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How to Calculate Corporate Taxable Financial Income

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  • 0:03 Corporate Taxable Income
  • 3:40 Gross Income
  • 5:40 Expenses and Deductions
  • 8:40 Specially Treated Items
  • 9:43 Relationship to Accounting
  • 10:19 Lesson Summary
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Lesson Transcript
Instructor: Michael Eagan

Michael teaches tax, accounting and finance courses and has a law degree, an MBA, and an LL.M in Taxation.

This lesson addresses the calculation of a corporation's taxable income as determined under U.S. federal income tax principles and discusses the major inclusions, exclusions, and allowable deductions.

Corporate Taxable Income

Let's say that today is your first day as a practicing accountant. A small business owner walks through the door with a box full of receipts, a draft trial balance, and questions about his corporation's tax liabilities. Luckily, you've just completed your corporate tax class, so you're ready for his questions!

He tells you - and the trial balance confirms - that his corporation had a loss during its first year. ''This means I have a tax loss too, right?'' he asks. Going further, he tells you that he would like to use that loss to offset his individual income. ''Sit down,'' you tell your new client. ''Let me explain how the corporate income tax works.''

Addressing his first question, you explain that unlike financial accounting income, taxable income is determined with respect to the rules and procedures of US income tax law as defined by the Internal Revenue Code (or the IRC), Treasury Department Regulations (or the Regulations), Internal Revenue Service (the infamous IRS) authorities (such as Revenue Rulings), and a vast body of court case law. The timing, you explain, of income and expense for purposes of the tax calculation may differ from the timing of income or expense under financial accounting principles. This creates, you add, 'book-tax' differences, which must be accounted for in the financial statements. Moreover, you tell him, some items of financial statement income and expense may not even be taxable or deductible for tax purposes. ''Therefore,'' you tell your client, ''a loss for financial statement purposes does not mean the corporation will also have a loss for tax purposes.''

Turning to his second question, you explain that corporations, with limited exceptions, are separate, taxable entities and pay a tax on their taxable income based on a graduated rate schedule (IRC 11(a)). Corporations generally report their taxable income and calculate their tax liability on the Form 1120. ''Unfortunately, you explain to your client, losses inside a corporation, because they are separate taxable entities, can't offset individual income. Moreover,'' you add, ''corporation income is, as we will see, potentially subject to double tax because dividends you receive from your corporation are taxable to you but not deductible to the corporation. Perhaps we should have a conversation on whether the corporate form is the best form for your business.''

''So what is corporate taxable income?'' your client asks. ''It's a simple formula,'' you tell him. ''Taxable income is defined by Internal Revenue Code ('IRC') section 63 on gross income less allowable deductions. Again, you explain, the timing of both gross income and the allowable deductions is determined under US tax law, not financial accounting concepts, which may lead to book-tax differences. These book-tax differences, in fact, are reported on the Schedule M-3 on the corporation's Form 1120. The background,'' you explain, ''is that large corporations were reporting large amounts of net income on their financial statements but paying little tax. The IRS, in this case, wanted to understand why and now requires corporations to reconcile their financial statement income to their taxable income.''

''So, let's talk about the two components of taxable income: gross income and allowable deductions.''

Gross Income

Gross income is defined in IRC section 61 and broadly captures all income from whatever source derived, unless specifically excluded. Specific examples of gross income include business income, compensation for services such as fees and commissions, interest income, rents, royalties, and dividends. Income is included in gross income whether earned in exchange for money, property, or services.

''Four aspects of gross income are noteworthy,'' you tell your client:

  1. While broad, gross income is not as broad as an economic concept of income, which would capture all accretions to wealth, realized or unrealized, and is limited, generally, to realized gains (losses, too, must generally be realized). ''One realizes gain or loss,'' you explain, ''generally when you dispose of or sell an asset. The realization principle is a fundamental concept in the US tax system, and in a case called Glenshaw Glass, the Supreme Court held that in order for income to be included in taxable income, income needed to be realized.''

  2. Cost of goods sold reduces business gross income. But the components of COGS, notably the inventory methods used, may differ between tax and financial statement income.

  3. Gross income generally includes income from the discharge or cancellation of a debt obligation, subject to a possible exclusion. This was the holding in another famous Supreme Court case - Kirby Lumber - which concluded that the relief from debt was an accession to wealth, and therefore, included in gross income.

  4. Certain income is specifically excluded from gross income, including, in certain cases, cancellation of debt income. Exclusions relevant to corporations, as opposed to unique to individuals, include contributions to corporate capital and state and local government bond interest.

Expenses and Deductions

''Only expenses specified as deductible in the IRC or its regulations reduce gross income when calculating taxable income,'' you explain. ''Some common corporate deductions include:''

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