TAX II (CORPORATE TAX)
Burke:
PART I – INTRODUCTION
CHAPTER 1 – An Overview of the Taxation of corporations and Shareholders
I. INTRO
A. Taxation of Business Entities:
B. Influential Policies:
i. The Double Tax: The relationship between the corporate tax and the shareholder tax can be favorable or unfavorable, but it is clearly a double tax system. The classification is crucial to double tax (partnerships are not double taxed…flow through). Elect into single level tax if incorporated entity. However, many corporate entities can’t do this.
1. Pre-2003 Biases: Some corps treated as single tax and others as double. Why are they taxed separately? Who bears burden of corporate tax? (economists have no good answer). Consumers have costs passed onto them. As a practical matter, Corporate tax raises LOTS of revenue for government.
a. Bias in favor of non-corporate investments. Why be taxed as corporations if you are a partnership.
b. Bias in favor of debt. If a corporation borrows in order to finance its capital structure, the interest on that debt is deductible by the corporation. It reduces its income, and is thus taxed less. On the other hand, if people contribute capital to the corporation, and corporation makes payment to shareholders that us not interest (a dividend), this does NOT create a deduction for the corporation.
c. Bias in favor of retaining earnings within the corporation. It is expensive to make distributions to shareholders.
d. All biases prior to 2003 Act – IRC § 1(h)(11): This act imposes a 15% shareholder rate on “qualified” dividends. 1(h) talks about rate of taxation on capital gains. 1(h)(11) says for purposes of this section that term net capital gains means that dividends for purposes of rate will be taxed as capital gains. Prior to this, dividends were treated as ordinary income.
i) Single level tax? Not exactly. You are still taxed at the corporate level…it’s just that qualified dividends are taxed at 15%. This reduces burden on the shareholder. In theory, it will make corporations more willing to give.
ii) Bargain? Perhaps lower overall burden on shareholder. If individual income were taxed at a huge rate, double tax with a capital gains rate would really help a taxpayer.
2. Diminishing Revenue from Corporate Tax: The amount of corporate income out there is getting smaller. Perhaps it’s deferred or not counted through corporate tax shelters. Burke thinks lots of revenue is being lost to tax shelters. This is what created the pressure for tax shelters.
3. EFFECT OF DOUBLE RATE: At high rate brackets, it’s about 45-50%. What effect, thus, does a 15% rate on dividends impose? Debt will still generate an interest deduction at the corporate level, so it will still be favored, albeit just barely. Small businesses, however, will consider whether to take off earnings as salary (taxed at 35% but with a corporate deduction), or to leave it in the corporation and distribute it as capital gain. This question will depend on the rate relationship between the corporations and the shareholders.
a. Policy: does this make sense? Burke doesn’t think so. The whole notion of corporate integration is that you want income taxed once, but only once, and at least once, at the corporate level. Thus, single tax is all you need. The problem with the 15% dividend is that it reduces the burden of the corporate tax, but much of corporate income (thanks to shelters, depreciation, etc.) has not been taxed. If the money hasn’t been taxed at the corporate level period, aren’t we creating an individual-level tax shelter? Corporations won’t pay tax on these monies at the corporate level, and get bennies for giving it away at the individual-level.
4. Dividends of subs to parents who own 100%: If sub filed a “consolidated return” with parent, the parent is not taxed. Otherwise, there would be a triple tax… the sub corporate level, the parent corporate level, and the individual shareholders of the parent level.
a. IRC §243 If sub doesn’t file a consolidated return, parent may exclude that dividend so that parent doesn’t have income from that dividend. Tax eliminated at parents’ level. Shareholder of parent is taxed and sub is taxed, but that’s it.
i) If sub is only 20% owned by parent (or something way less than full ownership), parent DRD goes down to 70%.
ii) Example: Sub. has $100 income it gives to a parent corporate shareholder that doesn’t have a big percentage ownership in the sub. Of the $100 that goes to the parent, 70% of that is excluded in a Dividend Exchanged Deduction. Parent is only taxed on $30 at the 35% regular corporate rate (corporations don’t get 15% capital gains rate!. Thus, it comes out to like a 10% taxation rate in total.
5. Related Party Provisions: If a parent owns more than 50%, they are treated as a related party, triggering IRC §262.
ii. Rates on Ordinary Income:
1. Individual Rate: 35%
2. Corporate Rate: 35%
3. Thus, double taxation doesn’t help shareholder, unless dividend is a capital gain. Post the 1986 act (strengthened double tax system), you see attempt by corporations to reduce the burdens on corporate tax to engage in corporate tax shelters.
iii. Preferential Capital Gains Rate: Note, no such thing as a preferential capital gains rate for corporations, merely individuals.
