPAI).

F.

G.

1.

The deduction phases in over several years (for 2007-2009, it is a 6% deduction).

2.

QPAI is "Domestic" production gross receipts less cost of goods sold and other
applicable overhead costs.

3.

Domestic production gross receipts are essentially sales of any property produced in
the U.S. including property that is manufactured produced, grown, extracted or
constructed.

Compensation
1.

Executive compensation for a publicly held company is not deductible over

$1,000,000.

2.

Bonuses paid by an accrual basis taxpayer must be paid by 2 1/2 months after yearend in order to be deductible.

Bad Debts = Specific Charge-Off method are permitted for accrual basis taxpayers if
the debt has become worthless which is unlike the treatment for GAAP (allowance
method). Since a cash basis taxpayer has not included the amount in gross income, a bad
debt is not deductible, except in the case of an uncollectible check.

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Becker CPA Review Regulation 3 Class Notes

H.

Business Interest Expense general business interest expense is deductible.

Investment interest expense is limited to "net (taxable) investment income" same rule
as individuals. Prepaid interest expense must be allocated to the period to which it is
related.

I.

Charitable Contributions 10% of adjusted taxable income - taxable income before the
charitable contribution deduction, the dividends received deduction, any net operating loss
carryback, any capital loss carryback, and the US production activities deduction.

J.

Business and Casualty Losses deductible (after insurance reimbursement); no $100

limitation and No 10% AGI limitation. Partially destroyed, the loss is limited to the lesser
of the decline in value or the adjusted basis immediately before the casualty.

K.

Following is a list of items that are treated differently for GAAP and tax purposes and it is
important you understand how and why they are treated differently. This list touches on
some of the more common items, but there are many more listed in the textbook.
1.

Organizational expenditures $5,000 immediately and amortize excess over 180

months.

2.

Goodwill, intangibles Amortize over 15 years.

3.

Life insurance Premiums on key employees when the corporation is the beneficiary
not deductible as a fringe benefit for employees, deductible.

4.

Meals and entertainment 50% deductible.

5.

Penalties and fines not deductible.

6.

Taxes Federal, state and local payroll taxes are deductible. Federal income taxes
not deductible. Foreign income taxes may be used as a credit.

7.

Political and lobbying expenses generally not deductible except direct-type

lobbying of local government.

L.

Capital gains and losses also have very different tax treatment between corporations and
individuals. The $3,000 deduction for losses is not available to corporations, capital gain
tax rates for corporations are the same as the ordinary rates, and net capital losses have a
3-year carryback and a 5-year carryforward. This is a commonly tested area of the
exam.

M.

NOLs 2/20 carryback/forward rule. When determining the NOL, do not take the
charitable contribution deduction but do use the dividends received deduction.

N.

Dividends Received Deduction (DRD) 70% (0% to <20% ownership); 80% (20% to <80%
ownership); 100% (80% or more ownership). The DRD equals the lesser of 70% (or 80%)
dividends received or 70% (or 80%) of taxable income except if you are going to be a loser
i.e., the full DRD will create an NOL, then take the full DRD. Don't take the DRD
personally: Personal service corporations, personal holding companies, and (personally
taxed) S corporations.

O.

Depreciation
1.

Understand (MACRS) Modified Accelerated Cost Recovery System - For property

other than real estate 200% for 3, 5, 7, 10-year property. 150% for 15 and 20-year
property. Half-year convention unless purchase more than 40% of property in the
last quarter than mid-quarter convention. For real estate straight-line 27.5-year
residential and 39-year non-residential. Use mid-month convention.

2.

Section 179 deduction for machinery and equipment $250,000 deduction if

purchased up to $800,000 in machinery and equipment, reduced dollar for dollar on
any purchased in excess of $800,000.

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Becker CPA Review Regulation 3 Class Notes

III.

3.

Depletion and Amortization rules. Cost Depletion = Cost/Estimated resources or

Percentage Depletion 50% of taxable income except for oil or gas then 100%.
Amortization - 15 year straight-line for intangibles. Note that research expenses are
amortized over 60 months.

4.

Section 1231, 1245 and 1250 rules 1231 Net 1231 gain = Capital gain. Net 1231
loss = ordinary loss (fully deductible). 1245 All accumulated depreciation on
machinery and equipment is recaptured as ordinary income. 1250 - Any accelerated
depreciation on real estate in excess of straight-line depreciation is recaptured as
ordinary income.

C CORPORATION - TAXATION
A.

Filing is due on 15th day of 3rd month (March 15th for calendar year taxpayers).

B.

