I. Overview
A. Taxation of Business Entities
1. Relevant sections
· § 1. Individual tax rates.
§ 1(h)(10). Pass-thru entities defined. § 1(h)(11). Qualified dividends as ordinary income for noncorporate shareholders.
· § 11. Corporate tax rates.
· § 55. Corporate AMT.
· § 61. Gross income defined. § 62. Adjusted gross income defined. § 63(a). Taxable income is “gross income minus the deductions allowed by this chapter.”
· § 1001. Determination of gain and loss. (c). All gain or loss is recognized. § 1011. Adjusted basis. § 1012. Cost basis in property. § 1041. Death basis for shareholder. § 1031. Like-kind exchange. § 1041. Exchanges between spouses.
· § 1221. Capital asset defined. § 1201. Maximum corporate rate on net capital gains is 35%, so on preference. Note the more subtle preference in that capital gains enable a corporation to use its capital losses. § 1222. Requires a sale or exchange for realization of a capital gain or loss.
· § 7701(a)(3) and Regulations. Check-the-box provisions.
2. Themes
· Corporations are separate and distinct entities from their owners; if they were not taxed, individuals would use their entities as tax havens to shelter income. This was especially the case when individual tax rates were as high as 70 and 80%.
· Corporations are taxed at two levels: earnings are taxed once at the entity level and again at the shareholder level.
The present policy is to tax (qualified) dividends at a special rate of 15% rather than as ordinary income.
The present system may create biases towards (1) retention of corporate earnings rather than distribution as dividends and (2) the use of excessive debt financing.
· Progressive rate. The tax system is technically progressive, however because of the “bubbles,” the system is only progressive for small corporations.
· Preferential capital gains rate eases the tax burden. This preference allows shareholders to “bail out” earnings as part of a redemption.
With the present tax preference for dividends, the traditional incentive for the bailout has almost disappeared.
· Nonrecognition assumes that certain
he taxpayer and his documents represent
· Assignment of Income doctrine. A taxpayer cannot assign income to another party in an attempt to avoid taxation on the assigned income. Lucas v. Earl.
· Sham Transaction/Economic Substance.
A sham is a transaction that never actually occurred but is represented by the taxpayer as having transpired. If a transaction is a sham, it is not recognized for tax purposes. Courts tend to reserve this label for the most egregious cases.
Sham transaction case law is inconsistent. One formulation: To find a sham, the court must find (1) no business purpose besides tax avoidance and (2) no economic substance because there is no possibility of profit.
Economic substance law is also inconsistent. There are several approaches, one of which looks at a transaction objectively (economic substance) and subjectively (business purpose).
