Contributing Author: Toby Stock
Introduction
Cognitive scientists document that repeated exposure to topics results in better learning, and that integrating topics also yields retention benefits. Despite this, income tax classes are frequently so “jam-packed” with topics that it is difficult to re-visit earlier topics or integrate them with new topics. However, an opportunity to achieve a measure of integration exists when we cover book-tax differences. I like to take this opportunity to re-visit the taxation of property transactions when discussing how to compute book-tax differences.
Idea for Class Discussion or Assignment (See notes below for some thoughts on this.)
In each of these problems, I ask students to compute corporate taxable income using only the information provided in the problem. The net income numbers in each example include the items that follow as is appropriate under GAAP. There are no differences between book values and adjusted bases.
- I like to start with a simple problem that illustrates that corporations cannot deduct net capital losses.
| Net income before tax | $100 |
| Sale of LT capital asset | 60 |
| Sale of ST capital asset | <80> |
- I then add §1231 asset considerations with the next problem.
| Net income before tax | $100 |
| Sale of LT business machine | <30> |
| Sale of LT business land | 100 |
| Sale of ST business furniture/fixtures | 60 |
| Sale of ST capital asset | <80> |
- Finally, I ask them to compute corporate taxable income for a complex problem that includes many elements of the netting process, including depreciation recapture.
| Net income before tax | <$125> |
| Sale of LT business land | 80 |
| Sale of LT business machine (Accumulated MACRS was $180) |
60 |
| Sale of ST business machine | <30> |
| Sale of LT capital asset | <170> |
| Sale of ST capital asset | 70 |
| Four years ago, the corporation deducted a net section 1231 loss of $90. | |
| Capital loss carryover from last year | 20 |
Obviously, this problem is not for the “faint of heart” but it gets the idea across that students do actually use what they learned earlier in later applications.
Assignment Notes
- Net income includes net capital losses, but taxable income does not. The two sales reduce net income by $20 but the net loss is nondeductible, resulting in a net book-tax difference of +$20. Accordingly, taxable income is $120 (= $100 + $20 net capital loss).
- The net gain from the four property sales increases net income by $50. However, the effect on taxable income is an increase of $60, resulting in a net book-tax difference of +$10. Specifically, the gain on the short-term land is ordinary income. The net §1231 gain = $70. The net § 1231 gain offsets most of the short-term capital loss to result in a net short-term capital loss = $10, which is nondeductible. Therefore, corporate taxable income is $110 (= $100 + $10 net capital loss).
- The net gain from the five current-year property sales increases net income by $10 (= $80+$60-$30-$170+$70). However, the effect on taxable income is an increase of $80. Specifically, the loss on the short-term machine is ordinary. The § 1245 ordinary income on the machine is $60, resulting in no remaining § 1231 gain. The § 1231 gain from the land is $80, but the lookback rule recharacterizes $50 of that as ordinary income. This results in a net § 1231 gain of $30, which is treated as a long-term capital gain. This results in a net capital loss of $90 (= <$170> + $30 + $70 – $40), which is nondeductible. Therefore, the net increase in taxable income from the property sales is +$80 (= <$30> + $60 § 1245 gain + $50 lookback gain), which results in a net book-tax difference of +$70. Accordingly, taxable income = <$55> (= <$125> + $70).