Select Page

Corporate Income Tax II
University of San Diego School of Law
Burke, Karen

Tax II Outline
Burke, Spring 2012
 
 
 
 
I.    Introduction
A.   The Way The Corporation Is Taxed
1.   Double Taxation: Two-level tax on distributed earnings
a.   Once at corporate level, again at shareholder level
b.   Compare: Single-level tax system (pass-through entities)
2.   Generally, people would choose to only have their income taxed once
a.   However, some publicly traded corporations and pre-existing organizations are forced into the double tax system.
B.   Corporate Tax Rates
1.   Current:
 
a.   § 11:
i. ii.
Rates: 15%, 25%, 34%, 35% Flat 34% kicks in at $335,000.
 
b.   Personal Service Corporation
i.   Flat 35%
c.   Alternative Minimum Tax
 
i. ii. iii.
20% rate
$40,000 exemption (phased out) Adjustments to taxable income, § 56
 
d.   § 199 Deduction: Equivalent to 3% rate reduction when fully phased in
2.   McCain Proposals
a.   2001 and 2003 Acts made permanent (15% CG and dividend rate)
b.   Reduction in Corporate Tax Rate
 
i.
ii.
Immediate reduction from 35% to 34%
Between 2009-2014: 34% phased down to 25%
 
c.   Temporary expensing for short-lived equipment
 
i.
 
ii.
Interest deduction disallowed (only if borrowing is used to buy specific expensed equipment
Sharp reduction in corporate tax
 
d.   Unspecified corporate tax broadeners
e.   Estate tax exemption:
i.   Increased from $3.5 million to $4.5 million
f.   Estate tax rate:
i.   Reduced from 45% to 15%
3.   Obama Proposals
a.   Leaves maximum corporate tax rate at 35%, cf Rangel proposal (31%)
b.   Highest tax rate on CG/dividend from 15% to 20%
c.   Leaves estate tax at 2009 levels ($3.5 million exemption at 45% top rate)
4.   Policy:
a.   Prior to 2003
 
i.
 
ii.
TPs would not want to take dividends because they would be treated as ordinary income.
TPs would want to sell stock back to the corporation because the gain
would be treated as a capital gain (15% tax rate).
 
b.   2003-2010
 
i. ii.
Dividends are taxed at the same rate as capital gains (15%)
There is still some benefit to selling a stock back to the corporation
(instead of a dividend), because of basis recovery, but the advantage is not as great was it was pre-2003.
 
c.   2003 Act rate change
 
i. ii.
Only affects individual shareholders
If a corporation recognizes capital gains, the capital gain is taxed at the same rate as ordinary income.
 
 
 
 
Tax II Outline Page 1
 
iii. iv.
A corporation can only offset its capital gains against capital losses. A corporation generally likes dividends because it gets a dividends received deduction (DRD).
 
1)   Equivalently the same as excluding that amount of income.
5.   Burke's opinion: no tax legislation in 2009
a.   Congress is focused on health care.
b.   Most likely tax legislation in 2009 is about the estate tax, since there is no estate tax in 2010 and the current laws regarding the estate tax are set to expire at the
end of 2010.
 
i.
 
ii.
Burke thinks that Congress will bring back the estate tax in 2010, but at
2009 exemption levels.
She also thinks that they will do it for the revenue.
 
c.   Doesn’t think the corporate tax will go away.
 
i.
 
ii.
She believes the corporate tax will be lowered (because of competitiveness arguments).
Burke thinks that certain corporate deductions will be eliminated, or
allowed to expire.
 
d.   Thought that the McCain proposal would allow corporations to expense equipment and write it off immediately (instead of capitalizing and depreciating).
e.   Thinks that there will be a 1986 style of corporate tax reform
 
i. ii. iii.
Lowering tax rates
Increasing the tax base
Tightening up international tax rules.
 
