I’m working on a accounting discussion question and need an explanation and answer to help me learn.

Identify at least the two main tax issues suggested for each of the scenarios described below:
Victoria’s son needs $5,000 for tuition at the Motown School of Dance. Victoria, who is in the 32 percent marginal tax rate bracket, intends to pay the tuition by selling stock worth $5,000 that she paid $2,000 for several years ago. 
The Lester Partnership wants to develop a shopping mall on a former farm. The farmer wanted $260,000 for the land, $80,000 for the farm buildings, and $130,000 for the farmhouse. Although it wanted only the land, Lester agreed to the farmer’s terms. It then paid Ace Wrecking Company $20,000 to tear down the buildings. Lester was able to sell the scrap lumber from the buildings for $12,000.
Instructions:
Your answers should be phrased in the form of questions.  Do not answer the questions.  A complete submission should include at least four questions in total.
Note that the questions you pose should be question that can only be answered by conducting tax research such as reviewing the tax code or case law.  It should not be a question of fact that can be answered by asking the client or reviewing the transaction documents.
Because learning changes everything.®
Taxation of
Business Entities,
2023 Edition
Chapter 5
Corporate Operations
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Learning Objectives
1
1. Describe the corporate income tax formula and discuss
tax considerations relating to corporations’ accounting
periods and accounting methods.
2. Identify common permanent and temporary book–tax
differences and compute a corporation’s taxable income
and associated income tax liability.
© McGraw Hill
2
Learning Objectives
2
3. Describe a corporation’s tax return reporting and
estimated tax payment obligations.
© McGraw Hill
3
Corporate and Individual Tax Formula
Minus
Corporate Tax Formula
Individual Tax Formula
Gross income
Gross income
Deductions
For AGI deduction
Equals
Adjusted gross income
Minus
From AGI deduction:
(1)Greater of:
(a)Standard deduction or
(b)Itemized deductions
(2)Charitable contribution deduction for taxpayers who do not
itemize deduction*
(3)Deduction for qualified business income
Equals
Taxable income
Taxable income
Times
Tax rates
Tax rates
Equals
Regular income tax liability
Regular income tax liability
Add
Other taxes
Other taxes
Equals
Total tax
Total tax
Minus
Credits
Credits
Minus
Prepayments
Prepayment
Equals
Taxes due (or refund)
Taxes due(or refund)
*Charitable contribution deduction applies for 2021. As of press time, the charitable deduction for nonitemizers had not
been extended to 2022.
© McGraw Hill
4
Book–Tax Differences
1
Financial income often is the starting point for
computing taxable income.
• Reconcile to taxable income.
• Book–tax adjustments for differences between financial
accounting rules.
• Companies preparing financial statements with tax
accounting methods won’t have book–tax differences.
© McGraw Hill
5
Book–Tax Differences
2
Unfavorable differences.
• Add-back to book income to compute taxable income.
Favorable differences.
• Subtract from book income to compute taxable income.
Permanent differences (never reverse).
Temporary differences (reverse over time).
© McGraw Hill
6
Common Permanent Book–Tax
Differences
1
• Interest income from municipal bonds (Fav).
• Death benefit from life insurance on key
employees (Fav).
• Life insurance premiums (Unfav).
• 50 percent of meals expense for meals not
purchased from restaurants in 2021 and 2022
(Unfav).
• Entertainment expenses (Unfav).
• Fines, penalties, and political contributions
(Unfav).
© McGraw Hill
7
Common Permanent Book–Tax
Differences
2
• Federal income taxes (Unfav).
• Dividends-received deduction (Fav).
• Stock option expense from Incentive Stock
Options (ISOs) (Unfav).
• Stock option expense (when total book expense is
different than tax deduction) (Unfav/Fav).
© McGraw Hill
8
Common Temporary Book–Tax
Differences
1
• Equity income.
• Depreciation.
• Gain/loss on sale of depreciable asset.
• Bad debt expense.
• §263A uniform inventory capitalization costs.
