Question

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XYZ is a calendar-year corporation that began business on January 1, 2017. For 2018, it reported the following information in its current-year audited income statement. Notes with important tax information are provided below. Exhibit 16-6.

XYZ corp.	Book Income
Income statement
For current year
Revenue from sales	$	40,000,000
Cost of Goods Sold		(27,000,000	)
Gross profit	$	13,000,000
Other income:
Income from investment in corporate stock		300,000	1
Interest income		20,000	2
Capital gains (losses)		(4,000	)
Gain or loss from disposition of fixed assets		3,000	3
Miscellaneous income		50,000
Gross Income	$	13,369,000
Expenses:
Compensation		(7,500,000	)4
Stock option compensation		(200,000	)5
Advertising		(1,350,000	)
Repairs and Maintenance		(75,000	)
Rent		(22,000	)
Bad Debt expense		(41,000	)6
Depreciation		(1,400,000	)7
Warranty expenses		(70,000	)8
Charitable donations		(500,000	)9
Meals		(18,000	)
Goodwill impairment		(30,000	)10
Organizational expenditures		(44,000	)11
Other expenses		(140,000	)12
Total expenses	$	(11,390,000	)
Income before taxes	$	1,979,000
Provision for income taxes		(720,000	)13
Net Income after taxes	$	1,259,000	14

Notes:

1. XYZ owns 30 percent of the outstanding Hobble Corp. (HC) stock. Hobble Corp. reported $1,000,000 of income for the year. XYZ accounted for its investment in HC under the equity method and it recorded its pro rata share of HC's earnings for the year. HC also distributed a $200,000 dividend to XYZ.
2. Of the $20,000 interest income, $5,000 was from a City of Seattle bond issued in 2017 that was used to fund public activities, $7,000 was from a Tacoma City bond issued in 2015 (a private activity bond), $6,000 was from a fully taxable corporate bond, and the remaining $2,000 was from a money market account.
3. This gain is from equipment that XYZ purchased in February and sold in December (i.e., it does not qualify as §1231 gain).
4. This includes total officer compensation of $2,500,000 (no one officer received more than $1,000,000 compensation).
5. This amount is the portion of incentive stock option compensation that was expensed during the year (recipients are officers).
6. XYZ actually wrote off $27,000 of its accounts receivable as uncollectible.
7. Tax depreciation was $1,900,000.
8. In the current year, XYZ did not make any actual payments on warranties it provided to customers.
9. XYZ made $500,000 of cash contributions to qualified charities during the year.
10. On July 1 of this year XYZ acquired the assets of another business. In the process it acquired $300,000 of goodwill. At the end of the year, XYZ wrote off $30,000 of the goodwill as impaired.
11. XYZ expensed all of its organizational expenditures for book purposes. XYZ expensed the maximum amount of organizational expenditures allowed for tax purposes.
12. The other expenses do not contain any items with book-tax differences.
13. This is an estimated tax provision (federal tax expense) for the year. Assume that XYZ is not subject to state income taxes.

Estimated tax information:

XYZ made four equal estimated tax payments totaling $480,000. For purposes of estimated tax liabilities, assume XYZ reported a tax liability of $800,000 in 2017. During 2018, XYZ determined its taxable income at the end of each of the four quarters as follows:

Quarter-end	Cumulative taxable income (loss)
First	$	350,000
Second	$	800,000
Third	$	1,000,000

Finally, assume that XYZ is not a large corporation for purposes of estimated tax calculations. (Do not round intermediate calculations. Round your answers to the nearest dollar amount.)

e. Determine the quarters for which XYZ is subject to underpayment of estimated tax penalties.

	Installment (1) Required cumulative payment (per quarter) under prior year tax method (2) Estimated tax payment under annualized method (3) Required payment based on current year tax liability (4) Required cumulative payment (5) Actual payments Underpayment penalty 1st quarter 2nd quarter 3rd quarter 4th quarter

Answer 1

Description	Book Income (Dr) Cr	Book-tax adjustments*		Taxable Income (Dr) Cr
		(Dr)	Cr
Revenue from sales	$40,000,000			$40,000,000
Cost of Goods Sold	(27,000,000)			(27,000,000)
Gross profit	$13,000,000			$13,000,000
Other income:
Income from investment in corporate stock	300,0001	(100,000) [T]		200,000
Interest income	20,000	(12,000) [P]		8,000
Capital gains (losses)	(4,000)		4,000 [T]	0
Gain on fixed asset dispositions	3,000			3,0002
Miscellaneous income	50,000			50,000
Gross Income	$13,369,000			$13,261,000
Expenses:
Compensation	(7,500,000)			(7,500,000)
Stock option compensation	(200,000)		200,000 [P]	0
Advertising	(1,350,000)			(1,350,000)
Repairs and Maintenance	(75,000)			(75,000)
Rent	(22,000)			(22,000)
Bad debt expense	(41,000)		14,000 [T]	(27,000)
Depreciation	(1,400,000)	(500,000) [T]		(1,900,000)
Warranty expenses	(70,000)		70,000 [T]	03
Charitable contributions	Moved below
Meals and entertainment	(18,000)		9,000 [P]	(9,000)

