CORPORATE TAX REGIME
Corporate Double Tax
· Not a flow through tax entity (LLC/LLP) taxed at corporate & SH level
· Double Tax creates Three biases:
· Against corporate as opposed to non-corporate investment
· In favor of excessive debt financing: No §163 deductions for interest
· Retention of earnings b/c of taxed distributions (15%)
Judicial Doctrines
· Sham Entity: The corporation must be formed for legitimate business purposes
· Sham Transaction: Transactions must have some economic purpose other than tax avoidance motive. If only reason is tax, then will not be respected and treated as if the transaction did not occur.
· Business Purpose: Transaction only respected if legitimate business purpose
· Substance over Form: Estate of Franklin
· Assignment of Income: Lucas v. Earl: Income from services which corporation truly earned is income. Income from property is attributed to owner of property.
· Step-Transaction: Courts combine formally distinct transactions if:
· Some courts require binding legal commitment to complete all steps at outset
· Some courts require only a mutual interdependence of steps or a preconceived intent to reach a particular result at the outset.
Computing Corporate Income Tax
· §11 imposes tax; rate schedule:
· 0-$50k=15%
· $50k-$75K=25%
· $75k-10mil=34%
· Over 10 mil=35%
· Qualified Personal Service Corp.
· §448(d)(2): corp. substantially engaged in the performance of services in health; law; engineering; architecture; accounting; actuarial science; performing arts or consulting. IF substantially all of the corp.’s stock is held by employees performing services for the corp.; retired EEs; estates of EEs or retirees
· §11(b)(2): flat 35% tax—removes ability to get lower corp. rate where highest individual rate would apply
· §63 Taxable income=GI—deductions (no std deduction; no above/below line or floors)
· Deductions:
· §162: deductions for business expenses
· §469(e)(2): net loss from passive leasing for closely held C corp. only up to active income
· §243: Dividends Received Deduction
· Dividends from another corp. must be included as income under §61, BUT partial offsetting deduction:
· 70% if owns less than 20% of stock of paying corp. by vote and value
· 80% if owns 20% or more of stock of paying corp. by vote and value
· 100% if owns 80% or more of stock of paying corp. by vote and value
· Policy: taxing conglomerates: triple and quadruple taxing—reduce tax rate
· §170 Charitable contributions up to 10% of Taxable Income
· Exemptions: §103 municipal bond interest is excluded
· Gains and Losses
· No passive loss limitations of §469 (only for individuals and closely held)
· §1201: 35% maximum tax for corporations
· §1211: to the extent of capital gains
· §1212: 3 year look back; 5 year look fwd
· §172 Net Operating Losses: 2 years back; 20 years forward
· §267 Losses and Related Taxpayers
· (a)(1): restriction on deducting losses between related persons, (which under §267(b)(2) includes individual and corp. or under (b)(3) two corporations under the same control group) more than 50% of whose stock is owned by that individual.
· (a)(2): method of accounting matching rules regarding deductible amounts. Designed to prevent a corp. from accruing and deducting obligations to a cash method SH owning more than 50%.
· Accounting: §448, corporations must use accrual method; better measure b/c can’t manipulate
· Taxable year: Corp can elect either calendar or fiscal unless personal service corpàmust use calendar §441(i)(2).
· §199 Domestic Production Credit
· Encourage US corp. to hire US workers in production activities
· 6% deduction of the lesser of taxable income or qualified prod. Activities; can’t exceed 50% of wages paid to US EEs
· “production activities”: farming; equipment leasing; licensing of software and films; construction; production of electric; natural gas; drinking water architecture or engineering processing of food or beverages NOT sale of food or beverages
· Controlled and Affiliated Corporations
· §1561 denies certain multiple tax benefits to a controlled group of corps.—making them aggregate their income for tax purposes instead of taking lowest possible tax rate individually
· §1563 “Controlled Group”
· Parent that owns 80% of vote or value of sub.
· Brother-Sister where SHs are less than five and own 80% or more of each co. by vote or value.
· §§1501; 1502; 1504 allows affiliated group to consolidate
· §1504(a)(2) “Affiliated Group”
· 80% voting AND value
Corporate Tax Shelters and Recognition of the Corporate Entity
· “Tax Shelter”: a realization of tax losses without corresponding economic loss through transaction having questionable economic substance apart from the desire to reduce taxes. Reliance on the literal language or ambiguities of the IRC to support a result that may be technically defensible but is inconsistent with the spirit of the law.
· UPS: Corp. tried avoiding tax on revenue from package insurance and founded another corp. as reinsurer outside US.