• Organizational expenditures or start-up cost.
• Like-kind exchange.
• Unearned rent revenue.
• Deferred compensation.
• Interest expense.
© McGraw Hill
9
Common Temporary Book–Tax
Differences
2
Nonqualified stock option compensation expense.
Net capital loss.
• Carry back three years and forward five years.
Net operating loss carryover.
Goodwill acquired in an asset acquisition (goodwill
with a book and tax basis).
© McGraw Hill
10
Book–Tax Differences from Dividends
1
Dividends:
• Included in gross income for tax purposes if received from
a domestic corporation.
• Income included in book income depends on ownership.
• If ownership < 20 percent, dividend is included in book income (same as tax). However, the unrealized gain or loss for the year is included in book income (assuming the stock is an investment held for trading). This unrealized gain or loss is not recognized for tax purposes. This is a temporary difference that will reverse when the stock is sold. © McGraw Hill 11 Book–Tax Differences from Dividends 2 • If ownership is at least 20 percent but not more than 50 percent, the receiving corporation reports its pro rata share of distributing corporation’s income (equity method) but the receiving corporation does not include the dividend in book income. • If ownership > 50 percent, consolidated financial
reporting; intercompany dividends are eliminated for
book purposes.
• If ownership ? 80 percent, consolidated tax reporting;
intercompany dividends from members of the
consolidated group are eliminated for tax purposes.
© McGraw Hill
12
Dividends Book–Tax Difference Example
PCC owns 30 percent of the stock of BCS, a U.S.
corporation, and applies the equity method of
accounting for book purposes. During 2022, BCS
distributed a $40,000 dividend to PCC. BCS
reported $100,000 of net income for 2022. Based on
this information, what is PCC’s 2022 book–tax
difference relating to the dividend and its investment
in BCS (ignoring the dividends-received deduction)?
Is the difference favorable or unfavorable?
© McGraw Hill
13
Dividends Book–Tax Difference Example
Solution
Answer: $10,000 unfavorable book–tax difference,
computed as follows:
Description
Amount
(1) Dividend received in 2022 (included in 2022 taxable
income but not in book income)
$ 40,000
(2) BCS 2022 net income on financial statements
$100,000
(3) PCC’s ownership in BCS stock
Explanation
30%
(4) PCC’s book income from BCS investment
$ 30,000
(2) × (3)
Unfavorable book–tax difference associated with dividend
$ 10,000
(1) ? (4)
© McGraw Hill
14
Limitation on Net Interest Expense
• Corporate net interest expense deductions are
limited to 30 percent of taxable income before
interest income or deductions (called adjusted
taxable income, ATI).
• Deductions disallowed are carried forward
indefinitely.
• This limitation does not apply to taxpayers with
annual average gross receipts (AGR) less than
$27 million for the prior three years.
© McGraw Hill
15
Book and Tax Treatment of Stock Options
Description
Book Deduction
Tax
Deduction
Incentive stock
option
Initial estimated
fair value of stock
options/requisite
service period
No deduction Unfavorable, permanent
Nonqualified
stock option (in
years before
exercise)
Initial estimated
fair value of stock
options/requisite
service period
No deduction Unfavorable, temporary
until exercise
© McGraw Hill
1
Book—Tax Difference
16
Book and Tax Treatment of Stock Options
Nonqualified
stock option (in
year of exercise)
Initial estimated
fair value of stock
options/requisite
service period
Bargain
element*
2
Favorable, temporary
(reversing unfavorable,
temporary difference in prior
years)
Favorable, permanent
difference if the bargain
element exceeds the initial
estimated value of stock
options; unfavorable
permanent difference
otherwise
*The bargain element is the difference between the fair market value of the stock
and the exercise price on the date the employee exercises the stock options.
© McGraw Hill
17
Stock Option Example 1
On January 1, 2022, PCC granted 20,000 NQOs with an
estimated $10 value per option ($200,000 total value). Each
option entitled the owner to purchase one share of PCC
stock for $10 a share (the per-share price of PCC stock on
January 1, 2022, when the options were granted). The
options vested at the end of the day on December 31, 2022
(employees could not exercise options in 2022). Assume no
options were exercised in either 2022 or 2023.
