Federal Income Tax II Outline

Winchester_FedTaxII_Spring_2018
FEDERAL INCOME TAXATION II – BUSINESSES
 
OVERVIEW OF BUSINESS ENTITIES
 
RULE: IF the participants in a contractual arrangement
Carry on a trade, business, financial operation, or venture, AND
Divide the profits
THEN that arrangement will constitute a separate/business entity for federal income tax purposes. Treas. Reg. § 301.7701-1(a)(2).
Example: A, B, and C purchase a single parcel of land as tenants-in-common and hold the land as an investment.
Example: A, B, and C purchase a single piece of land, subdivide the land, then sell the parcels individually.
Example: This does count as a separate entity. Doctor will locate and purchase a suitable four-unit building. Architect will remodel it. When the work is done, the renovated building will be sold by the Doctor-Architect real estate company and Architect will receive 25% of the net profits.
Example: If the doctor and architect in the above example agreed that the doctor will retain 3 units as rental property and the architect will receive 1 unit to hold as rental property, then it is compensation, not profit.
RULE: IF an arrangement
Is classified as a trust, Treas. Reg. § 301.7701-2(a), OR
Is subject to a special rule under the IRC, Treas. Reg. § 301.7701-2(a), OR
Is a joint undertaking merely to share expenses, Treas. Reg. § 301.7701-1(a)(2), OR
Example: Attorney 1 and Attorney 2 share an office and a secretary. Each attorney services and bills his own individual clients.
Is mere co-ownership of a property that is maintained, kept in repair, and rented to leased, Treas. Reg. § 301.7701-1(a)(2).
THEN that arrangement will NOT constitute a separate/business entity.
3 possible classifications of businesses for federal tax purposes
Corporation
Any corporation incorporated under state law, Treas. Reg. § 301.7701-2(b)(1), OR
Any Association, Treas. Reg. § 301.7701-2(b)(2), OR
Publicly traded partnership. IRC § 7704.
Partnership
If not a corporation (by default or election), AND
At least 2 members.
Disregarded
Not a corporation (by default or election), AND
Only 1 member.
Example: An LLC with only 1 member will be treated, by default, as disregarded.
 
Number
of Owners
Incorporated
Entity
Unincorporated
Entity
One
Corporation by
default;
S corporation by
election, if eligible
Disregarded by default;
Association
(Corp.) by election
Multiple
Corporation by
default;
S corporation by
election, if eligible
Partnership by default;
Association
(Corp.) by election
 
C CORPORATIONS – BUSINESS OPERATIONS
 
CORPORATE TAXATION – GENERALLY
RULE: Corporate Tax Rate: The tax rate on corporations is 21%. IRC § 11(b)(1).
RULE: Long Term Capital Gains: Corporations are not taxed at preferential rates for long term capital gains. It just counts as regular income.
RULE: Capital Losses: Capital losses can only be used to offset capital gains. IRC § 1211(a).
It is important for corporations to distinguish between regular income and capital gains because they can use the capital losses to offset the capital gains.
RULE: A corporation whose capital losses exceed its capital gain in a given year can…
Carry the losses back 3 years, IRC § 1212(a)(1)(A), OR
Carry the losses forward 5 years, IRC § 1212(a)(1)(A).
RULE: A corporation is treated as having earned the income derived from services performed by an employee who is also the corporation’s sole shareholder (personal service corporation), Haag v. Commissioner, IF…
1. The service-performer employee must be an employee who the corporation has the right to direct or control in some meaningful sense. Haag v. Commissioner.
This can be satisfied with a simple employment agreement.
2. There must be a contract or similar indicium recognizing the corporation’s controlling position with respect to the service-performer. Haag v. Commissioner.
                          
This must be some kind of contract or IRS report from the third party the services are being performed for recognizing the corporation as the controlling entity. This is basically an outsider’s verification.
Personal Service Corporation: Incorporating yourself into a corporation. So, instead of (Individual à Partnership) you make it (Individual à Corporation à Partnership) so you can you take advantage of the corporate tax rates. To do this, you have to make a contribution of capital to the corporation for shares. In Haag, the doctor contributed his partnership interest to the corporation in exchange for shares. You can also hire yourself as an employee of the corporation. In this way, the doctor can take money out of the corporation by either (1) taking money out as dividends, or (2) paying himself a salary.
 
REALLOCATION OF INCOME
Reallocation: This is just the IRS adjusting the numbers on the tax return to reflect the reallocation.
Example:
Corporation pays individual $100.
The corporation was paid $1,000 by the partnership.
The IRS can reallocate and change the numbers to $1,000 income to the individual.
$1,000 expense to the corporation.
RULE: The government will be able to reallocate income between 2 parties, IRC § 482, IF…
1. There are 2 or more trades, businesses, or organizations, IRC § 482, AND
This is 2 businesses, commonly controlled.
Courts allow this to count by counting the individual as a business. The courts construe the individual, in the broadest sense, as a business.
However, some circuits don’t recognize individuals as a trade, business, or an organization. Because of this, Congress enacted IRC § 269A.
2. The enterprises are owned or controlled by the same interests, IRC § 482, AND
3. Reallocation of income among the enterprises is necessary to clearly reflect income or to prevent the evasion of taxes. IRC § 482.
If the amount of taxes is close, the court may say that the difference wouldn’t matter, but if you try to take advantage of the system, they will nail you and completely eliminate any advantage you get from your classification.
RULE: The government will be able to reallocate income between 2 parties, IRC § 269A, IF…
1. Substantially all of the services of a personal service corporation are performed for 1 other entity, IRC § 269A(a)(1), AND
2. The purpose of forming the personal service corporation is for the avoidance or evasion of taxes or securing some other benefit not otherwise available. IRC § 269A(a)(2).
Summary: IRC § 482 & IRC § 269A essentially do the same thing. IRC § 269A was put in place to rectify a circuit, but both tools are still in play for circuits that didn’t curtail IRC § 482.
 
