us internal revenue service: p542--1998

8/14/2019 US Internal Revenue Service: p542--1998

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ContentsIntroduction ........................................ 1

Important Change for 1998 ............... 2

Important Reminders ......................... 2

Business Taxed as a Corporation .... 2

Nontaxable Exchange of Property forStock ............................................. 2

Capital Contributions ......................... 3

Paying and Filing Income Taxes ...... 3Estimated Tax ................................. 3Income Tax Returns ....................... 4

Income and Deductions .................... 5Below-Market Loan ......................... 5Capital Losses ................................ 5Charitable Contributions ................. 5Corporate Preference Items ........... 6Dividends-Received Deduction ....... 6Extraordinary Dividends .................. 7Going Into Business ....................... 7Related Persons ............................. 8

U.S. Real Property Interest ............ 8

Figuring Taxable Income ................... 8Net Operating Losses ..................... 8At-Risk Limits .................................. 8Passive Activity Limits .................... 8

Figuring Tax ........................................ 9Tax Rate Schedule ......................... 9Credits ............................................. 9Recapture Taxes ............................ 9Alternative Minimum Tax (AMT) ..... 9

Accumulated Earnings Tax ............... 10

Reconciliation Statements ................ 10Schedule M1 ................................. 10Schedule M2 ................................. 11Earnings and Profits Computations 11

Distributions ....................................... 13Amount of Distribution .................... 13Distributions of Appreciated

Property ................................... 13Taxable Status of Distribution ........ 13Adjustment to Earnings and Profits 14Distribution of Stock and Stock

Rights ....................................... 14Constructive DividendsInsurance

Premiums ................................. 14

Sample Returns .................................. 15Form 1120A (Short Form) ............ 15Form 1120 ...................................... 18

How To Get More Information .......... 24

Index .................................................... 25

IntroductionThis publication discusses the general taxlaws that apply to ordinary domestic corpo-rations. It explains the tax law in plain lan-guage so that it will be easier to understand.However, the information provided does notcover every situation, replace the law, orchange its meaning.

Departmentof theTreasury

InternalRevenueService

Publica tion 54 2Cat. No. 15072O

CorporationsFor use in preparing

1998 Returns


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Some corporations may meet the quali-fications for electing to be S corporations. Forinformation on S corporations, see the in-structions for Form 1120S.

See the sample filled-in Forms 1120 and1120A near the end of this publication.

Important Changefor 1998No alternative minimum tax (AMT) forsmall corporations. For tax years beginningafter 1997, the tentative minimum tax of asmall corporation is zero. This means that asmall corporation will not owe AMT.

For AMT purposes, a corporation is asmall corporation if it meets any of the fol-lowing tests.

1) This is its first tax year.

2) This is its second tax year and its annualgross receipts for its first tax year werenot more than $5,000,000.

3) This is its third tax year and its averageannual gross receipts for its first two taxyears were not more than $5,000,000.

4) This is its fourth tax year and its averageannual gross receipts for its first threetax years were not more than$5,000,000.

5) This is its fifth or later tax year and itmeets both of the following tests.

a) Its average annual gross receiptsfor its first 3-tax-year period begin-ning after 1993 were not more than$5,000,000.

b) Its average annual gross receiptsfor all later 3-tax-year periods be-ginning after 1993 and ending be-

fore the current tax year were notmore than $7,500,000.

For these tests, gross receipts for a short taxyear are annualized.

For more information on the AMT, seeAlternative Minimum Tax (AMT).

Important RemindersUnresolved tax problems. The Problem Resolution Program (PRP), which is ad-ministered by the Taxpayer Advocate, is fortaxpayers who have been unable to resolvetheir problems with the IRS. If you have a taxproblem you cannot clear up through normalchannels, you can call the IRS at 1877 7774778 for PRP assistance. If you prefer,you can write to the office that last contactedyou (or your local district director) and ask forPRP assistance. If you have access toTTY/TDD equipment, you can call 1800 8294059 to obtain this assistance.

Although the PRP office cannot changethe tax law or a technical tax decision, it canclear up problems that resulted from previouscontacts and ensure your case is given acomplete and impartial review. For more in-formation, see Publication 1546, The Problem Resolution Program of the Internal Revenue Service.

Comments on IRS enforcement actions.The Small Business and Agricultural Regula-tory Enforcement Ombudsman and 10 Re-gional Fairness Boards were established toreceive comments from small business aboutfederal agency enforcement actions. TheOmbudsman will annually evaluate theenforcement activities and rate each agency'sresponsiveness to small business. If you wishto comment on the enforcement actions of theIRS, call 18887343247.

Useful ItemsYou may want to see:

Publication

526 Charitable Contributions

535 Business Expenses

536 Net Operating Losses

544 Sales and Other Dispositions ofAssets

925 Passive Activity and At-Risk Rules

946 How To Depreciate Property

Form (and Instructions)

1120 U.S. Corporation Income Tax Re-turn

1120A U.S. Corporation Short-FormIncome Tax Return

1120W (WORKSHEET) Estimated Taxfor Corporations

1120X Amended U.S. Corporation In-come Tax Return

2220 Underpayment of Estimated Taxby Corporations

3800 General Business Credit

4562 Depreciation and Amortization

4626 Alternative MinimumTaxCorporations

5452 Corporate Report of NondividendDistributions

7004 Application for Automatic Exten-sion of Time To File CorporationIncome Tax Return

8832 Entity Classification ElectionSee How To Get More Information near

the end of this publication for informationabout getting publications and forms.

Business Taxed as aCorporationThe rules you must use to determine whethera business is taxed as a corporation changedfor businesses formed after 1996.

Business formed before 1997. A businessformed before 1997 and taxed as a corpo-ration under the old rules will generally con-tinue to be taxed as a corporation.

Business formed after 1996. The followingbusinesses formed after 1996 are taxed ascorporations.

1) A business formed under a federal orstate law that refers to it as a corpo-ration, body corporate, or body politic.

2) A business formed under a state law thatrefers to it as a joint-stock company or

joint-stock association.

3) An insurance company.

4) Certain banks.

5) A business wholly owned by a state orlocal government.

6) A business specifically required to betaxed as a corporation by the InternalRevenue Code. (For example, certain

publicly traded partnerships.)7) Certain foreign businesses.

8) Any other business that elects to betaxed as a corporation by filing Form8832.

For more information, see the instructions forForm 8832.

Nontaxable Exchangeof Property for StockIf you transfer property (or money and prop-erty) to a corporation in exchange for stock inthat corporation (other than nonqualified pre-ferred stock, described later), and imme-diately afterwards you are in control of thecorporation, the exchange is usually not tax-able. This rule applies both to individuals andto groups who transfer property to a corpo-ration. It also applies whether the corporationis being formed or is already operating. Itdoes not apply in the following situations.

The corporation is an investment com-pany.

You transfer the property in a bankruptcyor similar proceeding in exchange forstock used to pay creditors.

The stock is received in exchange for thecorporation's debt (other than a security),or for interest on the corporation's debt(including a security) that accrued whileyou held the debt.

If this provision applies to you, you mustattach to your return a complete statementof all facts pertinent to the exchange.

Control of a corporation. To be in controlof a corporation, you or your group of trans-ferors must own, immediately after the ex-change, at least 80% of the total combinedvoting power of all classes of stock entitled tovote and at least 80% of the outstandingshares of each class of nonvoting stock.

Example 1. You and Bill Jones purchaseproperty for $100,000. You both organize acorporation when the property has a fairmarket value of $300,000. You transfer theproperty to the corporation for all its author-ized capital stock, which has a par value of$300,000. No gain is included in income byyou, Bill, or the corporation.

Example 2. You and Bill transfer theproperty having a basis of $100,000 to acorporation in exchange for stock having afair market value of $300,000. This representsonly 75% of each class of stock of the cor-poration. The other 25% already was issuedto someone else. You and Bill recognize ataxable gain of $200,000 on the transaction.

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Services rendered. The term property doesnot include services rendered or to be ren-dered to the issuing corporation. The valueof stock received for services is income to therecipient.

Example. You transfer property worth$35,000 and render services valued at $3,000to a corporation in exchange for stock valuedat $38,000. Right after the exchange you own85% of the outstanding stock. No gain is in-cluded in income on the exchange of prop-erty. However, you recognize ordinary incomeof $3,000 as payment for services you ren-dered to the corporation.

Property of relatively small value. Theterm property does not include property of arelatively small value when it is compared tothe value of stock and securities alreadyowned or to be received for services by thetransferor, if the main purpose of the transferis to qualify for the nonrecognition of gain orloss by other transferors.

Property transferred will not be consideredto be of relatively small value if its fair marketvalue is at least 10% of the fair market valueof the stock and securities already owned orto be received for services by the transferor.

Stock received in disproportion to prop-erty transferred. If a group of transferorsexchange property for corporate stock, eachtransferor does not have to receive stock inproportion to his or her interest in the propertytransferred. If a disproportionate transfertakes place, it will be treated for tax purposesin accordance with its true nature. It may betreated as if the stock were first received inproportion and then some of it used to makegifts, pay compensation for services, or sat-isfy the transferor's obligations.