What is PCC’s book–tax difference associated with the
nonqualified options in 2022? In 2023? Is each difference
favorable or unfavorable? Is it permanent or temporary?
© McGraw Hill
18
Stock Option Example 1 Solution
Answer: $100,000 unfavorable, temporary book–
tax difference in 2022 and again in 2023. PCC
reports $100,000 of compensation expense for book
purposes in 2023 and $0 for tax purposes (the
options were not exercised) and another $100,000
of compensation expense for book purposes in
2023 and $0 for tax.
© McGraw Hill
19
Stock Option Example 2
Assume the same facts in Example 1 and that on
March 1, 2024, employees exercised all 20,000
options at a time when the PCC stock was trading at
$25 per share.
What is PCC’s book–tax difference associated with
the stock options in 2024? Is it a permanent
difference or a temporary difference? Is it favorable
or unfavorable?
© McGraw Hill
20
Stock Option Example 2 Solution
Answer: $200,000 favorable, temporary book–tax difference
in 2024 and a $100,000 favorable permanent book–tax
difference. PCC claims a $300,000 tax deduction in 2024,
equal to the number of shares purchased (20,000) times the
bargain element of $15 per option exercised ($25 ? $10).
PCC does not deduct any additional compensation expense
for book purposes in 2024 because the vesting period ended
in 2023. $200,000 of the tax deduction is a reversal of the
total 2022–2023 unfavorable, temporary book–tax difference.
The excess $100,000 tax deduction is a favorable permanent
difference.
© McGraw Hill
21
Stock Option Example 3
Assume that on March 1, 2024, employees
exercised all 20,000 options at a time when the
PCC stock was trading at $25 per share. What is
PCC’s book–tax difference associated with the stock
options in 2024? Is it a permanent difference or a
temporary difference? Is it favorable or unfavorable?
© McGraw Hill
22
Stock Option Example 3 Solution
Answer: $200,000 favorable, temporary book–tax difference
in 2024 and a $100,000 favorable permanent book–tax
difference. PCC gets a $300,000 tax deduction in 2024,
equal to the number of shares purchased (20,000) times the
bargain element of $15 per option exercised ($25 ? $10).
PCC does not deduct any additional compensation expense
for book purposes in 2024 because the vesting period ended
in 2023. $200,000 of the tax deduction is a reversal of the
total 2022–2023 unfavorable, temporary book–tax difference.
The excess $100,000 tax deduction is a favorable permanent
difference.
© McGraw Hill
23
Net Capital Losses
No current deduction for net capital losses (capital losses in
excess of capital gains).
Carry back net capital losses three years and carry forward
five years.
• Use carryover amounts on FIFO basis.
Unfavorable, temporary book–tax difference in year of net
capital loss.
Favorable, temporary book–tax difference in year carryback
or carryover is used.
© McGraw Hill
24
Net Operating Loss Deduction
1
No current tax benefit from current-year loss.
NOLs from tax years beginning after 12/31/17 can be carried
forward indefinitely; deduction is limited to 80 percent of
taxable income before the NOL deduction.
NOLs from pre-2018 tax years can be carried back 2 years
and forward 20 years.
To compute NOL for year, no deduction for:
• NOL carrybacks or carryovers from other years.
• Capital loss carrybacks (carryovers are allowed).
© McGraw Hill
25
Net Operating Loss Deduction
2
No current tax benefit from current-year loss.
NOL deductibility rules depend on year in which NOL was
incurred.
For NOLs originating in tax years beginning before 2018,
• NOLs are carried back two years and forward 20 years.
• Can offset up to 100% of taxable income before the NOL
deduction.
© McGraw Hill
26
Net Operating Loss Deduction
3
For NOLs originating in tax years beginning after
2017 and before 2021.
