US Internal Revenue Service: p542--2000

8/14/2019 US Internal Revenue Service: p542--2000

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ContentsImportant Changes for 2000 ............. 1

Introduction ........................................ 2

Business Taxed as a Corporation .... 2

Exchange of Property for Stock ....... 2

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

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

Income and Deductions .................... 5Below-Market Loans ....................... 5Capital Losses ................................ 5Charitable Contributions ................. 5Corporate Preference Items ........... 6Dividends-Received Deduction ....... 6Extraordinary Dividends .................. 6Going Into Business ....................... 7Related Persons ............................. 7U.S. Real Property Interest ............ 8

Figuring Taxable Income ................... 8Net Operating Losses ..................... 8At-Risk Limits .................................. 9Passive Activity Limits .................... 9

Figuring Tax ........................................ 9Tax Rate Schedule ......................... 9Credits ............................................. 10Recapture Taxes ............................ 10Alternative Minimum Tax (AMT) ..... 10

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

Distributions to Shareholders .......... 11Money or Property Distributions ..... 11Distributions of Stock or Stock

Rights ....................................... 11Constructive Distributions ............... 11

Reporting Dividends and OtherDistributions ............................. 11

Sample Returns .................................. 13Form 1120A .................................. 13Form 1120 ...................................... 16

How To Get Tax Help ......................... 22

Index .................................................... 23

Important Changesfor 2000Accounting methods. Certain small busi-ness taxpayers may be eligible to adopt orchange to the cash method of accounting andmay not be required to account for invento-ries. For more information, including the defi-nition of a small business taxpayer, see Pub-lication 553, Highlights of 2000 Tax Changes.

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Departmentof theTreasury

InternalRevenueService

Publica tion 54 2Cat. No. 15072O

CorporationsFor use in preparing

2000 Returns


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and calling 1800THELOST (18008435678) if you recognize a child.

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 given does notcover every situation and is not intended to

replace the law or change its meaning.Some corporations may meet the quali-fications for electing to be S corporations. Forinformation on S corporations, see the in-structions for Form 1120S, U.S. Income Tax Return for an S Corporation.

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

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html .

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

Useful ItemsYou may want to see:

Publication

526 Charitable Contributions

535 Business Expenses538 Accounting Periods and Methods

544 Sales and Other Dispositions ofAssets

925 Passive Activity and At-Risk Rules

Form (and Instructions)

1096 Annual Summary and Transmittalof U.S. Information Returns

1099DIV Dividends and Distributions

1120 U.S. Corporation Income TaxReturn

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

1120W (WORKSHEET) Estimated Taxfor Corporations

1120X Amended U.S. CorporationIncome Tax Return

1138 Extension of Time for Payment ofTaxes by a Corporation Expectinga Net Operating Loss Carryback

1139 Corporation Application forTentative Refund

2220 Underpayment of Estimated Taxby Corporations

3800 General Business Credit

4466 Corporation Application for QuickRefund of Overpayment ofEstimated Tax

4562 Depreciation and Amortization

4626 Alternative MinimumTaxCorporations

5452 Corporate Report of NondividendDistributions

7004 Application for AutomaticExtension of Time To FileCorporation Income Tax Return

8109 Federal Tax Deposit Coupon

8582CR Passive Activity CreditLimitations

8832 Entity Classification ElectionSee How To Get Tax Help near the end

of this publication for information about get-ting 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.

A business formed under a federal orstate law that refers to it as a corporation,body corporate, or body politic.

An association. A business formed under a state law that

refers to it as a joint-stock company or joint-stock association. An insurance company. Certain banks. A business wholly owned by a state or

local government. A business specifically required to be

taxed as a corporation by the InternalRevenue Code (for example, certainpublicly traded partnerships).

Certain foreign businesses. Any other business that elects to be taxed

as a corporation by filing Form 8832.

For more information, see the instructions forForm 8832.

Exchange of Propertyfor StockIf you transfer property (or money and prop-erty) to a corporation solely in exchange forstock in that corporation (other than nonqual-ified preferred stock, described later), andimmediately thereafter you are in control ofthe corporation, the exchange is usually nottaxable. This rule applies both to individualsand to groups who transfer property to a cor-poration. It also applies whether the corpo-

ration is being formed or is already operating.It does not apply in the following situations.

The corporation is an investment com-pany.

The property is transferred in a bank-ruptcy or similar proceeding in exchangefor stock 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.

TIPBoth the corporation and any person involved in a nontaxable exchange of property for stock must attach to their

income tax returns a complete statement of all facts pertinent to the exchange. For more information, see section 1.3513 of the regulations.

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 of the

corporation.Example 1. You and Bill Jones buy

property 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 recognized by you, Bill,or the corporation.

Example 2. You and Bill transfer theproperty with a basis of $100,000 to a corpo-ration in exchange for stock with a fair marketvalue of $300,000. This represents only 75%of each class of stock of the corporation. Theother 25% was already issued to someoneelse. You and Bill recognize a taxable gain

of $200,000 on the transaction.

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. Property transferredwill be considered to be of relatively smallvalue if its fair market value is less than 10%of the fair market value of the stock and se-curities already owned or to be received forservices 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. However, if a disproportionatetransfer takes place, it may be treated as if

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the stock were first received in proportion andthen some of it used to make gifts, pay com-pensation for services, or satisfy the trans-feror's obligations.

Money or other property received. If, in anotherwise nontaxable exchange of propertyfor corporate stock, you also receive moneyor property other than stock, you may haveto recognize gain. You must recognize gainonly up to the amount of money plus the fairmarket value of the other property you re-

ceive. The rules for figuring the recognizedgain in this situation generally follow those fora partially nontaxable exchange discussed inPublication 544 under Like-Kind Exchanges.If the property you give up includes depre-ciable property, the recognized gain mayhave to be reported as ordinary income fromdepreciation. No loss to the recipient is rec-ognized. See chapter 3 of Publication 544.

