Corporate Taxation – Prof. Michelle Cecil – Spring 2014
SUBCHAPTER C – OVERVIEW
I. Definition: Subchapter C is anything corporation that is not an S Corp.
a. Note: Even if a corporation meets the requirements of an S Corp., it must elect to be an S Corp.
II. Code: C Corps. are governed by Subchapter C of the Code
a. C corps. are separate entities from their shareholders
i. § 11 imposes tax on C corps.
1. 2 ways for shareholders to get value from corporation:
a. Dividends
i. Subject to “double tax”
1. Income earned by corp. is taxed by corp. and
2. taxed again to shareholders when earnings are distributed to shareholders (dividends)
b. Sell stock
2. Generally flat tax of 34% (effectively) — if corp. earns over $100k (and less than $15M) in taxable income
a. Corps. have a mildly progressive tax structure, but phased out at $100k by § 11(b)
i. Corporate tax rates — § 11(b)(1)
1. $0 – 50,000 = 15%
2. $50,001 – 75,000 = 25%
3. $75,001 – 10M = 34%
4. $10M+ = 35%
ii. Phase out at $100k — § 11(b)(1)
1. $100k+: Tax increased by 5% of excess of $100k – max of $11,750
2. $15M+: Tax increased by 3% of excess of $15M – max of $100,000
b. Double tax
i. Because corp. is subject to double tax, it is the least attractive as a business entity from a tax standpoint
1. All others are treated as flow-through entities — only one level of tax à at partner, shareholder, member level
ii. Why still C corps?
1. Non-tax benefit not available in any other form
a. Free transferability of interest
i. Can sell stock without getting anyone else’s approval – why all publicly held companies are on stock exchange
b. Centralized management — now with LPs and LLCs, management can be centralized in a few people (more efficient) and still maintain single tax level benefit
c. Continuity of life — can draft LPs and LLCs so that there is no limit of life
i. When S/H dies, bankrupt, etc. – corporation survives
d. Limited liability — again, LPs and LLCs provide this
i. C and S corps. can have ltd. liab. – investor can only lose what puts into stock, but no more
2. Business still go into corporate form, even if better off in LPs or LLCs, b/c familiar with form
a. Used to set up GP as an S corp. to a LP – all would have ltd. liab. à even sophisticated investors sometimes like familiarity of corporation
iii. Elimination of double tax
1. Possibilities
a. Eliminate corporate tax
b. Eliminate individual tax
i. Dividends
1. Bush’s proposal: eliminate tax on dividends
2. Passed: Most dividends are taxed like capital gains – max. rate of 15% (unless special gains)
a. Expires in 2008
ii. Capital gains (gains from sale of stock)
2. Currently, corp. can eliminate double tax by –
a. Disguised dividend strategy
i. Pay shareholders dividends disguised as something else
1. Interest to lenders
2. Rent to landlords
3. Salary to employees
a. If corp. pays in salary, included as ordinary income, but corp. can deduct — so long as reasonable
ii. Only works with small corps. where shareholders have dual roles
b. Retained earnings strategy
i. Formerly: 70% individual tax rate; 46% corporate rate; 20% capital gains rate
ii. Corporations could lower overall combined tax rate on earned income from individual rate of 70% to combined rate of no higher than 66%
1. Currently, highest corp. and indiv. rates are 36% and cap. gains are lower – Now that corp. rates are no longer lower than indiv. rates, this strategy is n/a
c. Dying
i. Taxed at corporate level
ii. Inheritance of stock gets stepped up basis (except 2010 – transferred basis)
1. Stepped up basis eliminates built in gain
2. Note: Not the best tax planning device if want to enjoy gain while alive
3. Assume for this class that double tax is alive and well and difficult to avoid
III. Difference in taxing of individuals v. corporations
a. Corps. don’t have some types of income – alimony
b. Corps. don’t have some exclusions – employee fringe benefits
c. Corps. don’t get preferential treatment for capital gains – 15% for individuals
d. Most difference is in deductions
Deduction
Individual
Corporation
Medical
Yes
No
Moving
Yes
No
Personal Exemptions
Yes
No
Standard Deductions
Yes
No
Investment Expenses (hire financial planner)
Yes (§212) — subj. to 2% floor (only ded. to extent > 2% gross income)
Yes (§ 162) — not subj. to 2% floor (can deduct in full — ord. and necc. bus. expenses)
IRAs
Sometimes
No
Charitable Contributions
only those made during taxable year
ltd. to 50% of AGI (note: no concept of AGI for corps.)
