Question

XYZ is a calendar-year corporation that began business on January 1, 2018. For the year, it reported the following information in its current-year audited income statement. Notes with important tax information are provided below. Use 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 2018 that was used to fund public activities, $7,000 was from a Tacoma City bond issued in 2017 (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 2018. During 2019, 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.)

a. Compute XYZ’s taxable income.

I am not sure how to do this review problem. I do not know where to begin.

Answer 1

Computation of XYZ's Taxable Income
Description	Book Income	Book-tax adjustments	Taxable Income	Difference in book adjustment	Notes/ Reference
	(Dr) Cr	(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	$       300,000	$ (100,000)		$        200,000	Temporary Diff.	Note 1
Interest income	$         20,000	$   (12,000)		$            8,000	Permanent Diff.
Capital gains (losses)	$         (4,000)		$       4,000	$                 -	Temporary Diff.
Gain on fixed asset dispositions	$           3,000			$            3,000		Note 2
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	$                 -	Permanent Diff.
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	$        (27,000)	Temporary Diff.
Depreciation	$ (1,400,000)	$ (500,000)		$   (1,900,000)	Temporary Diff.
Warranty expenses	$       (70,000)		$     70,000	$                 -	Temporary Diff.	Note 3
Charitable contributions	$                -		$             -	$                 -	Adjustment required after income tax
Meals and entertainment	$       (18,000)		$       9,000	$          (9,000)	Permanent Diff.
Goodwill impairment	$       (30,000)		$     20,000	$        (10,000)	Temporary Diff.	Note 4
Organizational expenditures	$       (44,000)		$     36,400	$          (7,600)	Temporary Diff.	Note 5
Other expenses	$     (140,000)			$      (140,000)
Federal income tax expense	$     (720,000)		$   720,000	0	Permanent Diff.
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	$      (222,040)	Temporary Diff.	Note 6
Taxable income before DRD and DPAD				$     1,998,360
Dividends received deduction (DRD)		$ (160,000)		$      (160,000)	Permanent Diff.
Domestic production activities deduction		$   (90,000)		$        (90,000)	Permanent Diff.
Book/Taxable income	$    1,259,000	$ (862,000)	$1,351,360	$     1,748,360
Notes :
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 the year, 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 outstandings of Hobble Corp., it is entitled to an 80% Dividends Received Deduction (DRD). Its DRD is $160,000 ($200,000 dividend x 80%).