Income & Deductions

Rules on income and deductions that apply to individuals also apply, for the most part, to corporations. However, some of the following special provisions apply only to corporations.

Below-Market Loans

A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. A below-market loan generally is treated as an arm's-length transaction in which the borrower is considered as having received both the following:

• A loan in exchange for a note that requires payment of interest at the applicable federal rate, and
• An additional payment.

Treat the additional payment as a gift, dividend, contribution to capital, payment of compensation, or other payment, depending on the substance of the transaction.

See Below-Market Loans in chapter 5 of Publication 535 for more information.

Capital Losses

A corporation can deduct capital losses only up to the amount of its capital gains. In other words, if a corporation has an excess capital loss, it cannot deduct the loss in the current tax year. Instead, it carries the loss to other tax years and deducts it from capital gains that occur in those years.

First, carry a net capital loss back 3 years. Deduct it from any total net capital gain that occurred in that year. If you do not deduct the full loss, carry it forward 1 year (2 years back) and then 1 more year (1 year back). If any loss remains, carry it over to future tax years, 1 year at a time, for up to 5 years. When you carry a net capital loss to another tax year, treat it as a short-term loss. It does not retain its original identity as long-term or short-term.

Example. In 2001, a calendar year corporation has a net short-term capital gain of $3,000 and a net long-term capital loss of $9,000. The short-term gain offsets some of the long-term loss, leaving a net capital loss of $6,000. The corporation treats this $6,000 as a short-term loss when carried back or forward.

The corporation carries the $6,000 short-term loss back 3 years to 1998. In 1998, the corporation had a net short-term capital gain of $8,000 and a net long-term capital gain of $5,000. It subtracts the $6,000 short-term loss first from the net short-term gain. This results in a net capital gain for 1998 of $7,000. This consists of a net short-term capital gain of $2,000 ($8,000 - $6,000) and a net long-term capital gain of $5,000.

S corporation status. A corporation may not carry a capital loss from, or to, a year for which it is an S corporation.

Rules for carryover and carryback. When carrying a capital loss from one year to another, the following rules apply.

• When figuring the current year's net capital loss, you cannot combine it with a capital loss carried from another year. In other words, you can carry capital losses only to years that would otherwise have a total net capital gain.
• If you carry capital losses from 2 or more years to the same year, deduct the loss from the earliest year first.
• You cannot use a capital loss carried from another year to produce or increase a net operating loss in the year to which you carry it back.

Refunds. When you carry back a capital loss to an earlier tax year, refigure your tax for that year. If your corrected tax is less than you originally owed, you can apply for a refund. File Form 1120X to report the corrected tax.

Charitable Contributions

A corporation can claim a limited deduction for charitable contributions made in cash or other property. The contribution is deductible if made to, or for the use of, a qualified organization. For more information on qualified organizations, see Publication 526, Charitable Contributions.

You cannot take a deduction if any of the net earnings of an organization receiving contributions benefit any private shareholder or individual.

Publication 78. You can ask any organization whether it is a qualified organization and most will be able to tell you. Or you can check IRS Publication 78, Cumulative List of Organizations, which lists most qualified organizations. The publication is available on the Internet at www.irs.gov or your local library may have a copy. You can also call Tax Exempt/Government Entities Customer Service at 1-877- 829-5500 to find out if an organization is qualified.

Cash method corporation. A corporation using the cash method of accounting deducts contributions in the tax year paid subject to the limit discussed later.

Accrual method corporation. A corporation using an accrual method of accounting can choose to deduct unpaid contributions for the tax year the board of directors authorizes them if it pays them within 2 1/2 months after the close of that tax year. Make the choice by reporting the contribution on the corporation's return for the tax year. A copy of the resolution authorizing the contribution and a declaration stating that the board of directors adopted the resolution during the tax year must accompany the return. An officer authorized to sign the return must sign the declaration under penalty of perjury.

Limit. A corporation cannot deduct charitable contributions that exceed 10% of its taxable income for the tax year. Figure taxable income for this purpose without the following.

• The deduction for charitable contributions.
• The deduction for dividends received.
• Any net operating loss carryback to the tax year.
• Any capital loss carryback to the tax year.

