Exam is closed book: 2 questions 1 objective 1 subjective.
1) CHAPTER 1 – PERSPECTIVE
a) The Business as an Entity Under State Law
i) No Separate Entity
(1) Sole Proprietor – Conducting a business without an entity. Person owns property in the sole proprietorship.
ii) Separate Entity
(1) Partnership – Under state law partnership exists when two or more individuals engage collectively in an activity with the expectation of generating profits. Each partner is responsible for an obligation arising during partnership. Treated as accounting entities and is computed but taxed directly to the owners.
(a) Professor – Because a partnership is a separate entity that owns contributed property, if a partner pulls out of the partnership, then they will get the value of the property they contributed and not necessarily the actual property contributed
(2) Corporation – Recognized by state law as a separate entity from the owners. Corporation owns all assets of enterprise. Only responsible for extent of investment if obligation arises. “C” corporations Pay tax on the enterprise’s income. Certain corporations, known as “S” corporations can elect to be treated as accounting entities.
(3) Limited Liability Company – Treated as a separate entity like a corporation. Only responsible for extent of investment if obligation arises. Taxed the same as a partnership. Thus, Treated as a pass through entity.
b) The Business as a Taxpaying Entity – The “C” Corporation
i) Look to Subchapter “C”
ii) Two Levels of Taxation – a “C” corporation is taxed twice
(1) When it earns income and
(2) When it distributes the earnings
iii) Is there a disadvantage in being taxed as a “C” corporation?
iv) “C” corporation Tax Rate Formula
(1) [(Corporate Income) * Corporate Tax Rate] +[ (Corporate Income – Corporate Tax Rate) Individual Tax Rate] v) When is it advantageous to be taxed as a “C” corporation?
(1) The corporation does not need to pay it out in the current year that they make the money so you can get deferred gains.
(2) If there is no corporate income tax then it is advantageous
(3) But if corporate tax is equal or greater than individual tax, then it will ALWAYS be less advantageous
c) The Business as a Tax Accounting Entity – The “S” Corporation and the Partnership
i) Look to Subchapter “K” and Subchapter “S”.
(1) Subchapter “S” and “K” are similar.
ii) Referred to as “pass through entities”
(1) We ascribe the income of the entity to each individual that owns the business. If there are two partners in the business and there is $200 in revenue split two ways, then each of the partners has $100 in income.
iii) Not subject to entity level tax
iv) With a higher individual tax burden, partners often had to withdraw business profits fro the partnership which in turn created a need for capital and stunted enterprise growth.
v) Exception – There are some partnerships and LLC that will be taxed a “C” corporation under the I.R.C. These are known as Publicly Traded Partnerships.
vi) Exception – the entity is not ENTIRELY non-existent. There are ways that a partnership is different from the taxation of a sole proprietorship.
d) Proposal for Uniform Taxation of All Businesses
i) Currently there is more of a tax burden on “C” corporations than pass-through entities
ii) Process of creating a uniform taxation is called “Integration”
iii) Treasury Department Report – Integration of the Individual and Corporate Tax Systems
(1) Four Goals of an Integrated System
(a) Make uniform the taxation of investment across sectors of the economy
(b) Make more uniform the taxation of returns earned on alternative financial instruments particularly debt and equity
(c) Distort as little as possible the choice between retaining and distributing earnings
(d) Create a system that taxes capital income once
(2) Three possible prototypes for integration:
(a) Dividend Exclusion – Exclusion of dividends from shareholder’s gross income.
(b) Shareholder Allocation – Shareholders include gross income of the business but get a credit for the corporate tax paid.
(i) Equality of retained and distributed corporate earnings, which creates an incentive to distribute earnings.
(ii) Committee does not favor this prototype because of the policy results and the administrative complexity
(c) Comprehensive Business Income Tax (CBIT)
(i) Would treat debt and equity similarly.
(ii) No deduction for debt or dividend payments, but not included in gross income of the recipient.