Money or other property received. If, in anotherwise nontaxable exchange of propertyfor corporate stock, you also receive money

or property other than stock, you may havea taxable gain. You are taxed only up to theamount of money plus the fair market valueof the other property you receive. The rulesfor figuring the taxable gain in this situationgenerally follow those for a partially nontaxa-ble exchange discussed in Publication 544under Like-Kind Exchanges. If the propertyyou give up includes depreciable property, thetaxable gain may have to be reported as or-dinary income because of depreciation. Noloss is recognized. See chapter 3 of Publica-tion 544.

Nonqualified preferred stock. Nonqualifiedpreferred stock is treated as property otherthan stock. Generally, this applies to preferred

stock with one or more of the following fea-tures.

The holder has the right to require theissuer or a related person to redeem orpurchase the stock.

The issuer or a related person is requiredto redeem or purchase the stock.

The issuer or a related person has theright to redeem the stock and, on the is-sue date it is more likely than not that theright will be exercised.

The dividend rate on the stock varies withreference to interest rates, commodityprices, or similar indices.

For a detailed definition of nonqualified pre-ferred stock, see section 351(g)(2) of theInternal Revenue Code.

Liabilities. If the corporation assumes yourliabilities, or the property is taken subject toa liability, the exchange is not generallytreated as if you received money or otherproperty. There are two exceptions to thistreatment.

1) If the liabilities the corporation assumesare more than your adjusted basis in theproperty you transfer, gain is recognizedup to the amount of the excess. How-ever, if the liabilities assumed give riseto a deduction when paid, such as atrade account payable or interest, nogain is recognized.

2) If there is no good business reason forthe corporation to assume your liabilities,or if your main purpose in the exchangeis to avoid federal income tax, the as-sumption is treated as if you receivedmoney in the amount of the liabilities.

Example. You transfer property to a cor-poration for stock. You also receive $10,000in the exchange. Your adjusted basis in the

transferred property is $20,000. The stockyou receive has a fair market value (FMV) of$16,000. The corporation also assumes a$5,000 mortgage on the property. Gain is re-alized as follows:

The liability assumed is not treated asmoney or other property. Therefore, the rec-ognized gain is limited to $10,000, the amountof cash received.

Loss on exchange. If you have a loss froman exchange and own, directly or indirectly,more than 50% of the corporation's stock, youcannot deduct the loss. This is true even ifyou do not control the corporation (own lessthan 80% of its stock). For more information,see Sales and Exchanges Between Related Parties and its discussion Nondeductible Loss in chapter 2 of Publication 544.

Basis of stock or other property received.The basis of the stock you receive is generallythe adjusted basis of the property you trans-fer. Increase this amount by any amount thatwas treated as a dividend, plus any gain rec-ognized on the exchange. Decrease thisamount by any cash you received, the fairmarket value of any other property you re-ceived, and any loss recognized on the ex-change. Also decrease this amount by theamount of any liability the corporation as-sumed or acquired from you, unless paymentof the liability gives rise to a deduction whenpaid.

The basis of any other property you re-ceive is its fair market value on the date of thetrade.

Basis of property transferred. A corpo-ration that receives property from you in ex-change for its stock has the same basis youhad in the property increased by any gain yourecognized on the exchange.

Capital ContributionsThis section explains the tax treatment ofcontributions from shareholders and non-shareholders.

Paid-in capital. Contributions to the capitalof a corporation, whether or not by share-holders, are paid-in capital. These contribu-tions are not taxable to the corporation.

However, contributions to a corporation in

aid of construction or any other contributionas a customer or potential customer is taxableto the corporation.

Basis. The basis of property contributed tocapital by a shareholder is the same as thebasis the shareholder had in the property in-creased by any gain recognized on the ex-change.

The basis of property contributed to capitalby a person other than a shareholder is zero.

If a corporation receives a cash contribu-tion from a person other than a shareholder,reduce the basis of property acquired with themoney during the 12-month period beginningon the day it received the contribution by theamount of the contribution. If the amount

contributed is more than the cost of theproperty acquired, then reduce, but not belowzero, the basis of the other properties heldby the corporation on the last day of the12-month period in the following order.

1) Depreciable property.

2) Amortizable property.

3) Property subject to cost depletion but notto percentage depletion.

4) All other remaining properties.

Reduce the basis of property in a categoryto zero before going to the next category.

There may be more than one piece ofproperty in each category. Base the re-

duction of the basis of each property on theratio of the basis of each piece of property tothe total bases of all property in that category.If the corporation wishes to make this adjust-ment in some other way, it must get IRSconsent. The corporation files a request forconsent with its income tax return for the taxyear in which it receives the contribution.

Paying and FilingIncome TaxesThe federal income tax is a pay-as-you-gotax. A corporation generally must make esti-mated tax payments as it earns or receivesincome during its tax year. After the end of theyear, the corporation must file an income taxreturn. This section will help you determinewhen and how to pay and file corporate in-come taxes.

Estimated TaxGenerally, a corporation must make install-ment payments of estimated tax if it expectsits estimated tax (income tax minus credits)to be $500 or more. If the corporation doesnot pay the installments when they are due,it may be subject to an underpayment pen-alty. This section will explain how to avoid thispenalty.

FMV of stock received ............................... $16,000Cash received ............................................ 10,000Liability assumed by corporation ............... 5,000Total received ............................................ $31,000Minus: Adjusted basis ofproperty transferred ................................... 20,000Realized gain ............................................ $11,000

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When to pay estimated tax. Installmentpayments of estimated tax are due by the15th day of the 4th, 6th, 9th, and 12th monthsof the corporation's tax year.

Example 1. Your corporation's tax yearends December 31. Installment payments ofestimated tax are due on April 15, June 15,September 15, and December 15.

Example 2. Your corporation's tax yearends June 30. Installment payments of esti-mated tax are due on October 15, December

15, March 15, and June 15.If any date falls on a Saturday, Sunday,

or legal holiday, the installment is due on thenext regular business day.

How to figure each required installment.Use Form 1120W as a worksheet to figureeach required installment of estimated tax.You will generally use one of the following twomethods to figure each required installment.You should use the method that requires thesmallest installment payments.

Note: In these discussions, return gen-erally refers to the corporation's original re-turn. However, an amended return is consid-ered the original return if the amended returnis filed by the due date (including extensions)of the original return.

Method 1. Each required installment is25% of the income tax the corporation willshow on its return for the current year.

Method 2. Each required installment is25% of the income tax shown on the corpo-ration's return for the previous year.

To use Method 2:

1) The corporation must have filed a returnfor the previous year,

2) The return must have been for a full 12months, and

3) The return must have shown a positive

tax liability (not zero).Also, if the corporation is a large corporation,it can use Method 2 to figure only the firstinstallment.

A large corporation is one with at least $1million of modified taxable income in any ofthe last 3 years. Modified taxable income istaxable income figured without net operatingloss or capital loss carrybacks or carryovers.

Other methods. If a corporation's incomeis expected to vary during the year because,for example, its business is seasonal, it maybe able to lower the amount of one or morerequired installments by using one or both ofthe following methods.

1) The annualized income installmentmethod.

2) The adjusted seasonal installmentmethod.

Use Schedule A of Form 1120W to see ifusing one or both of these methods will lowerthe amount of one or more required install-ments.

Refiguring required installments. If af-ter the corporation figures and deposits esti-mated tax, it finds that its tax liability for theyear will be much more or less than originallyestimated, it may have to refigure its requiredinstallments. If earlier installments wereunderpaid, the corporation may owe anunderpayment penalty.

An immediate catchup payment should bemade to reduce the amount of any penaltyresulting from the underpayment of any ear-lier installments, whether caused by a changein an estimate, not making a deposit, or amistake.

Underpayment penalty. If the corporationdoes not pay a required installment of esti-mated tax by its due date, it may be subjectto a penalty. The penalty is figured separatelyfor each installment due date. The corporationmay owe a penalty for an earlier due date,even if it paid enough tax later to make up theunderpayment. This is true even if the cor-poration is due a refund when its return isfiled.

Form 2220. Use Form 2220 to determineif a corporation is subject to the penalty forunderpayment of estimated tax and, if so, theamount of the penalty.

If the corporation is charged a penalty, theamount of the penalty depends on the fol-lowing three factors.

1) The amount of the underpayment.

2) The period during which the underpay-ment was due and unpaid.

3) An interest rate that is published quar-

terly by the IRS in the Internal RevenueBulletin.

A corporation generally does not have tofile Form 2220 with its income tax return be-cause the IRS will figure any penalty and billthe corporation. However, even if the corpo-ration does not owe a penalty, complete andattach the form to the corporation's tax returnif:

1) The annualized income installmentmethod was used to figure any requiredinstallment,

2) The adjusted seasonal installmentmethod was used to figure any requiredinstallment, or

3) The corporation is a large corporationand Method 2 was used to figure its firstrequired installment.

