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Income Tax of Corporations and Shareholders
University of Mississippi School of Law
Davis, Donna Raye

INCOME TAX OF CORPORATIONS AND SHAREHOLDERS – SPRING 2016 – PROFESSOR DAVIS

Do you want to be a C corporation or not? Treated as a C corp unless elect to be an S corp.

Need to consider 3 tax rates (mix tells you whether you want to be a C corp or not)

Personal individual ordinary tax rate
Personal capital gains tax rate
Corporate tax rate

Individual rates top out at 39.6% (Sole proprietors taxed individually)
LLCs are generally taxed as partnership.No specific LLC rules in tax code.

Partnerships are tax conduits (flow through/pass-through entities)
Meaning it is not a tax paying entity, only provides tax information to service and partners/members
Income and deductions appear on partner’s individual returns

Corporations are tax-paying entities if C corps

Incorporate under state law, but Federal law (tax code) determines if C or S
C is double taxation entity, taxed at corporate level and shareholder level
But can defer paying second level of tax until dividends are distributed
Dividends are treated as long-term capital gains (better than OI rate) 15-20%
So generally speaking, don’t want to be a C corp because even though initial corporate rate may be lower, total taxes are higher

**This is a general assumption.Corporate tax rate may not be 35%, but effective rate around low 20s.So if capital intensive corporation, may not be a bad idea to be a C corporation.**

Why have C corps been attractive in the past?Only have to pay currently, can defer shareholder level of tax.Reinvest the difference between paid corporate tax rate and potential individual rate that would have otherwise been paid.
Encourages corporate policy to be low dividend paying, increasing retained earnings.

S corporations are flow-through entities like partnerships/LLCs

So why not be an S corp?

Inflexible, rigid.Can only have certain number/type of shareholders.So not much incentive to be an S corp these days.
Many S corps are remnants of C corps that did not transfer to LLC/Partnership because that is a dissolution which is expensive

What will we be looking at this semester?

How do you get assets into a corporation and what are the effects?

Concerned w/ relationship of corporation and shareholders/owners

Treatment of misc. things: dividends, stock redemption, downsizing, liquidation

Where are corporate rates? § 11

Progressive rates – first “bubble” kicks in before $50,000.Amount in excess of lower bracket is taxed at higher rate.We will use flat 35% rates?

Corporations do not have capital gains preference (§1 only applies to individuals)
After tax earnings flow to shareholders as dividends, which are taxed as capital gains (we will use 20% rate- most people who are recognizing taxable dividends have high income)
Capital Gains Rates- must have a capital asset (§1221). Must have been held more than 1 year. Dividends are not capital assets but get capital rates because included in §1.
§453 Installment Method

Land with FMV of 100k, basis of $25k = $75k gain
If you sell the right kinds of assets on an installment note (payments beyond current year) then you can use the “installment method” to recognize gain
As each payment is received, pay tax liability on that amount of proceeds but not tax on whole
Ratio: Payment Received X Gross Profit Ratio (gain on whole asset/total K price)

In above example, $20k X .75=$15k gain
Done every year for 5 years (until 100k paid). Total gain taxed is $75k.

: If note is disposed before payments are made (disposition of installment note) then must recognize gain

Common Law of Corporate Taxation – Doctrines

Sham Transaction Doctrine
Economic Substance Doctrine
Substance Over Form
Business Purpose
Step Transaction Doctrine

The Corporation as a Separate Taxable Entity

Comm’r v.Bollinger – Bollinger sets up corporation to get higher interest loan. Kentucky usury laws limited interest rates that could be charged to non-corporate individuals. Moline doctrine said it is a separate taxable entity even if one shareholder. Bollinger points to National Carbide factors for true corporate agents that are not recognized as separate from their owners. IRS argued failed 5th and 6th national carbide factors. Court said 6th was fine because it was acting only as an agent and was not the owner of the property. Court said they weren’t really sure what 5th factor meant, but said they felt it was just reiterating the Moline separate entity doctrine, and said arm’s length transaction was not a requisite of agency.

CHAPTER 2: FORMATION OF A CORPORATION

§351: Defers gains for property transferred for stock at shareholder level

Absent this provision, transfer would be realization event and recognized gain
Transferor must take lower basis, gain is recognized on sale of stock
Three basic requirements for non-recognition under §351:

One or more persons must transfer “property” (includes cash) to the corporation;
The transfer must be solely in exchange for stock of the corporation; and
The transferor or transferors, as a group, must be in “control” (§368(c)) of the corporation “immediately after the exchange.”