· Holding: Not a sham because the transaction had real economic effects and there was a bona fide business purpose. It was a kind of transaction generally undertaken in business AND it was pursuant to a valid business purpose.
· Dissent: The economic risk was infinitesimal; it wasn’t arm’s length and UPS maintained all costs associated with the reinsurer
· Integration: Since the tax system influences business decisions and this is not desirable, there have been proposals to fully integrate or partially integrate the taxation of corps.:
· Full Integration: treat corps. As complete pass through, but there would have to be a record of SHs at all times for this pass through and there would be high administrative costs.
· Partial Integrations: Eliminate dividend tax by giving SHs credits (England)? Have a different rate for earnings by the corp.(Germany)? Deductions for dividends tax IF the corp. has already been taxed? (Bush proposed)
· Corporate Classification
· §7701(a)(3): The term corporation includes associations; joint-stock companies and insurance companies
· REG 301.7701: Check the box: corp; ptshp; trust; nothing if no entity under state law— nothing
· Implications of Check-the-box: stuck with it for 5 years and if you change, it is treated as a realization event where the corp. is liquidated and then transformed into ptshp/etc.
· Traditional Characteristics of Corp.: Associates; objective to carry on business and divide gains; continuity of life; centralization of management; limited liability; free transferability of interests.
· §7704 Publicly Traded Partnerships: treated as corp. unless 90% or more of GI is passive income.
· Recognition of the Corporate Entity as a Separate Entity
· National Carbide Factors in determining whether Corp. is Agent (Bollinger Overrules):
· Whether Corp. operates in name and for account of principal
· Whether Corp. binds principal by its actions
· Whether Corp. transmits money received to the principal
· Whether receipt of income is attributable to the services of EEs of the principal and to assets belonging to the principal
· If corp. 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
· Its business purpose must be the carrying on of the normal duties of an agent.
· Bollinger Factors
· Agency relationship is set forth in a written agreement at time the asset is acquired
· The corp. functions as agent and not principal with respect to the asset for all purposes
· Corp. is held out as the agent and not principal in all dealings with 3ptys relating to the asset
· Moline Properties: “The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.”:
· Organized for legitimate Business Purpose
· Does in fact fulfill a legitimate Business Purpose
· Consequences if Corp. is characterized as an agent:
· Tax nothing
· Avoid double tax (possible)
· Losses can pass through to SH (indefinite; $3k up to ordinary income)
FORMATION OF A CORPORATION
Non-recognition to the Shareholders
1. 351(a): “no gain or loss shall be recognized if property is transferred to a corp. by one or more persons solely in exchange for stock in such corp. and immediately after the exchange such person or persons are in control of the corp.”
· Policy: mere change in form
2. “Control” §368(c): control is the ownership of (1) at least 80% of the total combined voting power of all classes of stock entitled to vote AND (2) at least 80% of the total number of shares of all other classes of stock.
3. “Immediately after the exchange”: REG 1.351-1: does NOT necessarily require simultaneous exchange by 2 or more persons, BUT there must be a situation where the rights of the parties have been previously defined AND there is an integrated plan: mutually interdependent steps.
–Intermountain Lumber: Ownership immediately after the exchange depends upon who has the benefits and burdens of ownership. Substance over form.
–If you have a binding obligation to dispose shares you receive in a 351 transfer, you cannot count those shares. (involuntary transfers v. voluntary transfers)
–Stock options do not count until realized
–Control must be had by the persons contributing property
–Ways to ensure 351 protection: (1) real option agreements; (2) sell assets to potential transferor and both contribute; (3) not have a binding agreement at all; (4) make sure all parties put in some property.
4. “Property”: §351(d): broadly defined including cash; capital assets; inventory; A/R; notes; patents; other intangible assets such as nonexclusive licenses and industrial know-how.
–§351(d)(1): Stock issued for services shall not be considered as issued in return for property.
–If services are performed AND property is transferred §351(a) permits
–BUT REG 1.351-1(a)(1)(ii): if (1) primary purpose is to qualify SH for nonrecognition and (2)stock or securities issued fro property, which is relatively small value in comparison to the value of the stock and securities already owned by the person who transferred such property will not be counted.
–Ways around this test: (1) have two classes of shares one with big dividend (preferred (2) get the common stock valued at $0 due to dividend; (3) split up the classes; (4) any amount of property contributed does not have to be much because the common stock is worthless.
–§351(e): Investment Co. Exception: recognition on property transfer
5. “Solely for Stock”: REG 1.351-1(a): stock is an equity investment and does not include stock rights or options.