Carryover of excess contributions. You can carry over, within certain limits, to each of the subsequent five years any charitable contributions made during the current year that exceed the 10% limit. You lose any excess not used within that period. For example, if a corporation has a carryover of excess contributions paid in 2000 and it does not use all the excess on its return for 2001, it can carry the rest over to 2002, 2003, 2004, and 2005. Do not deduct a carryover of excess contributions in the carryover year until after you deduct contributions made in that year (subject to the 10% limit). You cannot deduct a carryover of excess contributions to the extent it increases a net operating loss carryover.

More information. For more information on the charitable contribution deduction, see the instructions for Forms 1120 and 1120-A.

Corporate Preference Items

A corporation must make special adjustments to certain items before it takes them into account in determining its taxable income. These items are known as corporate preference items and they include the following.

• Gain on the disposition of section 1250 property. For more information, see Section 1250 Property under Depreciation Recapture in chapter 3 of Publication 544.
• Percentage depletion for iron ore and coal (including lignite). For more information, see Mines and Geothermal Deposits under Mineral Property in chapter 10 of Publication 535.
• Amortization of pollution control facilities. For more information, see Pollution Control Facilities in chapter 9 of Publication 535 and section 291(a)(5) of the Internal Revenue Code.
• Mineral exploration and development costs. For more information, see Exploration Costs and Development Costs in chapter 8 of Publication 535.

For more information on corporate preference items, see section 291 of the Internal Revenue Code.

Dividends-Received Deduction

A corporation can deduct a percentage of certain dividends received during its tax year. This section discusses the general rules that apply. For more information, see the instructions for Forms 1120 and 1120-A.

Dividends from domestic corporations. A corporation can deduct, within certain limits, 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing corporation's stock, it can, subject to certain limitations, deduct 80% of the dividends received.

Ownership. Determine ownership, for these rules, by the amount of voting power and value of the paying corporation's stock (other than certain preferred stock) the receiving corporation owns.

Small business investment companies. Small business investment companies can deduct 100% of the dividends received from taxable domestic corporations.

Dividends from regulated investment companies. Regulated investment company dividends received are subject to certain limits. Capital gain dividends received from a regulated investment company do not qualify for the deduction. For more information, see section 854 of the Internal Revenue Code.

No deduction allowed for certain dividends. Corporations cannot take a deduction for dividends received from the following entities.

1. A real estate investment trust (REIT).
2. A corporation exempt from tax under section 501 or 521 of the Internal Revenue Code either for the tax year of the distribution or the preceding tax year.
3. A corporation whose stock was held less than 46 days during the 90-day period beginning 45 days before the stock became ex-dividend with respect to the dividend. Ex-dividend means the holder has no rights to the dividend.
4. A corporation whose preferred stock was held less than 91 days during the 180-day period beginning 90 days before the stock became ex-dividend with respect to the dividend if the dividends received are for a period or periods totaling more than 366 days.
5. Any corporation, if your corporation is under an obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.

Dividends on deposits. Dividends on deposits or withdrawable accounts in domestic building and loan associations, mutual savings banks, cooperative banks, and similar organizations are interest, not dividends. They do not qualify for this deduction.

Limit on deduction for dividends. The total deduction for dividends received or accrued is generally limited (in the following order) to:

1. 80% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from 20%-owned corporations, then
2. 70% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from less-than-20%-owned corporations (reducing taxable income by the total dividends received from 20%-owned corporations).

Figuring the limit. In figuring the limit, determine taxable income without the following items.

1. The net operating loss deduction.
2. The deduction for dividends received.
3. Any adjustment due to the nontaxable part of an extraordinary dividend (see Extraordinary Dividends, later).
4. Any capital loss carryback to the tax year.

Effect of net operating loss. If a corporation has a net operating loss (NOL) for a tax year, the limit of 80% (or 70%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 80% (or 70%) of taxable income limit.

Example 1. A corporation loses $25,000 from operations. It receives $100,000 in dividends from a 20%-owned corporation. Its taxable income is $75,000 (($25,000) + $100,000) before the deduction for dividends received. If it claims the full dividends-received deduction of $80,000 ($100,000 × 80%) and combines it with an operations loss of $25,000, it will have an NOL of ($5,000). Therefore, the 80% of taxable income limit does not apply. The corporation can deduct the full 20%, or $80,000.