How to pay estimated tax. Unless you vol-unteer to or are required to make electronicdeposits, you should mail or deliver yourpayment with a completed Form 8109 to anauthorized financial institution or to the Fed-eral Reserve Bank for your area. For moreinformation, see the instructions for Form1120W.

Electronic deposits. Use the Electronic Federal Tax Payment System (EFTPS) tomake electronic deposits of tax. A corporationis required to use EFTPS for the following taxpayments.

For all tax payments due after June 1997,if the corporation's total deposits of socialsecurity, Medicare, and withheld incometaxes were more than $50,000 in 1995.

For all tax payments due after 1997, if thecorporation's total deposits of social se-curity, Medicare, and withheld incometaxes were more than $50,000 in 1996.

For all tax payments due after 1998, if thecorporation's total deposits of social se-curity, Medicare, and withheld incometaxes were more than $50,000 in 1997.

If you are required to use EFTPS and do notdo so, you may be subject to a penalty. If you

are not required to use EFTPS, you may vol-unteer to do so.

To enroll in EFTPS, call18009458400 or 1800555 4477. For general information about

EFTPS, call 18008291040.

Quick refund of overpayments. Any cor-poration that overpaid its estimated tax for thetax year may be able to apply for a quick re-fund of the overpayment.

Form 4466. Use Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, to apply for a quick refundof an overpayment of estimated tax if theoverpayment is:

At least 10% of the expected tax liability,and

At least $500.

Use Form 4466 as a worksheet to figure thecorporation's expected tax liability and theoverpayment of estimated tax.

File Form 4466 after the end of the cor-poration's tax year but before:

1) The 16th day of the 3rd month after theend of the tax year, and

2) The corporation files its income tax re-turn.

An extension of time to file the corporation'sincome tax return will not extend the time forfiling Form 4466. The IRS will act on the formwithin 45 days from the date you file it.

Income Tax ReturnsThis section will help you determine when andhow to report a corporation's income tax.

Who must file. Unless exempt under section501 of the Internal Revenue Code, all do-mestic corporations (including corporations inbankruptcy) must file an income tax return

whether or not they have taxable income.What form to file. A corporation must gen-erally file Form 1120 to report its income,gains, losses, deductions, credits, and to fig-ure its income tax liability. However, a corpo-ration may file Form 1120A if its gross re-ceipts, total income, and total assets are eachunder $500,000 and it meets certain otherrequirements. Also, certain organizationsmust file special returns. For more informa-tion, see the instructions for Forms 1120 and1120A.

When to file. Generally, a corporation mustfile its income tax return by the 15th day of the3rd month after the end of its tax year. A newcorporation filing a short-period return mustgenerally file by the 15th day of the 3rd monthafter the short period ends. A corporation thathas dissolved must generally file by the 15thday of the 3rd month after the date it dis-solved.

Example 1. A corporation's tax year endsDecember 31. It must file its income tax returnby March 15th.

Example 2. A corporation's tax year endsJune 30. It must file its income tax return bySeptember 15th.

If the due date falls on a Saturday, Sun-day, or legal holiday, the corporation may fileon the next business day.

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Extension of time to file. File Form 7004 to request a 6-month extension of timeto file a corporation's income tax return. TheIRS will grant the extension if the corporationcompletes the form properly, files it, and paysany balance due by the due date for the re-turn for which the extension applies.

Form 7004 does not extend the time forpaying the tax due on the return. Interest willbe charged on any part of the final tax duenot shown as a balance due on Form 7004.The interest is figured from the original duedate of the return to the date of payment.

For more information, see the instructionsfor Form 7004.

Penalty for late filing of return. A corpo-ration that does not file its tax return by thedue date, including extensions, may be pe-nalized 5% of the unpaid tax for each monthor part of a month the return is late, up to amaximum of 25% of the unpaid tax. If thecorporation is charged a penalty for late pay-ment of tax (discussed next) for the sameperiod of time, this penalty is reduced by theamount of that penalty. The minimum penaltyfor a return that is over 60 days late is thesmaller of the tax due or $100. The penaltywill not be imposed if the corporation canshow that the failure to file on time was dueto a reasonable cause. Corporations that filelate must attach a statement explaining thereasonable cause.

Penalty for late payment of tax. A corpo-ration that does not pay the tax when duemay be penalized 1 / 2 of 1% of the unpaid taxfor each month or part of a month the tax isnot paid, up to a maximum of 25% of the un-paid tax. The penalty will not be imposed ifthe corporation can show that the failure topay on time was due to a reasonable cause.However, this penalty does not apply to latepayments of required installments of esti-mated tax.

Trust fund recovery penalty. If income,

social security, and Medicare taxes that acorporation must withhold from employeewages are not withheld or are not depositedor paid to the IRS, the trust fund recoverypenalty may apply. The penalty is the fullamount of the unpaid trust fund tax. Thispenalty may apply to you if these unpaidtaxes cannot be immediately collected fromthe business.

The trust fund recovery penalty may beimposed on all persons who are determinedby the IRS to be responsible for collecting,accounting for, and paying over these taxes,and who acted willfully in not doing so.

A responsible person can be an officeror employee of a corporation, an accountant,or a volunteer director/trustee. A responsibleperson also may include one who signschecks for the corporation or otherwise hasauthority to cause the spending of businessfunds.

Willfully means voluntarily, consciously,and intentionally. A responsible person actswillfully if the person knows the requiredactions are not taking place.

For more information on withholding andpaying these taxes, see Publication 15, Cir- cular E, Employer's Tax Guide.

Amended return. Use Form 1120X to cor-rect any error in a Form 1120 or Form 1120Aas originally filed, or as later adjusted by anamended return, a claim for refund, or anexamination.

Income andDeductionsRules on income and deductions that applyto individuals also apply, for the most part, tocorporations. However, some of the followingspecial provisions apply only to corporations.

Below-Market LoanIf a corporation issues a shareholder or anemployee a below-market loan, the corpo-ration reports additional income.

A below-market loan is a loan which pro-vides for no interest or interest at a rate belowthe federal rate that applies. Treat a below-market loan as an arm's-length transaction inwhich the lender is considered to have made:

1) A loan to the borrower in exchange fora note that requires payment of interestat the applicable federal rate, and

2) A payment to the borrower.

Treat the lender's payment to the borroweras a gift, dividend, contribution to capital,payment of wages, or other payment, de-pending on the substance of the transaction.

See Below-Market Interest Rate Loans inchapter 8 of Publication 535 for more infor-mation.

Capital LossesA corporation can deduct capital losses onlyup to its capital gains. In other words, if acorporation has a net capital loss, it cannotdeduct the loss in the current tax year. Itcarries the loss to other tax years and deductsit 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 whichoccurred in that year. If you do not deduct thefull loss, carry it forward 1 year (2 years back)and then 1 more year (1 year back). If anyloss remains, carry it over to future tax years,1 year at a time, for up to 5 years. When youcarry a net capital loss to another tax year,treat it as a short-term loss. It does not retainits original identity as long term or short term.

Example. In 1998, a corporation has anet short-term capital gain of $3,000 and anet long-term capital loss of $9,000. Theshort-term gain offsets some of the long-termloss, leaving a net capital loss of $6,000. Ittreats this $6,000 as a short-term loss whencarried back or forward.

The corporation carries the $6,000 short-term loss back 3 years to 1995. In 1995, thecorporation had a net short-term capital gainof $8,000 and a net long-term capital gain of

$5,000. It subtracts the $6,000 short-term lossfrom 1998 first from the net short-term gain.This results in a net capital gain for 1995 of$7,000. This consists of a net short-termcapital gain of $2,000 ($8,000 $6,000) anda net long-term capital gain of $5,000.

S corporation status. A corporation maynot carry a capital loss from, or to, a year forwhich it is an S corporation.

Rules for carryover and carryback. Whencarrying a capital loss from one year to an-other, the following rules apply.

When figuring this year's net capital loss,you cannot use any capital loss carried

from another year. In other words, youmay only carry capital losses to years thatwould otherwise have a total net capitalgain.

If you carry capital losses from 2 or moreyears to the same year, deduct the lossfrom the earliest year first. When youfully deduct that loss, deduct the lossfrom the next earliest year, and so on.

You cannot use a capital loss carriedfrom another year to produce or increasea net operating loss in the year to whichyou carry it.

Refunds. When you carry back a capital lossto an earlier tax year, refigure your tax for thatyear. If your corrected tax is less than youoriginally owed, you may apply for a refund.File Form 1120X.

Charitable ContributionsA corporation can claim a limited deductionfor any charitable contributions made in cashor other property. The contribution is deduct-ible if made to or for the use of a qualifiedorganization. For more information on qual-ified organizations, see Publication 526.

You cannot take a deduction if any of thenet earnings of an organization receivingcontributions benefit any private shareholderor individual.

Publication 78. You can ask any organiza-tion whether it is a qualified organization, andmost will be able to tell you. Or you can checkIRS Publication 78, Cumulative List of Or- ganizations, which lists most qualified organ-izations. You may find Publication 78 in yourlocal library's reference section. If not, youcan call the IRS tax help telephone numbershown for your area in your tax package tofind out if an organization is qualified.