Nonqualified preferred stock. Nonqualifiedpreferred stock is treated as property otherthan stock. Generally, it is preferred stockwith any of the following features.

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

buy the stock. The issuer or a related person is required

to redeem or buy 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, the exchange is generally nottreated as if you received money or otherproperty. There are two exceptions to thistreatment.

If the liabilities the corporation assumesare more than your adjusted basis in theproperty you transfer, gain is recognizedup to the difference. However, if the li-abilities assumed give rise to a deductionwhen paid, such as a trade account pay-able or interest, no gain is recognized.

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.

For more information on the assumption ofliabilities, see section 357(d) of the InternalRevenue Code.

Example. You transfer property to a cor-poration for stock. Immediately after thetransfer you control the corporation. You alsoreceive $10,000 in the exchange. Your ad-

justed basis in the transferred property is$20,000. The stock you receive has a fairmarket value of $16,000. The corporation alsoassumes a $5,000 mortgage on the propertyfor which you are personally liable. Gain isrealized as follows.

The liability assumed is not treated asmoney or other property. The recognizedgain is limited to $10,000, the amount of cashreceived.

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. For more information,see Sales and Exchanges Between Related Persons 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 from you, unless payment of the li-ability gives rise to a deduction when paid.

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

CAUTION

!As this publication was being pre- pared for print, Congress was con- sidering legislation that would change

the above tax treatment. For more information about this and other important tax changes,see Publication 553, Highlights of 2000 TaxChanges .

Basis of property transferred. A corpo-ration that receives property from you in ex-change for its stock generally has the samebasis you had in the property increased byany gain you recognized on the exchange.However, the increase for the gain recognizedmay be limited. For more information, seesection 362 of the Internal Revenue Code.

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.

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,the corporation must reduce the basis of anyproperty acquired with the contribution during

Fair market value of stock received ... ....... $16,000 the 12-month period beginning on the day itreceived the contribution by the amount of thecontribution. If the amount contributed is morethan the cost of the property acquired, thenreduce, but not below zero, the basis of theother properties held by the corporation onthe last day of the 12-month period in thefollowing 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 each cat-egory to zero before going to the next cate-gory.

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 IRS ap-proval. The corporation files a request forapproval 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 if it expects its estimated taxfor the year to be $500 or more. If the corpo-ration does not pay the installments whenthey are due, it may be subject to an under-payment penalty. This section will explainhow to avoid this penalty.

When to pay estimated tax. Installmentpayments are due by the 15th day of the 4th,6th, 9th, and 12th months of the corporation'stax year.

Example 1. Your corporation's tax yearends December 31. Installment payments aredue on April 15, June 15, September 15, andDecember 15.

Example 2. Your corporation's tax yearends June 30. Installment payments are dueon October 15, December 15, March 15, andJune 15.

If any due date falls on a Saturday, Sun-day, or legal holiday, the installment is dueon the next 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 yields thesmallest installment payments.

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

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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 positivetax liability (not zero).

Also, if the corporation is a large corporation,it can use Method 2 to figure the first install-ment only.

A large corporation is one with at least$1 million of modified taxable income in anyof the last 3 years. Modified taxable income

is taxable income figured without net operat-ing loss or capital loss carrybacks or carry-overs.

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 any required installments.

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

In this situation, an immediate catchuppayment should be made to reduce any pen-alty resulting from the underpayment of anyearlier installments, whether caused by achange in an estimate, not making a deposit,or a mistake.

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 for underpayments thatis published quarterly by the IRS in theInternal Revenue Bulletin.

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 any of the following apply.

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

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

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 or are required to make electronic de-

posits, you should mail or deliver your pay-ment with a completed Form 8109 to anauthorized financial institution. For more in-formation, see the instructions for Form1120W.

Electronic Federal Tax Payment Sys- tem (EFTPS). You may have to deposit taxesusing EFTPS. You must use EFTPS to makedeposits of all depository tax liabilities (in-cluding social security, Medicare, withheldincome, excise, and corporate income taxes)you incur in 2001 if you deposited more than$200,000 in federal depository taxes in 1999or you had to make electronic deposits in2000. If you first meet the $200,000 thresholdin 2000, you must begin depositing usingEFTPS in 2002. Once you meet the $200,000threshold, you must continue to make de-posits using EFTPS in later years.

If you must use EFTPS but fail to do so,you may be subject to a 10% penalty.

If you are not required to use EFTPS be-cause you did not meet the $200,000 thresh-old during 1998, or during any subsequentyear, then you may voluntarily make yourdeposits using EFTPS. However, if you areusing EFTPS voluntarily, you will not be sub-

ject to the 10% penalty if you make a depositusing a paper coupon.

For information about EFTPS, access theIRS web site at www.irs.gov , or see Publi-cation 966, The Easiest Way to Pay Your Federal Taxes.

To enroll in EFTPS, call:

18009458400, or 18005554477.

Quick refund of overpayments. A corpo-ration that has overpaid its estimated tax forthe tax year may be able to apply for a quickrefund.

Form 4466. Use Form 4466 to apply fora quick refund of an overpayment of esti-mated tax. A corporation can apply for a quickrefund if the overpayment is:

At least 10% of its expected tax liability,and

At least $500.

Use Form 4466 to figure the corporation'sexpected tax liability and the overpayment ofestimated tax.

File Form 4466 before the 16th day of the3rd month after the end of the tax year, butbefore the corporation files its income taxreturn. An extension of time to file the corpo-ration's income tax return will not extend thetime for filing Form 4466. The IRS will acton the form within 45 days from the date youfile it.

Income Tax ReturnThis section will help you to determine whenand how 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 returnwhether or not they have taxable income.

Which form to file. A corporation mustgenerally 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 1120 A 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 due date is extendedto the next business day.

Extension of time to file. File Form 7004 to request a 6-month extension of timeto file a corporation income tax return. TheIRS will grant the extension if you completethe form properly, file it, and pay any balancedue by the due date for the return.