C.   Unfavorable Biases of Corporate Tax
1.   Bias in favor of non-corporate investment
a.   Would rather be taxed as a partnership
2.   Bias in favor of debt-finance (rather than equity)
a.   Interest is deductible, but dividends are not deductible
3.   Bias in favor of retention
a.   Retain earnings and distribute at preferential capital gain rates
 
i.
 
ii.
By keeping the money in the corporation, you defer any tax to the shareholders.
Deferral by itself may or may not be a benefit, but keeping the money in
the corporation and then using it to buy back stock ensures that any gain will be treated as a capital gain (which has preferential tax treatment).
 
D.   Capital Gains Rates: 2003 v. 2010
1.   2003 Act:
a.   § 1(h)(11): Dividends taxed at capital gain rate (until 2010)
i.   Dividends are not classified as capital gains.
b.   Tried to get rid of the biases in the two-level corporate tax.
i.   Wanted to lessen the burden on shareholders and, hence, investment in corporations.
c.   Economic perspective:
i.   Taxing dividends at 15% eliminates some biases of the double tax system.
d.   Beneficiaries:
 
i.
 
ii.
iii.
Large shareholders in major corporations because large dividends were dispersed after the Act passed.
Owners of businesses that had been hoarding retained earnings.
Everyone, assuming that this would stimulate the economy
 
e.   Corporate Anti-Bailout Provisions
i.   Intended to protect revenue to make it more likely to have ordinary income.
1)   Pre-2003: The Code was designed to make it difficult to get the CG
tax treatment.
 
ii.
If the 2003 Act were permanent, the anti-bailout provisions would be
 
 
 
Tax II Outline Page 2
 
 
 
2.   2010
a.
unnecessary.
 
Assume the dividend rate does return to ordinary rates.
 
i. ii.
Many rates are set to expire in 2010, including the 15% dividend rate.
If the rate is scheduled to return to ordinary rates, there will be a massive bailout on the eve of rate change.
 
b.   Alternative Scenario: Retain 15% dividend rate.
i.   Increase individual income tax rates
1)   Necessary because of the financial shortfall caused by the tax cuts.
 
ii.
Reduce corporate tax rates
 
1)
 
 
 
2)
3.   Burke's view
Argument: Because the U.S. corporate tax rate (34%/35%) is higher than the corporate tax rate in other countries, the U.S. can be more competitive overseas if we reduce our corporate tax rate.
Could encourage companies to retain earnings.
 
a.   Individual tax rates will increase to 40-45% for those earning $200,000+.
b.   Corporate tax rates could drop to 25%.
 
i.
 
ii. iii.
At that point, it may become desirable to stash money in the corporation where it will be taxed at a 25% rate.
It will be better than if it were in a pass-through entity or holding on to it.
Historical basis: Pre-1986, corporate tax rate was lower than the individual tax rate.
 
E.   Dividends Received Deduction
1.   § 243: Dividends received deduction on dividends received by a corporate shareholder.
a.   DRD reduces effective tax rate.
b.   DRD meant to limit triple (or more) taxation.
c.   Still not as good as any pass-through entity.
d.   Since 1986, there has been a shift away from corporations to single -level tax entities.
2.   Ex. Receive $100 as dividend. Assume 80% DRD, so only 20% is taxed.
a.   $80 is excluded under the DRD.
b.   Effective tax rate is only 7% (20% * 35%)
c.   Only $7 is taxed.
3.   Pre-2003 Act
a.   Assume corporation earns $100 (taxed at 35%)
b.   Corporation pays $35 in tax, has $65 remaining to distribute to SH
 
i. ii. iii.
Assume $65 dividend is taxed at 35% in SH hands
SH pays $22.75 tax.
Total tax burden is 57.75% ($35 + $22.75)
 
4.   Post-2003 Act
a.   Assume corporation earns $100 (taxed at 35%)
b.   Corporation has only $65 available for distribution
 
i. ii. iii.
F.   Debt vs. Equity
Assume $65 dividend is taxed at 15% in SH hands. SH pays $9.75 tax.
Total tax burden is 44.75% ($35 + $9.75)
 