You can find an electronic version ofPublication 78 on the IRS Home Pageat www.irs.ustreas.gov/prod/bus_info/

eo/eosearch.html.

Cash method corporation. A corporationusing the cash method of accounting candeduct contributions only in the tax year paid.

Accrual method corporation. A corporationusing an accrual method of accounting canchoose to deduct unpaid contributions for thetax year the board of directors authorizesthem if it pays them within 2 1 / 2 months afterthe close of that tax year. Make the choiceby reporting the contribution on the corpo-ration's return for the tax year. A copy of theresolution authorizing the contribution and adeclaration stating the board of directorsadopted the resolution during the tax yearmust accompany the return. An officer au-thorized to sign the return must sign the dec-laration under penalties of perjury.

Limit. A corporation cannot deduct as chari-table contributions for a tax year more than10% of its taxable income. Figure taxable in-come for this purpose without the following.

Deduction for contributions. Deductions for dividends received and

dividends paid.

Any net operating loss carryback to thetax year.

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Any capital loss carryback to the tax year.

Carryover of excess contributions. Youcan carry over (with certain limits) any chari-table contributions made during the year thatare more than the 10% limit to each of thefollowing 5 years. You lose any excess notused within that period. For example, if acorporation has a carryover of excess contri-butions paid in 1997 and it does not use allthe excess on its return for 1998, it can carrythe rest over to 1999, 2000, 2001, and 2002.

Do not deduct a carryover of excess contri-butions in the carryover year until after youdeduct contributions made in that year (sub-

ject to the 10% limit). You cannot deduct acarryover of excess contributions to the extentit increases a net operating loss carryover toa succeeding tax year.

Corporate Preference ItemsTax law gives special treatment to someitems of income and deduction called adjust-ments or tax preference items. They mayresult in an additional tax called the alterna-tive minimum tax (discussed later). The cor-poration adjusts the following items before ittakes them into account in determining itstaxable income.

Section 1250 capital gain treatment.Generally, for section 1250 property dis-posed of during the tax year, 20% of anyexcess of (a) the amount that would beordinary income if the property was sec-tion 1245 property over (b) the amounttreated as ordinary income under section1250, must be recognized as ordinaryincome under section 1250.

Section 1250 property. This includesall real property that is subject to an al-lowance for depreciation and that is notand never has been section 1245 prop-erty.

Section 1245 property. This includes

any property that is or has been subjectto an allowance for depreciation, if theproperty is either personal property orother section 1245 property described inchapter 3 of Publication 544.

Percentage depletion. For iron ore andcoal (including lignite), reduce the allow-able percentage depletion deduction by20% of any excess of (a) the percentagedepletion deduction allowable for the taxyear (determined without this adjust-ment), over (b) the adjusted basis of thedepletable property at the close of the taxyear (figured without the depletion de-duction for the tax year).

Pollution control facilities. Reduce the

amortizable basis of pollution control fa-cilities by 20% in determining the amorti-zation deduction for that property.

Mineral exploration and development costs. Reduce the allowable deductionfor these costs by 30%. Special rulesapply to the amount not allowed becauseof this adjustment. This reduction alsoapplies to the intangible drilling costs of an integrated oil company. See section291(b) of the Internal Revenue Code formore information.

These adjustments apply to all corporations.However, they do not apply to an S corpo-ration unless it or a predecessor was a C

corporation for any of the 3 immediately pre-ceding tax years.

Dividends-ReceivedDeductionA corporation can deduct a percentage ofcertain dividends received during its tax year.

Dividends from domestic corporations. Acorporation can deduct, with certain limits,70% of the dividends received if the corpo-ration receiving the dividend owns less than20% of the distributing corporation.

20%-or-more owners allowed 80% deduction. A corporation can deduct, withcertain limits, 80% of the dividends receivedor accrued if it owns 20% or more of thepaying domestic corporation. The payingcorporation is a 20%-owned corporation.

Ownership. Determine ownership, forthese rules, by the amount of voting powerand value of the paying corporation's stock(other than certain preferred stock) the re-ceiving corporation owns.

Dividends on debt-financed portfolio stock. For dividends received on debt-financed portfolio stock of domestic corpo-rations, reduce the 70% or 80% dividends-

received deduction. Reduce the deduction bya percentage related to the amount of debtincurred to purchase the stock. This appliesto stock whose holding period begins afterJuly 18, 1984. For more information, seesection 246A of the Internal Revenue Code.

Small business investment companies.Small business investment companies candeduct 100% of the dividends received froma taxable domestic corporation.

Affiliated corporations. Members of an af-filiated group of corporations can deduct100% of the dividends received from a mem-ber of the same affiliated group if they meetcertain conditions. See section 243 of theInternal Revenue Code for the definition ofan affiliated group of corporations.

Dividends from regulated investmentcompany. Regulated investment companydividends received are subject to certain lim-its. Capital gain dividends do not qualify forthe deduction. For more information, seesection 854 of the Internal Revenue Code.

Dividends on preferred stock of publicutilities. A corporation can deduct 42% ofthe dividends it receives on certain preferredstock (issued before October 1942) of aless-than-20%-owned taxable public utility. Acorporation can deduct 48% of the dividendsit receives on certain preferred stock of a20%-or-more-owned taxable public utility. Formore information, see section 244 of theInternal Revenue Code.

Dividends from Federal Home LoanBanks. Certain dividends received fromFederal Home Loan Banks qualify for thedividends-received deduction. For more in-formation, see section 246 of the InternalRevenue Code.

Dividends from foreign corporations. Acorporation can deduct a percentage of thedividends it receives from 10%-owned foreigncorporations. For more information, see sec-tion 245 of the Internal Revenue Code.

No deduction allowed for certain divi-dends. Corporations cannot take a deductionfor dividends received from the following en-tities.

1) A real estate investment trust.

2) A corporation exempt from tax either forthe tax year of the distribution or thepreceding tax year.

3) A corporation whose stock has beenheld less than 46 days during the 90-dayperiod beginning 45 days before thestock becomes ex-dividend with respectto the dividend.

4) A corporation whose preferred stock hasbeen held less than 91 days during the180-day period beginning 90 days beforethe stock becomes ex-dividend with re-spect to the dividend if the dividends re-ceived on it are for a period or periodstotaling more than 366 days.

5) Any corporation, if your corporation isunder an obligation (pursuant to a shortsale or otherwise) to make related pay-ments for positions in substantially simi-lar or related property.

Dividends on deposits. So-called dividendson deposits or withdrawable accounts in do-mestic building and loan associations, mutualsavings banks, cooperative banks, and simi-lar organizations are interest. They do notqualify for this deduction.

Limit on deduction for dividends. The totaldeduction for dividends received or accruedis generally limited (in the following order) to:

1) 80% of the difference between taxableincome and the 100% deduction allowedfor dividends received from affiliatedcorporations, or by a small business in-vestment company, for dividends re-ceived or accrued from 20%-owned cor-porations, and

2) 70% of the difference between taxableincome and the 100% deduction allowedfor dividends received from affiliatedcorporations, or by a small business in-vestment company, for dividends re-ceived or accrued fromless-than-20%-owned corporations (re-ducing taxable income by the total divi-dends received from 20%-owned corpo-rations).

Figuring limit. In figuring this limit, de-termine taxable income without the followingitems.

1) The net operating loss deduction.

2) The deduction for dividends received.

3) Any adjustment due to the part of anextraordinary dividend that is not taxable(see Extraordinary Dividends, later).

4) The deduction for contributions to aCapital Construction Fund (CCF).

5) Any capital loss carryback to the taxyear.

Effect of net operating loss. If a corpo-ration has a net operating loss for a tax year,the limit of 80% (or 70%) of taxable incomedoes not apply. To determine whether acorporation has a net operating loss, figurethe dividends-received deduction without the80% (or 70%) of taxable income limit.

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Only your corporation can elect to amor-tize its start-up or organizational costs. Ashareholder cannot make this election.

You cannot amortize any costs you incurin setting up your corporation. The corpo-ration can amortize these costs, but only if itreimburses you for them. These costs thenbecome part of the basis of your interest inthe business. You can recover them onlywhen you sell your interest in the corporation.

Related PersonsThe related person rules apply to the follow-ing entities.

1) An individual and a corporation the indi-vidual controls.

2) Two corporations that are members ofthe same controlled group.

3) A partnership and a corporation con-trolled by the same person.

4) An S corporation and a C corporation ifcontrolled by the same persons.

These rules deny the deduction of losseson the sale or exchange of property betweenrelated persons. They also deny the de-duction of certain unpaid business expensesand interest on transactions between thepersons. Losses on the sale or exchange ofproperty between members of the same con-trolled group of corporations are deferredrather than denied. Under certain conditions,the IRS may reallocate income and de-ductions between two or more businessesdirectly or indirectly controlled by the sameinterests.

For an explanation of these tax rules, seechapters 2 and 8 of Publication 535, andPublication 544.