• Carried back five years and carried forward indefinitely.
• Can offset up to 100% of taxable income before the NOL
deduction in tax years beginning before 2021.
• Can offset up to 80% of taxable income after deducting NOL
carryovers from NOLs originating in tax years beginning before
2018.
© McGraw Hill
27
Net Operating Loss Deduction
4
For NOLs originating in tax years beginning after
2020.
• Carryback not allowed. NOLs carried forward indefinitely.
• Can offset up to 80% of taxable income after deducting
NOL carryovers from NOLs originating in tax years
beginning before 2018.
© McGraw Hill
28
Net Operating Loss Deduction
5
• NOLs deducted in FIFO order (oldest first).
• Corporations can elect to forgo carryback if
carryback is otherwise available.
• If a corporation carries back a NOL, it must carry it
back to the earliest carryback year (that is, to the
fifth year prior or the second year prior).
© McGraw Hill
29
NOL Example
XYZ Inc. has a net operating loss of $200,000 for
the 2022 tax year. It also has a $10,000 NOL
carryover from 2017. XYZ reported taxable income
in 2023 of $200,000 before the NOL deduction.
What is XYZ’s 2023 taxable income after the NOL
deduction?
© McGraw Hill
30
NOL Example Solution
$38,000 taxable income in 2023. In 2023, XYZ can deduct
the 2017 NOL in full. This reduces its 2023 taxable income to
$190,000 before deducting the 2022 NOL. The 2021 NOL
can offset the lesser of the up to 80 percent of taxable
income in 2023 after deducting the pre 2018 NOL ($190,000
× 80% = $152,000). Thus, XYZ can deduct $152,000 of the
2022 NOL carryover to reduce taxable income in 2023. This
reduces XYZ’s 2023 taxable income to $38,000. Note that
the remaining $48,000 of unused NOL from 2022 can be
carried forward indefinitely.
© McGraw Hill
31
Charitable Contributions
1
Amount of deduction.
• Capital gain property.
• Generally fair market value.
• Ordinary income property.
• Generally adjusted basis.
Accrual-method corporation.
• Deduct when accrued if:
• Approved by board of directors before year-end.
• Paid within three and one-half months after end of year (two and
one-half months if June 30 year end).
© McGraw Hill
32
Charitable Contributions
2
In 2022, deduction for charitable donations is limited
to 10 percent of taxable income before deducting:
• Any charitable contributions.
• The dividends-received deduction (DRD).
• Net capital loss carrybacks.
Carry forward excess contributions for five years.
© McGraw Hill
33
Charitable Contributions
3
In 2021 (and 2020), deduction for qualified charitable
donations is limited to 25 percent of taxable income (10
percent for other donations) before deducting:
• Any charitable contributions.
• The dividends-received deduction (DRD).
• Net capital loss carrybacks.
Carry forward excess contributions for five years.
A qualified contribution is a cash contribution made by an
electing corporation to a public charity or private operating
foundation (except for donations to donor advised funds or
supporting organizations).
© McGraw Hill
34
Charitable Contribution Example
In 2022, PCC donated a total of $700,000 of cash to
the American Red Cross. PCC’s taxable income
before the charitable contribution deduction, NOL
carryover ($24,000), and DRD ($15,000) was
$6,287,000. What is PCC’s charitable contribution
deduction for the year, assuming the donation is a
qualified contribution? What is its charitable
contribution carryover to next year, if any?
© McGraw Hill
35
Charitable Contribution Example Solution
Answer: $626,300 charitable contribution deduction and $73,700
charitable contribution carryover, computed as follows:
Description
Amount
Explanation
(1) Taxable income before any charitable
contribution, NOL carryover from previous
year, and DRD
$6,287,000
Exhibit 16-8
(2) NOL carryover from previous year (from
Example 16-10)
(24,000)
(3) Charitable contribution limit modified
taxable income
$6,263,000
(4) Total charitable contributions for year
$700,000
(5) Tax deduction limitation percentage
10%
Deduction in determining taxable income
limit
(1) + (2)
Percentage limitation for qualified
contribution
(6) Charitable contribution déduction limitation
$ 626,300
(3) × (5)
(7) Charitable contribution deduction for
year
$ 626,300
Lesser of (4) or (6)
Charitable contribution carryover (expires
If unused by the end of 2027)
$ 73,700
(4) ? (7)
© McGraw Hill
36
Dividends-Received Deduction
Deduction to mitigate more than two levels of tax.
