ACCUMULATED EARNINGS TAX

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The accumulated earnings tax (AET) is imposed only on a corporation that, for the purpose of avoiding income tax at the shareholder level, allows earnings and profits to accumulate instead of being distributed. The accumulated earnings tax is imposed by Sec. 531 on unreasonably large accumulations of earnings in a corporation..
Without showing a reason for the accumulation, the minimum Accumulated Earnings Credit is $250,000 for corporations other than personal service corporations (viz. Health, law, engineering, accounting etc.) for whom minimum credit base is $150,000.
The Accumulated Earnings Credit (AEC) is deducted from taxable income (TI) to determine accumulated taxable income (ATI)
The AET will be imposed regardless of the number of shareholders, provided the corporation does not qualify as a personal holding company.
A corporation is liable for the AET when it accumulates (does not distribute) earnings beyond the greater of
$250,000 or
Reasonable business needs.
The tax equals 20% of accumulated (undistributed) taxable income.
Taxable Income
+/- Adjustments
Current E&P
– Dividend Paid
– AEC
ATI
* 20%
AET
The AET is only a tax on ATI (undistributed current year earnings less dividend paid deduction in excess of AEC). However, the undistributed prior year earnings still factor into the calculation of whether total accumulated earnings exceed the accumulated earnings credit or reasonable business needs.
The taxpayer is allowed a dividends paid deduction in determining accumulated taxable income for dividends paid after the close of any tax year provided the dividends are actually paid on or before the 15th day of the third month following the year-end.

Business Nexus for Sales Tax

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For a taxing authorities to tax sales and income-generating activities, nexus is required to be established of a physical and/or financial presence within a jurisdiction. Here are the 5 drivers in establishing the nexus …

  • A physical location in the state
  • Resident employees working in the state
  • Real or intangible property (owned or rented) within the state
  • Employees who regularly solicit business within the state
  • Significant sales or transactions within the state

The Uniform Division of Income for Tax Purposes Act (UDITPA)

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Before a state can tax a non resident, a minimum presence in the taxing state by the non resident must be established. In the context of Uniform Division of Income for Tax Purposes, income is distributed among multiple tax jurisdictions by allocation of income and apportionment of income.

In the context of dividing income for tax purposes among multiple tax jurisdictions, compare (1) allocation of income and (2) apportionment of income.
Allocation                Identifying nonbusiness income to a specific state
Apportionment        Identifying business income from operations to a specific state
The term “allocation” is used in tax discussions to identify investment income from assets held solely for investment purposes by foreign entities, and “apportionment” is the term used to describe formulas used to calculate what portion of a firm’s total world-wide earnings is from operations within a particular state.
All business income is apportioned to a taxing state by multiplying the business income by the sum of the property, payroll, and sales factors divided by three.
Apportioned income = [Total business income × (Property factor + Payroll factor + Sales factor)]/3
Property factor = Average value of in-state real and tangible personal property used / Average value of all real and tangible personal property used
Payroll factor = In-state compensation paid / Total compensation paid
Sales factor = In-state sales / Total sales
Non Business Income allocation based on
a) Interest & Dividend – Commercial Domicile
b) Patent & Copyright Royalties – Proportional Use within state or Commercial Domicile
c) Capital Gains & Losses – a) Real – Location of Property ; b)Tangible Personal – Location of Property or Commercial Domicile ; c) Intangible Personal – Commercial Domicile
d) Net Rents & Royalties – a) Real – Location of Property ; b)Tangible Personal – Location of Property or Commercial Domicile

 

