 Hello and welcome to the session in which you will review a Consolidated Taxable Income. In the prior session, we looked at why do companies consolidate, what are the benefits. In this session, we would look at the actual steps. Also, I will work a comprehensive example of what we called for the CPA Exam, a complete simulation. Now, bear in mind on the CPA exam itself, I highly doubt that you will see a full complete simulation and if you do, that's fine. Otherwise, what I want to show you is, as I'm going over the simulation, I'm going to tell you, for example, they might ask you specifically about this particular figure. For example, what is Consolidated Revenue? What is the charitable contribution for the Consolidated Group? What is the dividend-received deduction for the Consolidated Group? So they might ask you about a specific figure in the Consolidated Tax Return. Nevertheless, I'm going to be working a full example. I'm going to go over the steps. But on the exam, make sure you're aware you can answer multiple choice questions about each individual component. And I'm going to look at a comprehensive example in case that's needed. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. So an apparent company and its subsidiaries decide to file a joint tax return, consolidate. Well, they are treated as one single entity for tax purposes. So we're going to see this. But the first thing they do is each individual company compute their individual income, taxable income, individual taxable income. So step one is each company, let's assume you have three companies, A, B, and C. Each company first will compute their own individual taxable income. First, each company in this group calculates its taxable income, as if they were an independent company. This means that each figure out their own profit, losses, expenses, just they would do if they were filing separately. That's step one. So remember, we're dealing with three companies, A, B, and C. That's a step one. Step two, we're going to adjust for internal transaction. The next thing we do is we make certain adjustments for the transaction that occurs between those companies. And which companies are we dealing with? Company A, company B, and company C. Why this is necessary? Because these transactions are not considered external. So if A sold to B, or C sold to B, or B sold to A, those are internal transactions. So what we need to do, we need to make certain transactions. So if one company sells something to another company within the same group, within A, B, C, they cannot report the sale as they would have it if they made the sale to an external party, because it's an internal sale. They should not claim the income from the sale or the duct costs of goods sold, because it's in between the group. If there is a loss from selling property within the group, this loss is encountered right away in their combined income. It's only recognized when the property is eventually sold to the outside the group, outside A, B, and C. So anything that they sell to each other, any losses that we have to make adjustments, dividend. Dividend paid within the group, like from the parent, like let's assume A is the parent paid dividend to B, or A pay dividend to C, or C pay dividend to B, or B pay dividend to A. Well, any dividend between the parent and the subsidiaries or vice versa are not included. They are treated if they don't exist for tax purposes, because you cannot use them to reduce your taxable income. So we have to make step two is to make certain adjustments. After the adjustments are made, then we have to make adjustments at the consolidated level. So adjustments are made for items that are required to be determined at the consolidated level. Remember, we have A, B, and C. First, we eliminated intercompany transaction. That's fine. We made certain adjustments that eliminated all these transactions. At some point, we're gonna combine A, B, and C altogether. At this level, we're gonna have to make certain adjustments at the consolidated level. Once we combine A, B, and C, and A, B, C, instead of each company dealing with those items on their own, they are taken out as individual company calculation at the group level. For example, when we compute an OL, well, if the group has an overall losses, well, what we mean the group is, I'm gonna call the group ABC altogether. These losses are considered for the whole group together rather than each company separately. At this point, if there's any capital gains and capital losses, these are profit or losses from selling asset like property or investment. For the consolidated group, these gains and losses are total across all companies and net it out at the ABC level. Here we are making adjustments after we combined A, B, and C. We have to make certain adjustments. Also, section 1231, gain and losses. This relate to the sale or exchange of certain type of business property. Again, for the consolidated tax return, these gains and losses are combined for the entire group. This is where we make those adjustments after we made the adjustments to eliminate the intercompany transaction, post combination after we combine them, we make these adjustments. NOL, capital gains, capital losses, section 1231, this is where they can start to net against each other. Also, at this point, we will compute the DRD, the dividend-received deduction. Remember, this deduction is given by the government. This is a deduction that companies can take for certain dividend they receive from other companies. In a consolidated tax return, this deduction is calculated after combining the dividend received by all companies in the group. Remember the percentages. If we own less than 20% of a company, we have 50% dividend-received deduction, 20 to 80% will get a 65 dividend-received deduction. If we own more than 80% of a company, we will get 100% of a dividend-received deduction. Also, at this level, what we do, we look at our charitable contribution to determine how much we can take in a charitable contribution. And with our charitable contribution, money or assets given to charity and you can deduct them, however you are limited. When do you compute that limit for the group after you combine the charitable contribution from all companies in the group are taken into account and that's gonna be 10% of adjusted taxable income. And after we combine everything, now we are ready to perform the final step, which is what? Compute