1.   Assume Corporation/SH are both in 35% tax bracket; Corporation has $100 income and pays $100 interest to SH. (Debt investment)
a.   Corporation pays no tax ($100 income – $100 interest deduction).
b.   SH pays $35 tax ($100 interest income * 35%)
c.   SH is left with $65 tax ($100 – $35)
2.   Same facts, except Corporation pays $65 dividend to SH.
a.   Corporation pays $35 tax ($100 income * 35%) (Dividends not deductible)
b.   SH pays $9.75 tax ($65 dividend * 15%)
c.   SH is left with $55.25 after tax ($65 – $9.75)
 
 
Tax II Outline Page 3
 
G. 

e rules is not enough, it must meet the substance of what Congress intended.
1)   The difficulty is that in corporate taxation, the form of the
transaction determines how it is taxed.
5.   Recent tax shelter cases
a.   United Parcel Service
i.   Facts:
1)   Before restructuring, you could obtain insurance from UPS for an extra fee.
a)   Because of the great tracking system, they collected substantial
fees from the insurance.
b)   The fees were income to the corporation.
2)   UPS transferred the income from the insurance to an offshore subsidiary named OPL.
a)   UPS took stock in OPL and distributed OPL stock to its
 
 
Tax II Outline Page 5
 
 
 
 
 
 
 
ii.
 
b)
 
c) Holding:
shareholders.
Nominally, UPS collected the premiums and funneled them to
OPL (who doesn't have to pay tax because it's offshore). OPL is in charge if the package is lost.
 
1)   It has economic effects and a business purpose.
2)   It was a simple restructuring of the business.
3)   “Business purpose” satisfied if transaction occurs in connection with
“bona fide profit seeking business”
 
 
iii.
1) Dissent:
Easier to embed shelter in going concern, cf. ACM Partnership.
 
1)   There was no economic significance to the transaction and there was no real business purpose.
2)   Motivated by tax purposes.
 
iv.
Burke: Skeptical of the decision.
 
1)   If you can do restructuring and embed it in your ongoing decision, odds are you can convince a court that it is a real business transaction.
2)   If you start doing something you haven't done before and isn't really related to your core business, then it appears more like a tax shelter.
b.   DC Transit
 
i.
ii.
Sale and leasebacks.
Government has had some success against invalidating these sham transactions.
 
c.   Coltec
i.   Facts:
 
i)
 
ii)
 
iii)
iv)
 
v)
Found a way to create artificial losses by transferring money
($561m) to a subsidiary.
Borrowed $560 million to increase the basis, and then transferred it to the subsidiary.
Subsidiary assumed liabilities ($560m) from the parent company.
SH basis in stock was $561m basis, but because of the contingent liability the most anyone would pay you for it is $1m.
Amount realized was $1m when the stock basis was $561 million –>
$560 million loss.
 
ii.
 
iii.
iv.
 
v.
District Court: economic substance doctrine (ESD) is not an
“unconstitutional” violation of separation of powers
Circuit Court: economic substance doctrine is constitutional
ESD represents “judicial effort to enforce the statutory purpose of the tax code.”
Focus on transaction that purports to generate tax benefit.
 
J.   Entity Classification
1.   Check-the-box regime
a.   Eligible entity can elect partnership or corporation status if there are at least 2 members
b.   PS is the default classification
c.   Single-owner entity is disregarded (“tax nothing”)
2.   S Corporation alternative (for pass-through treatment)
a.   100 members, single class of stock
i.   Members of the same family are treated as 1 member.
3.   Elective change of classification
a.   Corporation to Partnership is taxable event (deemed liquidation); PS to Corp is a non-taxable event (tax-free incorporation).
b.   Getting into a corporation is easy; getting out of it is hard.