Example 2. Assume the same facts as in Example 1, except that the corporation only loses $15,000 from operations. Its taxable income is $85,000 before the deduction for dividends received. After claiming the dividends-received deduction of $80,000 ($100,000 × 80%), its taxable income is $5,000. Because the corporation will not have an NOL after applying a full dividends-received deduction, its allowable dividends-received deduction is limited to 80% of its taxable income, or $68,000 ($85,000 × 80%).

Extraordinary Dividends

If a corporation receives an extraordinary dividend on stock held 2 years or less before the dividend announcement date, it generally must reduce its basis in the stock by the nontaxed part of the dividend. The nontaxed part is any dividends-received deduction allowable for the dividends.

Extraordinary dividend. An extraordinary dividend is any dividend on stock that equals or exceeds a certain percentage of the corporation's adjusted basis in the stock. The percentages are:

1. 5% for stock preferred as to dividends, or
2. 10% for other stock.

Treat all dividends received that have ex-dividend dates within an 85-consecutive-day period as one dividend. Treat all dividends received that have ex-dividend dates within a 365-consecutive-day period as extraordinary dividends if the total of the dividends exceeds 20% of the corporation's adjusted basis in the stock.

Disqualified preferred stock. Any dividend on disqualified preferred stock is treated as an extraordinary dividend regardless of the period of time the corporation held the stock.

Disqualified preferred stock is any stock preferred as to dividends if any of the following apply.

1. The stock when issued has a dividend rate that declines (or can reasonably be expected to decline) in the future.
2. The issue price of the stock exceeds its liquidation rights or stated redemption price.
3. The stock is otherwise structured to avoid the rules for extraordinary dividends and to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the disposition of the stock.

These rules apply to stock issued after July 10, 1989, unless it was issued under a written binding contract in effect on that date, and thereafter, before the issuance of the stock.

More information. For more information on extraordinary dividends, see section 1059 of the Internal Revenue Code.

Going Into Business

When you go into business, certain costs you incur to get your business started are treated as capital expenses. See Capital Expenses in chapter 1 of Publication 535 for a discussion of how to treat these costs if you do not go into business.

You can choose to amortize certain costs over a period of 60 months or more. To qualify, the cost must be one of the following.

1. A business start-up cost.
2. An organizational cost.

Business start-up costs. Start-up costs are costs incurred for creating an active trade or business or for investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in connection with an activity engaged in for profit or for the production of income before the trade or business begins, in anticipation of the activity becoming an active trade or business.

Qualifying costs. A start-up cost is amortizable if it meets both of the following tests.

1. It is a cost you could deduct if you paid or incurred it to operate an existing active trade or business (in the same field).
2. It is a cost you pay or incur before the date your active trade or business begins.

Start-up costs include costs for the following:

• Surveys of potential markets.
• Analyses of available facilities, labor, supplies, etc.
• Advertisements for the opening.
• Salaries and wages for employees who are being trained, and their instructors.
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
• Salaries and fees for executives and consultants, or for similar professional services.

Nonqualifying costs. Start-up costs do not include the following.

• Deductible interest.
• Taxes.
• Research and experimental costs.

Purchasing an active trade or business. Amortizable start-up costs include only costs incurred in the course of a general search for, or preliminary investigation of, the business. Investigative costs are costs that help you decide whether to purchase any business and which business to purchase. Alternatively, costs you incur in the attempt to purchase a specific business are capital expenses and you cannot amortize them.

Disposition of business. If you completely dispose of your business before the end of the amortization period, you can deduct any remaining deferred start-up costs to the extent allowable under section 165 of the Internal Revenue Code.

Organizational costs. The costs of organizing a corporation are the direct costs of creating the corporation.

Qualifying costs. You can amortize an organizational cost only if it meets all of the following tests.

1. It is for the creation of the corporation.
2. It is chargeable to a capital account.
3. It could be amortized over the life of the corporation, if the corporation had a fixed life.
4. It is incurred before the end of the first tax year in which the corporation begins business. A corporation using the cash method of accounting can amortize organizational costs incurred within the first tax year, even if it does not pay them in that year.

The following are examples of organizational costs.

