CORPORATE INCOME TAX
Taxation of Corporate Income – Introduction
· Corporations are taxpaying entities that are separate and distinct from their shareholders
· Ever since the enactment of the individual income tax in 1913, corporate income generally has been taxed twice (first when earned by the corporation and again when distributed to the shareholder as dividends or in liquidation)
· Qualified personal service corporations are taxed at a flat-rate of 35 %
o QPSC are corporations engaged in health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting businesses, if substantially all of the stock is owned directly or indirectly by employees performing such services. See IRC 448(d)(2).
· Application of the deduction sections, such as 162 and 165, are generally guided by the premise that all corporations are engaged in trade/business
· Under 1212(a), capital losses are allowed only to the extent of capital gains, with a 5 year carryover and a 3 year carryback on any excess losses
· Sec. 199 provides a special deduction for TP operating a trade/business that engages in domestic manufacturing activities
· Most C Corps are required to use the accrual method of accounting.
o Exceptions are provided for corporations with average annual gross receipts of less than $5 million and for personal service corporations
· Sec. 1032 provides that a corporation does not realize income upon the sale or issuance of its own shares for property, money, or services
· A maximum corporate tax rate that is the same as the maximum individual tax rate, coupled with the double tax of corporate earnings (even though 15 %), serves as a disincentive to organizing businesses in the corporate form unless nontax factors strongly indicate that the corporate form is necessary or desirable
Identifying Taxable Corporate Entities
· For Fed. Inc. Tax purposes, T. Reg. 301.7701-2 provides that a business entity with 2 or more members is classified as either a partnership or a corporation.
· Under T. Reg. 301.7701-2(b), any business organized as a corporation under relevant state law or federal law automatically is classified as a corporation for federal income tax purposes, as are insurance companies and most banks.
· A business entity that is not listed in T. Reg. 301.7701-2(b) as a corporation is classified as a p’ship and an entity that is classified as such may elect to be taxed as a corporation. If no election is made, the entity is by default classified as a p’ship.
· Any business entity that is not required to be treated as a corporation for federal tax purposes may choose its classification under the rules of T. Reg. 301.7701-3. Those rules provide that an eligible entity with at least 2 members can be classified as either a p’ship or a [corporation]. An eligible entity with a single member can be classified as a [corporation] or can be disregarded as an entity separate from its owner.
· The default for foreign entities is based on whether the members have limited liability. If all members have limited liability, the entity will be classified as a corporation.
· An LLC that has 2 or more members is an entity separate and distinct from its members and is treated as either a p’ship or a corporation. An LLC with 2 or more members that does NOT elect to be taxed as a corporation will be treated as a p’ship for purposes of federal income tax. Thus, an LLC is taxed as a corporation only if it affirmatively elects to be treated as such for federal tax purposes.
· Sec. 7704 generally treats as a corporation any p’ship the interests in which are traded on an established securities market or are readily tradeable on a secondary market or a substantial equivalent of a secondary market
Regard and Disregard of the Corporate Entity
Strong v. Comm. (T.C. 1976)
Facts: Petitioners formed a p’ship for purpose of constructing & operating an apt complex on real estate contributed by several partners. In order to get financing, it was necessary to transfer the property to a corporation wholly owned by the p’ship so they could be in compliance with the usury laws. NOL were generated which were reported on the p’ship’s returns. IRS alleged that corporation, as owner of the property, was the proper party to report the losses. Petitioners allege that corporation was merely a sham or device used for the purpose of avoiding the NY usury statute.
Holding: Petitioners formed a corporation. Court cites Moline Properties and states the bar is low and that very little corporate activity will result in corporate status for tax purposes.
Comm. v. Bollinger (1988)
Facts: Group of real-estate p’ships created a corporation for the sole purpose of holding nominal title to property and borrowing necessary funds for the p’ship real-estate business. Lender suggested that the p’ship establish a corporation to hold nominal title to the collateral and borrow the necessary funds since the interest rate the lender could charge corporate borrowers under the state usury law was higher than the rate for noncorporate borrowers. The corporation had no other assets, liabilities, employees, or bank accounts.
