Corporate taxation is a major component of the REG section, and understanding how C corporations are taxed is essential for passing. Unlike partnerships and S corporations, which are pass-through entities, C corporations are subject to an entity-level tax on their income. This creates a layer of complexity that includes issues around double taxation, the dividends received deduction, corporate formation, distributions, and liquidations. The CPA exam tests these concepts through both multiple-choice questions and task-based simulations.
This study guide covers the core C corporation tax topics you need to master for the REG section.
C Corporation Taxable Income
The calculation of taxable income for a C corporation follows a general framework similar to individual taxation but with important differences. The basic formula is:
Gross Income - Deductions = Taxable Income
The corporate tax rate is a flat 21% following the Tax Cuts and Jobs Act. Prior graduated rates no longer apply to most exam questions, but understand that the flat rate simplifies the calculation significantly.
Gross income for a corporation includes:
- Sales revenue minus cost of goods sold
- Dividend income
- Interest income
- Rental income
- Royalty income
- Capital gains
- Other income items
Key Corporate Deductions
Dividends Received Deduction (DRD)
The DRD is unique to C corporations and exists to mitigate the impact of triple taxation (taxing dividends at every corporate level). The deduction depends on the ownership percentage:
- Less than 20% ownership: 50% deduction of dividends received
- 20% to less than 80% ownership: 65% deduction
- 80% or more ownership: 100% deduction (affiliated group)
Important limitation: The DRD generally cannot exceed the applicable percentage of the corporation's taxable income (computed without the DRD, any NOL deduction, and any capital loss carryback). However, this limitation does not apply if applying the DRD creates or increases a net operating loss.
Organizational and Start-Up Costs
A corporation may elect to deduct up to $5,000 of organizational expenditures and up to $5,000 of start-up costs in the first year, with each amount reduced dollar-for-dollar for costs exceeding $50,000. Remaining costs are amortized over 180 months beginning with the month the corporation begins business.
Charitable Contribution Deduction
C corporations may deduct charitable contributions up to 10% of taxable income (computed before the charitable deduction, the DRD, any NOL carryback, and any capital loss carryback). Excess contributions can be carried forward five years.
Exam tip: The 10% limitation for corporations differs from the individual limitations (generally 60% of AGI for cash to public charities). This distinction is frequently tested.
Net Operating Loss (NOL)
Under current law, NOLs can be carried forward indefinitely but cannot be carried back (with limited exceptions). The NOL deduction is limited to 80% of taxable income in the carryforward year.
Capital Losses
C corporations may only deduct capital losses to the extent of capital gains. Net capital losses cannot offset ordinary income. Unused capital losses can be carried back three years and forward five years, and they are always treated as short-term capital losses in the carryover year.
Estimated Tax Payments
C corporations must make estimated tax payments if they expect their tax liability to be $500 or more. Payments are generally due on the 15th day of the 4th, 6th, 9th, and 12th months of the taxable year. To avoid a penalty, the corporation must pay the lesser of:
- 100% of the current year's tax liability, or
- 100% of the prior year's tax liability (not available for large corporations after the first installment)
Exam tip: Individual estimated tax rules differ from corporate rules. Individuals can use 100% of the prior year's tax (110% if AGI exceeds $150,000). Be careful not to mix these up.
Corporate Formation: Section 351
Section 351 provides that no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock of that corporation, if the transferors are in control of the corporation immediately after the exchange. Control is defined as owning at least 80% of the total combined voting power and at least 80% of the total shares of all other classes of stock.
Key rules for Section 351:
- Property must be transferred. Services do not qualify as property for Section 351 purposes.
- Boot (non-stock consideration received, such as cash or debt relief) triggers gain recognition to the extent of boot received, but not in excess of the realized gain.
- Basis - The shareholder's basis in the stock received equals the basis of the property transferred, minus any boot received, plus any gain recognized.
- Corporation's basis in the property received equals the transferor's basis, plus any gain recognized by the transferor.
- Losses are never recognized in a Section 351 exchange.
Corporate Distributions
When a C corporation distributes property (including cash) to its shareholders, the tax treatment depends on the corporation's earnings and profits (E&P):
- Dividend - To the extent of current and accumulated E&P, the distribution is a taxable dividend.
- Return of capital - Any amount exceeding E&P reduces the shareholder's stock basis.
- Capital gain - Any amount exceeding both E&P and stock basis is treated as capital gain.
Current E&P is allocated to distributions on a pro-rata basis throughout the year, while accumulated E&P is allocated in chronological order. If current E&P is positive but accumulated E&P is negative, you must net them to determine dividend treatment. This ordering is a classic exam topic.
Stock Redemptions
A stock redemption is treated as either a sale (capital gain treatment) or a dividend, depending on whether the redemption meets certain tests:
- Substantially disproportionate - After the redemption, the shareholder owns less than 50% of voting power and less than 80% of the pre-redemption voting percentage.
- Complete termination - All of the shareholder's stock is redeemed. Attribution rules may be waived if certain conditions are met.
- Not essentially equivalent to a dividend - Determined based on all facts and circumstances; the shareholder must experience a meaningful reduction in ownership.
If the redemption qualifies for sale treatment, the shareholder recognizes capital gain or loss. If not, the distribution is treated as a dividend to the extent of E&P.
Corporate Liquidations
When a corporation liquidates, there are tax consequences at both the corporate and shareholder levels:
Corporate Level
The corporation recognizes gain or loss as if it sold its assets at fair market value. However, losses are not recognized on distributions to related parties if the distribution is not pro rata or involves disqualified property.
Shareholder Level
Shareholders treat the liquidating distribution as a sale of their stock, recognizing capital gain or loss equal to the difference between the fair market value of the property received and their stock basis.
Section 332: Subsidiary Liquidation
When a parent corporation liquidates an 80%-or-more-owned subsidiary, no gain or loss is recognized by either the parent or the subsidiary. The parent takes a carryover basis in the subsidiary's assets.
Exam Preparation Strategy
To master corporate taxation for the REG section:
- Start with the taxable income calculation and make sure you can apply the DRD correctly, including the limitation.
- Know Section 351 inside and out, especially the control requirement, boot rules, and basis calculations.
- Understand the E&P ordering rules for distributions.
- Practice stock redemption analysis using the substantially disproportionate and complete termination tests.
- Know the basic rules for corporate liquidations at both the corporate and shareholder levels.
Think CPA offers REG practice questions that test corporate taxation concepts in the format and difficulty level you will encounter on exam day. Working through these questions systematically will help you identify gaps in your understanding and build confidence for the corporate tax portion of the REG section.