Accrual basis corporation. An accrual ba-sis taxpayer cannot deduct expenses owedto a related cash basis person until paymentis made, and the amount is includible in the

gross income of the person paid. This ruleapplies even if the relationship ceases beforethe amount is includible in the gross incomeof the person paid.

Complete liquidations. The disallowanceof losses from the sale or exchange of prop-erty between related persons does not applyto liquidating distributions. It does not applyto any loss of either the distributing corpo-ration or a distributee for a distribution incomplete liquidation.

Interest paid to related persons. A corpo-ration's deduction for interest expense maybe limited if it paid (or accrued) interest torelated persons not subject to tax on the interest received. The deduction for this in-terest is disallowed for any tax year that thecorporation has:

1) Excess interest expense, and

2) A debt to equity ratio greater than 1.5 to1 at the end of that tax year.

However, the deduction is disallowed only tothe extent of the corporation's excess interestexpense. The corporation can carry the dis-allowed interest to later years.

Not subject to tax on the interest meansthat the related person is not subject to U.S.income tax on the interest income. For ex-ample, the related person may be a foreignparent corporation not subject to U.S. tax.

Excess interest expense. Excess inter-est expense is the excess of the corporation'snet interest expense over the sum of 50% ofits adjusted taxable income plus any excess limit carryforward.

Excess limit. Excess limit means theexcess of 50% of the corporation's adjustedtaxable income over its net interest expense.

If a corporation has an excess limit for atax year, that amount becomes an excesslimit carryforward to the next tax year. Whenthe corporation does not use it up in the nexttax year, it can carry it forward to the following2 tax years.

More information. For more information,including the definition of adjusted taxable income, see section 163(j) of the InternalRevenue Code.

U.S. Real Property InterestIf a domestic corporation acquires a U.S. realproperty interest from a foreign person or firm,the corporation may have to withhold tax onthe amount it pays for the property. Theamount paid includes cash, the FMV of otherproperty, and any assumed liability. If a do-mestic corporation distributes a U.S. realproperty interest to a foreign person or firm,it may have to withhold tax on the FMV of theproperty. A corporation that fails to withholdmay be liable for the tax, penalties that apply,and interest. For more information, see U.S.Real Property Interest in Publication 515,Withholding of Tax on Nonresident Aliens and Foreign Corporations.

Figuring TaxableIncomeYou can figure a corporation's taxable incomeby subtracting its allowable deductions fromits income on page 1 of Form 1120 or1120A. This section discusses some specialrules that may apply to the following corpo-rations.

Any corporation whose deductions for theyear are more than its income.

A closely held corporation. A personal service corporation.

Net Operating LossesIf a corporation's deductions for the year aremore than its income for the year, the corpo-ration has a net operating loss (NOL). A cor-poration can use an NOL by deducting it fromincome in another year or years. However,there are rules for figuring the NOL that eitherlimit what it can deduct or permit deductionsnot ordinarily allowed.

For more information on how to figure anNOL, when to use it, how to claim an NOLdeduction, and how to figure an NOL carry-over, see Publication 536.

At-Risk LimitsThe at-risk rules limit your losses from mostactivities to your amount at risk in the activity.The at-risk limits apply to certain closely heldcorporations (other than S corporations).

Closely held corporation. For the at-riskrules, a corporation is a closely held corpo-ration if at any time during the last half of the

tax year, more than 50% in value of its out-standing stock is owned directly or indirectlyby or for five or fewer individuals.

To figure if more than 50% in value of thestock is owned by five or fewer individuals,apply the following rules.

1) Stock owned directly or indirectly by orfor a corporation, partnership, estate, ortrust is considered owned proportion-ately by its shareholders, partners, orbeneficiaries.

2) An individual is considered to own thestock owned directly or indirectly by orfor his or her family. Family includes onlybrothers and sisters (including half-brothers and half-sisters), a spouse, an-cestors, and lineal descendants.

3) If a person holds an option to buy stock,he or she is considered to be the ownerof that stock.

4) When applying rule (1) or (2), stockconsidered owned by a person underrule (1) or (3) is treated as actuallyowned by that person. Stock consideredowned by an individual under rule (2) isnot treated as owned by the individualfor again applying rule (2) to consideranother the owner of that stock.

5) Stock that may be considered owned byan individual under either rule (2) or (3)is considered owned by the individualunder rule (3).

More information. For more information onthe at-risk limits, see Publication 925.

Passive Activity LimitsThe passive activity rules generally limit yourlosses from passive activities to your passiveactivity income. Generally, you are in a pas-sive activity if you have a trade or businessactivity in which you do not materially partic-ipate during the tax year, or a rental activity.

The passive activity rules apply to per-sonal service corporations and closely heldcorporations.

Personal service corporation. For thepassive activity rules, a corporation is a per-sonal service corporation if it meets all of thefollowing requirements.

1) It is not an S corporation.

2) Its principal activity during the testingperiod is performing personal services.The testing period for any tax year is theprevious tax year. If the corporation has

just been formed, the testing period be-gins on the first day of its tax year andends on the earlier of:

a) The last day of its tax year, orb) The last day of the calendar year in

which its tax year begins.

3) Its employee-owners substantially per-form the services in (2). This requirementis met if more than 20% of the corpo-ration's compensation cost for its activ-ities of performing personal servicesduring the testing period is for personalservices performed by employee-owners.

4) Its employee-owners own more than10% of the fair market value of its out-standing stock on the last day of thetesting period.

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Personal services. Personal services arethose in any of the following fields.

Accounting. Actuarial science. Architecture. Consulting. Engineering. Health. Law. Performing arts. Veterinary services.

Employee-owners. A person is anemployee-owner of a personal service cor-poration if both of the following apply.

1) He or she is an employee of the corpo-ration, or performs personal services foror on behalf of the corporation as an in-dependent contractor, on any day of thetesting period.

2) He or she owns any stock in the corpo-ration at any time during the testing pe-riod.

Closely held corporation. For the passiveactivity rules, a corporation is closely held ifall of the following apply.

1) It is not an S corporation.

2) It is not a personal service corporation,defined earlier.

3) At any time during the last half of the taxyear, more than 50% of the value of itsoutstanding stock is directly or indirectlyowned by five or fewer individuals. In-dividual includes certain trusts and pri-vate foundations.

More information. For more information onthe passive activity limits, see Publication925.

Figuring TaxAfter you figure a corporation's taxable in-come, you can figure its tax on Schedule J(Form 1120) or Part I (Form 1120A). Thissection discusses the tax rate schedule,credits, recapture taxes, and the alternativeminimum tax.

Tax Rate ScheduleMost corporations figure their tax by using thefollowing tax rate schedule. This section dis-cusses an exception that applies to qualifiedpersonal service corporations. Other ex-ceptions are discussed in the instructions forSchedule J, Form 1120 (Part I, Form1120A).

Qualified personal service corporation. Aqualified personal service corporation is taxedat a flat rate of 35% on taxable income. Acorporation is a qualified personal servicecorporation if it meets both of the followingtests.

1) Substantially all of the corporation's ac-tivities involve the performance of per-sonal services (as defined earlier underPersonal services ).

2) At least 95% of the corporation's stock,

by value, is owned, directly or indirectly,by any of the following.

a) Employees performing the services.

b) Retired employees who had per-formed the personal services.

c) Any estate of the employee orretiree described above.

d) Any person who acquired the stockof the corporation as a result of thedeath of an employee or retiree (butonly for the 2-year period beginningon the date of the employee's orretiree's death).

See section 1.4481T of the Regulations fordetails.

CreditsA corporation's tax liability is reduced if it cantake any credits. The following list includessome credits that are available to corpo-rations.

Credit for federal tax on fuels used forcertain purposes (see Publication 378).

Credit for prior year minimum tax (seeForm 8827).

Foreign tax credit (see Form 1118). General business credit (see General

business credit, later).

Nonconventional source fuel credit (seeInternal Revenue Code section 29). Possessions tax credit (see Form 5735). Qualified electric vehicle credit (see Form

8834).

General business credit. Your generalbusiness credit for the year consists of yourcarryforward of business credits from prioryears plus your total current year businesscredits. Current year business credits includethe following credits.

Alcohol used as fuel credit (Form 6478). Contributions to selected community de-

velopment corporations credit (Form

8847). Disabled access credit (Form 8826). Employer social security and Medicare

taxes paid on certain employee tips credit(Form 8846).

Empowerment zone employment credit(Form 8844).

Enhanced oil recovery credit (Form8830).

Indian employment credit (Form 8845). Investment credit (Form 3468). Low-income housing credit (Form 8586). Orphan drug credit (Form 8820).

Renewable electricity production credit(Form 8835).

Research credit (Form 6765). Welfare-to-work credit (Form 8861). Work opportunity credit (Form 5884).

In addition, your general business credit forthe current year may be increased later by thecarryback of business credits from later years.

To claim a general business credit, youwill first need to get the form or forms you

need to claim your current year businesscredits. The above list contains a list of cur-rent year business credits. The form used toclaim each credit is shown in parentheses. Inaddition to the credit form, you may also needto file Form 3800.

