QUIRK – CORPORATE TAX – SPRING 2013
I. Corporate Formation
A. Choice of Form and Entity Classification
Non-tax Factors When Selecting Type of Entity
· Limited Liability
· Form of management
· Access to capital markets
· Benefits available to employees
· Ease of exit/dissolution
o Businesses should also consider any State statutes w/ regard to restrictions on distributions; to profit-sharing ratios; and to other financial matters.
Tax Factors When Selecting Type of Entity
· Undistributed Earnings Tax on corporations
· Double Taxation of Corporations
· FACTS: High income cartoonist established a C corp to shield income from 90% individual rate.
· Whether something is a personal service is dependent upon whether capital is a material income producing factor. When Capital is a material income producing factor, it is not a personal service
· A business purpose is not required to form a corporation.
· §269A gives the secretary authority to allocate tax items as necessary to prevent avoidance or evasion of Federal income tax or clearly to reflect the income of the personal service corporation or any of its employee-owners.
Personal Holding Company Tax
· A 15% penalty tax is imposed upon undistributed personal holding company income.
· It applies if:
o at any time during the last half of the taxable year, more than 50% in value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals; and
o at least 60% of the corp's adjusted ordinary gross income constitutes “personal holding company income”.
§ Personal Holding Company Income – The portion of adjusted ord. gross income consisting of listed types of personal service or personal asset income, such as amounts under personal service contracts, dividends, rents, and the like.
· Chain of corporate entities connected through stock ownership w/ a common parent corporation.
· A parent corporation is “affiliated” to its subsidiary if it possesses at least 80% of the total voting power and 80% of the total value of the stock of the subsidiary.
Subchapter S Corporations
· Eligible Corporations
o Must be a domestic Corporation
o w/ no more than 100 shareholders
§ certain family members are counted as only one shareholder
§ Nonresident aliens are NOT permitted Shareholders
§ entities allowed = certain family trusts and estates, voting trusts, and nonprofit entities.
o w/ only one class of stock.
§ Does not restrict disparities in voting power or rights.
§ Regulations say that stocks will be considered of the same class so long as they have “identical rights to distribution and liquidation proceeds.”
· Control of Other Entities
o Can hold a Pship interest, but can't hold an interest in a controlled subsidiary.
o Can control a Qualified Subchapter S subsidiary or “Qsub” §1361(b)(3)(B)
· Tax Considerations
o S corp is not a taxable entity.
o SHs taxed on distributive share regardless of whether distributions actually made (Phantom Income) (Taxed when share is computed, not when it is actually distributed)
o Pro Rata Distributions required
B. The Corporate Capital Structure
Debt vs. Equity
· Murphy Logging Co. – Brothers operating Pship and formed new corp. Each contributed $500 to New Corp in return for 33 1/3% of its stock. New Corp took out bank loan of $240,000 which Brothers guaranteed. New Corp bought Pship property for purposes of restoring the depreciable basis.
o IRS recast the transaction such that the property was contributed capital to the New Corp and as such, a tax free exchange (exchanged basis). It also said the $238,000 paid for the property was really a constructive dividend.
o IRS uses thin capitalization as its reasoning.
o Ct. Says that know-how, potential contracts, and good will were enough such that the brothers were sufficiently at risk w/ respect to New Corp. and that such risk outweighed the argument of thin capitalization.
o RULE: If there is a thinly capitalized company, guarantees of debt may be viewed as equity b/c the guarantor bears the risk of loss on that “investment”
o BIG FACTOR WHEN ANALYZING DEBT = IS IT SUBORDINATED? If yes, its more like equity.
· Plantation Patterns – If a corp is thinly capitalized and an individual guarantees a loan to the corp, it runs the risk of having the loan restructured as a debt of the individual, who then made a capital contribution to the corp. Subsequent payments on the loan by the corp. will not be allowed as interest expense, but will instead be reclassified as dividends paid to the individual debt holder.
Section 1244 Small Business Stock Losses
· When an individual or a partnership suffers certain losses on §1244 stock, the loss can be treated as an ordinary loss. Otherwise, rules of §§165(g) and 166 apply to losses on securities giving them capital loss treatment.
· Available for both Common and Preferred stock
o Only available to the individual or pship to which the stock was issued.
o $50,000 cap for individuals and $100,000 for joint filers (Excess treated as capital).
o Corp. must be
§ a domestic US Corp.,
§ a small business corp at the time of issuance,
· Small business corp = the aggregate money and property received for stock, contributions to capital, or paid in surplus does not exceed $1M.
· Stock must have been received for money or property.
· More than 50% of the receipts for the past 5 years cannot be from passive sources.
C. Incorporation and Contributions to Capital
1)Shareholder Nonrecognitions: §351 Eligibility Requirements and Policy
· To encourage incorporation
· Transfering capital to a corporation is merely a change in form of ownership, no economic gain has been realized.
Issues Surrounding Transfers to Corporation
· Is it a good 351
· Any realized gain?
· Any recognized gain?
· What kind of recognized gain
· 358/1223 – SH basis/holding period
· 362/1223(2) – Corp basis/holding period
Requirements for nonrecognition
· Property is transferred to the corpo
o Current Treasury View – post-reorg stock transfers, even if pursuant to a binding K, will not cause a reorg to violate continuity-of-interest principles as long as the transfers are made to unrelated parties.
o Rev. Rul. 2003-51- Look at the substance of the entire transaction instead of its form. As long as the transaction does not necessarily go against the purposes of §351, it will qualify for nonrecognition.
o AMERICAN BANTAM CAR – T/p argued that 351 did not apply because they wanted the corporation to have a cost (higher) basis in the transferred property for depreciation.
§ Initially, the corp. liquidated and trustee sold all assets to Associates for $5,000 cash and assumption of liabilities.
§ Associates used underwriters to form new corp. whereby underwriters would sell the stock, and when they reached a certain sales #, they would be compensated w/ stock in the new corp.
§ Underwriters met sales # required for compensation a year after deal was set up.
§ ISSUE: did Associates have control immediately after transfer (i.e. did Associates still have control, and thus did 351 nonrecognition apply, even though there was a risk they might be divested of such control)?
§ Associates argue that the transfer to underwriters was part of an integrated plan so that immediately after the transaction, they DID NOT have control.
§ Government say Associates had control immediately after transfer and court agreed.
§ REASONING: Although Associates put stock in escrow for underwriters, Associates still had ownership rights over stock.
· Underwriters did not actually get ownership until a year after Associates had ownership/control.
· Ct. looks at MUTUAL INTERDEPENDENCE TEST – “Where the steps are so interdependent that the legal relations created by one transaction would have been fruitless w/out a completion of the series.” This test poses the issue – who had control for 18 months while stock was in escrow.
Exceptions to Nonrecognition
· A transfer to an investment company is not eligible for nonrecognition
o includes transfers that result in: 1) the diversification of the transferor's assets and 2) the transferee company is “a regulated investment company, a REIT, or a corporation that holds more than 80% of its assets for investment and are readily marketable stocks or securities, or interests in regulated investment companies or REITS.”
o Investment Corporation = more than 80% of assets include stock, securities, other equity interests in a corp., debt, options, futures contracts, foreign currencies, et al.