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 the

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smaller of the tax due or $100. The penaltywill not be imposed if the corporation canshow the failure to file on time was due to areasonable cause. Corporations that file latemust attach a statement explaining the rea-sonable 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.

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 United States Treasury, thetrust fund recovery penalty may apply. Thepenalty is the full amount of the unpaid trustfund tax. This penalty may apply to you ifthese unpaid taxes cannot be immediatelycollected from the 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 Form1120A.

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 LoansA below-market loan is a loan on which nointerest is charged or on which interest ischarged at a rate below the applicable federalrate. A below-market loan generally is treatedas an arm's-length transaction in which theborrower is considered as having receivedboth the following:

A loan in exchange for a note that re-quires payment of interest at the appli-cable federal rate, and

An additional payment.

Treat the additional payment as a gift, divi-dend, contribution to capital, payment ofcompensation, or other payment, dependingon the substance of the transaction.

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

Capital LossesA corporation can deduct capital losses onlyup to the amount of its capital gains. In otherwords, if a corporation has an excess capitalloss, it cannot deduct the loss in the currenttax year. Instead, it carries the loss to othertax years and deducts it from capital gainsthat occur in those years.

First, carry a net capital loss back 3 years.Deduct it from any total net capital gain thatoccurred 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 2000, a calendar year cor-poration 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 ofthe long-term loss, leaving a net capital lossof $6,000. The corporation treats this $6,000as a short-term loss when carried back orforward.The corporation carries the $6,000 short-term loss back 3 years to 1997. In 1997, 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 lossfirst from the net short-term gain. This resultsin a net capital gain for 1997 of $7,000. Thisconsists of a net short-term capital gain of$2,000 ($8,000 $6,000) and a net long-termcapital 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. When

carrying a capital loss from one year to an-other, the following rules apply.

When figuring this year's net capital loss,you cannot combine it with a capital losscarried from another year. In other words,you can carry capital losses only to yearsthat would otherwise have a total netcapital gain.

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 back.

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 can 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 web site atwww.irs.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 that 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 charitablecontributions that exceed 10% of its taxableincome for the tax year. Figure taxable in-

come for this purpose without the following.

The deduction for charitable contribu-tions.

The deduction for dividends received.

Any net operating loss carryback to thetax year.

Any capital loss carryback to the tax year.

Carryover of excess contributions. Youcan carry over, within certain limits, to eachof the subsequent five years any charitablecontributions made during the current yearthat are more than the 10% limit. You lose

any excess not used within that period. Forexample, if a corporation has a carryover ofexcess contributions paid in 1999 and it doesnot use all the excess on its return for 2000,it can carry the rest over to 2001, 2002, 2003,and 2004. Do not deduct a carryover of ex-cess contributions in the carryover year untilafter you deduct contributions made in thatyear (subject to the 10% limit). You cannotdeduct a carryover of excess contributions tothe extent it increases a net operating losscarryover.

More information. For more information onthe charitable contributions deduction, seethe instructions for Forms 1120 and 1120A.

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Corporate Preference ItemsA corporation must make special adjustmentsto certain items before it takes them into ac-count in determining its taxable income.These items are known as corporate prefer-ence items and they include the following.

Gain on the disposition of section 1250 property. For more information,see Section 1250 Property under Depre- ciation Recapture in chapter 3 of Publi-cation 544.

Percentage depletion for iron ore and coal (including lignite). For more infor-mation, see Mines and Geothermal De- posits under Mineral Property in chapter10 of Publication 535.

Amortization of pollution control facilities. For more information, see Pollution Control Facilities in chapter 9 of Publica-tion 535 and section 291(a)(5) of theInternal Revenue Code.

Mineral exploration and development costs. For more information, see Explo- ration Costs and Development Costs inchapter 8 of Publication 535.

For more information on corporate preferenceitems, see section 291 of the Internal Reve-nue Code.

Dividends-ReceivedDeductionA corporation can deduct a percentage ofcertain dividends received during its tax year.This section discusses the general rules thatapply to this deduction. For more information,see the instructions for Forms 1120 and1120A.

Dividends from domestic corporations. Acorporation can deduct, within 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% de-

duction. A corporation can deduct, withincertain limits, 80% of the dividends receivedor accrued if it owns 20% or more of thepaying domestic 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.

Small business investment companies.Small business investment companies candeduct 100% of the dividends received fromtaxable domestic corporations.

Dividends from regulated investmentcompanies. 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.

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 undersection or 501 or 521 of the Internal

Revenue Code either for the tax year ofthe distribution or the preceding tax year.

3) A corporation whose stock was held lessthan 46 days during the 90-day periodbeginning 45 days before the stock be-came ex-dividend with respect to thedividend.

4) A corporation whose preferred stock washeld less than 91 days during the180-day period beginning 90 days beforethe stock became 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 with respect to positions for sub-stantially similar or related property.

Dividends on deposits. Dividends on de-posits or withdrawable accounts in domesticbuilding 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 from less-than-20%-owned corporations (reducing taxableincome by the total dividends receivedfrom 20%-owned corporations).

Figuring the limit. In figuring the limit,determine taxable income without the follow-ing items.

1) The net operating loss deduction.

2) The deduction for dividends received.

3) Any adjustment due to the nontaxablepart of an extraordinary dividend (seeExtraordinary Dividends, later).

4) 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.

Example 1. A corporation loses $25,000from operations. It receives $100,000 in divi-dends from a 20%-owned corporation. Itstaxable income is $75,000 before the de-duction for dividends received. If it claims thefull dividends-received deduction of $80,000($100,000 80%) and combines it with theoperations loss of $25,000, it will have a net

operating loss of $5,000. The 80% of taxableincome limit does not apply. The corporationcan deduct $80,000.

Example 2. Assume the same facts asin Example 1, except that the corporationloses $15,000 from operations. Its taxableincome is $85,000 before the deduction fordividends received. However, after claimingthe dividends-received deduction of $80,000($100,000 80%), its taxable income is$5,000. But because the corporation will nothave a net operating loss after a fulldividends-received deduction, its allowabledividends-received deduction is limited to80% of its taxable income, or $68,000($85,000 80%).

