Question

explain the significance of the following deductions:

1) The Dividends Received Deduction (Form 1120, Line 29b)

2) The Domestic Production Activities Deduction (Form 1120, Line 25)

3) The Net Operating Loss Deduction (Form 1120, Line 29a)

Answer 1

SOLUTION

(1) Dividends Received Deduction (Form 1120, Line 29b)

The taxation of dividends is one of the most complicated aspects of the u.s. tax system. For individuals, some types of dividends get taxed at different rates than others. But corporations are sometimes eligible for even bigger write-offs on dividends they receive, thanks to the dividends received deduction. The dividends received deduction, or drd for short, allows corporations to deduct a percentage of their dividend income

The DRD guidelines are laid out in Section 243 of the Internal Revenue Code. The general rule is that if a company receives dividends from another corporation, then it is allowed to deduct 70% of those dividends under the DRD. That effectively cuts the tax rate on dividends from a top corporate rate of 35% down to 10.5%.

However, there are other rules that apply under certain specific situations. If the corporation receives the dividends from a small-business investment company as defined under small-business law, then it can deduct 100% of the dividends, effectively paying no tax at all. Similarly, for qualifying dividends paid by a corporation that's in the same affiliated group, the 100% deduction applies under the DRD.

Finally, a separate rule offers a different DRD amount. If the corporation receiving the dividend owns at least a 20% stake in the company paying the dividends, then the DRD amount rises to 80%. That cuts the tax rate all the way to 7% on dividend income received.

(2) Domestic Production Activities Deduction (Form 1120, Line 25)

Background

Businesses with "qualified production activities" can take a tax deduction of 3 percent from net income. That's the easy part. The more complicated the business, the more complicated the math for calculating the domestic production activities deduction.

In a nutshell, businesses engaged in manufacturing and other qualified production activities must implement cost accounting mechanisms to make sure that their tax deductions are accurately calculated.

Companies Eligible to take Deduction of Domestic production Activities

A company engaged in the following lines of business can qualify for the domestic production activities deduction. The "qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199 include:

• Manufacturing based in the U.S.
• Selling, leasing, or licensing items that have been manufactured in the U.S.
• Selling, leasing, or licensing motion pictures that have been produced in the U.S.
• Construction services in the U.S., including building and renovation of residential and commercial properties
• Engineering and architectural services relating to a U.S.-based construction project
• Software development in the U.S., including the development of video games

Companies not eligible to take Deduction of Domestic production Activities

The following lines of business are specifically excluded from claiming the domestic production activities deduction:

• Construction services that are cosmetic in nature, such as painting
• Leasing or licensing items to a related party
• Selling food or beverages prepared at a retail establishment

(3) Net Operating Loss Deduction (Form 1120, Line 29a)

Definition

A net operating loss (NOL) is a loss taken in a period where a company's allowable tax deductions are greater than its taxable income. When more expenses than revenues are incurred during the period, the net operating loss for the company can generally be used to recover past tax payments. The reasoning behind this is that corporations deserve some form of tax relief when they lose money, so they may apply the net operating loss to future income tax payments, reducing the need to make payments in future periods.

Example

Company A has taxable income of $500,000, tax deductions of $700,000 and a corporate tax rate of 30%. Its NOL is $500,000 - $700,000 = -$200,000. Because Company A does not have taxable income, it does not pay taxes that year. Otherwise it would have paid $250,000 x 30% = $75,000 in taxes. Because the company had an NOL the previous year, it may put the NOL toward the current year’s tax bill or apply it against taxable income in previous years.

Application Rules

A business may carry the taxable amount back to the two previous years and apply it against taxable income for a refund. For example, an NOL occurring in 2018 may be used for lowering tax payments in 2017 or 2016. Because the time value of money shows that tax savings at that time is more valuable than in the future, this is the more beneficial choice. However, if the business did not pay taxes in prior years, or the owner’s income is expected to substantially increase in the future and raise the company’s tax rate, the business may also carry forward the amount over the next 20 years, reducing the amount of taxable income during that time.

If a business creates NOLs in more than one year, they are to be drawn down completely in the order that they were created before drawing down another NOL. Because any remaining NOL is canceled after 20 years, this reduces the risk of the NOL not being used.

Limitation Imposed under Setion 382

An NOL may be considered a valuable asset because it can lower a company’s amount of taxable income. For this reason, the Internal Revenue Service (IRS) restricts using an acquired company simply for its NOL’s tax benefits. Section 382 of the Internal Revenue Code states that if a company with a NOL has at least a 50% ownership change, the acquiring company may use only that part of the NOL in each concurrent year that is based on the long-term tax-exempt bond rate multiplied by the stock of the acquired company. However, purchasing a business with a substantial NOL may mean an increased amount of money going to the acquired company’s shareholders than if the business possessed a smaller NOL.