Exempt Organizations in US

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1EXEMPT STATUS 
Exempt status generally depends on the nature and purpose of an organization. An organization is tax-exempt only if it is a class specifically described by the IRC as one on which exemption is conferred. An organization operated for the primary purpose of carrying on a trade or business for profit is generally not tax-exempt. Religious organizations, schools, and animal welfare organizations are all considered exempt because their activities do not involve making a profit.
 Among the types of organizations that may qualify as exempt are corporations, trusts, foundations, funds, community funds, etc. A more complete list can be found in Sec. 501(c) along with the permitted stated purposes and requirements. A foundation may qualify for exemption from federal income tax if it is organized for the prevention of cruelty to animals.
Organizations formed and operated exclusively for religious, charitable, scientific, educational, literary, or similar purposes are a broad class of exempt organizations. A partnership cannot qualify as an exempt organization, and no part of the net earnings may accrue to the benefit of any private shareholder or individual
Tax-exempt status is available to various classes of nonprofit organizations under Sec. 501(a). Sec. 501(c)(2) through (25) lists several organizations that may qualify for tax-exempt status, including civic leagues, fraternal benefit societies and labor, agricultural, or horticultural organizations. Blue Cross and Blue Shield organizations are health insurance companies, not qualifying organizations.  A privately owned nursing home are not exempt organizations
School qualifies for exempt status under IRC 501(c)(3). No part of net earnings may inure to the benefit of any private shareholder or individual.
The exempt status of an otherwise qualified social club is lost if part of net earnings benefit any private shareholder. Exempt status is also lost if more than 35% of its receipts are from sources other than membership fees, dues, and assessments. Of this 35%, up to 15% may be from the use of the club’s facilities or services by the general public, etc.
No substantial part of activities of an exempt organization may be  to influence legislation or a political candidacy; otherwise, it will lose its exempt status. An organization that exceeds the lobbying expenditure limit will be subject to an excise tax of 25% of the excess amount and not loss of exempt status. Direct Participation in a political campaign will cause loss of exempt status, not indirect participation.
2PROHIBITED TRANSACTIONS 
Certain employee trusts lose exempt status if they engage in prohibited transactions, e.g., lending without adequate security or reasonable interest, or paying unreasonable compensation for personal services. Reasonable compensation is permissible.
3PRIVATE FOUNDATIONS 
Each domestic or foreign exempt organization is a private foundation unless it receives more than one-third of its support (annually) from its members and the general public, in which case it becomes a public charity.
A private foundation must use Form 990-PF as its annual information return.
A charitable, religious or scientific organization is presumed to be a private foundation unless it either a) is a church with annual gross receipts of under  $5,000 or b) Notifies the IRS that is not a private foundation (on Form 1023) must file Form 1023 if the application was filed within 27 months from the end of the month it was organized.
4FEEDER ORGANIZATION 
An organization must independently qualify for exempt status. It is not enough that all of its profits are paid to exempt organizations.
5REQUIREMENTS FOR EXEMPTION 
To establish its exemption, an organization must file a written application with the key director for the district in which the principal place of business or principal office of the organization is located. There are specific forms depending on the type of organization applying for the exemption.
Religious, charitable, scientific, educational, etc., organizations (public charities) use Form 1023.Form 1024 is used by most others. If filed with 15 month period, retroactive treatment is available
6ANNUAL INFORMATION RETURN
Publication 557 states that annual information returns, employment tax returns, and a report of cash received are all returns that might be required of a tax-exempt organization.
Exempt organizations generally are required to file annual information return on or before the 15th day of the 5th month following the close of the taxable year.
The amount of contribution received is reported and all substantial contributions must be identified.
 Those exempted from the requirement are
1. A church or church-affiliated organization
2. An exclusively religious activity or religious order
3. An organization (other than a private foundation) having annual gross receipts that are not more than $50,000 (they must only file an e-postcard)
4. A stock bonus, pension, or profit-sharing trust that qualified under Sec. 401
5. A Keogh plan whose total assets are less than $100,000
Private Foundations are required to file annual information returns on Form 990 or Form 990-F, regardless of the amounts of gross receipts
Organization with under $50,000 in gross receipts that do not have to file an annual notice will be required to File a Form 990-N. The form must be filed on or before the 15th day of the 5th month following the close of the taxable year. Failure to file the annual report 3 years in a row will subject the organization to loss of its exempt status, requiring the organization to reapply for recognition.
A parent or central exempt organization files a separate return for itself. If it chooses, the organization may also file a group information return for two or more local organizations, as long as none of the local organizations are private foundations.
Form 990-EZ is a shortened version of Form 990. It is designed for use by small exempt organizations and nonexempt charitable trusts. An organization may file Form 990-EZ instead of Form 990 if it meets both of the following requirements:
Gross receipts are less than $200,000, and
Total assets are less than $500,000.