the taxes. We calculate the taxable income for the whole group. Then we apply the tax rate for a C corporation. It's 21%. This is the taxable income for, remember ABC, ABC as a group, as a consolidated group. Then we factor in any tax credit, prepayment to figure out if we owe taxes or if we have a refund due for the whole group. Now the best way to illustrate this is to actually look at an example with numbers and I will go over the steps separately explaining how we perform the computation. As I mentioned at the beginning of this recording, you may or may not see a complete simulation on the exam about consolidation. They might ask you about a specific figure about consolidated revenue or what's the DRD for the whole consolidated group or what's the charitable contribution for the group. And if they do ask you about a complete simulation, I'm gonna go over one with you today. So the first thing we have to look at is we are dealing with three company, X, Y and Z. So let's take a look at each one separately because this is what you do first. Remember step one is you compute the taxable income for each company separately for X, 20 million in gross receipts, 12.5 million in cost of goods. Sold gross profit is 750,000. They received dividend of 310,000. Now here's what we know about the dividend that we received for this company. Let me just scroll down a little bit because here we have additional information. Y and Z corporation paid 110. So this is all you have to make a note of now is of that 310,000. Just kind of you wanna make a note of it because we have to look at this information separately. So 140,000 of this 310 is coming from Y and Z. What does that mean? It means 170,000 is the external dividend that X was paid. Total income for X, 7,810,000. General and administrative expenses, 3,188, interest expense, taxes, this is the total deduction and this is taxable income before NOL and DRD and the DRD computed for company X is 280,500. Remember what we said for the DRD? This is gonna have to be computed at the consolidated level. So this DRD is for X, is for company X specifically. Let's just real quick go over Y. Again, we are giving revenues, cost of goods sold gross profit of 4.6 million, the general administrative, notice they have a charitable contribution of 196,000 and it seems they can take this based on the company level. Taxes then they have taxable income before taxable income. Then company Z, they have revenues, cost of goods sold gross profit of 3.5 million. They have a section 1231 gain and loss of 31500, general administrative, they don't have a charitable contribution and no dividend. So this is what we have now. The first thing we are going to do is learn if there's anything else is interrelated company. So we already know that part of the 310,000, part of the dividend is what? Part of it is coming from Y and Z. Let's see if we have anything else that's intercompany. Let's take a look at the notes here. Intercompany sales, Y corporation sold to X corporation, generating sold inventory, generating a profit of 120,000 which is eliminated from Y gross profit in the consolidated figure. Or what does that mean? That means we have a sale, an intercompany sale from Y to X and that amount is 140,000. What does that mean? It means in this number here we have 140,000. What do we need to do with this number? We need to eliminate. So let's start 120,000 from profit, not sales from profit. So the first thing we're going to do we're going to start to take it from sales and profit because it says here, let me go back here. It says generating profit of 120, generating profit of 120. So what we need to do, we need to remove this from sales and obviously from when we remove it from sales we remove it from profit as well. So let's start with that. So we're going to do the adjustments about intercompany sales. So starting with adjusting, removing 120,000. Now I'm going to go ahead because that's the only thing for sales. I'm going to combine sales between X, Y and Z plus the adjustments. If we go through sales and X, Y and Z the combined sales is 50,880,000. This is the combined. Cost of goods sold, there is no adjustment for cost of goods sold. If we add up cost of goods sold the combined is 35,100,000. Gross profit we have to take out 120,000 or sales minus cost of goods sold. Now remember the dividend, what did I say about the dividend? What we said is the dividend is there are 100 and how much? 140,000 should be eliminated from this dividend. Why? Because that dividend is paid from Y and Z. Again, this is where we are completing this step two basically. So 140,000 need to be eliminated. If 140,000 need to be eliminated what does that mean? It means the combined dividend or the net dividend that stays for the consolidated group is 110 because of the 310,140 is intercompany income. Now the section 1231 gain and losses if there's anything this happens if there's any interrelated this happens at the consolidated level but here we are not told that this is an outside. So we have section 1231. It seems this is external unless we are told otherwise unless we are told otherwise. Let's see if we are told otherwise, let's see. Transaction 1231, Z corporation sold equipment to Y corporation recording section 1231 gain of 31,500. Well, if it's between the entities we have to take it out. Then what we have to do is we have to take out the gain. Well, we take out the gain and what's left and when we add up all the adjustments to total income we have to reduce total income by 291,500. The dividend of 140, the intercompany sales and the section 1231 gains those are, they will need to be removed from total income. And that's basically the adjustments as we mentioned in step two, remember step two we have to kind of take care of the adjustments that is taken care of. Then what we have to do any BRD, any, what else? Any BRD, any charitable contribution they have to be taking at the what? At the consolidated level. Therefore we have to take out, eliminate any charitable contribution. Why? Because we need to figure out what is how much can we take at the consolidated level not the company level. So notice what we have to do here. We have a deduction of 196, we have to eliminate this. We have a dividend received deduction. So those two, let me just highlight them. I'm looking at this number here. Highlight, literally highlight so you can see it. I'm looking at these two figures here. The 