• Own less than 20 percent: 50 percent DRD.
• Own at least 20 percent but less than 80 percent: 65 percent DRD.
• Own 80 percent or more: 100 percent DRD.
Deduction is limited to the lesser of:
• Dividend × DRD%, or
• DRD modified taxable income × DRD%.
•
Modified taxable income = taxable income before DRD, any NOL, and
capital loss carrybacks.
•
If full DRD increases or creates an NOL, this limit does not apply.
Creates favorable, permanent book–tax difference.
© McGraw Hill
37
Dividends-Received Deduction Example
Description
(1) Taxable income before the
dividends-received
deduction(includes dividend
income)
Scenario A
Scenario B
Explanation
$ 50,000
$25,000
3,000
3,000
(3) DRD modified taxable
income
$ 53,000
$ 28,000
(4) Dividend income
$ 30,000
$ 30,000
50%
50%
§243(a)
(6) Dividends-received
deduction before limitation
$15,000
$ 15,000
(4) × (5)
(7) Dividends-received
deduction limitation
$26,500
$ 14,000
(3) × (5)
DRD deduction
$15,000
$ 14,000
Lesser of (6) or (7)
(2) NOL carryover
(5) Dividend-received
deduction percentage based
on ownership
© McGraw Hill
(1) +(2)
38
Corporate Income Tax Liability
• Flat tax rate of 21 percent applied to all C
corporation taxable income.
© McGraw Hill
39
Compliance
Corporations report taxable income on Form 1120.
• Small corporations complete Schedule M-1.
• Large corporations complete Schedule M-3.
• Book–tax differences referred to as M adjustments.
Corporate returns are due three and one-half months after
the close of the tax year (June 30 year-end exception).
• Automatic six-month extension for filing (October 15 for
calendar-year corporations).
Consolidated tax returns.
• Affiliated groups essentially treated as one corporation.
© McGraw Hill
40
EXHIBIT 5-10 Form 1120, Schedule M-1
1
Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return
Note: The corporation may be required to Me Schedule M-3. See instructions.
Access the text alternative for slide images.
© McGraw Hill
41
EXHIBIT 16-10 Form 1120, Schedule M-1
2
Schedule M-1
Statement 1
Other expenses recorded on books this year not deducted on this return
Compensation expense (stock options)
$ 100,000
Bad debt expense
70,000
Warranty expense
170,000
Life insurance premiums
34,000
Total other expenses
© McGraw Hill
$ 374,000
42
Estimated Payments
1
Corporations with a federal income tax liability of $500
or more are required to pay their estimated income tax
in quarterly installments.
• Installments due on the 15th day of:
• 4th month (25% of required annual payment).
• 6th month (50% of required annual payment).
• 9th month (75% of required annual payment).
• 12th month (100% of required annual payment).
Corporations may owe a penalty for underpayment.
• Payments based on required annual payment.
© McGraw Hill
43
Estimated Payments
2
Required annual payment:
• 100 percent of tax liability on prior-year return.
• Doesn’t apply if no liability in prior year.
• 100 percent of current-year tax liability.
• 100 percent of estimated current-year tax liability using
annualized method.
Rules for large corporations:
• $1,000,000 of taxable income in prior three years.
• May use prior-year liability for first quarter payment only.
© McGraw Hill
44
Estimated Payments
3
EXHIBIT 5-11 Estimated Taxable Income Computation under Annualized
Income Method.