Extraordinary DividendsIf a corporation receives an extraordinarydividend on stock held 2 years or less beforethe dividend announcement date, it generallymust reduce its basis in the stock by thenontaxed part of the dividend. The nontaxedpart is any dividends-received deduction al-lowable for the dividends.

Extraordinary dividend. An extraordinary

dividend is any dividend on stock that equalsor exceeds a certain percentage of the cor-poration's adjusted basis in the stock. Thepercentages 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-dayperiod as one dividend. Treat all dividendsreceived that have ex-dividend dates withina 365-consecutive-day period as extraor-dinary dividends if the total of the dividendsexceeds 20% of the corporation's adjustedbasis in the stock.

Disqualified preferred stock. Any dividendon disqualified preferred stock is treated asan extraordinary dividend regardless of theperiod the corporation held the stock.

Disqualified preferred stock is any stockpreferred as to dividends if any of the follow-ing apply.

1) The stock when issued has a dividendrate that declines (or can reasonably beexpected to decline) in the future.

2) The issue price of the stock exceeds itsliquidation rights or stated redemptionprice.

3) The stock is otherwise structured toavoid the rules for extraordinary divi-dends and to enable corporate share-holders to reduce tax through a combi-nation of dividends-received deductionsand loss on the disposition of the stock.

These rules apply to stock issued afterJuly 10, 1989, unless it was issued under awritten binding contract in effect on that date,and thereafter, before the issuance of thestock.

More information. For more information onextraordinary dividends, see section 1059 ofthe Internal Revenue Code.

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Going Into BusinessWhen you go into business, certain costs youincur to get your business started are treatedas capital expenses. See Capital Expenses in chapter 1 of Publication 535 for a dis-cussion of how to treat these costs if you donot go into business.

You can choose to amortize certain costsfor setting up your business over a period of60 months or more. The cost must qualify asone of the following.

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

Business start-up costs. Start-up costs arecosts incurred for creating an active trade orbusiness or investigating the creation or ac-quisition of an active trade or business.Start-up costs include any amounts paid orincurred in connection with any activity en-gaged in for profit and for the production ofincome before the trade or business beginsin anticipation of the activity becoming anactive trade or business.

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

1) It is a cost you could deduct if you paidor incurred it to operate an existing ac-tive trade or business (in the same field).

2) It is a cost you pay or incur before theday your active trade or business begins.

Start-up costs include costs for the fol-lowing items.

A survey of potential markets. An analysis of available facilities, labor,

supplies, etc.

Advertisements for the opening of thebusiness.

Salaries and wages for employees who

are being trained, and their instructors. Travel and other necessary costs for se-

curing prospective distributors, suppliers,or customers.

Salaries and fees for executives andconsultants, or for other professionalservices.

Nonqualifying costs. Start-up costs donot include costs for the following items.

Deductible interest. Taxes. Research and experimental costs.

Purchasing an active trade or business. Amortizable start-up costs for pur-chasing an active trade or business includeonly costs incurred in the course of a generalsearch for, or preliminary investigation of, thebusiness. Investigative costs are costs thathelp you decide whether to purchase a busi-ness and which business to purchase. Alter-natively, costs you incur in the attempt topurchase a specific business are capital ex-penses and you cannot amortize them.

Disposition of business. If you com-pletely dispose of your business before theend of the amortization period, you can de-duct any remaining deferred start-up costs tothe extent allowable under section 165 of theInternal Revenue Code.

Organizational costs. The costs of organ-izing a corporation are the direct costs ofcreating the corporation.

Qualifying costs. You can amortize anorganizational cost only if it meets all of thefollowing 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 thecorporation, if the corporation had a fixedlife.

4) It is incurred before the end of the firsttax year in which the corporation is inbusiness. A corporation using the cashmethod of accounting can amortize or-ganizational costs incurred within thefirst tax year, even if it does not pay themin that year.

The following are examples of organiza-tional costs.

The costs of temporary directors. The cost of organizational meetings. State incorporation fees. The cost of accounting services for set-

ting up the corporation. The cost of legal services for items such

as drafting the charter, bylaws, terms ofthe original stock certificates, and min-utes of organizational meetings.

Nonqualifying costs. The followingcosts are not organizational costs. They arecapital expenses that you cannot amortize.

Costs for issuing and selling stock or se-curities, such as commissions, profes-sional fees, and printing costs.

Costs associated with the transfer of as-sets to the corporation.

How to amortize. You deduct start-up and

organizational costs in equal amounts over aperiod of 60 months or more. You can choosea period for start-up costs that is different fromthe period you choose for organizationalcosts, as long as both are 60 months or more.Once you choose an amortization period, youcannot change it.

To figure your deduction, divide your totalstart-up or organizational costs by the monthsin the amortization period. The result is theamount you can deduct each month.

When to begin amortization. Theamortization period starts with the month youbegin business operations.

How to make the choice. To choose toamortize start-up or organizational costs, youmust attach Form 4562 and an accompany-ing statement to your return for the first taxyear you are in business. If you have bothstart-up and organizational costs, attach aseparate statement to your return for eachtype of cost.

Generally, you must file the return by thedue date (including any extensions). How-ever, if you timely filed your return for the yearwithout making the choice, you can still makethe choice by filing an amended return withinsix months of the due date of the return (ex-cluding extensions). For more information,see the instructions for Part VI of Form 4562.

Once you make the choice to amortizestart-up or organizational costs, you cannotrevoke it.

Corporations. Only your corporation canchoose to amortize its start-up or organiza-tional costs. You, as a shareholder, cannotamortize any costs you incur in setting upyour corporation. The corporation, however,can amortize these costs.

Start-up costs. If you choose to amortizeyour start-up costs, complete Part VI of Form4562 and prepare a separate statement thatcontains the following information.

A description of the business to which thestart-up costs relate.

A description of each start-up cost in-curred.

