IRS Tax Forms  
Publication 542 2001 Tax Year

Figuring Taxable Income

You figure a corporation's taxable income by subtracting its allowable deductions from its income on page 1 of Form 1120 or 1120-A. This section discusses special rules that may apply to the following corporations.

  • Corporations whose deductions for the year are more than its income.
  • Closely held corporations.
  • Personal service corporations.

Net Operating Losses

A corporation generally figures and deducts a net operating loss (NOL) the same way an individual, estate, or trust does. The same carryback and carryforward periods apply, and the same sequence applies when the corporation carries two or more NOLs to the same year. For more information on these general rules, see Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.

A corporation's NOL generally differs from individual, estate and trust NOLs in the following ways.

  1. A corporation can take different deductions when figuring an NOL.
  2. A corporation must make different modifications to its taxable income in the carryback or carryforward year when figuring how much of the NOL is used and how much is carried forward to the next year.

A corporation also uses different forms when claiming an NOL deduction.

The following discussions explain these differences.

Figuring the NOL

A corporation figures an NOL in the same way it figures taxable income. It starts with its gross income and subtracts its deductions. If its deductions are more than its gross income, the corporation has an NOL.

However, the following rules for figuring the NOL apply.

  1. A corporation cannot increase its current year NOL by carrybacks or carryovers from other years.
  2. A corporation can take the deduction for dividends received, explained later, without regard to the aggregate limits (based on taxable income) that normally apply.
  3. A corporation can figure the deduction for dividends paid on certain preferred stock of public utilities without limiting it to its taxable income for the year.

Dividends-received deduction. The corporation's deduction for dividends received from domestic corporations is generally subject to an aggregate limit of 70% or 80% of taxable income. However, if a corporation sustains an NOL for a tax year, the limit based on taxable income does not apply. In determining if a corporation has an NOL, the corporation figures the dividends-received deduction without regard to the 70% or 80% of taxable income limit.

For more information on the dividends-received deduction, see Dividends-Received Deduction under Income and Deductions, earlier.

Example. A corporation had $500,000 of gross income from business operations and $625,000 of allowable business expenses. It also received $150,000 in dividends from a domestic corporation for which it can take an 80% deduction, ordinarily limited to 80% of its taxable income before the deduction. It figures its NOL as follows:

Income from business $500,000
Dividends 150,000
Gross income $650,000
Deductions (expenses) (625,000)
Taxable income before special deductions $25,000
Minus: Deduction for dividends received, 80% of $150,000 (120,000)
Net operating loss ($95,000)

Because the corporation had an NOL, the limit based on taxable income does not apply.

Claiming the NOL Deduction

The form a corporation uses to deduct its NOL depends on whether it carries the NOL back or forward.

For a carryback. If a corporation carries back the NOL, it can use either Form 1120X or Form 1139. A corporation can get a refund faster by using Form 1139. It cannot file Form 1139 before filing the return for the corporation's NOL year, but it must file Form 1139 no later than one year after the year it sustains the NOL.

If the corporation does not file Form 1139, it must file Form 1120X within 3 years of the due date, plus extensions, for filing the return for the year in which it sustains the NOL.

For a carryforward. If a corporation carries forward its NOL, it enters the carryforward on Schedule K (Form 1120), line 12. It also enters the deduction for the carryover (but not to exceed the corporation's taxable income after special deductions) on line 29(a) of Form 1120 or line 25(a) of Form 1120-A.

Carryback expected. If a corporation expects to have an NOL in its current year, it can automatically extend the time for paying all or part of its income tax for the immediately preceding year. It does this by filing Form 1138. It must explain on the form why it expects the loss.

The payment of tax that may be postponed cannot exceed the expected overpayment from the carryback of the NOL.

Period of extension. The extension is in effect until the end of the month in which the return for the NOL year is due, (including extensions).

If the corporation files Form 1139 before this date, the extension will continue until the date the IRS notifies the corporation that its Form 1139 is disallowed in whole or in part.