1) “C” CORPORATION OPERATIONS
a) Corporate Income Tax
i) Tax Rates
(1) I.R.C. §§ 1, 11(b), 1211(a), 1212(a)
(2) § 11(b)(1)(A)-(D) – Corporate marginal tax rates range from 15% to 35% currently
(a) Bracket 1 – Up to $50k – 15%
(b) Bracket 2 – Up to $75k – 25%
(c) Bracket 3 – Up to $10M – 34%
(d) Bracket 4 – More than $10M – 35%
(e) Surcharge at 100k that have to pay an additional 5% up to 11,750. At this point the marginal tax rate is 39%.
(f) Surcharge at 15M that have to pay an extra 3% up to 100k. At this point the marginal tax rate is 38%
(g) Why set the marginal tax rate schedules this way?
(i) The bubble bracket is to recoup from the early points of the bracket when you were paying only 15% and 25%. We do this by bumping up the marginal tax rate until you average 34% tax rate. So the point is to make the marginal rate = the average rate quicker.
(3) § 1561(a) prevents spreading corporate tax burden among numerous related corporations to take advantage of lower marginal tax rates. § 1561(a) aggregates the taxable income of all members of a “controlled group of corporations” A controlled group includes all corporations with respect to which any five or fewer individuals (and certain related parties) satisfy the following two conditions:
(a) Ownership of at least 50% of the stock of each corporation.
(b) The people own more than 50% of the stock of each corporation taking into account each person’s interest only to the extent of the smallest interest owned by that person in any of the corporations.
(4) There is a phase-out of the lower tax brackets, such that once a corporation makes between $335,000 and $10,000,000, the corporation is basically taxed at a flat rate of 34%.
(5) A corporation has no preferential treatment for long-term capital gains. § 1212(a) limits capital loss carry-forwards to five years.
(a) Gross Income (§ 61) MINUS
(b) Deductions (§ 63) EQUALS
(c) Taxable Income MULTIPLIED BY
(d) Applicable Tax Rates (§ 11) EQUALS
(e) Gross Tax Liability MINUS
(f) Credits EQUALS
(g) Regular Net Liability OR
(h) Alternative Minimum Tax § 50
(7) Capital gains rate does not apply to corporations.
(a) How do we know? §1 notes capital gains and that section does not apply to corporations
(b) So then why do corporations have to sort out capital gains and losses? §1211(a) – if a corporation has capital losses, they can only subtract those capital losses to the extent that they have capital gains. There is 3 year carry back and five year carry-forward for the capital gains.
ii) Scope of Corporate Gross Income
(1) Inclusionary Aspects – Income From Services
(a) § 61 – Says what gross income is. §62, however, does not apply to corporations. This is because there is no AGI in corporate taxes, there is only gross income and deductions from the gross income.
(b) Haag v. Comm’r
(i) Facts – P, a physician, assigned his interest in a medical partnership to P.C., a one-man professional service corporation. P entered into an employment agreement with P.C. and performed medical services on behalf of P.C. P received a salary from P.C. R sought to allocate P.C.’s medical partnership income to P pursuant to the assignment of income doctrine and § 482.
(ii) Holding – Two requirements before a corporation, rather than its employee, will be considered the controller of the income and taxable thereon: (a) the employee must be an employee of the corporation whom the corporation has the right to direct or control in some meaningful sense; (b) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position. In this case, both elements were met and P.C., not P, controlled the earning of income from the medical partnership, and the assignment of income doctrine therefore does not apply. § 482 permits reallocation of income actually earned by one member of a controlled group to other members of that group if (a) there are two or more trades, businesses, or organizations, (b) the enterprises are owned or controlled by the same interest, and (c) reallocation of income among the enterprises is necessary to clearly reflect income or to prevent the evasion of taxes. In this case, (a) The dual business requirement is to be construed broadly. P is in the business of providing medical services as an employee of the P.C., and the P.C., as a partner, is in the business of providing medical services through P. (b) P’s business and the P.C. are under common control. (c) To determine whether a reallocation is necessary to clearly reflect income or to prevent the evasion of taxes, the court must decide whether the agreement between the taxpayer and the corporation reflected arm’s-length dealing. In 1979 and 1980, the taxable income that P would have recognized absent incorporation is much greater than the amount that he reported as income from his salary from the P.C.