1. 15% Rate. Seven different kinds of capital gains rates. 15% is the most common. Now that dividends are treated as capital gains for rate purposes, congress has to think about how this affects traditional capital gains.
a. Example: Corporation gives a distribution of $100 in dividends (earnings and profits). In the days of treating dividends as ordinary income, this would be unfavorable. It would be a 35% rate. However, now that dividends are 15%, regardless of whether financial gain is classified as dividends or capital gains, the ONLY DIFFERNECE is whether you get BASIS RECOVERY.
b. Basis Recovery: Difference between capital gains and dividends today. This is the only stake in classification, FOR NOW (see warning below). Capital gains get basis recovery, dividends do not. Distinguish between capital gains distribution and the dividend distribution, and thus whether person gets to recover their basis in stock upon sale. This is not so very significant. The old rate differential was significant.
c. Warning – reversion in 2008: IRC §1(h)(11) (Tax Act of 2003) is designed to fade away in 2008. The reason is that this change, combined with others, is costly. So Republican Congress did a five year trial (couldn’t make them permanent). BUT, in addition to the other tax cuts, these rate changes hurt revenue, and this revenue would have to be replaced. Thus, the system we have now is not stable.
d. Corporations don’t get a preferential capital gains rate! They pay at 35%, NOT 15%!
iv. Nonrecognition – IRC §351, 358 and 362.
1. Formation of a Corporation: Intended to facilitate the formation of incorporations (allowing people to get together and contribute to a joint enterprise). However, government must then do something with Basis rules to preserve gains at the shareholder level and the corporate level. Stock sold on a gain of the asset contributed (shareholders basis) is taxed. The corporation will meanwhile take the basis of whatever the asset is worth if they sell that asset. This is a double tax burden, and it is quite real even accepting the lower tax rate for dividends.
2. Reorganization of a Corporation: The reorganization of a corporation is not treated as a gain or loss.
v. Special Rate for Manufacturing Activities – IRC §199: Congress wanted to save domestic U.S. manufacturers from being killed by foreign competition, so they are taxed at a better rate. However, lots of weird companies are classed as manufacturers…like Starbucks!
C. The Common Law of Corporate Taxation and the ECONOMIC SUBSTANCE DOCTRINE
i. Sham Transaction: In a sham transaction, the IRS says the transaction was not real… it was only done to avoid taxes. This is relatively uncommon. Courts use the Economic Substance Doctrine to test this. This is a judicially created doctrine.
ii. Substance Over Form: For a transaction to be respected, transaction has to have “economic substance.” See UPS, infra p. 5 (applying two-pronged approach) Courts are split in which of the following tests to apply (but the majority require both)
how much a profit would be enough to call transaction a tax shelter.
iii. How do we stop tax shelters?
1. Judicial response: See the economic substance test, above. Many people think that the courts should decide what a tax shelter is through the economic substance doctrine.
2. Anti-Tax Shelters – IRC §358: Congress’ attempt to attack tax shelters.
3. Listed Transactions: IRS has mandated that corporations must fully state transactions or take penalties. Promoters must also pay penalties for failure to disclose transactions. Higher ethical standards also put out there.
G. The Integration Alternative: What you’re seeing with tax shelters is that after the 1986 act (which supposedly strengthened the corporate tax), more corporations ended up with positive tax liability. Lets say you integrate corporate and shareholder taxes…this would relieve the corporate tax burden entirely. Goal would be to have one level of tax at the shareholder level (ALI tried to do this… but failed).
i. Complication: You have to keep track of how much corporation would pay in taxes =). If you think about it, corporations often don’t pay any tax due to tax shelters and depreciation. You have to create a “PTI” (“Previously Taxed Income”).
ii. Excerpt from Canellos, “Tax Integration by Design or by Default”
iii. Integration of Individual and Corporate Tax Systems, Report of the Department of the Treasury (1992):
iv. Description of President’s Dividend Exclusion Proposal, Treasury Department Jan. 21 2003 – Eliminate the Double Taxation of Corporate Earnings: President said “Wah hoo! Lets exclude dividends from taxation!” Congress saw the income loss on straight dividend exclusion and said “Ahh! Don’t exclude it…just pay a 15% rate on it. Same as capital gains.”
1. How do you assess the 15% dividend rate? You can look at it as a first step to complete corporate integration. Also, who gets dividends? People who are already doing pretty well. Yeah, most people got dividends through pension accounts. Tax exempt entities also get dividends. The people who have lots and lots of stock, however, are from very high tax brackets.
a. Mutual funds can also make use of qualified dividends.
b. However, taking dividends exposes you to potential AMT rates. =)
H. CORPORATE CLASSIFICATION:
i. In General: We don’t have a very good distinction between what entities get single taxed and which are subject to two levels of tax. Perhaps we are moving to an entity where privately traded entities get one level of tax, public ones get two.
ii. Corporations vs. Partnerships – IRC §7701: IRC implies that a partnership is an unincorporated entity with more than just one partner.
1. Check the Box Regulations: You can elect to be classified as a partnership. You could also elect to be taxed as a corporation (two level tax). Treasury, when it made these regulations, could not divide up the world between public and private organizations (see above). Even mom and pop outfits are by default C-Corps. when they incorporate unless they elect S-Corp. status.
2. General Classification Rules: In default circumstances, if you have 2 or more members, you are a partnership. If you are a publicly traded organization, IRC §7704 mandates that you are a C-Corp.
a. Election:
i) S Corporation: Flow through taxes. Single class of stock.