Who must file Form 3800. You must fileForm 3800 if any of the following apply.

You have more than one of the creditslisted earlier (other than the empower-ment zone employment credit).

You have a carryback or carryforward ofany of these credits (other than the em-powerment zone employment credit).

Any of these credits (other than the low-

income housing credit or the empower-ment zone employment credit) is from apassive activity. (For information aboutpassive activity credits, get Form8582CR.)

The empowerment zone employmentcredit is subject to special rules. The credit isfigured separately on Form 8844 and is notcarried to Form 3800. For more information,see the instructions for Form 8844.

See the instructions to Form 3800 formore information about the general businesscredit.

Recapture TaxesA corporation's tax liability is increased if itmust recapture credits that it has taken inprior years. The following list includes somecredits that a corporation may need to re-capture.

Indian employment credit (see the in-structions for Form 8845).

Investment credit (see Form 4255). Low-income housing credit (see Form

8611).

Qualified electric vehicle credit (see theinstructions for Form 8834).

Alternative Minimum

Tax (AMT)The tax laws give special treatment to sometypes of income and allow special deductionsand credits for some types of expenses.These laws enable some corporations withsubstantial economic income to significantlyreduce their regular tax. The purpose of thecorporate alternative minimum tax (AMT) isto ensure that these corporations pay a mini-mum amount of tax on their economic in-come. A corporation owes AMT if its tentativeminimum tax is more than its regular tax.

Tentative minimum tax of a small corpo-ration. For tax years beginning after 1997,the tentative minimum tax of a small corpo-

Tax Rate Schedule

If taxable income is:Of the

But not amountOver over Tax is: over

$0 50,000 15% 0$50,000 75,000 $ 7,500 + 25% $50,000

75,000 100,000 13,750 + 34% 75,000100,000 335,000 22,250 + 39% 100,000335,000 10,000,000 113,900 + 34% 335,000

10,000,000 15,000,000 3,400,000 + 35% 10,000,00015,000,000 18,333,333 5,150,000 + 38% 15,000,00018,333,333 ---------- 35% 0

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ration is zero. This means that a small cor-poration will not owe AMT.

Small corporation. For AMT purposes,a corporation is a small corporation if it meetsany of the following tests.

1) This is its first tax year.

2) This is its second tax year and its annualgross receipts for its first tax year werenot more than $5,000,000.

3) This is its third tax year and its averageannual gross receipts for its first two taxyears were not more than $5,000,000.

4) This is its fourth tax year and its averageannual gross receipts for its first threetax years were not more than$5,000,000.

5) This is its fifth or later tax year and itmeets both of the following tests.

a) Its average annual gross receiptsfor its first 3-tax-year period begin-ning after 1993 were not more than$5,000,000.

b) Its average annual gross receiptsfor all later 3-tax-year periods be-ginning after 1993 and ending be-fore the current tax year were not

more than $7,500,000.For these tests, gross receipts for a short taxyear are annualized.

Form 4626. Use Form 4626 to figure thetentative minimum tax of a corporation that isnot a small corporation for AMT purposes.

AccumulatedEarnings TaxA corporation can accumulate its earnings fora possible expansion or other bona fidebusiness reasons. However, if a corporation

allows earnings to accumulate beyond thereasonable needs of the business, it may besubject to an accumulated earnings tax of39.6%. If the accumulated earnings tax ap-plies, interest applies to an underpayment oftax from the date the corporate return wasoriginally due, without extensions. This taxapplies regardless of the number of share-holders.

Treat an accumulation of $250,000 or lessgenerally as within the reasonable needs ofmost businesses. However, treat an accu-mulation of $150,000 or less as within thereasonable needs of a business whose prin-cipal function is performing services in anyof the following fields.

Accounting. Actuarial science. Architecture. Consulting. Engineering. Health. Law. Performing arts. Veterinary services.

In determining if the corporation has accu-mulated earnings and profits beyond its rea-sonable needs, value the listed and readilymarketable securities owned by the corpo-

ration and purchased with its earnings andprofits at net liquidation value, not at cost.

The reasonable needs of the business in-clude:

Specific, definite, and feasible plans foruse of the earnings accumulation in thebusiness, and

The amount necessary to redeem thecorporation's stock included in a de-ceased shareholder's gross estate, if theamount does not exceed the reasonably

anticipated total estate and inheritancetaxes, and funeral and administration ex-penses incurred by the shareholder's es-tate.

The absence of a bona fide businessreason for a corporation's accumulatedearnings may be indicated by many differentcircumstances, such as a lack of regular dis-tributions to its shareholders.

The fact that a corporation has an unrea-sonable accumulation of earnings is sufficientto establish liability for the accumulatedearnings tax unless the corporation shows theearnings were not accumulated to allow itsindividual shareholders to avoid income tax.

ReconciliationStatementsWhen you file Form 1120, you must completeSchedules M1 and M2 if the total assetsof the corporation are at least $25,000. If youfile Form 1120A, you must complete Part IVif the total assets of the corporation are atleast $25,000.

Schedule M1. Schedule M1 starts with thenet income (loss) per books. This amount isafter allowance of federal income tax accruedfor the year for which the return is being filed,as shown in the corporation's profit and loss

account. Schedule M1 provides for neces-sary adjustments to reconcile this amountwith the taxable income shown on Form 1120,line 28, page 1.

Part IV. Part IV, Form 1120A is similarto Schedule M1 on Form 1120. It reconcilesthe income per books with the taxable incomeon line 24, page 1 of Form 1120A.

Schedule M2. Schedule M2 analyzes theunappropriated retained earnings shown inthe corporation's balance sheet, Schedule L.

To complete these schedules, you mustfirst get additional information from your cor-poration's books and records.

Example. The following profit and lossaccount appeared in the books of the WelldonCorporation for calendar year 1998. It filesForm 1120 and completes Schedules M1and M2, as illustrated later.

The corporation analyzed the retainedearnings and the following items appeared inthis account on its books.

The following items appear on page 1 ofForm 1120.

Schedule M1Line 1. $140,825 is the net income per books.It is shown in the profit and loss accountpreviously as net income per books afterfederal income tax.

Line 2. $62,225 is the federal income taxaccrued for the tax year.

Line 3. $3,600 is the excess of capital lossesover capital gains. The net loss is from thesale of securities.

Line 4. Line 4 would show all income andcredits included in taxable income but not re-corded in the corporation's books. This canoccur if the corporation valued assets on itsbooks at an amount greater than that used fortax purposes. When it has a sale of theseassets, the gain included in taxable incomeis greater than that recorded in the books. Itshows the difference on this line.

Line 5. The corporation shows expensesrecorded on its books that it does not deducton this return. The $500 listed on line 5b isfor contributions that were over the 10% limit.The corporation itemizes the remaining non-deductible expenses on a statement attached

Insurance premiums onlives of corporate officers(corporation is beneficiaryof policies) ... .. .. .. .. .. .. .. .. .. .. .. 9,500Compensation of officers .. 40,000Salaries and wages .. .. .. .. .. . 28,000Repairs . .. .. .. .. .. .. .. .. .. .. .. .. .. .. . 800Taxes ................................. 10,000Contributions:

Deductible ....... $23,000Other ............... 500 23,500

Interest paid (loan to pur-chase tax-exempt bonds) .. 850Depreciation ... .. .. .. .. .. .. .. .. .. . 5,200Loss on securi ties . .. .. .. .. .. .. 3 ,600Net income per books afterfederal income tax ............. 140,825Federal income tax accruedfor 1998 ............................. 62,225

Total .................................. $1,864,500 $1,864,500

Item Debit Credit

Balance, January 1 . ................ $225,000Net profit (before federal in-come t ax) . ... ... ... ... .. ... ... ... ... ... .. 203,050Reserve for contingencies ...... $10,000Income tax accrued for the year 62,225Dividends paid during the year 140,089Refund of 1995 income tax ..... 18,000Balance, December 31 ........... 233,736

Total ....................................... $446,050 $446,050

Gross sales ($1,840,000 less returnsand allowances of $20,000) ......... ........ $1,820,000Cost of goods sold ................................ 1,520,000Gross profit from sales ......................... $300,000Interest income ..................................... 10,000Total income ........................................ $310,000

Deductions:Compensation of officers ....... $40,000Salaries and wages ................ 28,000Repairs ................................... 800Taxes ...................................... 10,000Contributions (maximumallowable) ............................... 22,500Depreciation ........................... 6,200

Total deductions ................................. 107,500Taxable income ................................... $202,500

Account Debit Credit

Gross sales ....................... $1,840,000Sales returns and allow-ances ................................. $20,000Cost of goods sold ............ 1,520,000Interest income from:

Banks .............. $10,000Tax-exemptstate bonds ..... 5,000 15,000

Proceeds from life insur-ance (death of corporateofficer) ............................... 6,000Bad debt recoveries (no taxdeduction claimed) ............ 3,500