196 for company Y, the charitable contribution and the 250,500 for company X those are, they have to be taking at what level at the combined level. We cannot take them, we cannot take them at the corporate level. So let's complete first the combined columns, the combined columns. Let's complete the combined columns then we take the adjustments at the end. So now what we do is we take total income which is 15,780 plus the dividend from the outside party. When it comes to the expenses the general administrative and interest there is no adjustments to be made. Just we add all the numbers. We add the taxes, no adjustments to be made. Then we compute our total deduction. Then we come up with taxable income before NOL and DRD. And this is what we have to do if there's any DRD. Obviously we don't compute any DRD at this level. And this is taxable income before DRD of 8,187,600. Now what's left is this. Let's figure out how much did Y corporation actually paid in charitable contribution. Z corporate contribution was 230 but it was limited for 196. So I'm sorry, not Z, it was Y, not Z. This is just, it's a minor mistake. This is Y. So if we go back here, Y. Remember Y had a charitable contribution and we said we cannot take 196. We may be able to take it, we may not. We may be able to take more. We need to know how much they actually, how, Y, how much they actually contributed. And they contributed actually to the charities 230 but they were limited to 196. Okay, if they were limited now we have to compute that limitation again at the consolidated level. So 196 here, we will have to figure this one out. Well, how do we compute this? Well, what we have here, dividend is, what do we do? We can take 10% out of the charitable contribution, 10%. Well, what is 10%? We have the combined income of X, Y and Z before NOL and special deduction is 8,187,600 dollars. If we take this times, 10%, that's gonna give us, we can take in charitable contribution, 818,716. What does that mean? It means at the consolidated level, at the consolidated level, we can take, and this is one of the benefits of consolidating is we can take the full 230,000 because at the company level, at Y level, we could only take 196, they were limited. At the consolidated level, we were able to take the full amount. Let me just look at the, again, I'm copying all the consolidated figures, but in addition to that, now we can take the full charitable contribution. Now, what else left? Now we have to compute our dividend-received deduction. Our dividend-received deduction was initially 250,500 at the company level, at the company level, which is right here at the company level of company X. Now, what we have to do is we have to figure out the dividend-received deduction for the full group and they might ask you, I mentioned like, what could they ask you? For example, what could they ask you? They could ask you as a multiple choice because I don't wanna proceed any further without saying this. For example, they could have give you some piece of information and asking you to compute total income for this company, the consolidated income, which you had to do what? Eliminate the 120, eliminate the 140, eliminate the 31,500. They could have asked you only, what is the net, the consolidated sales, which is this number here? They could have asked you, what is the consolidated gross profit, which is this number here? So they, or this is a complete picture, or they could have asked you, what is the charitable contribution at the consolidated level? Then you have to focus on the charitable contribution, what you have to do, if they ask you this, you have to go through all the computation to figure out the taxable income before NOL and DRD is plenty and if we multiply it by 10% we're good to go. Now what's left is the dividend received deduction. Remember, company X reported 310,000 of dividend of which we said 140 was from Y and Z, which is what's left is 170. The only dividend received deduction we take is for this 170, because that's from external party. Now we have to figure out how much do we own in this company, in the company that paid us the dividend? So the information should be given to you and this could be the only multiple choice about this. We happen to own 60%, okay? We happen to own 60% of this company. So if we own 60% of this company that paid us 170, well, we need to know our dividend received deduction will be how much, will be 65%. We own 60% shares of that company. Well, if that's the case, the dividend received deduction for the whole group should be 110,500. Now I can complete my computation. I complete my total deduction. I can perform this computation, then put the dividend received deduction for the consolidated group and I will figure out my taxable income and if they ask you about the taxable income then you have to go through this computation. So basically what we did is this, to summarize, the first thing we did is we eliminated what needs to be eliminated, which is the inter-sales. Let me just go through this real quick, which is in step two, eliminated the inter-sales, the inter-company dividend, any section 1231 capital gains, capital losses, inter-companies, we eliminated all of those. Then we kind of, we made adjustments, elimination need adjustments. Then we kind of took out the charitable contribution in DRD to figure out what's the consolidated figures. Consolidated means those adjustments are made on the consolidated figures. And it appears that rather than 196, as a group, we can take 230. However, as a group, the only dividend received deduction we take is the dividend received deduction that we received from, from what? From an outside company that's X own 60% of. What should you do now? You really want to look at this, you really want to look at this consolidated problem. Look at it, examine it, go to FARHAT lectures, look at additional resources that's gonna help you do what? Be comfortable with the consolidated process. Now I'm not sure, the new CPA exam, I'm not sure how much they will give you about this, but if they are using the old CPA exam material, you will see multiple choice questions, but in case they gave you a simulation, I hope this illustration helps put things into perspective, showed you the big picture, but notice I broke it down to you, I broke it to you in several steps. FARHAT lectures is always here to help. Good luck, stay motivated and stay safe, invest in yourself.