(iii) Note – § 269A delegates the same reallocation powers to the IRS as § 482, but § 269A only applies when substantially all the services of a personal service corporation are performed for one entity and the principal purpose of the PSC is the avoidance of federal income tax by reducing the income or securing a tax benefit that would not otherwise be available to an owner-employee.
(iv) Classnotes – this case illustrates how seriously the tax code takes the idea that a corporation is a separate entity. See §482 – Allocation of Income and Deductions Among Taxpayers.
(2) Inclusionary Aspects – Gains From Property
(a) § 1001
(i) Gain = Money + FMV of property – Adjusted Basis (§ 1011, § 1012, § 1016)
(ii) Look to see if there is something that is realized BUT NOT recognized
1. Example: § 1031 Like Kind Exchange
(b) General Utilities & Operating Co. v. Helvering – OVERRULED BY STATUTE
(i) Facts – Corporations owns stock in islands. Another party wants to purchase shares. If they purchase from corporation there would be double taxation. So they distribute appreciated stock to shareholders and then the shareholder sell the stock
(ii) Issue – Is the distribution of appreciated property, a taxable event?
(iii) Holding – No. A corporation’s distribution of appreciated property to its shareholders is not a realization event to the distributing corporation. Also, this isn’t a sale; assets were not used to discharge the indebtedness.
(iv) NOTE – This decision was codified at §311(a). This section was, however overruled by statute by §311(b). § 311(b)(1) states now that corporation recognizes gain as if they sold property at FMV. Losses still are not usually recognized, however.
(3) Exclusionary Aspects – General
(a) Castner Garage v. Comm’r
(i) Facts – Pittam owned a majority interest in Island, which in turn owned majority interests in both Castner Garage and Universal Motor. Each of the corporations were the beneficiaries of disability insurance policies for Pittnam, and when Pittnam became disabled, the corporations received payments.
(ii) Holding – The exemption allowed in § 22(b)(5) for amounts received through accident or health insurance as compensation for personal injuries or sickness, is not limited to the insured or to individual taxpayers other than the insured, but includes corporations which have insurable interests. § 22(b)(5) is general in its application.
(iii) Note –The court will looks at the wording and the justification of the statute to find whether there is exclusive applications to individuals
(b) Note – Premiums paid by a corporation for life insurance or disability insurance are not allowed as a deduction if the corporation is the beneficiary of the policy. See § 264(a)(1).
(4) Exclusionary Aspects – Corporate Specific
(a) CONTRIBUTION IN EXCHANGE FOR NOTHING – Contributions of capital in exchange for nothing to a corporation are not taxable to the corporation under § 118 and § 362(a). The corporation merely takes a transferred basis.
(i) What is the basis when it is not recognized?
1. § 118(e) – It says see § 362. §362(a)(2) says that the basis is transferred basis.
(b) CONTRIBUTION IN EXCHANGE FOR STOCK – But, if it issues its own stock in exchange for money, § 118 doesn’t apply. Instead, § 1032 provides that a corporation does not recognize gain when it receives money or other property in exchange for its own stock.
(i) The § 1032 exclusion includes treasury stock.
(c) TRANSFER OF PROPERTY NOT CORPORATIONS STOCK IN EXCHANGE FOR MONEY – What if sell shares that aren’t part of the corporation, to a shareholder in exchange for money?
(i) This is merely a sale
(d) TRANSFER FROM SHAREHOLDER TO CORPORATION OF PORPERTY THAT IS NOT CORPORATION’S OWN SHARES – Shareholder gives appreciated property in exchange for money – This is just like a sale.
(5) Reducing Double Taxation
(a) A corporation cannot deduct dividends it pays
b) Scope of Corporate Deductions
i) Some deduction provisions that apply differently to corporations include:
(1) § 163(d) and § 163(h) – Interest expense.
(a) §163(d) limits interest when incurring the interest to purchase an investment. In this case individuals cannot take an interest expense more than interest income. This does nto apply to corporations, though.
(b) 163(h) disallows personal interest but it does not apply to corporations
(2) Bad Debt deductions under § 166(d).
