Corporate Taxation Spring 2017
Professor Donna Davis
Part 1: Introduction
Chapter One – An Overview of the Taxation of Corporations and Shareholders
Taxation of Business Entities
A tax is imposed annually, at the rates set forth in Section 11, on the taxable income of a corporation. That income is taxed again if and when a corporation distributes dividends to its shareholders.
Because the corporation is treated as a separate taxable entity, transactions between corporations and their shareholders are taxable events.
The double tax regime generally applicable to corporations and the pass through system governing partnerships and limited liability companies represent the Code’s two fundamental alternatives for taxing business enterprises.
The Double Tax
The concept at the heart of Subchapter C is the double taxation of corporate income.
Many large and profitable publicly traded corporations are taxed at effective rates well below the statutory maximum, and many major shareholders, such as wealthy charities and qualified retirement funds, do not pay taxes on the dividends they receive.
Critics also point to the adverse impact of the tax on the allocation of economic resources; its complexity; the disadvantages it places on U.S. companies in the global economy; and many other evils; including three distinct biases:
Against corporate as opposed to noncorporate investment
In favor of debt financing for businesses organized as C corporations
In favor of retention of earnings at the corporate level as opposed to distribution of dividends
Tax Rates on Ordinary Income: Corporate and Individual
For C corporations with significant taxable income, the corporate income tax is essentially 34 or 35 percent flat rate tax with no preferential rate for long-term capital gains.
Corporations with smaller amounts of income can take advantage of lower rates (15 and 25 percent) on their first $75,000 of taxable income, but the modest benefit of these rates begins to phase out as the corporation’s taxable income rises about $100,000
Profits of C corporations are potentially taxed both at the corporate and shareholder levels wen they are distributed as dividends or when the shareholders sell their stock.
The relationships among all these taxes have influenced the choice of legal entity in which to conduct a business or investment activity.
Preferential Capital Gains Rates
Rather than paying dividends. Tax advisors devised techniques to “bail out” earnings at capital gains rates.
Under the realization principle, gains and losses are not taxable until they are realized in a sale, exchange or other event that makes the gain or loss “real” and more easily measureable.
To ensure that any realized gain or loss is merely deferred rather than eliminated, the typical nonrecognition provision includes corollary rules providing for transferred and exchanged bases and tacked holding periods.
Taxpayers may be encouraged to structure sales of a corporate business to come within an applicable nonrecognition provision in order to avoid (or at least defer) tax at the corporate and shareholder levels
The Common Law of Corporate Taxation
In scrutinizing taxpayer behavior, the courts at an early date went beyond the literal statutory language and began to formulate a set of doctrines that have become the “common law” of federal taxation.
Sham Transaction Doctrine
If a transaction is a “sham” it wont be respected for tax purposes.
A “sham” is best defined as a transaction that never actually occurred but is represented by the taxpayer to have transpired – with favorable tax consequences of course.
Because a sham often connotes near fraudulent behavior, the courts tend to reserve this doctrine in its purest form for the more egregious cases.
“To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction had no economic substance because no reasonable possibility of profit exists”
Economic Substance Doctrine
“Claimed tax benefits should be denied if the transactions that give rise to them lack economic substance apart from tax considerations even if the purported activity actually occurred.
Most courts have been receptive to the doctrine, but they disagree over its proper formulation. Some apply a two part test requiring a taxpayer to:
Establish the presence of economic substance, and
Establish the presence of a business purpose
Substance over Form
The form of a transaction frequently is determinative of its tax consequences.
Courts are willing to go beyond the formal papers
Most C Corporations have the flexibility to adopt either a calendar year or a fiscal year as their annual accounting period.
Certain “personal service corporations” must use a calendar year, however, unless they can show a business purpose for using a fiscal year.
For this purpose, a “personal service corporation” is one whose principal activity is the performance of personal services that are substantially performed by “employee-owners’ who collectively own more than 10% (by value) of the corporation’s stock.
In general, C Corporations are required to use the accrual method of accounting.
§267(a)(1) provides that losses from sales or exchanges of property between an individual shareholders and a more-than-50% owned corporation may not be deducted.
The forced matching rules in §267(a)(2) prevent an accrual method corporation from accruing and deducting compensation paid to a cash method owner-employee in the year when the services are performed but deferring payment until the following taxable year to provide the employee with a timing advantage.
Because Corporations are easier to create than individuals, multiple corporations might be used to save taxes.
Corporations are a controlled group if they constituted either a “parent-subsidy controlled group” or a “brother-sister controlled group” under ownership tests in §1563.
The Code permits an “affiliated group of corporations” to elect to consolidate its results for purposes of tax reporting.
The effect of a consolidated return election is to treat the affiliated group as a single corporate entity for tax purposes.
§1504(a)(2) employs an 80% of voting power and value standard to test corporate ownership of another corporation. That standard is met if a corporation possesses at least 80% of the total voting power of the stock in another corporation and has at least 80% of the total value of the stock of such corporation.