6. Intentional Avoidance of §351:
–Since there is no loss recognition under §351, it may be beneficial if you realize a loss you want to recognize or you want a high depreciable basis: pre-arrange sale that breaks control test or intentional inclusion of boot in the form of installments (but there will be a risk that this will be characterized as equity in substance)
Boot
1. §351(b): Boot is other money or property received besides what is allowed by §351(a). Its character is determined by the character of the assets put in.
2. §351(b): Realized gain is recognized to the extent of boot received; character of recognized gain is determined by reference to the character of the property transferred to the corporati
that is subject to the liability has agreed and is expected to satisfy. OR (B) the FMV of those other assets. POLICY: prevents double counting the same liability for basis adjustment purposes.
3. Schemes:
–Contribute cash and increase basis of property so less liability assumed (avoid 357(c))
–sign a note to corporation for difference btw basis of prop. and liability
–contribute more assets to corp. to increase basis
–Peracchi: SH gave corp. note to adjust basis in contributed property via TUFTS (FMV) and thus avoid §357(c)’s realization of gain from difference btw liabilities assumed and basis of transferred prop. CT said that the SH put assets on line and so not a sham. IRS argued that no basis b/c not really legit promise.
4. REV RUL 95-74 Contingent Liabilities: IRS states that any environmental cleanup liabilities assumed by subsidiary are not liabilities for purposes of §357(c)(1) and §358(d) as long as expenses have not increased basis in any assetàthen excludable from §357(c)(3) gain.
5. Black &Decker: Creation of a subsidiary and transfer of contingent liabilities that couldn’t deduct; argument that under 357(c) not counted because contingent and no gain. Ct said not tax avoidance motive because purpose was to manipulate basis rules, not avoid tax so not within §357(b).
6. §358(h) IRS response to Black and Decker: If basis of property transferred exceeds FMV of tentative stock basis/property gotten, the basis reduced by amount of any liability whcich is assumed. Does not apply if trade or business is also transferred.
Contributions to Capital
1. One-way transaction, not an exchange
2. Rules:
–No gain or loss to SH, just increases purchase price of stock (no code provision
–§118(a): no gross income to corp.
–§362(a)(2): corp. gets transferred basis
–Special basis rules if nonshareholder (like the city) contributes under §362(c)
–REGS 118: pro rata and non pro rata are covered, so long as nothing in turn received. If corp. is receiving money in exchange for goods and services/etc. this is income to corp. and does not fall within exclusion of §118.
3. Fink: family owned business and in order to make co. look more favorable to outside investors, contributed 10% of stock to reduce outstanding SHs. SHs tried saying loss because loss of AB and nothing in return. Ct. finds this to be a capital contribution and increases basis of Shs held because not a capital expenditure under §263. POLICY: if ordinary loss deductions were allowed, it would give every SH of a financially trouble corp. the ability to transfer every share and obtain loss rather than letting corp. die. §165(g) worthless stock rule (not an ordinary loss; capital).
4. If contributing pro-rataàdefinitely a capital contribution rather than debt/etc.
Organizational and Start-Up Expenses
1. §195(a): start up expenses must be capitalized, not deducted because they provide a long term benefit.
2. §195(b): if taxpayer elects, may deduct in the year business begins the lesser of: (1)(A)(i): amount of start up expenditures w/respect to active business OR (ii) $5k reduced by amt which start up expenditures are over $50k AND (B) the remainder shall be allowed as a deduction ratably over 180 mos.
3. §195(c): Start-up expenses are any amount:
–(A) paid or incurred in connection with:
(i) investigating the creation or acquisition of an active business
(ii) creating an active trade or business OR
(iii) any activity engaged in for profit and for the production of income before the day which active business begins in anticipation of such activity becoming active business AND
–(B) which, if paid/incurred in connection with the operation of an EXISTING business would be allowable as a deduction for year paid/incurred.
4. 248(a): if corp. elects, (1) the corp. may deduct in year it begins the lesser of:
–(A) the amount of organizational expenditures w/respect to the taxpayer OR
–(B) $5k reduced by amt which organizational expenses exceed $50k AND (2) remainder shall be deducted over 180 mos. starting first month
5. §248(b): organization expenditures mean any expense which (1) is incident to the creation of the corp.; (2) is chargeable to capital account (cap. expense) AND (3) is of character which, if expended incident to the creation of a corp. having a limited life, would be amortizable over such life.
6. REG 1.248-1(b)(2) Organizational Expenses:
Are: legal services incident to organization of corp. like drafting corp. charter, by laws, minutes of org. meetings; terms of original stock issue; necessary accounting services;
Are Not: expenses connected with issuing or selling shares of stock or other securities such as commissions; professional fees; printing costs