Unrelated Business Income Tax (UBIT)

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UNRELATED BUSINESS INCOME TAX
Unrelated business income (UBI) is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose constituting the basis for an organization’s tax-exempt status. But income is not subject to tax as UBI if substantially all the work is performed for the organization by unpaid volunteers.
Exempt organizations subject to tax on UBI are required to comply with the Code provisions regarding installment payments of estimated income tax by corporations [Sec. 6655(g)(3)].
Eg. Income derived from bingo games is not treated as unrelated business income if the games are conducted in a state in which bingo games are ordinarily not carried out or conducted on a commercial basis and if the games are not illegal under the state’s or locality’s law.
Eg. The sale of the educational materials by the trade association for seminars oriented toward its members is most likely an activity that is substantially related to the performance of the exempt purpose of the trade association.
Unrelated business income (UBI) over $1,000 of a tax-exempt corporation is subject to tax at corporate regular income tax rates.
An unrelated business income (UBI) tax return (Form 990-T) is required of an exempt organization with at least $1,000 of gross income used in computing the UBI tax for the tax year.

S Corporation Election and Termination

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ELECTION
All eligible corporation must make the election for S Corporation status by filing Form 2553
All shareholders at the time the election is made must file a consent
Each person who was a shareholder at any time during the part of the tax year before the election is made must also consent. If any former shareholder do not consent, the election is considered made for the following year
For an election to be effective from the first day of the same tax year, the election must be made within the first 2 1/2 months of the beginning of the corporation’s tax year. Election made after 2 1/2 months of the corporation’s tax year will become effective on the first day of the following tax year
IRS can treat a late filed election as timely filed if it determines that reasonable cause existed for failing to file the election in a timely manner
After a revocation or termination of an election, a new election cannot be effectively made for 5 years beginning after the 1st taxable year without the consent of the IRS [Eg. Revocation of S Corp Status on 31 Dec 2020, reelect S Corp Status without IRS consent on 1 January 2026]
TERMINATION
An S corporation election is terminated by any of the following:
Consent from a majority of shareholders (voting and nonvoting) – 50% or more of total shareholders – MCQ
Any eligibility requirement not being satisfied on any day
E.g., accepting a disallowed entity as a shareholder, exceeding 100 shareholders, etc.
For 3 consecutive years, the corporation has both Subchapter C E&P and passive investment income greater than 25% of gross receipts

Upon Termination event, S Corporation becomes a C Corporation

S Corporation Election

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REQUIREMENTS OF S STATUS
An S corporation must
Be a domestic and eligible corporation
Have only one class of stock
Have no more than 100 shareholders
Have only allowed shareholders (individuals, estates, or qualified trusts)
A Non – Resident alien (NRA) may not own shares of S Corp [Must be a citizen / resident of US]
Family Members in a six generation range are considered as one shareholder
Partnerships, Charitable Remainder Unitrusts and Charitable Remainder Annuity Trusts may not be shareholders of S Corp
Domestic International Sales Corporations (DISC) cannot elect S Status

 