• Temporary directors.
• Organizational meetings.
• State incorporation fees.
• Accounting services for setting up the corporation.
• Legal services for items such as drafting the charter, bylaws, terms of the original stock certificates, and minutes of organizational meetings.

Nonqualifying costs. The following costs are not organizational costs. They are capital expenses that you cannot amortize.

• Costs for issuing and selling stock or securities, such as commissions, professional fees, and printing costs.
• Costs associated with the transfer of assets to the corporation.

How to amortize. Deduct start-up and organizational costs in equal amounts over a period of 60 months or more. You can choose an amortizable period for start-up costs that is different from the period you choose for organizational costs, as long as both are not less than 60 months. The amortization period starts with the month you begin business operations. Once you choose an amortization period, you cannot change it.

To figure your deduction, divide your total start-up or organizational costs by the months in the amortization period. The result is the amount you can deduct for each month.

How to make the choice. To choose to amortize start-up or organizational costs, you must attach Form 4562 and an accompanying statement to your return for the first tax year you are in business. If you have both start-up and organizational costs, attach a separate statement to your return for each type of cost.

Generally, you must file your return by the due date (including any extensions). However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the original return (not including extensions). For more information, see the instructions for Part VI of Form 4562.

Once you make the choice to amortize start-up or organizational costs, you cannot change it.

Start-up costs. If you choose to amortize your start-up costs, complete Part VI of Form 4562 and prepare a separate statement that contains the following information.

• A description of the business to which the start-up costs relate.
• A description of each start-up cost incurred.
• The month your active business began (or was acquired).
• The number of months in your amortization period (not less than 60).

You can choose to amortize your start-up costs by filing the statement with a return for any tax year prior to the year your active business begins. If you file the statement early, the choice becomes effective in the month your active business begins.

You can file a revised statement to include any start-up costs not included in your original statement. However, you cannot include on the revised statement any cost you previously treated on your return as a cost other than a start-up cost. You can file the revised statement with a return filed after the return on which you choose to begin amortizing your start-up costs.

Organizational costs. If you choose to amortize your organizational costs, complete Part VI of Form 4562 and prepare a separate statement that contains the following information.

• A description of each cost.
• The amount of each cost.
• The date each cost was incurred.
• The month your active business began (or was acquired).
• The number of months in your amortization period (not less than 60).

The election to amortize must be made by the due date of the return, including extensions.

Related Persons

A corporation that uses an accrual method of accounting cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until the corporation makes the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied under this rule, the rule will continue to apply even if the corporation's relationship with the person ends before the expense or interest is includible in the gross income of that person. These rules also deny the deduction of losses on the sale or exchange of property between related persons.

Related persons. For purposes of this rule, the following persons are related to a corporation.

1. Another corporation that is a member of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
2. An individual who owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
3. A trust fiduciary when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
4. An S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
5. A partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
6. Any employee-owner if the corporation is a personal service corporation (defined later), regardless of the amount of stock owned by the employee-owner.

Ownership of stock. To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

1. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.
2. An individual is treated as owning the stock owned, directly or indirectly, by or for his or her family. Family includes only brothers and sisters (including half brothers and half sisters), a spouse, ancestors, and lineal descendants.
3. Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual's partner.
4. To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Personal service corporation. For this purpose, a corporation is a personal service corporation if it meets all of the following requirements.

1. It is not an S corporation.
2. Its principal activity is performing personal services. Personal services are those performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and performing arts.
3. Its employee-owners substantially perform the services in (2).
4. Its employee-owners own more than 10% of the fair market value of its outstanding stock.

Reallocation of income and deductions. Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly, or indirectly, by the same interests.

Complete liquidations. The disallowance of losses from the sale or exchange of property between related persons does not apply to liquidating distributions.

More information. For more information about the related person rules, see Publication 544.

U.S. Real Property Interest

If a domestic corporation acquires a U.S. real property interest from a foreign person or firm, the corporation may have to withhold tax on the amount it pays for the property. The amount paid includes cash, the fair market value of other property, and any assumed liability. If a domestic corporation distributes a U.S. real property interest to a foreign person or firm, it may have to withhold tax on the fair market value of the property. A corporation that fails to withhold may be liable for the tax, and any penalties and interest that apply. For more information, see U.S. Real Property Interest in Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

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