Taxation of Business Entities and Oil and Gas
A. Uniform taxation of Businesses
1. CBIT- Comprehensive Business Income Prototype
a. Not allow deductions for dividends or interest paid by the Corp, while excluding from income any dividends or interest received by SH and Debtholders.
II. C Corporation Operations
A. Corporate Income Tax
1. Tax Rates [IRC §1 (tax on indiv.), 11(b)(tax on corps), 1211(a)(cap loss), 1212(a)(cap loss)] a. Corp tax: $50,000 (15%); next 25,000 (25%); Excess of 75,000 (34%); excess of 10,000,000(35%)
i. To prevent people from fragmenting their businesses to remain in the lower tax rate, §1561(a) in effect, aggregates the taxable income of all members of a “controlled group of corporations”
· Controlled Group of Corporations: all corps in which any five or fewer people own more than 50% of the stock of each corp. taking into account each person’s interest only to the extent of the smallest interest owned by that person in any of the corporations.
2. Scope of Corporate Gross Income
a. Inclusionary aspects –Income from services [IRC §61(a)(1),(2); 269A (tax evasion); 482] i. Hagg v. Commissioner
· Doctor incorporates and takes less compensation for his services than he would have absent incorporation. Court holds that he would not have accepted this employment with a third party so include in Gross Inc.
· RULE: When one member of a group of controlled entities performs services on behalf of another member of the group for less than an arm’s length charge, respondent may make allocations to reflect an arms’ length charge for such services.
b. Inclusionary aspects—Gains from property [IRC §61(a)(3), 311, 1001] i. General Utilities & Operating Co. v. Helvering (not good law)
· GU buys 20,000 shares of IE and paid $2,000. Later GU sells to SC through their SH. GU first distributes the stock to its shareholders as dividends a pro-rata portion of the IE stock valued at 56.12 ½ per stk. Then the SH sold to SC. GU sold 910 sh directly and returned that amount for taxation. Is distribution of stock to SHH a sale under §1001?
– HOLDING: Not a sale, no recognition of capital gain.
– §311 no gain or loss will be recognized if stock is transferred to SHH as stock
①. SINCE 1986 added §311(b)
a. If a corp distributes property other than an obligation to which (a) applies, the fair market value of such property exceeds its adjusted basis (in the hands of the distributing corporation), then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.
c. Exclusionary aspects—General
i. All income derived by a taxpayer is included in gross income, unless it is specifically excluded by statute.
ii. Castner Garage, Limited v. Commissioner
· 104(a)(3) rules that a corporation can exclude income from life insurance proceeds.
iii. §118, contribution to capital excluded from gross income.
d. Exclusionary Aspects—Corporate specific [§118, 362(a)(2), 1032(nonrec of GL for exchange of stk for prop)] i. See ORGANIZING A CORP Chart
3. Scope of Corporate Deductions
a. Reducing Double Taxation
i. A corporation may not deduct the dividends it pays. But, under §162(a) a corp can deduct compensation for services
ii. Elliotts, Inc. v. Commissioner
· Elliott received $2000 per month + 50% net profits as bonus. IRS says $65,000 is max deductions the corp can recognize under §162(a)(1). Issue: deductibility by a corp of payments made to employee who is also a SH.
· To determine deductibility Under §162 Two-Prong Test:
– Amount of Compensation must be reasonable and
①. Independent Investor Test: Factors–Role in Company, External Comparison, Character and Condition of Company, Conflict of Interest, Internal Consistency
– The payments must in fact be purely for services.
· There is a 1 mil limit for deductions allowed for annual compensation to its CEO and 4 highest paid positions
iii. Thoni Service Corporation v. United States
· TSC sold land worth $1,600,000 to Thoni for $75,000.
· For TSC 1001(b) AR: $75,000 1011 AB $55,000= G $20,000
– Then: B of land = $75,000 under §1012
– 1,600,000 AR – $75,000AB = $1,525,000 G
· IRS: V= $1,600,000 – $75,000 = $1,525,000 disguised DIVIDEND
– SO TSC should have 1,600,000 – 55,000 recognized 1,545,000G – 0 b/c div not deductible
iv. Fin Hay Realty Co. v. United States
· LAW: you can deduct interest paid on indebtedness (loans as well) §163. Finlaw and Hay each had $10,000 stk and $53,000 notes. Finlaw dies, transfers to Findaughter 1 and 2. They buyout Hay. FH pays interest to D1,2 for notes. IRS says they are not really notes, but loans or equity-stock.
v. Maxwell v. Commissioner
· Maxwell injured by mixer. Workers comp case. §104(a)(2). §162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year.
· Works best if you get a separate lawyer and make it look legit.
b. Inhibiting Triple Taxation [§243,246,1059] i. Triple taxation can occur when a corp is a SH of another corp, So Congress enacted measures to mitigate this
· §243: allows a corp receiving div. a deduction = or at least 70% of the div. received.
ii. Litton Industries, Inc. v. Commissioner
· Litton receives a 30 mil dividend from Stouffer (subsidiary). Subsequently, Litton sells Stouffer to Nestle for 105,000,000. Transfers the promissory note of 30mil to Nestle.
· §243 allows a
out regard to the section. §563(b) [you must have paid div to use this]
C. Consequences of Operation Loss
1. IRC §172
a. A net operating loss (the difference between the amount of deductions allowed and gross income) can be carried back(§172(b)(1)(A)(i)) first to 2 years back, then the immediate prior year. If still the loss is not absorbed, the loss can be carried over (§172(b)(1)(A)(ii)) to the next 20 tax years.
D. Distinguishing Corporation From Shareholders
1. Commissioner v. Bollinger pg 93
a. Bollinger is a G.C. of Creekside North Apts. Used Creekside as agent to get loans. Bollinger was the Principal and owner of Creekside, so the Creekside is not liable to tax.
i. 6 National Carbide factors to determine agency relationship:
· Whether the corp operates in the name and for the account of the principal
· Binds the principal by its actions
· Transmits money received to the principal
· Whether receipt of income is attributable to the services of employees of the principal
· If the corporation is a true agent
· Its business purpose must be the carrying on of the normal duties of an agent.
III. S Corporations Operations [S chapter governed by §§1361-1378] A. Computation of Gross Income and Deductions
1. An S corp does not pay taxes §1363(a) however, it must still file an annual informational return reporting gross income and deductions. The return includes a separate schedule for all shareholders where the S corp reports the amount of each item of the corp’s income and deductions allowed to that SH.
2. A corporation is eligible for S Corp status if:
a. The corp is a domestic corp
b. The corp has no more than 100 SH
c. All of the corp’s SH are individuals
d. The corp issues only one class of stock
B. Allocation to Shareholders
1. Shareholders Taxed When Income Earned [§1366(a)-(c), 1367(a)] a. Knott v. Commissioner
i. Income need not be distributed in order to be included in the taxable income of SH.
2. Rigid Allocation Rule [§1366(a), 1377(a)] a. Pro rata (§1377)
b. Closing of Books §1377(a)(2): election to allocate a share of the income actually earned through the date the interest terminates to the terminating shareholder.