S Corporations – Special Taxes

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1Special taxes imposed on S corporations.
Passive investment income (PII) tax
Built-in gains (BIG) tax
LIFO recapture
General business credit recapture
1.01PASSIVE INVESTMENT INCOME(PII) TAX
Passive investment income includes gross receipts from royalties, rents, dividends, interest, and annuities. If an S corporation has pre-S corporation E&P (from the period it was a C corporation) at the end of a tax year and its passive investment income is more than 25% of its gross receipts, the S corporation may be subject to a tax @ 21% on excess net passive income.
Net Passive Income does not include net operating losses. Net Passive income is PII reduced by expenses directly attributable to its production
PII Tax liability is allocated to the PII Items and reduces the amount of the item passed through to shareholders. S Corporations are required to make estimated payments of PII Tax
1.02BUILT IN GAINS TAX
If, within 5 years from the date a corporation converts from C to S status, an S corporation sells a property with appreciation inherent (FMV of property is greater than AB of property on the date of conversion), the S corporation is subject to a tax of 21% on the net gain recognized (up to the amount of built-in gain on conversion).
Built in Gain Tax is applicable for C Corp converted into S Corp after 1986
The tax liability is passed through as a loss, pro rata to its shareholders  – a) It reduces basis in each shareholder’s stock and any AAA balance b) Subchapter CE&P are not reduced by BIG Tax Liability
S Corporation are required to make estimated payment of BIG Tax
Shareholders report their share of individual gains reduced by taxes paid by S Corp that are attributable to such gains.
1.03LIFO RECAPTURE
Any excess of the FIFO inventory value over the LIFO Inventory value at the close of the last tax year of C Corporation status is gross incom to a corporation that used the LIFO method to inventory goods.
Basis of inventory is increased by the amount on which the recapture tax is imposed
The recapture income is spread over 4 years: the last C Corp Year and the first 3 years of S Corp

 

Auditing Through The Computer

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Auditing through the computer – Uses the computer to test the processing logic and controls within the system and the records produced

Test Data Approach – In the test data approach, the auditor prepares a set of dummy transactions specifically designed to test control activities that management claims to have incorporated into the processing programs.

Parallel Simulation – A parallel simulation uses a controlled program (auditor developed program) to reprocess sets of client transactions (real transactions and not dummy) and compares the auditor-achieved results with those of the client.

Integrated Test Facility – Using the integrated test facility (ITF) method, the auditor creates a dummy record within the client’s actual system (e.g., a fictitious employee in the personnel and payroll file). Dummy and actual transactions are processed.

Embedded Audit Module – An embedded audit module is an integral part of an application system that is designed to identify and report actual transactions and other information that meets the criteria of having audit significance (e.g., transactions over $5,000).

Purchases-Payables-Cash Disbursement Cycle

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Testing of Completeness Assertion for Accounts Payable and Purchases

Reconciling total amounts in subsidiary ledgers with the general ledger
Performing analytical procedures (e.g., comparing accounts payable turnover with the previous year)
Tracing subsequent payments to recorded payables
Searching for unvouchered (unsupported) payables

Testing of Accuracy Assertion for Accounts Payable and Purchases

Obtaining management representation letters
Comparing general ledger balances and financial statement balances.

Accounts payables and purchases are subject to higher risks of an understatement. External confirmations are not effective in disclosing unrecorded payables. If confirmations are to be made, the blank form of positive confirmations should be used.

Cut-Off Assertion for Accounts Payable and Purchases

Purchases cutoff – Determining whether accounts payables are recorded at year-end for goods whose titles are obtained
FOB shipping point: title obtained when shipped
FOB destination: title obtained when received
Cash disbursement cutoff test – Testing the recording of cash disbursement and accounts payables reduction
Tracing the last check written to the accounting records

Rights and Obligations assertion for accounts payables and purchases

Inquiring of management about the nature of recorded liabilities

Occurrence assertion for accounts payables and purchases – Vouching recorded payables to requisitions, purchase orders, receiving reports, and approved invoices

Classification and understandability assertion for accounts payables and purchases
Evaluating
Classification of accounts payables as current liabilities
Disclosures of
Unusual significant transactions
Purchases and payables with related parties