can be made w/in 2.5 months after year if board authorizes ** if accrual method** (benefit: corps. don’t know if profitable until after year end)
ltd. to 10% of taxable income
Capital Losses
STCG + LTCG + $3k
unused losses can be carried forward indefinitely
STCG + LTCG only (§ 1211) — CL can only be ded. to extent of CG
unused losses can be carried back 3 years and forward 5 years
Capital Gains Preference
Generally, long term cap. gains are capped at a max. of 15% (note: 25% for unrecaptured 1250 gains and 28% for collectibles)
There is no cap. gains pref. (but § 1201 would cap gains at 35% if corp. rates go higher)
Bad Debt Deduction
Short term capital loss only on non-business bad debts
Ordinary loss on all bad debts (all bad debts are considered business debts to corporations)
Deductibility of Losses (Business, not capital, losses)
Losses deductible only if trade or business or investment losses — § 165(c)
All losses sustained during the taxable year are deductible — § 165(a) (corps. assumed to be in business for profit — all losses are business losses)
Dividends Received Deduction **see details below**
No deduction for dividends received during the taxable year
70, 80, or 100% dividends deduction allowed, depending on % stockholdings
At Risk Rules
Deductibility of losses subject to the at risk rules
Deductibility of losses not subj. to the at risk rules
(Corps. not perceived to be good tax shelter mechanisms)
Passive Loss Rules
Deductibility of losses subj. to the passive loss rules
Deductibility of losses not subj. to the passive loss rules — § 169
(Corps. not perceived to be good tax shelter mechanisms; NOTE: Ps are the good tax shelters — don’t care what economic effects of investments, only tax consequences)
Domestic Production Activities Deduction
No
9% deduction for domestic production activities income (less related expenses) = 3% reduction in tax rate in their active income
Includes manufacturing, construction, energy production, engineering, architecture, farming, licensing computer software
example: 1M in DPA, 9% of that is 90K, 1M-90K is 910K, apply 34%, which works out to a third to 90k
value of deduction = deduction x tax burden
i. Dividends received deduction — § 243
1. Amount of deduction depends on amount of stock owned
a. < 20% = 70% DRD (30% of dividend included in income)
b. >=20% < 80% = 80% DRD (20% of dividend incl. in income)
c. >=80% = 100% DRD (none of dividend included in income)