Goodwill impairment	(30,000)		20,000 [T]	(10,000)4
Organizational expenditures	(44,000)		36,400 [T]	(7,600)5
Other expenses	(140,000)			(140,000)
Federal income tax expense	(720,000)		720,000 [P]	0
Total expenses before charitable contribution, NOL, DRD, and DPAD deduction	(11,610,000)			(11,040,600)
Income before charitable contribution, DRD, and DPAD	$1,759,000			$2,220,400
Charitable contributions	(500,000)		277,960 [T]	(222,040)7
Taxable income before DRD and DPAD				$1,998,360
Dividends received deduction (DRD)		(160,000) [P]		(160,000)
Domestic production activities deduction		(90,000) [P]		(90,000)
Book/Taxable income	$1,259,000	(862,000)	1,351,360	$1,748,360

*[T] reflects temporary book-tax differences and [P] reflects permanent book-tax differences.

1. Using the equity method, XYZ accounts for $100,000 of income for book purposes ($1,000,000 x .3).
2. This is ordinary income for tax purposes (used in trade or business held for less than a year) so it is not netted with the capital loss.
3. Warranty expense is deductible for tax purposes when paid.
4. For tax purposes, XYZ is allowed to amortize goodwill acquired in an asset acquisition on a straight-line basis over 180 months. In 2011, it is allowed to amortize goodwill for 6 months because the goodwill was acquired in July. Its deductible amortization expense for goodwill is $10,000 ($30,000/180 months x 6 months). So, the Schedule M-1 adjustment is $20,000 unfavorable.
5. Because XYZ reported less than $50,000 in organization expenditures it is allowed to immediately expense $5,000 and amortize the remaining costs $39,000 ($44,000 – 5,000) over 180 months (15 years). Because XYZ began business in January, it is allowed to deduct a full year’s worth of amortization. In total, its XYZ’s deductible amortization is $7,600 [$5,000 + 2,600 ($39,000/15)].
6. The charitable contribution deduction is limited to $222,040 which is 10% of taxable income before the charitable contribution, DRD, or DMD ($2,220,400 x 10%).
7. Because XYZ owns 30% of HC, it is entitled to an 80% DRD. Its DRD is $160,000 ($200,000 dividend x 80%).

b. XYZ’s regular income tax liability is $594,442 ($1,748,360 x 34%).

c. XYZ’s Schedule M-1 is as follows:

	Schedule M-1
1	Net income per books	$1,259,000
2	Federal income tax provision	720,000
3	Excess of capital losses over capital gains	4,000
4	Income subject to tax not recorded on books this year (itemize)
5	Expenses recorded on books this year not deducted on this return
	a. Depreciation
	b. Contributions carryover	277,960
	c. Travel and entertainment	9,000
	Stock option compensation (incentive stock options)	200,000
	Bad debt expense	14,000
	Warranty expense	70,000
	Goodwill impairment	20,000
	Organizational expenditures	36,400
6	Add lines 1 through 5	$2,610,360
7	Income recorded on books this year not included on this return
	a. Tax exempt interest	12,000
	Income from investment in corporate stock	100,000
8	Deductions on this return not charged against book income this year
	a. Depreciation	500,000
	b. Contributions carryover
	Domestic production activities deduction	90,000
9	Add lines 7 and 8	702,000
10	Income (line 28, page 1) – line 6 less line 9	$1,908,360

Note that line 10 does not reconcile to XYZ’s taxable income. It reconciles to taxable income before the dividends received deduction of $160,000. XYZ’s taxable income is $1,748,360 ($1,908,360 -160,000).

. XYZ’s alternative minimum tax liability is $0, computed as follows:

AMT Calculation
Category	Item/Calculation	Amount
Taxable income or loss before NOL deduction		$1,748,360
Preference items	Private activity bond	7,000
Adjustments	Depreciation	200,000
	ACE adjustment	9,450
Alternative minimum taxable income (AMTI)		$1,964,810
Subtract: Exemption (completely phased-out)		(0)
AMT base		$1,964,810
x 20%		.2
Tentative minimum tax		$392,962
Subtract: Regular income tax ($1,748,360 x 34%)		$594,442
Alternative minimum tax if positive.		$0

ACE Adjustment
Description	Modification to AMTI
Tax-exempt interest income from tax exempt bond that funds a public activity (as opposed to private activity)	+$5,000
Organizational expenditures that were expensed during the year	+7,600
Total	12,600
ACE Adjustment ($12,600 total x 75%)	$9,450