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140 ,82562,2253,600

50 0

See at t ached it emized st at ement(not shown) $10 ,8 50 11,350

218 ,0 0 0

225,000140 ,825

Refund - 1995 income t ax18 ,0 0 0

383,825

5,000Insurance proceeds 6 ,00 0Bad debt recovery 3,500 14,50 0

1,00 0

1,00 015,50 0

202,500

140 ,0 8 9

10 ,0 0 0150 ,0 8 9233,736

Reserve forcont ingencies

Schedule M-2

Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return (See page 16 of instructions.)Net income (loss) per books1 Income recorded on books this year not

included on this return (itemize):7

Federal income tax2Tax-exempt interest $Excess of capital losses over capital gains3

Income subject to tax not recorded on booksthis year (itemize):

4

Deductions on this return not chargedagainst book income this year (itemize):

8Expenses recorded on books this year notdeducted on this return (itemize):

5DepreciationaContributions carryover $bDepreciationa

Contributions carryover $bc Travel and entertainment $

Add lines 7 and 8910 Income (line 28, page 1)line 6 less line 96 Add lines 1 through 5

Analysis of Unappropriated Retained Earnings per Books (Line 25, Schedule L)Balance at beginning of year1 Distributions: a Cash5Net income (loss) per books2 b StockOther increases (itemize):3 c Property

Other decreases (itemize):6

Add lines 5 and 674 8Add lines 1, 2, and 3 Balance at end of year (line 4 less line 7)

$$

Note: You are not required to complete Schedules M-1 and M-2 below if the total assets on line 15, column (d) of Schedule L are less than $25,000.

to the return. These include the following ex-penses.

Line 6. This is the total of lines 1 through 5.

Line 7. The corporation shows income re-corded on its books during the year that itdoes not include on the return because theincome is not taxable. This totals $14,500 andincludes interest on tax-exempt state bondsof $5,000, insurance proceeds of $6,000, anda bad debt recovery of $3,500.

Line 8. Line 8 shows the total of all tax de-ductions on the return not charged againstbook income. The corporation enters $1,000on line 8a. It represents the difference be-tween the depreciation claimed on the cor-poration's income tax return and its books. Ifthe corporation had other deductions to item-ize on this line and there was not enoughspace, it would attach a statement to the re-

turn listing them.

Line 9. This is the total of lines 7 and 8.

Line 10. $202,500 is the difference betweenlines 6 and 9. The amount on line 10 mustagree with the taxable income before the netoperating loss deduction and special de-ductions shown on line 28, page 1, Form1120.

Schedule M2Line 1. $225,000 is from Schedule L for thebeginning of the tax return year.

Line 2. $140,825 is the net income per books(after federal income tax).

Line 3. $18,000 is the refund of 1995 incometax. Show all other increases to retainedearnings on this line.

Line 4. This is the total of lines 1, 2, and 3.

Line 5. $140,089 is the distributions toshareholders charged to retained earnings

during the tax year.

Line 6. Line 6 is for any decreases (otherthan those on line 5) in unappropriated re-tained earnings. These decreases are notdeductible on the tax return at the time ofappropriation. However, a deduction may beallowable on a later return. A common ex-ample of this is an amount set aside for con-tingencies. A customer was injured on com-pany property during 1998 and the companyretained an attorney. The company set up acontingent liability of $10,000 for the custom-er's claim. If they settle the claim during 1999for $5,000 and the attorney's fee is $2,500,the company charges $7,500 to retainedearnings (appropriated). It deducts $7,500 inarriving at taxable income for 1999. Anothercommon example of items entered on this lineis the payment of the prior year's federal tax.Attach a schedule to the return listing all itemstaken into account to arrive at the amountshown on this line.

Line 7. This is the total of lines 5 and 6.

Line 8. $233,736 is the corporation's retainedearnings at the end of its tax year. Determinethis amount by subtracting the total on line 7from the total on line 4. This amount mustagree with the amount on Schedule L for theend of the return year.

Earnings andProfits ComputationsIn determining the taxable status of corporatedistributions to shareholders, it is necessaryto know the corporation's earnings and pro-fits. See Taxable Status of Distribution underDistributions, later.

Taxable distributions come first from cur-rent earnings and profits and then from ac-cumulated earnings and profits. Accumulatedearnings and profits means earnings andprofits accumulated since February 28, 1913.

To the extent that the distributions are morethan both the current and accumulatedearnings and profits, the distributions may bepartly or completely nontaxable.

If the distributions are either partly orcompletely nontaxable because they exceedcurrent and accumulated earnings and profits,the corporation attaches Form 5452 to its in-come tax return. See the instructions to Form5452 for more information. With Form 5452,you will need to attach computations of cur-rent and accumulated earnings and profitsalong with schedules reconciling earningsand profits with taxable income and retainedearnings. One format for showing the com-putation of current year earnings and profitsis shown later. See Table 1.

Example. In addition to the facts set outearlier, the Welldon Corporation incorporatedon January 1, 1946, and uses an accrualmethod of accounting. Its accumulatedearnings and profits as of December 31,1997, were $1,200. It made cash distributionsduring its 1998 calendar tax year of $140,089.This consisted of $85,089 to preferredshareholders and $55,000 to common share-holders. The entire distribution to preferredshareholders is a taxable dividend. The$27,500 distribution on March 15, 1998, tocommon shareholders is a taxable dividendto the extent of $27,318 (99.33%), and the$27,500 distribution on September 15, 1998,to common shareholders is a taxable dividend

Insurance premiums on lives of corporateofficers (corporation is beneficiary) ........... $9,500Nondeductible interest incurred to pur-chase tax-exempt bonds ........................... 850Nondeductible contributions ...................... 500Total ......................................................... $10,850

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Table 1. Welldon Corporation Current-Year Computation of Earnings and Profits Calendar Tax Year 1998

* Identical items on the same list in Schedule M and Earnings and Profits(Alphabet) Items completely offset in same year. Start with (a) each year.(Dates) Items which as of the final balance sheets date have been completely offset in various years. Use consecutive dates to show the years for locating offsets.(x) Items which have not been completely offset and are differences between Schedule M and Earnings and Profits.

Earnings and ProfitsCurrent-YearAccumulatedIncorporated 1/1/ 46

Accrual Accounting Basis

12/31/97 Balance forward

Taxable income (line 28, p.1) per returnFederal income taxesper books

Excess of capital losses over capital gains(Tax Basis)

Contributions in excess of 10% limitLife ins. prem. in excess of cash surrender

valueNondeductible interest paid for tax-exempt

state bondsNondeductible contributions

Total itemized per line 5, Schedule M-1Tax-exempt interest received on tax-exempt

state bondsLife ins. proceeds in excess of cashsurrender value

Bad debt recovery (not charged againsttaxable income)

Total itemized per line 7, Schedule M-1Depreciation on return in excess of straight

lineRefund of 1995 federal income taxesReserve for contingencies

Current-year earnings and profitsCash distributions:Preferred:

3/15, 6/15, 9/15, 12/15/98$8.5089/SH10,000 share distribution

Schedule M Per Return

DR(Debit)

CRCredit

DR(Debit)

CR(Credit) CR BAL KEY

per tax returns

1998

Common:3/15/98$1.10/SH25,000 shares

From current-year earnings and profitsFrom acc. earnings and profitsFrom capital

Total distributions

9/15/98$1.10/SH25,000 shares

From current-year earnings and profitsFrom capital

Total distributions

Total cash distributions

Current-year change

Balance forward 12/31/98

$500

9,500

850500

$5,0006,000

3,500

(E)

(F)

(G)(H)

(J)(K)

(L)

94.974.360.67

100%

94.975.03

100%

$85,089

$26,1181,200

182$27,500

26,1181,382

$27,500

%

(Q)

(R)(S)(T)

(U)(V)

3,600

11,350

10,000

140,089227,264

(C)$62,225

(D)

(I)

(P)

(W)

$225,000 (A)

202,500 (B)

1,000

(M)

18,000(N)

236,000

(O)

8,736 (X)

$233,736 (Y)

14,500

$62,225

3,600

9,500

850500

77,175

$85,089

26,118

26,118

137,325

$202,500

$1,200

5,0006,000

1,000

214,500137,325

137,325

(1,200)

($1,200)

-0-

500

*aa

**

*

**

**

x

*1-95

x

*

**x

*x

KEY SYSTEM

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to the extent of $26,118 (94.97%). The bal-ance of retained earnings in Schedule M2as of December 31, 1998, is $233,736, butearnings and profits has a zero balance.

Explanation of Items in Table 1This section contains explanations of items(A) through (Y) in Table 1.

A) Retained earnings will generally differfrom accumulated earnings and profits be-cause of differences in computing book andtax earnings. See item (X), below.

B) Use taxable income (before the specialdeductions) as the starting point for figuringcurrent-year earnings and profits.

C) Taxes accrued for book income maydiffer from the amount of the actual federalincome tax liability. In this case, earnings andprofits reflect only the latter amount.

D) Capital losses are allowable in the yearincurred, but must be added back in the taxyear they are applied against gains to preventa double deduction.