(1) Taxable Income
(first_month of year)
(2) Annualization
Factor
First quarter
3
12/3 = 4
Second quarter
3
12/3 = 4
Third quarter
6
12/6 = 2
Fourth quarter
9
12/9 =1.3333
Installment
© McGraw Hill
(1) × (2) Annual
Estimate
Taxable Income
45
Estimated Payments
4
EXHIBIT 5-12 Estimated Taxable Income Computation under Annualized
Income Method.
Installment
(1) Annual
Estimated
Taxable
Income
(2) Tax on
Estimated
Taxable
Income
(3)
Percenta
ge of Tax
Required
to Be
Paid
First quarter
25%
Second quarter
50
Third quarter
75
Fourth Quarter
100
© McGraw Hill
(4) [(2) × (3)]
Required
Cumulative
Payment
(5) Prior
Cumulative
Payment
(4) ? (5)
Required
Estimated
Tax
Payment
46
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®
www.mheducation.com
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Corporate Operations
Chapter 5
Taxation of Business
Entities, 2023 Edition
Because learning changes everything.®
1
Describe the corporate income tax formula and discuss tax
considerations relating to corporations’ accounting periods and
accounting methods.
Identify common permanent and temporary book–tax
differences and compute a corporation’s taxable income and
associated income tax liability.
© McGraw Hill
2.
1.
Learning Objectives
2
2
Describe a corporation’s tax return reporting and estimated tax
payment obligations.
© McGraw Hill
1.
Learning Objectives
3
Taxable income
Taxable income
Tax rates
Regular income tax liability
Other taxes
Total tax
Credits
Prepayments
Taxes due (or refund)
Equals
Times
Equals
Add
Equals
Minus
Minus
Equals
© McGraw Hill
*Charitable contribution deduction applies for 2021. As of press time, the charitable deduction for nonitemizers had not been extended
to 2022.
Taxes due(or refund)
Prepayment
Credits
Total tax
Other taxes
Regular income tax liability
Tax rates
From AGI deduction:
(1)Greater of:
(a)Standard deduction or
(b)Itemized deductions
(2)Charitable contribution deduction for taxpayers who do not itemize
deduction*
(3)Deduction for qualified business income
Minus
For AGI deduction
Adjusted gross income
Deductions
Gross income
Gross income
Equals
Minus
Individual Tax Formula
Corporate Tax Formula
Corporate and Individual Tax Formula
4
1
© McGraw Hill
• Companies preparing financial statements with tax accounting
methods won’t have book–tax differences.
• Book–tax adjustments for differences between financial
accounting rules.
• Reconcile to taxable income.
Financial income often is the starting point for computing
taxable income.
Book–Tax Differences
5
2
© McGraw Hill
Permanent differences (never reverse).
Temporary differences (reverse over time).
• Subtract from book income to compute taxable income.
Favorable differences.
• Add-back to book income to compute taxable income.
Unfavorable differences.
Book–Tax Differences
6
Interest income from municipal bonds (Fav).
Death benefit from life insurance on key employees
(Fav).
Life insurance premiums (Unfav).
50 percent of meals expense for meals not purchased
from restaurants in 2021 and 2022 (Unfav).
Entertainment expenses (Unfav).
Fines, penalties, and political contributions (Unfav).
© McGraw Hill
•
•
•
•
•
•
1
Common Permanent Book–Tax
Differences
7
Federal income taxes (Unfav).
Dividends-received deduction (Fav).
Stock option expense from Incentive Stock Options (IS
Os) (Unfav).
Stock option expense (when total book expense is
different than tax deduction) (Unfav/Fav).
© McGraw Hill
•
•
•
•
2
Common Permanent Book–Tax
Differences
8
Depreciation.
Gain/loss on sale of depreciable asset.
Bad debt expense.
§263A uniform inventory capitalization costs.
Organizational expenditures or start-up cost.
Like-kind exchange.
Unearned rent revenue.
Deferred compensation.
Interest expense.
•
•
•
•
•
•
•
•
•
© McGraw Hill
Equity income.