(3) Charitable Contributions under § 170(b)(2)
(4) Loss deductions – See §§ 165(c); 165(f); 1211(a); 469(a)(2)(B)-(C)
(a) §165(c) is a limitation for individuals. This does not apply to corporations, however.
(b) Corporations can deduct 3k of capital losses plus capital gains. Corporations don’t get that extra 3k
(5) Deductions Only Allowed to Individuals – §§ 212-223.
(6) Special Deductions for Corporation – 241-250
ii) The Way Deductions Work
(1) Remember that cannot take deduction unless provided by code. This is why dividend distributed is not a deduction. The code makes no reference to a dividend paid deduction.
iii) What is better, a dividend or ordinary income? Hypo . . .
(1) Shareholder employee (S/E) gives Labor (L) and Capital (K) to a Corporation
(2) Corporation makes P profits before any payments to shareholder employee
(3) S = salary payment to the S/E
(4) Corporation’s Tax Liability
(a) Taxable Income = Profits (P) – Salary (S)
(b) Tax = Tax Rate for Corporation (tc) (P-S)
(c) Leftover = (1-tc)(P-S)
(5) Individual’s Tax
(a) Ordinary Income (OI) = S
(b) Dividend – (1-tc)(P-S)
(c) Tax = Tax Rate on Ordinary Income (toi)(S) + Tax Rate on dividend td(1-tc)(P-S)
(6) Total Tax (Corporation and Individual
(a) (tc) (P-S) + (toi)(S) + td(1-tc)(P-S)
(b) The variable is S so if we increase S will there be more or less tax?
(i) Less in corporate tax
(ii) More in ordinary income
(iii) Less in dividend
(iv) Current Code = Ordinary Income = Corporate Tax = .35
(v) In essence, this means that you are getting savings when you can disguise more as salary. Corproate tax and ordinary income cancel out. What you are left with is less in dividend. SO YOU WANT TO OVERSTATE SALARY.
iv) Reducing Double Taxation
(1) Elliotts, Inc. v. Comm’r
(a) Facts – TP is a corporation. It paid its sole shareholder, Elliott, $2,000 per month plus a bonus of 50% of net profits at year end. Elliott has total managerial responsibility, performs the functions of both a sales and a credit manager, and works approximately 80 hours every week. For the tax years ending 2-28-75 and 2-28-76, the TP claimed compensation deductions relating to Elliott of $181k and $192k, respectively. The Commissioner found these deductions to be in excess of the amounts TP could deduct as reasonable salary under § 162(a)(1) and limit
Steamship v. Commissioner, in which the corporation was up for sale, a seller found, and an agreement reached before the subsidiary declared the dividend and the purchasing company paid the dividend on behalf of the subsidiary as part of the purchase price. The 2nd Circuit held that the dividend and sale were one transaction and refused to treat “dividend” as a dividend.
(3) Limitations on the Dividends Received Deduction
(a) § 246(c) provides that the DRD is not allowed with respect to dividends received on stock held for at less than 46 days during a 91-day period centering around the ex-dividend distribution.
(b) § 1059 provides that a corporate shareholder that receives an “extraordinary dividend” must reduce its basis in the stock of the “dividend-paying-corporation” by the amount of any dividend receive deduction allowed for the extraordinary dividend, unless the recipient held the stock for more than two years before the dividend announcement date.
(i) An extraordinary dividend is a dividend that equals or exceeds 10% of the recipient’s basis in the stock of dividend-paying corporation.
(c) These limitations’ purpose is to prevent a corporation from buying a corporation that it knows to be paying a dividend, receive the dividend and obtain the exclusion, and then turn around and selling the stock at a loss. Say for example, a corporation will be entitled to a 70% DRD on a $2 million dividend. The corporation would pay tax on $600,000 of dividends, but would take a loss of $2 million when the stock is sold.
vi) Corporate Alternative Minimum Tax §§ 55-59
(1) 20% flat rate based on AMTI – See § 55(b)
(a) AMTI – is a taxable income base in which certain deductions are minimized or disallowed and is always at least 75% of the corporation’s adjusted current earnings. More goes into the base.