E) Excess contributions, like excess capi-tal losses, are allowable in the year made andadded back in the year deducted.

F) Since only the premium in excess of thecash surrender value represents an expenseto the corporation, only that amount reduces

earnings and profits.G) Nondeductible interest expenses areexpenses of the corporation that reduceearnings and profits.

H) Nondeductible contributions sametreatment as item (G).

I) Sum of items (E) through (H).J) Add tax-exempt interest income to

earnings and profits because it is income tothe corporation.

K) Insurance proceeds (in excess of cashsurrender value) same treatment as item(J).

L) Recovery of a debt written off on thebooks but not deducted on tax return.

M) Sum of items (J), (K), and (L).N) Depreciation claimed on the tax return

over the straight line amount increases cur-rent earnings and profits.

Note: For tangible property depreciatedunder MACRS, the adjustment to earningsand profits for depreciation is the amount fig-ured using the alternative depreciation sys-tem (ADS) of MACRS. If you take a section179 deduction, for purposes of figuringearnings and profits, you can only deduct thesection 179 amount that is figured ratablyover a 5-year period. The 5-year period be-gins with the tax year you take the section179 deduction. See Publication 946 for moreinformation on MACRS and the section 179deduction.

O) The refund represents a reduction ofthe corporation's 1995 income tax and affectsthe earnings and profits of a prior year.

P) This amount represents the differencebetween the corporation's book and tax basisof its reserve for contingencies. It will not af-fect earnings and profits until the corporationcan deduct it in computing taxable income.

Q) Preferred shareholders, in this case,have a right to current-year earnings andprofits before common shareholders.

R) Allocable share of remaining current-year earnings and profits.

S) Distributions that are more than thecurrent-year earnings and profits reduce ac-cumulated earnings and profits.

T) Distributions that are more thanearnings and profits and that represent divi-

dends that are not taxable to shareholdersreduce the corporation's capital.

U) Same as item (R).V) Same as item (T).W) Sum of items (Q) through (V).X) Represents the sum of the current year

differences (keyed as x) between figuring thecorporation's book and tax earnings. Theseitems plus items (O) and (S) account for thetotal current-year change of $8,736.

Y) Represents the accumulated differ-ences between the corporation's bookearnings and accumulated tax earnings.

For more information, see Revenue Pro-cedure 7517 in Cumulative Bulletin 19751on page 677.

DistributionsThis section discusses corporate distributionsto shareholders. These distributions may beordinary dividends, stock dividends, or a re-turn of capital. It discusses distributions inproperty, as well as distributions in money.This discussion generally applies only to reg-ular domestic corporations.

Any distribution to shareholders from

earnings and profits is generally a dividend.However, a distribution is not a taxable divi-dend if it is a return of capital to the share-holder. Most distributions are in money, butthey may also be in stock or other property.For information on shareholder reporting ofdividends and other distributions, see Publi-cation 550, Investment Income and Ex- penses.

File a Form 1099DIV with IRS for eachshareholder to whom a corporation paysgross dividends of $10 or more during a cal-endar year. The corporation files Form 1096to summarize and transmit its Forms1099DIV. File Form 5452 if the corporationpays dividends that are not taxable.

The corporation may furnish Forms1099DIV to shareholders after November 30of the year of payment (but not before thefinal payment for the year). However, it mayfurnish this statement to shareholders afterApril 30 of the year of payment if furnishedwith the final dividend for that calendar year.This information must be furnished by Janu-ary 31 of the year following the close of thecalendar year during which the corporationmakes the payments.

Withholding on dividends. Backup with-holding may require a corporation to withholdtax equal to 31% of the dividends paid tocertain shareholders. Backup withholding isnot required for dividend payments of lessthan $10. However, file Form 1099DIV if

there is backup withholding, regardless of theamount of the dividend. See Publication 505for more information on backup withholding.

Amount of DistributionThe amount of a distribution paid to anyshareholder is the money paid plus the FMV(on the distribution date) of other propertytransferred to the shareholder. Reduce (butnot below zero) the distribution by liabilitiesof the corporation assumed by the share-holder and by liabilities to which the propertyis subject.

The basis of property received by theshareholder is its FMV, defined earlier.

Property. Property means any property in-cluding money, securities, and indebtednessto the corporation, except stock of the dis-tributing corporation or rights to acquire thisstock.

Transfers of property to shareholders forless than FMV. A sale or exchange ofproperty between a corporation and a share-holder that is not a corporation may be adistribution to the shareholder.

If the FMV of the property on the date ofthe sale or exchange exceeds the price paidby the shareholder, the excess is a distribu-tion.

Corporation cancels shareholder's debt.If a corporation cancels a shareholder's debtwithout repayment by the shareholder, treatthe amount canceled as a distribution to theshareholder.

Distributions ofAppreciated PropertyThe distributing corporation generally doesnot recognize gain or loss on a distribution(not in complete liquidation) of property to itsshareholders.

However, if a corporation distributesproperty, other than its own obligations, to ashareholder and the property's FMV exceedsthe corporation's adjusted basis, treat theproperty as sold at the time of distribution.The corporation recognizes gain on the ex-cess of the FMV over the adjusted basis ofthe property.

Distributions of depreciated property. Ifthe FMV of depreciated property distributedto shareholders is more than the adjustedbasis of that property, the corporation mustreport ordinary income because of depreci-ation. This applies even though the distribu-tion, either as a dividend or in liquidation,might otherwise be not taxable.

Taxable Statusof DistributionThe part of a distribution from either currentor accumulated earnings and profits is a divi-dend. First, the part of the distribution that ismore than earnings and profits reduces theadjusted basis of the stock in the hands of theshareholder. Second, any amount that ex-ceeds the adjusted basis of that stock istreated by the shareholder as gain from thesale or exchange of property (usually capitalgain).

Whether a distribution is a taxable divi-dend to the shareholders, used to reduce theadjusted basis of their stock, or treated asgain from the sale of property, depends uponwhether the distribution is more than:

1) Earnings and profits for the tax year ofthe distribution (figured as of the closeof that year without reduction for anydistribution during the year), plus

2) Accumulated earnings and profits sinceFebruary 28, 1913.

The current earnings and profits at thetime of distribution do not necessarily deter-mine whether the distribution is a taxabledividend.

If there is a deficit in earnings and profitsfor the tax year of the distribution, the taxablestatus of the distribution depends on the

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amount of accumulated earnings and profits.In determining accumulated earnings andprofits, prorate the deficit in earnings andprofits for the current year to the dates ofdistribution.

Example 1. X, a calendar year corpo-ration, had accumulated earnings and profitsof $40,000 as of January 1, the beginning ofits tax year. X had an operating loss of$50,000 for the first 6 months, but hadearnings and profits of $5,000 for the entire

year. X distributed $15,000 to its shareholderson July 1.The entire distribution is an ordinary divi-

dend. Consider $5,000 as paid from thatyear's earnings and profits and $10,000 aspaid from accumulated earnings and profits.

Example 2. Assume the same facts asin Example 1, except that X had a deficit inearnings and profits (E & P) of $55,000 for theyear. To figure the available earnings andprofits, prorate the deficit to the date of thedistribution as follows:

This computation shows that the accumu-lated earnings and profits available at the timeof distribution was $12,500. Of the $15,000distribution, only $12,500 is a taxable divi-dend. The balance of the distribution, $2,500,reduces the adjusted basis of the stock in thehands of the shareholders. To the extent thatthe $2,500 balance is more than the adjustedbasis of their stock, the shareholders have again from the sale or exchange of property.

Nontaxable dividends. Nontaxable divi-dends are distributions to shareholders ontheir stock in the ordinary course of business.They are not taxable as dividends becausethe amount of the distributions is greater thanthe corporation's earnings and profits. AttachForm 5452 to the corporate return if nontax-able dividends are paid to shareholders.Tax-free stock dividends and distributions inexchange for stock in liquidations or redemp-tions are not nontaxable dividends.

Adjustment toEarnings and ProfitsFor a cash distribution, decrease the currentearnings and profits by the amount distrib-uted, but not below zero.

For a distribution of an obligation of thedistributing corporation, decrease theearnings and profits by the principal amountof that obligation, but not below zero.

For the distribution of an original issuediscount obligation, decrease earnings andprofits by the total issue price of the obli-gation, but not below zero.

For a distribution of other property, de-crease the earnings and profits by the ad-

justed basis of that property, but not belowzero.

However, for a distribution of appreciatedproperty (other than the corporation's obli-gations), increase the earnings and profits by

the excess of the FMV over the adjusted ba-sis of the property. Decrease them, but notbelow zero, by the FMV of the appreciatedproperty and also by the FMV (instead of ad-

justed basis) of other property distributed un-der the general rule of the preceding para-graph.

Also, the decrease in earnings and profitsby the FMV of distributed property in thepreceding paragraph is reduced for any li-ability to which the distributed property issubject and any liability assumed by theshareholder in connection with the distribu-tion.

Distribution ofSto

us internal revenue service: p542--1998

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