The month your active business began(or the month you acquired the business).

The number of months in your amorti-zation period (not less than 60).

You can choose to amortize your start-upcosts by filing the statement with a return forany tax year prior to the year your activebusiness begins. If you file the statementearly, the choice becomes effective in themonth of the tax year your active businessbegins.

You can file a revised statement to include

any start-up costs not included in your originalstatement. However, you cannot include onthe revised statement any cost you previouslytreated on your return as a cost other than astart-up cost. You can file the revised state-ment with a return filed after the return onwhich you choose to amortize your start-upcosts.

Organizational costs. If you choose toamortize your organizational costs, completePart VI of Form 4562 and prepare a separatestatement that contains the following infor-mation.

A description of each cost. The amount of each cost. The date each cost was incurred. The month your active business began

(or the month you acquired the business).

The number of months in your amorti-zation period (not less than 60).

The election to amortize must be madeby the due date of the return, including ex-tensions. Once made, it is irrevocable.

Related PersonsA corporation that uses an accrual methodof accounting cannot deduct business ex-penses and interest owed to a related personwho uses the cash method of accountinguntil the corporation makes the payment andthe corresponding amount is includible in therelated person's gross income. Determine therelationship, for this rule, as of the end of thetax year for which the expense or interestwould otherwise be deductible. If a deductionis denied under this rule, the rule will continueto apply even if the corporation's relationshipwith the person ends before the expense orinterest is includible in the gross income ofthat person. These rules also deny the de-duction of losses on the sale or exchange ofproperty between related persons.

Related persons. For purposes of this rule,the following persons are related to a corpo-ration.

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1) Another corporation that is a member ofthe same controlled group as defined insection 267(f) of the Internal RevenueCode.

2) An individual who owns, directly or indi-rectly, more than 50% of the value of theoutstanding stock of the corporation.

3) A trust fiduciary when the trust or thegrantor of the trust owns, directly or in-directly, more than 50% in value of theoutstanding stock of the corporation.

4) An S corporation if the same personsown more than 50% in value of the out-standing stock of each corporation.

5) A partnership if the same persons ownmore than 50% in value of the out-standing stock of the corporation andmore than 50% of the capital or profitsinterest in the partnership.

6) Any employee-owner if the corporationis a personal service corporation (de-fined later), regardless of the amount ofstock owned by the employee-owner.

Ownership of stock. To determinewhether an individual directly or indirectly

owns any of the outstanding stock of a cor-poration, the following rules apply.

1) Stock owned, directly or indirectly, by orfor a corporation, partnership, estate, ortrust is treated as being owned propor-tionately by or for its shareholders, part-ners, or beneficiaries.

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

3) Any individual owning (other than byapplying rule (2)) any stock in a corpo-

ration is treated as owning the stockowned directly or indirectly by that indi-vidual's partner.

4) To apply rule (1), (2), or (3), stock con-structively owned by a person under rule(1) is treated as actually owned by thatperson. But stock constructively ownedby an individual under rule (2) or (3) isnot treated as actually owned by the in-dividual for applying either rule (2) or (3)to make another person the constructiveowner of that stock.

Personal service corporation. For thispurpose, a corporation is a personal servicecorporation if it meets all of the following re-quirements.

1) It is not an S corporation.

2) Its principal activity is performing per-sonal services. Personal services arethose performed in the fields of ac-counting, actuarial science, architecture,consulting, engineering, health (includingveterinary services), law, and performingarts.

3) Its employee-owners substantially per-form the services in (2).

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

Reallocation of income and deductions.Where it is necessary to clearly show incomeor prevent tax evasion, the IRS can reallocategross income, deductions, credits, or allow-ances between two or more organizations,trades, or businesses owned or controlled di-rectly, or indirectly, by the same interests.

Complete liquidations. The disallowanceof losses from the sale or exchange of prop-erty between related persons does not applyto liquidating distributions.

More information. For more informationabout the related persons rules, see Publica-tion 544.

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 fair marketvalue of other property, and any assumed li-ability. If a domestic corporation distributes aU.S. real property interest to a foreign personor firm, it may have to withhold tax on the fairmarket value of the property. A corporationthat fails to withhold may be liable for the tax,and any penalties and interest that apply. Formore information, see U.S. Real Property In- terest in Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Corpo- rations.

Figuring TaxableIncomeYou figure a corporation's taxable income bysubtracting its allowable deductions from itsincome on page 1 of Form 1120 or 1120A.This section discusses special rules that mayapply to the following corporations.

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

A closely held corporation. A personal service corporation.

Net Operating LossesA corporation generally figures and deductsa net operating loss (NOL) the same way anindividual, estate, or trust does. The samecarryback and carryforward periods apply,and the same sequence applies when thecorporation carries two or more NOLs to thesame year. For more information on thesegeneral rules, see Publication 536, Net Op- erating Losses (NOLs) for Individuals, Es- tates, and Trusts.

A corporation's NOL generally differs fromother NOLs in the following ways.

1) A corporation can take different de-ductions when figuring an NOL.

2) A corporation must make different mod-ifications to its taxable income in thecarryback or carryforward year whenfiguring how much of the NOL is usedand how much is carried forward to thenext year.

A corporation also uses different formswhen claiming an NOL deduction from thoseused by individuals, estates, and trusts.

The following discussions explain thesedifferences.

Figuring the NOLA corporation figures an NOL in the same wayit figures taxable income. It starts with itsgross income and subtracts its deductions. Ifits deductions are more than its gross income,the corporation has an NOL.

However, the following rules for figuringthe NOL either limit what the corporation candeduct or permit deductions not ordinarily al-lowed.

1) A corporation cannot deduct any NOLcarrybacks or carryovers from otheryears.

2) A corporation can take the deduction fordividends received, explained later,without regard to the aggregate limits(based on taxable income) that normallyapply.

3) A corporation can figure the deductionfor dividends paid on certain preferredstock of public utilities without limiting itto its taxable income for the year.