GAIN/LOSS
RULE: IF there is a sale or other disposition of property, THEN the taxpayer must compute gain or loss, IRC § 1001(a), AND the entire amount of the gain or loss will be recognized. IRC § 1001(c).
EXCEPTION: IF there is a distribution of stock, of the corporation’s right to acquire its stock, or of property, AND the distribution is not a complete liquidation, THEN no gain or loss will be recognized. IRC § 311(a)(2).
Distribution: A corporation giving something to its shareholders (Example: dividend).
Liquidating distribution: The last distribution, when the company is dissolving and whatever equity is left is given to the shareholders.
Summary: Basically, as an economic matter, the corporation is poorer, but they are not getting the tax benefit of the loss. This is a huge deal and is why there are so few dividends. When a company gives dividends, the value of the company drops by the amount of the dividends.
Double Taxation: This is also part of the concept of double taxation:
Example: $100 (income) x 21% (tax rate) = $79
If you pay the full $100 as distributions, then the people the taxes are distributed to are taxed individually, and the corporation is taxed on the full $100
This is known as a “nondeductible outlay.”
If you pay the full $100 as a bonus to the CEO, then you will have no tax liability because you can deduct the entire amount.
EXCEPTION TO THE EXCEPTION: IF the corporation is distributing property (of the kind mentioned in IRC § 311(a)(2)), AND that property has a built-in gain, THEN the corporation has a taxable gain that equals the difference between the FMV and the basis. IRC § 311(b)(1).
Summary: Basically, the corporation is poorer after doing the distribution, but the tax code treats the company as having gained income.
What about when there is a loss? Then IRC § 311(a) governs and the loss is not recognized.
This is a heads I win tails you lose scenario.
What do these 3 rules mean together?
1. Corporations distribution of property with a built-in gain will have that gain subject to tax.
2. Corporations do not recognize a loss or gain from any distribution in any other case.
3. Corporations will recognize a gain or loss from a non-distribution activity.
 
INCOME (CONTRIBUTION OF CAPITAL AND SALE OF STOCK)
RULE: IF income is derived from any source THEN it is gross income. IRC § 61(a).
EXCEPTION: IF the taxpayer is a corporation, AND the income comes in the form of contributions of capital, THEN the corporation will not have to count the amounts received as income. IRC § 118(a).
RULE: IF there is a sale or other disposition of property, THEN the taxpayer must compute gain or loss, IRC § 1001(a), AND the entire amount of the gain or loss will be recognized. IRC § 1001(c).
EXCEPTION: IF a corporation receives money or other property in exchange for stock, including treasury stock, THEN a gain or loss will not be recognized.
Summary: Basically, when a company sells stock for money or property, they don’t have to report that as income to be taxed.
RULE: A corporation will inherit the basis of any property transferred to it that is subject to IRC § 118 & IRC § 1032. IRC § 362(a)(2).
Summary: IRC § 118(a) & IRC § 1032 were put in place to prevent the government from taxing the formation of a corporation.
 
NET OPERATING LOSS
RULE: You can use the net operating loss to offset up to 80% of your income each year following the year of the loss until you run out of available deduction. Basically, (1) Can offset up to 80% of taxable income in future years, and (2) Indefinite carry over. IRC § 172(a)(2).
RULE: Net operating loss: A net operating loss occurs when deductions exceed gross income (negative taxable income). IRC § 172(c).
Example:
Year 1: -$100 taxable income.
Year 2: $50 taxable income.
If you carry over, then you can utilize the carry over deduction to offset up to 80% of the current taxable year.
Year 2: $40 deductible. $10 tax bill
Year 3: $60 taxable income. $48 deductible. $12 tax bill.
Year 4: $70 taxable income. $$12 deductible. $58 tax bill.
Year 5: $80 taxable income. $0 deductible. $80 taxable income.
NOTE: RULE: Grandfather clause for corporations relying on the carrybacks from the old tax law structure. IRC § 172(a)(1).
 
DEDUCTIONS
NOTE: In corporations, the roles that key individuals play can be many. For example…
Possible roles of owners
Shareholder (paid dividends on stock) (cannot be deducted)
Creditor (paid interest on credit) (can be deducted)
Employee (paid compensation for work) (can be deducted)
Landlord (paid rent for usage of property) (can be deducted)
Intellectual property owner (paid for usage of intellectual property) (can be deducted)
RULE: A corporate’s gross income will be reduced by the amount of deductions the corporation can claim. IRC § 63(a).
NOTE: Deduction for stock: A corporation is not allowed a deduction on a dividend or other distribution of stock because no loss is recognizing. IRC § 311(a).
There is never a required amount of dividends that must be paid.
RULE: A corporation can deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. IRC § 162(a).
RULE: Deduction for salary and other compensation: A corporation is allowed a deduction ONLY for reasonable salaries or other compensation that it pays, ONLY IF the services are actually rendered, and ONLY IF they are ordinary and necessary expenses paid or incurred in carrying on a trade or business. IRC § 162(a)(1).
Structure for analysis of problem regarding reasonableness of compensation o