Chapter 3 Financial Statements, Cash Flow, and Taxes 75to be used to offset the pro! ts of another. (Similarly, one division’s losses can be used
to offset another division’s pro! ts.) No business wants to incur losses; but tax offsets
make it more feasible for large, multidivisional corporations to undertake risky new
ventures or ventures that will suffer losses during a developmental period.
Taxation of Small Businesses: S Corporations
As we noted in Chapter 1, the Tax Code allows small businesses that meet certain
conditions to be set up as corporations and thus receive the bene! ts of the corpo-
rate form of organization—especially limited liability—yet still be taxed as propri-
etorships or partnerships rather than as corporations. These corporations are called
S corporations. (Regular corporations are called C corporations.) If a corporation
elects S, all of its income is reported as personal income by its stockholders, on a
pro rata basis, and thus is taxed at the stockholders’ individual rates. Because the
income is taxed only once, this is an important bene! t to the owners of small cor-
porations in which all or most of the income earned each year will be distributed
as dividends. The situation is similar for LLCs.
Depreciation
Depreciation plays an important role in income tax calculations—the larger the
depreciation, the lower the taxable income, the lower the tax bill, and thus the
higher the operating cash " ow. Congress speci! es the life over which assets can be
depreciated for tax purposes and the depreciation methods that can be used. We
will discuss in detail how depreciation is calculated and how it affects income and
cash " ows when we study capital budgeting.
S Corporation
A small corporation that,
under Subchapter S of the
Internal Revenue Code,
elects to be taxed as a
proprietorship or a
partnership yet retains
limited liability and other
benefits of the corporate
form of organization.S Corporation
A small corporation that,
under Subchapter S of the
Internal Revenue Code,
elects to be taxed as a
proprietorship or a
partnership yet retains
limited liability and other
benefits of the corporate
form of organization.2006 2007
Original taxable income $ 2,000,000 $ 2,000,000
Carry-back credit "2,000,000 "2,000,000
Adjusted profit $ 0 $ 0
Taxes previously paid (40%) 800,000 800,000
Difference = Tax refund $ 800,000 $ 800,000
Total refund check received in 2009: $800,000 + $800,000 = $1,600,000
Amount of loss carry-forward available for use in 2009–2028:
2008 loss $12,000,000
Carry-back losses used 4,000,000
Carry-forward losses still available $ 8,000,000
Calculation of Loss Carry-Back and Carry-Forward for 2006–2007 Using a
$12 Million 2008 LossTabl e 3 - 8Explain this statement: Our tax rates are progressive.
What’s the di" erence between marginal and average tax rates?
What’s the AMT, and why was it instituted?
What’s a muni bond, and how are these bonds taxed?
What are long-term capital gains? Are they taxed like other income? Explain.
How does our tax system in# uence the use of debt! nancing by corporations?
What is the logic behind allowing tax loss carry-backs/carry-forwards?
Di" erentiate between S and C corporations.SELF^ TEST (^)