Dividends-received deduction. The corpo-ration's deduction for dividends received fromdomestic corporations is generally subject toan aggregate limit of 70% or 80% of taxableincome. However, if a corporation sustainsan NOL for a tax year, the limit based ontaxable income does not apply. In determiningif a corporation has an NOL, the corporationfigures the dividends-received deductionwithout regard to the 70% or 80% of taxableincome limit.

For more information on the dividends-received deduction, see Dividends-Received Deduction under Income and Deductions,earlier.

Example. A corporation had $500,000 ofgross income from business operations and$625,000 of allowable business expenses. Italso received $150,000 in dividends from adomestic corporation for which it can take an80% deduction, ordinarily limited to 80% of itstaxable income before the deduction. It fig-ures its NOL as follows:

Claiming the NOL DeductionThe form a corporation uses to deduct itsNOL depends on whether it carries the NOLback or forward.

For a carryback. If a corporation carriesback the NOL, it can use either Form 1120X or Form 1139 . A corporation can get a refundfaster by using Form 1139. It cannot file Form1139 before filing the return for the corpo-ration's NOL year, but it must file Form 1139no later than one year after the NOL year.

If the corporation does not file Form 1139,it must file Form 1120X within 3 years of thedue date, plus extensions, for filing the returnfor the year in which it sustains the NOL.

Income from business ........................... $500,000Dividends ............................................... 150,000Gross income ........................................ $650,000Deductions (expenses) .......................... (625,000)Taxable income beforespecial deductions ................................. $25,000Minus: Deduction for dividends re-ceived, 80% of $150,000 ...................... (120,000)

Net operating loss ............................... ($95,000)

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For a carryforward. If a corporation carriesforward its NOL, it enters the carryforward onSchedule K (Form 1120), line 12. It also en-ters the deduction for the carryover (but notto exceed the corporation's taxable incomeafter special deductions) on line 29(a) of Form1120 or line 25(a) of Form 1120A.

Carryback expected. If a corporation ex-pects to have an NOL in its current year, itcan automatically extend the time for payingall or part of its income tax for the immediately

preceding year. It does this by filing Form 1138. It must explain on the form why it ex-pects the loss.

The extension amount cannot exceed thetax overpayment in the carryback years dueto the NOL carryback.

Period of extension. The extension is ineffect until the end of the month in which thereturn for the NOL year is due, including ex-tensions.

If the corporation files Form 1139 beforethis date, the extension will continue until thedate the IRS notifies the corporation that itsForm 1139 is disallowed in whole or in part.

Figuring the NOL Carryover

If the NOL available for a carryback orcarryforward year is greater than the taxableincome for that year, the corporation mustmodify its taxable income to figure how muchof the NOL it will use up in that year and howmuch it can carry to the next tax year. Itscarryover is the excess of the available NOLover its modified taxable income for thecarryback or carryforward year.

Modified taxable income. A corporationfigures its modified taxable income in muchthe same way it figures taxable income withthe following exceptions.

It can deduct NOLs only from years before the NOL year whose carryover isbeing figured.

The corporation must figure its deductionfor charitable contributions without con-sidering any NOL carrybacks.

The modified taxable income for any yearcannot be less than zero.

Modified taxable income is used only tofigure how much of an NOL the corporationuses up in the carryback or carryforward yearand how much it carries to the next year. It isnot used to fill out the corporation's tax returnor figure its tax.

Ownership change. A loss corporation thathas an ownership change is limited on thetaxable income it can offset by NOLcarryforwards arising before the date of theownership change. This limit applies to anyyear ending after the change of ownership.

See sections 381, 382, 383, 384, and 269of the Internal Revenue Code and the relatedregulations for more information about thelimits on corporate NOL carryovers, definitionof a loss corporation, and corporate owner-ship changes.

Corporate equity reduction transactions.The part of an NOL generated by certain in-terest deductions attributable to a corporateequity reduction transaction can not be car-

ried back to a tax year before the tax year ofthe transaction. See sections 172(b)(1)(E)and 172(h) of the Internal Revenue Code formore information.

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 thetax 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 halfbrothers 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 the amountof your passive activity income. Generally,you are in a passive activity if you have atrade or business activity in which you do notmaterially participate during the tax year, oryou have a rental activity.

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

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


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, or

b) The last day of the calendar year inwhich 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.

Personal services. Personal services arethose performed in the fields of accounting,actuarial science, architecture, consulting,engineering, health (including veterinary ser-vices), law, and performing arts.

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 for,or on behalf of, the corporation (even ifhe or she is an independent contractorfor other purposes) 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.


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 indirectly,owned 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 figure its tax on Schedule J (Form1120) or Part I (Form 1120A). This sectiondiscusses the tax rate schedule, credits, re-capture taxes, and the alternative minimumtax.

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

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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 personalservices.

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(e) of the regulations for

details.

CreditsA corporation's tax liability is reduced if ittakes any credits. The following list includessome credits available to corporations.

Credit for federal tax on fuels used forcertain nontaxable purposes (see Publi-cation 378, Fuel Tax Credits and Refunds ).

Credit for prior year minimum tax (seeForm 8827 ).

Foreign tax credit (see Form 1118 ).

General business credit (see General business credit, next). Nonconventional source fuel credit (see

section 29 of the Internal Revenue Code).

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 ).

Tax Rate Schedule 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 ( Form

8830 ). 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 ).

Your general business credit for the currentyear may be increased by the carryback orcarryforward of business credits from otheryears.

To claim a general business credit, youmust first get the form or forms you need toclaim your current year business credits. Theabove list identifies current year businesscredits. The form used to claim each creditis shown in parentheses. In addition to thecredit form, you may also need to file Form3800.

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, see Form 8582 CR. )

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

See the Form 3800 instructions for moreinformation about the general business credit.

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

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

Investment credit (see the instructions forForm 4255 ).

Low-income housing credit (see the in-structions for Form 8611 ).

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

Alternative MinimumTax (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 corporations pay a minimumamount of tax on their economic income. A

corporation owes AMT if its tentative mini-mum 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-ration is zero. This means that a small cor-poration will not owe AMT.

