Ch3. Corporate Income Tax — Tax Structure and Rates

Corporate Income Tax Overview

Taxpayer: C-corporation (incorporated entity taxed as a corporation)
Individuals / pass-throughs: Pay individual income tax / pass-through tax

Corporate taxpayers by type:
Domestic C-corporation: Taxed on worldwide income
Foreign corporation: Taxed only on US-source income (effectively connected)

Filing:
- Form 1120 (C-corporation)
- Due: April 15 for calendar-year corporations
  (automatic 6-month extension via Form 7004)
- S-corporations file Form 1120-S (pass-through, due March 15)

Computing Corporate Taxable Income

Taxable income computation (Schedule M-1 reconciliation):
Book net income (per GAAP financial statements)
  + M-1 additions (income items for tax not on books):
    - Federal income tax accrued on books (add back; not deductible)
    - 50% of meals disallowed for tax
    - 100% of entertainment disallowed for tax
    - Fines and penalties (add back)
    - Excess compensation (§ 162(m))
    - Tax depreciation < book depreciation (add back excess book depreciation)
  − M-1 subtractions (deductions for tax not on books):
    - Dividends-received deduction (DRD — IRC § 243)
    - Tax depreciation > book depreciation (subtract excess tax depreciation)
    - Tax-exempt income included in book income
= Taxable income before special deductions
  − Net operating loss (NOL) deduction (max 80% of taxable income)
  − Dividends-received deduction
= Taxable income
  × 21% (flat federal corporate rate)
= Tentative corporate tax
  − Tax credits (R&D credit, WOTC, clean energy credits, etc.)
= Net corporate tax due

Key Non-Deductible Items (M-1 Add-Backs)

Items included in book expense that ARE NOT deductible for tax:
- Federal income tax itself (IRC § 275)
- State income taxes: deductible for federal tax, but create
  temporary book-tax differences
- Entertainment: 100% non-deductible post-TCJA 2017 (IRC § 274)
- Meals: 50% non-deductible (IRC § 274(n))
- Fines and penalties paid to government (IRC § 162(f))
- Political contributions (IRC § 162(e))
- Lobbying expenses (IRC § 162(e))
- Excessive officer compensation > $1M (IRC § 162(m), for public corps)

Items taxable for tax but not in book income:
- Advance payments received (may be taxable in year received)
- Gains on certain transactions recognized earlier for tax than for GAAP

Items deductible for book but not tax (temporarily):
- Warranty reserves (tax: deduct when incurred; book: accrue)
- Contingency reserves

Corporate Tax Rates

Federal corporate tax rate (post-TCJA, effective January 1, 2018):
All taxable income: 21% (flat rate)

Prior graduated structure (pre-2018):
15% on first $50,000
25% on $50,001–$75,000
34% on $75,001–$10M
35% over $10M

State corporate taxes (additional):
Range: 0% (South Dakota, Wyoming) to 11.5% (New Jersey)
State taxes are deductible on the federal return:
Effective federal rate after state tax deduction = 21% × (1 − state rate)

Example: California (8.84% state):
Federal taxable income: $10,000,000
Federal tax: $10M × 21% = $2,100,000
State CA tax (paid): $884,000 (deductible for federal)
Federal taxable income after CA deduction: $9,116,000
Adjusted federal tax: $9,116,000 × 21% = $1,914,360

Depreciation — Book vs. Tax Differences

Book (GAAP) depreciation:
- Straight-line over useful life (estimated by management)
- Creates consistent expense matching revenue

Tax depreciation (MACRS):
- IRC § 168: Modified Accelerated Cost Recovery System
- Faster write-off than GAAP (front-loaded)
- Recovery periods: 5–7 years (equipment), 27.5 (residential), 39 (commercial)

Section 179 (IRC § 179):
- Immediate expensing of qualifying assets
- 2024 limit: $1,220,000 (phases out when purchases exceed $3,050,000)

Bonus depreciation (IRC § 168(k)):
- First-year additional deduction
- 60% in 2024 (was 100% in 2022; phasing to 0% by 2027 under TCJA)

Tax depreciation > book depreciation → subtract from book income on M-1
(Creates a temporary difference; reverses when book > tax in later years)

Meals, Entertainment, and Business Gifts

Business meals (50% deductible):
- Must be directly related to or associated with business
- Original receipt must be kept showing: who, what business purpose, cost
- Includes meals while traveling on business

Entertainment (0% deductible post-2017):
- Client sporting events, theater, golf, club memberships
- No deduction regardless of business purpose

Business gifts:
- Deductible up to $25 per recipient per year (IRC § 274(b))

Interest expense limitation (IRC § 163(j)):
- "Excess business interest expense" deduction limited to
  30% of "adjusted taxable income" (EBITDA-like figure)
- Excess carries forward indefinitely

The four M-1 adjustments ★★★★★ : Add-backs increase taxable income above book; subtractions decrease. Federal tax, fines, entertainment = permanent add-backs. Depreciation timing differences = temporary. Memory tip: Permanent = never deductible (fines, entertainment); Temporary = timing only (depreciation)

Corporate tax rate: 21% flat ★★★★★ : Post-TCJA 2017, all C-corp income taxed at 21%. No graduated rate structure for corporations. Memory tip: 21% flat rate since January 1, 2018 — memorize this landmark change

Meals vs. entertainment ★★★★☆ : Meals = 50% deductible. Entertainment = 0% deductible (post-2017). Business gifts = $25/person limit. *Memory tip: Meals = half; Entertainment = nothing; Gifts =$ 25 ceiling*

Practice Quiz

Q. A corporation has book net income of $500,000, including$ 10,000 of federal income tax expense, $20,000 of entertainment expense, and$ 5,000 of fines. What is federal taxable income?

Book income $500,000 + add-back federal tax$ 10,000 + entertainment (non-deductible) $20,000 + fines$ 5,000 = $535,000 taxable income.

Q. Why are corporate fines and penalties non-deductible?

Allowing a deduction for government fines would reduce the deterrent effect by effectively having the government subsidize 21 cents of every dollar of penalty. IRC § 162(f) specifically disallows deductions for fines paid to government.