(2) After a corporation has paid AMT, it may use such AMT as a credit in future years when regular income tax exceeds AMT.
vii) Corporate Penalty Taxes
(1) Accumulated Earnings Tax — §§ 531-537
(a) The Accumulated Earnings Tax applies to corporations “formed or availed of” to avoid the shareholder income tax imposes when corporate earnings are distributed as dividends. See § 532.
(b) When a corporation accumulates earnings in excess of reasonable business needs, the proscribed intent to avoid shareholder income tax is deemed to exist, unless the taxpayer can prove by a preponderance of the evidence that it did not accumulate earnings for the purpose of avoiding the shareholder tax.
(c) § 531 makes the penalty the maximum rate that applies to dividends, currently 15% of accumulated taxable income. The corporate penalty tax does not substitute for the shareholder tax imposed when corporate earnings are actually distributed.
(d) § 532(b) – This penalty tax does not apply to personal holding companies.
(e) § 532(c) – This penalty tax is determined without regard to the number of shareholders of the corporation.
(f) § 535(b) gives the formula for computing accumulated taxable income.
(i) Start with taxable income:
(ii) Subtract taxes, dividends paid, and other non-deductible expenses.
(iii) Add tax-exempt income
(g) United States v. Donruss Co.
(i) Facts – Donruss Co. had $1.7 million of undistributed earnings. Donruss Co. gave several reasons for accumulating earnings: capital and inventory requirements, increasing costs, business and economic risks, and a desire to expand. At trial, the Government wanted a jury instruction stating that avoidance of shareholder tax does not have to be the sole purpose for the unreasonable accumulation of earnings. The trial court refused and gave an instruction stating that this did have to be the sole purpose. The jury found that the Donruss Co. had accumulated earnings beyond the reasonable needs of its business, but that it had not retained its earnings for the purpose of avoiding shareholder income tax.
(ii) Holding – The applicable test in order to rebut the presumption contained in § 533(a) is that the taxpayer must establish by the preponderance of the evidence that tax avoidance with respect to shareholders was not one of the purposes for the accumulation of earnings beyond the reasonable needs of the business. Court remanded stating that Donruss Co. has to show that the tax consequences didn’t contribute to his decision t accuulate earnings.
(h) Snow Mfg. Co. v. Comm’r
(i) Facts – Snow Manufacturing Co. remanufactured automobile parts. IRS determined that Snow Manufacturing Co. was subject to the accumulated earnings tax for its taxable years ended June 30, 1979, and June 30, 1980. The parties disagreed as to whether P’s reasonable business needs for fiscal 1979 and 1980 included the need to accumulate funds for expansion or relocation of its plant. The parties further disagreed as to whether petitioner’s reasonable business needs were to be compared to its accumulated earnings and profits or net liquid assets.
Holding – Snow Manufacturing Co. is subject to the accumulated earnings tax for its 1979 and 1980 fiscal years. Snow Manufacturing Co. lacked a “specific, definite, and feasible” plan for expansion. Because Snow Manufacturing Co.’s net liquid assets exceeded its accumulated earnings and profits, comparison of its reasonable business needs with its accumulated earnings and profits is the proper measure for the proscribed purpose test of § 533(a). Where a corporation accumulates earnings and profits, the most significant factor in determining whether the accumulated earnings tax applies is the reasonableness of the corporate accumulation. § 533(a) establishes the presumption that a corporation that accumulates earnings and profits beyond its reasonable business needs does so for the proscribed purpose of tax avoidance. The § 533(a) presumption, however, is rebuttable by a preponderance of evidence to the contrary. Therefore, the accumulated earnings tax is not imposed where a corporation has made an unreasonable accumulation but lacks the proscribed purpose. The ultimate question upon which imposition of the tax rests is whether tax avoidance with respect to shareholders was one of the purposes of a corporate accumulation. § 537(a) provides that the term “reasonable needs of the business,” includes the “reasonably anticipated needs of the business.” As § 1.537-1(b) indicates, “reasonably anticipated needs of the business” do not include the vague or uncertain plans of a corporate taxpayer to acquire new property: In order for a corporation to justify an accumulation of earnings and profits for reasonably anticipated future needs, there must be an indication that the future needs of the business require such