2. Policy: Would be more than double taxation on intercorporate dists.
SECTION 351
I. Realization Event — § 1001(a): Sale or disposition of property triggers rg = ar – ab
a. ar: fmv of property, cash, liability relieved (Crane), notes at face value (amt. payable upon maturity) [can be aggregated for rg calculation]
i. Question: § 357(c)(3) assets
1. Probably yes per statute
2. No case law support
b. ab: ab of all properties transferred [can be aggregated for rg calculation]
II. Recognized Gain: Realized gain must be recognized unless non-recognition provision applies
a. § 351 non-recognition requirements (3) [apply to facts of exchange]
i. One or more persons must transfer property to a corporation (“transferors”);
ii. Transfer must be solely in exchange for stock of the corporation; and
iii. Transferors must be in control of the corporation immediately after exchange
b. Definitions
i. Persons: Includes individuals, trusts, estates, corporations, and partnerships — § 7701(a)(1)
1. Note: Partnerships include LPs and LLCs for tax purposes
ii. Property: Defined by negative inference — § 351(d)
1. Does not include services [Note: Stock received for services is taxable for income — § 61]
a. Exception: If person transfers both property and services into corp. in exchange for stock, all stock received will count for control for § 351 services
i. Reg. 1.351-1(a)(1)(ii)(2) Ex. 3: If property put in (in addition to services) is nominal or token, then stock received in exchange for services won’t count for con
stock
b. RL = No losses recognized in boot transaction
ii. Liabilities assumed by corporation — § 357
1. General rule: Liabilities assumed are not treated as cash boot for purposes of § 351 — § 357(a)
a. Policy: Would frustrate the purpose of valid tax incorporations if would treat liabilities assumed as boot
2. Exceptions – Liabilities treated as cash boot
a. If liability is assumed for non-valid business purpose (“tainted liability”), that liability and all other liabilities assumed for that shareholder will be treated as cash boot — § 357(b)
i. Question: Even § 357(c)(3) liabilities? Probably yes per statute, but no case support
b. If liabilities assumed > ab of all assets transferred by that shareholder, excess is treated as gain — § 357(c)
i. The one time it doesn’t matter how much rg is — included even if more than rg
1. Policy: To prevent negative basis — TAX LAW ABHORS NEGATIVE BASIS!! [EXAM!!]
ii. Exception: Liabilities that would be deductible by transferor had he paid them are not treated as liabilities for § 357(c)(3) purposes
iii. AVOIDABLE BY Promissory Note: TP can transfer a promissory note to the corporation to avoid treating the excess as gain
c. If § 357(b) and (c) both apply, (b) takes precedence
i. Question: What if (c) applies and there is boot? Don’t know which to apply first — since (c) prevents negative basis, it should probably come last
iii. Judicial Doctrines (3)
1. Assignment of income doctrine
a. General rule: Income must be taxed to those who earns it
b. Exception: Valid business purpose for incorporation — Hempt Bros.
i. Held/Rule: § 351 overrides assignment of income so long as there is a valid business purpose for the incorporation
ii. Exception: Matching of income and deductions — § 482
2. Tax Benefit Rule
a. TP who gets tax benefit in one year by way of deduction has to recover that deduction as income in a later year if some event occurs that is inconsistent with the deduction
b. applies to accrual method TPs
i. example: will writer has to include the 11K in income even if not collected b/c event has occurred; allowed to take a deduction for bad debt for known uncollectable; when writer incorporates, writer gets 11K in stock for ARec which is inconsistent with the prior write-off (11k v. 10K) so writer would have to include 1K in income
c. UNKNOWN IF 351 OVERRIDES
i. Nash v. US – says it doesn’t override; however the accural TP didn’t receive any stock over the true value of the ARec
ii. Hillsboro Natl Bank v. Commissoner – dicta says it does override
3. Matching of income and deductions — § 482
a. Exception to Hempt. Bros.
III. Character of recognized gain
a. General rule: Character of recognized gain is determined by gain inherent in property transferred
i. Use handout on § 351
1. Capital v. non-capital assets
2. Holding period
3. Recapture
ii. If more than one asset is transferred in a boot transaction, determine character based on asset that produces the gain
b. Exception: Character of gain is determined by reference to fmv of all assets transferred (even if loss assets) — § 357(c); Reg. 1.357(c)(2).
i. Calculate the percentage (off of FMV) that is capital assets.
c. Misc.: Under tax benefit rule, may treat gain as ordinary income b/c recapture deduction was ordinary or under general rule
IV. Timing of gain
a. General rule: Must be included in income immediately
b. Exception: INSTALLMENT NOTE
i. Received installment note from corp. (where at least one payment will be received in later year after transaction) — see overhead on webcourse
1. Allocate transferred basis to stock up to its fmv
2. Remainder of basis is called excess basis
3. GPR = GP / Selling price
a. Selling price = fmv of all boot received + face amout of note
b. Gross profit = selling price – excess basis
4. GPR x all payments received (incl. boot in year of transaction) = amount included in income each year