Small corporation exemption. A corpo-ration is treated as a small corporation ex-empt from the AMT for its tax year beginningin 2000 if that year is the corporation's first taxyear in existence or:

1) It was treated as a small corporationexempt from the AMT for all prior taxyears beginning after 1997, and

2) Its average annual gross receipts for the3-tax-year period (or portion thereof)ending before its tax year beginning in2000 did not exceed $7.5 million ($5million if the corporation had only 1 priortax year).

For more information, see the instructionsfor Form 4626.

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 corporationallows 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 the tax from the datethe corporate return was originally due, with-out extensions.

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 thefields of accounting, actuarial science, archi-tecture, consulting, engineering, health (in-cluding veterinary services), law, and per-forming arts.

In determining if the corporation has ac-cumulated earnings and profits beyond itsreasonable 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.

Reasonable needs of the business includethe following.

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

If taxable income (line30, Form 1120, or line26, Form 1120A) is:

Of theBut not amount

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

Distributions toShareholdersThis section discusses corporate distributionsof money, stock, or other property to ashareholder with respect to the shareholder's

ownership of stock. However, this sectiondoes not discuss the special rules that applyto the following distributions.

Distributions in redemption of stock. Distributions in complete liquidation of the

corporation.

Distributions in corporate organizationsand reorganizations.

Certain distributions to 20% corporateshareholders.

Money or PropertyDistributionsMost distributions are in money, but they mayalso be in stock or other property. For thispurpose, property generally does not in-clude stock in the corporation or rights to ac-quire this stock. However, see Distributions of Stock or Stock Rights, later.

A corporation generally does not recog-nize a gain or loss on the distributions cov-ered by the rules in this section. However,see Gain from property distributions, later.

Amount distributed. The amount of a dis-tribution is generally the amount of anymoney paid to the shareholder plus the fairmarket value (FMV) of any property trans-ferred to the shareholder. However, thisamount is reduced (but not below zero) by thefollowing liabilities.

Any liability of the corporation the share-holder assumes in connection with thedistribution.

Any liability to which the property is subject immediately before, and immediatelyafter, the distribution.

The FMV of any property distributed to ashareholder becomes the shareholder's basisin that property.

Gain from property distributions. A cor-poration will recognize a gain on the distribu-tion of property to a shareholder if the FMVof the property is more than its adjusted basis.

This is generally the same treatment the cor-poration would receive if the property weresold. However, for this purpose, the FMV ofthe property is the greater of the followingamounts.

The actual FMV. The amount of any liabilities the share-

holder assumed in connection with thedistribution of the property.

If the property was depreciable or amor-

tizable, the corporation may have to treat allor part of the gain as ordinary income fromdepreciation recapture. For more informationon depreciation recapture and the sale ofbusiness property, see Publication 544.

Distributions of Stockor Stock RightsDistributions by a corporation of its own stockare commonly known as stock dividends.Stock rights (also known as stock options)are distributions by a corporation of rights toacquire its stock. Distributions of stock divi-dends and stock rights are generally tax-freeto shareholders. However, stock and stockrights are treated as property under the rulesdiscussed earlier if any of the following applyto their distribution.

1) Any shareholder has the choice to re-ceive cash or other property instead ofstock or stock rights.

2) The distribution gives cash or otherproperty to some shareholders and anincrease in the percentage interest in thecorporation's assets or earnings andprofits to other shareholders.

3) The distribution is in convertible pre-ferred stock and has the same result asin (2).

4) The distribution gives preferred stock tosome common stock shareholders andgives common stock to other commonstock shareholders.

5) The distribution is on preferred stock.(An increase in the conversion ratio ofconvertible preferred stock made solelyto take into account a stock dividend,stock split, or similar event that wouldotherwise result in reducing the conver-sion right is not a distribution on pre-ferred stock.)

For this purpose, the term stock includesrights to acquire stock and the term share-holder includes a holder of rights or convert-ible securities.

Constructive stock distributions. Youmust treat certain transactions that increasea shareholder's proportionate interest in theearnings and profits or assets of a corporationas if they were distributions of stock or stockrights. These constructive distributions aretreated as property if they have the same re-sult as a distribution described in (2), (3), (4),or (5) of the above discussion.

This treatment applies to a change in yourstock's conversion ratio or redemption price,a difference between your stock's redemptionprice and issue price, a redemption that is nottreated as a sale or exchange of your stock,and any other transaction having a similareffect on a shareholder's interest in the cor-poration.

Expenses of issuing a stock dividend. Youcannot deduct the expenses of issuing astock dividend. These include printing, post-age, cost of advice sheets, fees paid totransfer agents, and fees for listing on stockexchanges. The corporation must capitalizethese costs.

Constructive DistributionsThe following sections discuss transactionsthat may be treated as distributions.

Below-market loans. If a corporation givesa shareholder a loan on which no interest ischarged or on which interest is charged at arate below the applicable federal rate, the in-terest not charged may be treated as a dis-tribution to the shareholder. For more infor-mation, see Below-Market Loans underIncome and Deductions, earlier.

Corporation cancels shareholder's debt.If a corporation cancels a shareholder's debtwithout repayment by the shareholder, theamount canceled is treated as a distributionto the shareholder.

Transfers of property to shareholders forless than FMV. A sale or exchange ofproperty by a corporation to a shareholdermay be treated as a distribution to theshareholder. For a shareholder who is not acorporation, if the FMV of the property on thedate of the sale or exchange exceeds theprice paid by the shareholder, the excess maybe treated as a distribution to the shareholder.

Unreasonable rents. If a corporation rentsproperty from a shareholder and the rent isunreasonably more than the shareholderwould charge to a stranger for use of thesame property, the excessive part of the rentmay be treated as a distribution to theshareholder. For more information, seechapter 4 in Publication 535.