Holding: SCOTUS disregarded the corporation, finding that the corporate entity was acting as agent for the p’ship, which were the true owners of the property. Thus, SCOTUS upheld the partnerships’ reporting of income and loss on their p’ship tax returns and the pass-through of such income and loss to the individual partners. Court also cites Nat’l Carbide factors: (1) Whether the corporation operates in the name & for the account of the principal; (2) bind the principal by its actions; (3) transmits money rec’d to the principal; and (4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal are some of the relevant considerations in determining whether a true agency exists. (5) If the corporation is a true agent, its relations with its principal must not be dependent upon the fact that it is owned by the principal, if such is the case. (6) Its business purpose must be the carrying on of the normal duties of an agent. Court further states “it seems to us that the genuineness of the agency relationship is adequately assured, the tax-avoiding manipulation adequately avoided, when the fact that the corporation is action as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent and not principal with respect to the asset for all purposes, and the corporation is held out as the agent and not principal in all dealings with 3rd parties relating to the asset.
Note: As a general rule, once investors choose to incorporate, the corporation is viewed as a separate entity for tax purposes and the shareholders generally will be bound for tax purposes by their decision to incorporate. However, the Bollinger decision does leave open the possibility that in certain limited circumstances a properly incorporated entity will be disregarded for tax purposes.
Formation of the Corporation
Receipt of Stock for Property
Shareholder(s): See Sec. 351 (Transfer to Corp. Controlled by Transferor), 358 (Basis to Distributees), & 1223 (Holding Period of Property)
Contribution FMV Basis Gain/Loss Recognized
Claire Waste Truck 100,000 150,000 (50,000) 0
Don Land 100,000 30,000 70,000 0
Under Sec. 351, the shareholders will not recognize any gain or loss b/c each has made a contribution of property, the contribution is in exchange for stock, and the control group meets the 80 % test requirements. Under 1032, the corporation will not recognize any gain or loss.
Claire’s Basis in Stock under Sec. 358: = $150,000
Don’s Basis in Stock under Sec. 358 = $30,000
Notes: Claire will be able to tack her holding period of the truck with that of the stock. Don will also be able to tack the period he held the land.
Waste Truck = $100,000 (Sec. 362(e) limits loss recognition for the corporation)
Land = $30,000
Note: Claire could have made election with regard to transfer of waste truck under Sec. 362(e)(2)(C). If she had, she would have a basis in her stock of $100,000, and the corporation would have a basis in the waste truck of $150,000.
Contribution FMV Basis Real Gain/Loss Rec
Claire S Waste Truck 100,000 150,000 (50,000) 0
Claire L Waste Truck 100,000 60,000 40,000 0
Don Land 200,000 30,000 170,000 0
Under Sec. 351, the shareholders will not recognize any gain or loss b/c each has made a contribution of property, the contribution is in exchange for stock, and the control group meets the 80 % test requirements. Under 1032, the corporation will not recognize any gain or loss on the transfer of stock.
Claire’s Basis in Stock under Sec. 358: $210,000 (note no adjustments b/c no boot and no gain recognized)
Don’s Basis in Stock under Sec. 358: $30,000
Waste Truck = $140,000 (We see that Sec. 362(e) applies b/c we have built in losses of $50,000 that exceed our built in gains of $40,000. We thus have a net loss of $10,000, which will be our adjustment under 362(e). Have to allocate to loss property and in this case solid waste truck (#1) will have a reduction in basis of $10,000. Thus, its basis will be $140,000. Note that you can make an election to have Claire’s basis in stock be reduced by $10,000 instead, which would give her a basis of $200,000 and the Solid Waste Truck would then have a basis of $150,000.)
Liquid Waste Truck = $60,000
Land = $30,000