Federal Business Taxation
Memorize: A basic tenet of our tax laws is that a TP has the legal right to decrease or altogether avoid his taxes by means which the law permits.
The Business as an Entity Under State Law
I. Sole Proprietorships
a. Business directly owned by proprietor
i. Taxed under §1, Schedule C – normal income tax
ii. Business tax information reported with personal statements
iii. Joint owners may be treated individually as sole proprietors for tax purposes
a. Pass-through or Conduit taxation
b. Calculated as a business, but taxed to the individual partners
i. 701 – not taxed as income of the firm directly, but as income to the partners.
ii. 702 – in determining income tax, each partner is taxed according to their interest in the business on a pro rata basis of business income or loss. See also 703, 704.
1. Key: Allocation to partners of distributed share
2. Partners have to report distributive share of profit income, even if not distributed. If partnership retains earnings, partners are still taxed.
a. 11(a) – corporation computes its profit or loss and is taxed as an entity
b. 11(b) –“progressive” tax schedule, but most taxable corporations (except the largest ones) are subject to a flat rate of 34%
i. The flip side of §11
ii. 61(a)(7) – dividends and the double tax. Corporation is taxed once, and earnings taxed again when distributed as income to individual shareholders
c. C Corporations – “Regular corporations”
i. Corporate earnings are subject to “double tax,” once on corporate earnings, & once more when earnings are distributed to SH through their income taxes.
d. S Corporations
i. If there is no corporate expectation of advantageous RE scheme, then may elect to incorporate as S corp. Avoids tax liability on corporate earnings, but earnings must be reported. Shareholders are then taxed on their pro rata share of the corporate earnings no matter the income’s disposition (distributed to shareholders or not). The character of the monies reported (loss, gain, deduction, credit) is retained in the taxpayer’s hands.
ii. The enterprisers are owned or controlled by the same interest
iii. Reallocation of income among enterprisers is necessary to clearly reflect income or to prevent evasion of taxes
c. Gains from Property
i. General Utilities doctrine: §311(a). Distribution in kind allowed corp to distribute appreciated property to shareholders to avoid corp-level tax on sale. SH would then sell and not realize gain because of §301(d) FMV basis rule. Congress figured it out and basically (with limitations) repealed doctrine in §311(b).
ii. New General Rule: A corporation that recognizes gain on a nonliquidating distribution of appreciated property (non-loss) in an amount equal to the difference between the fair market value of the property and its adjusted basis.
1. Loss property: A corp may not recognize loss on the distribution of property with an adjusted basis that exceeds its FMV (Corp should sell the prop if it wants the loss).
III. Exclusionary Aspects