“Control” means 80% of all classes of stock and at least 80% of combined voting power of all classes of stock entitled to vote
Transferors include cash purchasers

If three requirements are met, basis determined by §358(a)(1) (“exchange basis”)
Holding period determined by §1223(1), which says that where a transferor receives property with an exchanged basis, such as 351 exchange, the holding period of that property is determined by including the period during which he held the transferred property IF the transferred property is a capital asset or a §1231 (business use) asset.If it is not, then the transferor’s holding period begins on date of exchange.
-exception for 351.

): Defers gains for property transferred for stock at corporate level

Corporation takes transferred basis from shareholder
So appreciated assets transferred into corporation will be taxed twice
Basis determined by §362(a): “transferred” or “carryover” basis
provides that if property has a transferred basis to the corporation, the transferor’s holding period likewise will carry over. Simply, holding period always tacks if property is 1221/1231 property.

Limitations on transfer of built-in losses. §362(e)

If you have a net built-in loss, you cannot carry that loss over to corporation.Can take at shareholder level only, exchange basis stays same for shareholder transferor.But corporation must take FMV basis, not transferred basis.
Corporation and shareholder may elect to take loss at corporate level and not shareholder level. Whoever has higher rate should take loss.

: Can only deduct losses up to capital gains. So “capital” determination matters even though holding period may not.

Problems with Double Taxation?

We don’t really know who has the burden of actually paying the tax.

At first glance looks like shareholders bear it, but don’t know that
So then who is paying? Companies look at taxes like any other business expense.As taxes go up, companies raise prices to recoup tax expense. So CONSUMERS really bear the burden.
Also, if they choose to cut costs instead of raising prices, then burden falls on WORKFORCE because of decreased wages or loss of jobs

So why don’t we just get rid of corporate tax?

Every business would be a corporation and would withhold earnings, only making minimal distributions. So this completely undercuts tax system, gov’t would get no revenue.
Hard to come up with an alternative system that works

Intermountain Lumber Co. v. Comm’r – Intermountain Lumber bought stock in SW. IL fil

e more property and the issuance of more stock would not change the percent of ownership
§ 351 (b)-the boot section (money is boot)-the corporation can give the shareholder back money or property but (b)(1) or (b)(2) will apply

Only recognize boot to the extent there is gain in the transaction
Never recognize loss on boot

Immediately After-does not mean simultaneous-must be in control after the end of the transaction-this can be found by one of three test

End Result Test-whether the final result was intended from the beginning of the transaction
Mutual Interdependence Test-whether the steps to the transactions are so interrelated that it would be fruitless to do one without the other
Binding Contracts Test-whether there was a binding contract to complete all the transactions
Multiple Properties Transferred: The amount received of stock and boot must be allocated to the various properties to determine gain on each property. Individual property FMV / aggregate FMV of all properties = the percent of the individual property x the stock and the boot

Part C: Debt: The amount of the debt that is attached to the property transferred is considered part of the amount realized

§ 357-Debt is not boot unless B or C apply

if it appears that the debt is being transferred for the purpose of avoiding Federal Income Tax on the exchange – or – it was not a bona fide business purpose — then the assumption of debt will be considered money received and will be treated like boot
if the amount of debt exceed the AB on the property then excess will be considered gain (must recognize all the excess gain-not limited to amount of gain in transaction)

Rev Ruling 66-142-must do on a SH by SH basis, but aggregate all the things given by that one person

Question Two-(What is the Basis for the Shareholders)

§ 358-Basis to Distributees

Shareholders basis will be the same as the basis they had in the property given up reduced and added to by a few things
: AB – FMV Property [boot] (includes assumption of debt) – Money + Gain = New Basis of the stock to the shareholders
Rev Ruling 1.358-2b2-If multiple types of stock and/or securities are transferred back to the shareholder the basis of the properties transferred shall be allocated among all of the stock and securities received in proportion to the fair market values of the stock of each class and the securities of each class

Amount of one stock / total amount of stocks transferred x AB of properties transferred

Question Three-(What is the Holding Period for the Shareholders)

§1223-allows for the tacking of the holding period of property with a carryover basis but requires the holding period to begin anew when a gain or loss is recognized (§1001); must be a capital asset or a §1231 asset to apply for shareholders

Applies to any property held in a trade or business that is not inventory or copyrights
When the basis is decided in whole or in part by the basis of the property given up then the holding period tacks
If you use § 351 then you must use § 358 (basis) and therefore § 1223 allow tacking