Figuring the NOL Carryover

If the NOL available for a carryback or carryforward year is greater than the taxable income for that year, the corporation must modify its taxable income to figure how much of the NOL it will use up in that year and how much it can carry over to the next tax year.

Its carryover is the excess of the available NOL over its modified taxable income for the carryback or carryforward year.

Modified taxable income. A corporation figures its modified taxable income the same way it figures its taxable income, with the following exceptions.

  • It can deduct NOLs only from years before the NOL year whose carryover is being figured.
  • The corporation must figure its deduction for charitable contributions without considering any NOL carrybacks.

The modified taxable income for any year cannot be less than zero.

Modified taxable income is used only to figure how much of an NOL the corporation uses up in the carryback or carryforward year and how much it carries to the next year. It is not used to fill out the corporation's tax return or figure its tax.

Ownership change. A loss corporation (one with cumulative losses) that has an ownership change is limited on the taxable income it can offset by NOL carryforwards arising before the date of the ownership change. This limit applies to any year ending after the change of ownership.

See sections 381, 382, 383, 384, and 269 of the Internal Revenue Code and the related regulations for more information about the limits on corporate NOL carryovers, definition of a loss corporation, and corporate ownership changes.

At-Risk Limits

The at-risk rules limit your losses from most activities to your amount at risk in the activity. The at-risk limits apply to certain closely held corporations (other than S corporations).

The amount at risk generally equals:

  • The money and the adjusted basis of property contributed by the taxpayer to the activity, and
  • The money borrowed for the activity.

Closely held corporation. For the at-risk rules, a corporation is a closely held corporation if, at any time during the last half of the tax year, more than 50% in value of its outstanding stock is owned directly or indirectly by, or for, five or fewer individuals.

To figure if more than 50% in value of the stock is owned by five or fewer individuals, apply the following rules.

  1. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or beneficiaries.
  2. An individual is considered to own the stock owned, directly or indirectly, by or for his or her family. Family includes only brothers and sisters (including half brothers and half sisters), a spouse, ancestors, and lineal descendants.
  3. If a person holds an option to buy stock, he or she is considered to be the owner of that stock.
  4. When applying rule (1) or (2), stock considered owned by a person under rule (1) or (3) is treated as actually owned by that person. Stock considered owned by an individual under rule (2) is not treated as owned by the individual for again applying rule (2) to consider another the owner of that stock.
  5. Stock that may be considered owned by an individual under either rule (2) or (3) is considered owned by the individual under rule (3).

More information. For more information on the at-risk limits, see Publication 925.

Passive Activity Limits

The passive activity rules generally limit your losses from passive activities to your passive activity income. Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate during the tax year, or you have a rental activity.

The passive activity rules apply to personal service corporations and closely held C corporations.

Personal service corporation. For the passive activity rules, a corporation is a personal service corporation if it meets all of the following requirements.

  1. It is not an S corporation.
  2. Its principal activity during the "testing period" is performing personal services, defined later. The testing period for any tax year is the previous tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:
    1. The last day of its tax year, or
    2. The last day of the calendar year in which its tax year begins.
  3. Its employee-owners substantially perform the services in (2). This requirement is met if more than 20% of the corporation's compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.
  4. Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.

Personal services. Personal services are those performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts by employee-owners.

Employee-owners. A person is an employee-owner of a personal service corporation if both of the following apply.

  1. He or she is an employee of the corporation or performs personal services for, or on behalf of, the corporation (even if he or she is an independent contractor for other purposes) on any day of the testing period.
  2. He or she owns any stock in the corporation at any time during the testing period.

Closely held corporation. For the passive activity rules, a corporation is closely held if all of the following apply.

  1. It is not an S corporation.
  2. It is not a personal service corporation (defined earlier).
  3. At any time during the last half of the tax year, more than 50% of the value of its outstanding stock is, directly or indirectly, owned by five or fewer individuals. "Individual" includes certain trusts and private foundations.

More information. For more information on the passive activity limits, see Publication 925.

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