•
1
Common Temporary Book–Tax
Differences
9
© McGraw Hill
Net operating loss carryover.
Goodwill acquired in an asset acquisition (goodwill with
a book and tax basis).
• Carry back three years and forward five years.
Nonqualified stock option compensation expense.
Net capital loss.
2
Common Temporary Book–Tax
Differences
10
1
© McGraw Hill
• If ownership < 20 percent, dividend is included in book income (same as tax). However, the unrealized gain or loss for the year is included in book income (assuming the stock is an investment held for trading). This unrealized gain or loss is not recognized for tax purposes. This is a temporary difference that will reverse when the stock is sold. • Income included in book income depends on ownership. • Included in gross income for tax purposes if received from a domestic corporation. Dividends: Book–Tax Differences from Dividends 11 2 © McGraw Hill • If ownership is at least 20 percent but not more than 50 percent, the receiving corporation reports its pro rata share of distributing corporation’s income (equity method) but the receiving corporation does not include the dividend in book income. • If ownership > 50 percent, consolidated financial
reporting; intercompany dividends are eliminated for
book purposes.
• If ownership ? 80 percent, consolidated tax reporting;
intercompany dividends from members of the
consolidated group are eliminated for tax purposes.
Book–Tax Differences from Dividends
12
© McGraw Hill
PCC owns 30 percent of the stock of BCS, a U.S.
corporation, and applies the equity method of accounting
for book purposes. During 2022, BCS distributed a
$40,000 dividend to PCC. BCS reported $100,000 of net
income for 2022. Based on this information, what is
PCC’s 2022 book–tax difference relating to the dividend
and its investment in BCS (ignoring the dividendsreceived deduction)? Is the difference favorable or
unfavorable?
Dividends Book–Tax Difference Example
13
$ 10,000
Unfavorable book–tax difference associated with dividend
© McGraw Hill
$ 30,000
(4) PCC’s book income from BCS investment
30%
$100,000
(2) BCS 2022 net income on financial statements
(3) PCC’s ownership in BCS stock
$ 40,000
Amount
(1) Dividend received in 2022 (included in 2022 taxable income but
not in book income)
Description
(1) ? (4)
(2) × (3)
Explanation
Answer: $10,000 unfavorable book–tax difference, computed as
follows:
Dividends Book–Tax Difference Example
Solution
14
Corporate net interest expense deductions are limited to
30 percent of taxable income before interest income or
deductions (called adjusted taxable income, ATI).
Deductions disallowed are carried forward indefinitely.
This limitation does not apply to taxpayers with annual
average gross receipts (AGR) less than $27 million for
the prior three years.
© McGraw Hill
•
•
•
Limitation on Net Interest Expense
15
Initial estimated fair
value of stock
options/requisite
service period
Nonqualified stock
option (in years
before exercise)
© McGraw Hill
Initial estimated fair
value of stock
options/requisite
service period
Book Deduction
Incentive stock
option
Description
No deduction
until exercise
No deduction
Tax
Deduction
Unfavorable, temporary
Unfavorable, permanent
Book—Tax Difference
Book and Tax Treatment of Stock Options
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Initial estimated
fair value of stock
options/requisite
service period
Bargain
element*
Favorable, permanent difference
if the bargain element exceeds
the initial estimated value of
stock options; unfavorable
permanent difference otherwise
Favorable, temporary (reversing
unfavorable, temporary
difference in prior years)
© McGraw Hill
*The bargain element is the difference between the fair market value of the
stock and the exercise price on the date the employee exercises the stock
options.
Nonqualified stock
option (in year of
exercise)
Book and Tax Treatment of Stock Options
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2
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What is PCC’s book–tax difference associated with the
nonqualified options in 2022? In 2023? Is each difference favorable
or unfavorable? Is it permanent or temporary?
On January 1, 2022, PCC granted 20,000 NQOs with an estimated
$10 value per option ($200,000 total value). Each option entitled
the owner to purchase one share of PCC stock for $10 a share (the
per-share price of PCC stock on January 1, 2022, when the options
were granted). The options vested at the end of the day on
December 31, 2022 (employees could not exercise options in
2022). Assume no options were exercised in either 2022 or 2023.
