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Business Taxation
Southern Illinois University School of Law
Drennan, William A.

Drennan – Federal Business Tax – Spring 2011
SIU Law School
Sole proprietorship
1.      A single 1040 filed by the individual
2.      Problems
a.       Exposed to liability
b.      Difficult to raise capital – no entity that allows the ownership to be split
 
LLC
1.      Only liable for amount invested
2.      If only one partner – its treated as a sole proprietorship
3.      Multiple-member LLC is taxed as a partnership
4.      May elect to be taxed as a C-Corp. or as an S-Corp.
 
Limited Partnership
1.      Limited partners are protected
2.      General partner may be personably liable
a.       Many times a separate entity may be the general partner
 
Corporation
1.      C Corp.
a.       Default corporation for tax purposes
b.      Double-taxed
c.       Required to be a taxed as a C Corp:
                                                               i.      Publicly traded corporations
d.      Before 1986, a C corp. was the best option
                                                               i.      Now it may be very expensive to switch to a S corp.
e.       Those taking advantage of “run-up-the-brackets”
                                                               i.      Using several C corps to keep income in the lower tax brackets
f.        Form 1120 used (rather than 1040)
2.      S Corp.
a.       Form 2553 must be filed
b.      Fees are much less than those for an LLC (p. 24 Corpak)
                                                               i.      Most-used business entity
 
 
If income is capital gains, it is only taxed up to 15%.
 
Pass-through entities are now generally favored over the C Corporation in all stages of the life cycle. S Corporations have also become even more popular in recent years.
 
Sometimes problems arise with timing to file a tax return for individuals or owners of flow-through entities, because the individual has to wait for the entity to file its K1 before the individual can file his tax return.
 
Control group rule – I.R.C. §1561 – cannot create many C-corporations to avoid a higher tax rate
 
Reading for Wednesday 2/2    – 55-78
 
 
C- Corporation
 
P. 60 Corpak Rules
 
Haag case –
·         Trapping a little bit of money in the C Corp is ok (cases in the past have allowed 14% or so (p. 27)
·         A statute of limitations issue probably prevented the IRS from bringing charges for the years 1976-1978. No issue of fraud was raised which would prevent a S/L.
 
Inclusionary Aspects
·         Income is defined the same way for a corporation as it is for an individual
·         Long term capital gain (IRC 1H) have a maximum tax rate of 15%
o   Not available for a C Corp.
o   But a C Corp cannot even deduct their capital losses either (harsh)
§  12-11(a)
§  12-12(a) – If a capital loss this year and no capital gains, it can be carried back up to three years to get a refund for those years or also carry it forward to future years with capital gains
 
General Utilities v. Helvering
·         General Utilities bought stock of Islands Edison for $2000
·         13 months later it was worth over $1 million (something suspicious but SEC didn’t exist yet)
·         Another corp. wanted to buy the stock
·         G.E. wanted to distribute the stock to the shareholders before selling it to avoid taxation
o   Corporations have no long-term capital gains rate
·         Scheme
o   Parties agreed and prepared agreements
o   First distribute the stock to the shareholders (tax-free step)
o   Shareholders sell stock
§  Taxed at maximum rate of 15%
§  Shareholders can tack the holding period that the corporation had because the distribution was a tax-free transaction (over 1 year for long-term capital gains rate of 15%)
o   G.E. held 910 shares and sold directly which they paid taxes on
·         Arguments
o   The dividends resulted in an indebtedness by the corporation to the shareholders – NO
o   This was just a sale of the stock regardless of the form of the transaction
§  The shareholders didn’t have anything to do with the transaction
·         But the proper arguments weren’t raised at trial so the taxpayer wins.
·         311(b)(1) Repealed this case
o   311(a) – Distributing property that has depreciated doesn’t matter, no gain or tax should be recognized. They cannot deduct it
§  Getting around it – Corporation should sell it to a third party and then you can deduct it
·         Will need a capital gain in the previous 3 or future 3 years
·         61(a)7
o   Gross income includes dividends
 
Exclusionary Aspects
 
Castner Garage
·         Keyman insurance – if something happens to one person, the insurance will cover the risk
·         104(a)(3) – exclude amounts paid through accidents or health insurance for personal injury or sickness
·         IRS says it only applies to individuals
·         The insurance proceeds were used to replace revenue
·         Taxpayer argues that exclusions should apply to corporation and persons the same
·         Rule – Exclusion available to individuals should also be available to corporations
 
A corporation issuing its own stock is not a taxable situation. (10-32 (p. 41))
No gain or loss is recognized.
Also section 118
Contributing appreciated property for stock (1001) looks like a taxable gain, but it is not.
351 – no gain or loss is recognized for the shareholder (tax-free)
358 – basis in stock and amount in property is the same for individual
362 – company will receive a carry-over basis on the property
 
Corporate Deductions (Avoiding the double tax)
·         Same as individuals
·         Charitable contributions (170(b)(2)) – only deduct to the extent of 10% of taxable income
o   Taking money from the shareholders (ultra-voires)
o   Now laws expressly allow charitable contributions by corps
§  It is actually self-serving as advertisement
·         Cannot deduct dividends
o   Dividends are not listed in the code as acceptable deductions
·         Corporation may pay out money to shareholders in ways that avoid the double-tax that allows a deduction
o   Compensation
o   Rent
o   Interest on a loan
 
Elliot

Litton before they entertained selling to Nestle.
a.       The $30 million was an appropriate dividend rather than being considered part of the sale transaction because it was done before the sale was contemplated.
2.      §243  Dividends received by corporations (p 6 Corpak)
3.      Litton has $30 million basis in the promissory note, so when Nestle purchased the note, there was no capital gain to be taxed and this saved $11 million
 
Corporate Penalty Taxes
 
Accumulated earnings tax
1.      Imposed by the IRS
2.      Corporations cannot hold on to unnecessary gains to avoid tax without making distributions to shareholders
3.      They are punishing the corporation because they shareholders are not paying tax on dividends.
4.      Purpose – §532 (p. 30 Corpak)
5.      §535(c) – now a corporation can accumulate up to $250K and avoid the accumulated earnings tax without showing a reasonable need for the business ($150K for P.C.’s)
 
United States v. Donruss Co.
1.      Donruss Co. did very well but failed to pay dividends which would be taxed
a.       Claimed the money on hand was for capital and inventory requirements, increasing costs, and risks inherent in the particular business as well as a desire to expand
b.      They paid the tax and asked for a refund so they got to choose the forum and ended up in federal court
2.      Issue was about the jury instruction:
a.       Avoiding tax as “one purpose” v. “dominant purpose”
b.      Statue §532 says “the purpose”
c.       Supreme Court sides with government and says that allowing just “the purpose” would allow anyone to avoid the tax by making up various reasons
3.      Today it doesn’t matter because the corporate rates are no lower than individual rates (applies to pre-1986)
 
Snow Manufacturing Company v. Commissioner
1.      Corporation has accumulated earnings they said were needed to aid in expansion to a new building and pay for the expansion
2.      Treasury Regulations §1.537-2 Grounds for accumulation
a.       (1) To provide for bona fide expansion
3.      Minutes from board meeting discussed the purchase of the property and discussed the expansion and tried to say an offer had been made on property, but there was no third party for the offer to be extended to
4.      The corporation needs a definite plan to rebut the presumption that the accumulation was made to avoid taxes.
a.       Must be “specific, definite, and feasible”
b.      Treas. Reg. §1.537-1 (p. 71 Corpak)