Unreasonable salaries. If a corporationpays an employee who is also a shareholdera salary that is unreasonably high consideringthe services actually performed by theshareholder-employee, the excessive part ofthe salary may be treated as a distribution tothe shareholder-employee. For more infor-mation, see chapter 2 in Publication 535.

Reporting Dividends andOther DistributionsA corporate distribution to a shareholder isgenerally treated as a distribution of earningsand profits. Any part of a distribution from ei-ther current or accumulated earnings andprofits is reported to the shareholder as adividend. Any part of a distribution that is notfrom earnings and profits is applied againstand reduces the adjusted basis of the stockin the hands of the shareholder. To the extentthe balance is more than the adjusted basisof the stock, the shareholder has a gain(usually a capital gain) from the sale or ex-change of property.

For information on shareholder reportingof corporate distributions, see Publication550, Investment Income and Expenses.

Form 1099DIV. File Form 1099DIV withthe IRS for each shareholder to whom youhave paid dividends and other distributionson stock of $10 or more during a calendar

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year. You must generally send Forms1099DIV to the IRS with Form 1096 byFebruary 28 (March 31 if filing electronically)of the year following the year of the distribu-tion. For more information, see the generalinstructions for Forms 1099, 1098, 5498, andW2G.

Generally, you must furnish Forms1099DIV to shareholders by January 31 ofthe year following the close of the calendaryear during which the corporation made thedistributions. However, you may furnish theForm 1099DIV to shareholders after No-vember 30 of the year of the distributions ifthe corporation has made its final distributionsfor the year. You may furnish the Form1099DIV to shareholders after April 30 of theyear of the distributions if you furnish themwith the final distributions for the calendaryear.

Backup withholding. Dividends may besubject to backup withholding at a 31% rate.For more information on backup withholding,see the general instructions for Forms 1099,1098, 5498, and W2G.

Form 5452. File Form 5452 if nondividenddistributions were made to shareholders.

A calendar tax year corporation must fileForm 5452 with its income tax return for thetax year in which the nondividend distributionswere made. A fiscal tax year corporation mustfile Form 5452 with its income tax return duefor the first fiscal year ending after the calen-dar year in which the nondividend distribu-tions were made.

Current year earnings and profits. If acorporation's earnings and profits for the year(figured as of the close of the year withoutreduction for any distributions made duringthe year) are more than the total amount ofdistributions made during the year, all distri-butions made during the year are treated asdistributions of current year earnings and

profits. If the total amount of distributions ismore than the earnings and profits for theyear, see Accumulated earnings and profits,later.

Example. You are the only shareholderof a corporation that uses the calendar yearas its tax year. In January, you use theworksheet in the Form 5452 instructions tofigure your corporation's current yearearnings and profits for the previous year.During the year, the corporation made four$1,000 distributions to you. At the end of theyear (before subtracting distributions madeduring the year), the corporation had $10,000of current year earnings and profits.

Since the corporation's current year

earnings and profits ($10,000) were morethan the amount of the distributions it madeduring the year ($4,000), all of the distribu-tions are treated as distributions of currentyear earnings and profits.

The corporation must issue a Form1099DIV to you by the end of January toreport the $4,000 distributed to you during theprevious year as dividends. The corporationmust use Form 1096 to report this informationto the IRS by February 28 (March 31 if filingelectronically). The corporation does not de-duct these dividends on the income tax returnit files by March 15.

Accumulated earnings and profits. If acorporation's current year earnings and profits(figured as of the close of the year withoutreduction for any distributions made duringthe year) are less than the total distributionsmade during the year, part or all of each dis-tribution is treated as a distribution of accu-mulated earnings and profits. Accumulatedearnings and profits are earnings and profitsthe corporation accumulated after February1913 and before the current year.

If the total amount of distributions is lessthan current year earnings and profits, seeCurrent year earnings and profits, earlier.

Used with current year earnings and profits. If the corporation has current yearearnings and profits, figure the use of accu-mulated and current earnings and profits asfollows.

1) Divide the current year earnings andprofits by the total distributions madeduring the year.

2) Multiply each distribution by the per-centage figured in (1) to get the amounttreated as a distribution of current yearearnings and profits.

3) Start at the beginning of the year andtreat the remaining part of each distribu-tion as a distribution of accumulatedearnings and profits.

4) If accumulated earnings and profits arereduced to zero, the remaining part ofeach distribution is applied against andreduces the adjusted basis of the stockin the hands of the shareholders. To theextent that the balance is more than theadjusted basis of the stock, it is treatedas a gain from the sale or exchange ofproperty.

Example. You are the only shareholderof a corporation that uses the calendar year

as its tax year. In January, you use theworksheet in the Form 5452 instructions tofigure your corporation's current yearearnings and profits for the previous year.At the beginning of the year, the corporation'saccumulated earnings and profits balancewas $20,000. During the year, the corporationmade four $4,000 distributions to you. At theend of the year (before subtracting distribu-tions made during the year), the corporationhad $10,000 of current year earnings andprofits.

Since the corporation's current yearearnings and profits ($10,000) were less thanthe amount of the distributions it made duringthe year ($16,000), part of each distributionis treated as a distribution of accumulatedearnings and profits. Treat the distributionsas follows.

1) Divide the current year earnings andprofits ($10,000) by the total amount ofdistributions made during the year($16,000). The result is .625.

2) Multiply each $4,000 distribution by the.625 figured in (1) to get the amount($2,500) of each distribution that istreated as a distribution of current yearearnings and profits.

3) The remaining $1,500 of each distribu-tion is treated as a distribution from ac-

cumulated earnings and profits. Thecorporation distributed $6,000 ($1,500 4) of accumulated earnings and profits.

The remaining $14,000 ($20,000 $6,000)of accumulated earnings and profits is avail-able for use in the following year.

The corporation must issue a Form1099DIV to you by the end of January toreport the $16,000 distributed to you duringthe previous year as dividends. The corpo-ration must use Form 1096 to report this in-

formation to the IRS by February 28 (March31 if filing electro

Documents

US Internal Revenue Service: p542--2000