Stock Option Example 1
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© McGraw Hill
Answer: $100,000 unfavorable, temporary book–tax
difference in 2022 and again in 2023. PCC reports
$100,000 of compensation expense for book purposes in
2023 and $0 for tax purposes (the options were not
exercised) and another $100,000 of compensation
expense for book purposes in 2023 and $0 for tax.
Stock Option Example 1 Solution
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© McGraw Hill
Assume the same facts in Example 1 and that on March 1,
2024, employees exercised all 20,000 options at a time
when the PCC stock was trading at $25 per share.
What is PCC’s book–tax difference associated with the
stock options in 2024? Is it a permanent difference or a
temporary difference? Is it favorable or unfavorable?
Stock Option Example 2
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© McGraw Hill
Answer: $200,000 favorable, temporary book–tax difference in
2024 and a $100,000 favorable permanent book–tax difference.
PCC claims a $300,000 tax deduction in 2024, equal to the number
of shares purchased (20,000) times the bargain element of $15 per
option exercised ($25 ? $10). PCC does not deduct any additional
compensation expense for book purposes in 2024 because the
vesting period ended in 2023. $200,000 of the tax deduction is a
reversal of the total 2022–2023 unfavorable, temporary book–tax
difference. The excess $100,000 tax deduction is a favorable
permanent difference.
Stock Option Example 2 Solution
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© McGraw Hill
Assume that on March 1, 2024, employees exercised all
20,000 options at a time when the PCC stock was trading
at $25 per share. What is PCC’s book–tax difference
associated with the stock options in 2024? Is it a
permanent difference or a temporary difference? Is it
favorable or unfavorable?
Stock Option Example 3
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© McGraw Hill
Answer: $200,000 favorable, temporary book–tax difference in
2024 and a $100,000 favorable permanent book–tax difference.
PCC gets a $300,000 tax deduction in 2024, equal to the number of
shares purchased (20,000) times the bargain element of $15 per
option exercised ($25 ? $10). PCC does not deduct any additional
compensation expense for book purposes in 2024 because the
vesting period ended in 2023. $200,000 of the tax deduction is a
reversal of the total 2022–2023 unfavorable, temporary book–tax
difference. The excess $100,000 tax deduction is a favorable
permanent difference.
Stock Option Example 3 Solution
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Favorable, temporary book–tax difference in year carryback or
carryover is used.
Unfavorable, temporary book–tax difference in year of net capital
loss.
• Use carryover amounts on FIFO basis.
Carry back net capital losses three years and carry forward five
years.
No current deduction for net capital losses (capital losses in excess
of capital gains).
Net Capital Losses
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• Capital loss carrybacks (carryovers are allowed).
• NOL carrybacks or carryovers from other years.
To compute NOL for year, no deduction for:
NOLs from pre-2018 tax years can be carried back 2 years and
forward 20 years.
NOLs from tax years beginning after 12/31/17 can be carried
forward indefinitely; deduction is limited to 80 percent of taxable
income before the NOL deduction.
No current tax benefit from current-year loss.
Net Operating Loss Deduction
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• Can offset up to 100% of taxable income before the NOL deduction.
• NOLs are carried back two years and forward 20 years.
For NOLs originating in tax years beginning before 2018,
NOL deductibility rules depend on year in which NOL was
incurred.
No current tax benefit from current-year loss.
Net Operating Loss Deduction
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3
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• Can offset up to 80% of taxable income after deducting NOL
carryovers from NOLs originating in tax years beginning before 2018.
• Can offset up to 100% of taxable income before the NOL deduction in
tax years beginning before 2021.
• Carried back five years and carried forward indefinitely.
For NOLs originating in tax years beginning after 2017
and before 2021.
Net Operating Loss Deduction
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• Carryback not allowed. NOLs carried forward