Corporations other than large corporations - can make estimates based on 100% of current
year tax or 100% of preceding year tax. Large corporations can only use 100% of current
year. Estimates are due on the 15th day of the 4th, 6th, 9th and 12th months.

C.

Corporate Alternative Minimum Tax

Regular taxable income
+ or - Adjustments - LIE
+ Preferences - PPP
+ or - ACE - MIND
<AMT NOL Deduction>
Minimum Taxable Income
<AMT Exception>
AMT
X 20%
Gross AMT
<Foreign Tax Credit>
Tentative Minimum Tax
<Regular tax Liability>
AMT

IV.

D.

Accumulated earnings tax is imposed on C corporations whose retained earnings are in

excess of $250,000 if those funds are improperly retained. Personal service corporations
are entitled to only $150,000 of retained earnings.

E.

Personal holding companies are more than 50% owned by 5 or fewer individuals and have
60% of adjusted ordinary gross income consisting of NIRD.

C CORPORATIONS - DISTRIBUTIONS
A.

Cash dividends from a C corporation are taxable to the shareholder who receives the
dividend. Distributions come out of current E&P first = dividends; then out of accumulated
E&P = dividends; then out of stock basis = return of capital (tax free); and then they are
taxed as capital gains.

B.

Stock dividends are generally not taxable to the shareholder (it depends on whether the
shareholder has a choice of receiving cash or other property).

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Becker CPA Review Regulation 3 Class Notes

V.

VI.

C CORPORATION - LIQUIDATION
A.

Generally, with a standard liquidation, the corporation recognizes gain on the sale of assets
and the shareholder recognizes gain to the extent of basis in the stock, which results in
double taxation. Basis in the assets in the shareholders' hands is the FMV.

B.

There are several types of tax-free reorganizations Type A Type F. Because these
events are non-taxable, neither the corporation nor the shareholder recognizes a gain.
Thus, the basis of the assets in the shareholders hands is the adjusted basis (NBV).

C.

Section 1244 stock allows for an ordinary loss up to $50,000 or $100,000 MFJ rather
than a capital loss in the event of a sale or the stock becomes worthless.

S CORPORATION
A.

Small closely held corporations that qualify may elect to be taxed as an S corporation.
Eligible shareholders must be an individual, estate, or trust. Individual shareholders may
not be nonresident aliens. There cannot be more than 100 shareholders and there can
only be one class of voting stock.

B.

If the election is made during the preceding year or any time before the 15th day of the third
month (3/15 for a calendar year taxpayer), the election is effective as of the beginning of
the year.

C.

New shareholders do not need to consent to the S election unless the shareholder owns
more than 50% of the stock.

D.

Three tax situations. Like partnerships, S corporations are generally not subject to
taxation. S corporation income flows through to its shareholders who include these
amounts on their individual returns. Here are three major exceptions.
1.

LIFO Recapture C corporations that elect S status must include in taxable income
for the last C corporation year the excess of inventory computed under FIFO over
LIFO.

2.

Built-in Gains unrealized built-in gains when an S corporation used to be a C

corporation and, upon conversion to an S corporation, the FMV of the corporate
assets exceeds the adjusted basis. Any sale of such assets over a 10-year period
will result in that gain being taxed at the corporate level.

3.

Tax on Passive Investment Income An S corporation is subject to an income tax

at the highest corporate rate on the lesser of net income or excess passive
investment income if the following two tests are met: the S corporation has
accumulated C corporation E&P and passive investment income (dividends, interest,
etc) exceeds 25% of gross receipts.

E.

Like partnerships, S corporations report separately and non-separately stated items - nonseparately = ordinary income. Separately stated include capital gain/losses, interest, rental
income, etc.

F.

Shareholder Basis
B
A
S
E

Initial Basis
+ Income (separately/non-separately stated even non-taxable)
+ Additional shareholder investments
- Distributions to shareholders
- Losses or expenses (even non-deductible)
Ending Basis

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Becker CPA Review Regulation 3 Class Notes

G.

Review Form K-1. This is the form given to shareholders to report to them and to the IRS
the individuals' portion of the S corporation income and expenses.

H.

If the shareholders of an S corporation revoke their election, a new election cannot be

made for five years without the consent of the IRS. S corporation status terminates when
there is a voluntary revocation, the corporation fails to meet the eligibility requirements
(e.g., a nonresident alien shareholder), or more than 25% of the corporation's receipts
come from passive investment income for three consecutive years and the S corporation
has C corporation E&P.

Simulations quite often the examiners will ask candidates to complete a tax form other than the ones
we have included in the review material. Don't panic! Read the form to determine what information is
needed in order to complete the form. Most forms are self explanatory since they need to be used by
all taxpayers. So relax, read the form and fill in the necessary information.

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