I. Ch. 1: Overview of the Taxation of Corporations and Shareholders
A. Corporation As a Separate Taxable Entity
1. p. 2-10; 13-23, code §§ 11(a), (b)(1) & (2); 63(a)
2. Choice of Entity
a. C Corporation
i. Subchapter C of the IRC governs the taxation of C Corporations
(1) Treated as a separate taxable entity or taxpayer.
(2) § 11(a): “A tax is imposed on the taxable income of every corporation.”
ii. Second Layer of Tax: When a C Corp. pays a dividend (must have sufficient earnings and profits), the shareholder must include the dividend in gross income.
(1) In 2003, § 1(h)(11) was added so that dividends are treated separately as capital gains. This eliminated the need to make distributions that would be characterized as capital gains as opposed to ordinary income.
(a) Max. Capital Gains Rate = 15%
(b) Max. Income Tax Rate (for indiv.) = 35%
(2) If your client is a C Corporation, a second layer of tax may be avoided by retaining earnings (not paying dividends), or having no taxable income.
(a) Beware of a constructive dividend, i.e. using corp. credit card.
(3) Hypo: Shareholder-owner has $50,000 left in a corporate acct after paying employees. If retained, this income will be taxed at 35%. (1) If corp. does retains earnings and SH sells his shares after building up the corp., he would pay a 15% capital gains rate. (2) If the corp. characterizes payment as compensation, it is deductible at the corp. level and is only taxed to the employee, as ordinary income. Compensation must be reasonable or the I.R.S. may characterize payment as a dividend instead of compensation, b/c a dividend is not tax deductible. Although this has reduced it to one level of income tax, you pick up additional employment tax (15.3%, split b/w employer and employee).
(a) A C Corporation can elect a fiscal year instead of a calendar year. For the calendar year, the tax is due the 15th day of the 3rd month of the taxable year. This also applies to S Corp. For LLCs and partnerships, it is due the 4th month of the taxable year (April 15).
(b) Corp. redeems stock: Capital gain (15%) = A/R – A/B in § 1001(a).
(c) Corp. buys property from indiv. in exchange for stock: Indiv’s Gain = value of stock – A/B in property.
iii. Hypo: $100,000 of pre-tax profit. The corp. pays a 35% tax under § 11. Now, the corp. pays out $65,000 in dividends, which are taxed to SH at 15%, as net capital gain under § 1(h)(11). 100,000 – 35,000 = 65,000 – 9,750 (15% of 65k) = 55,250
iv. § 11(b) Amount of tax.—
(1) (1) In general.–The amount of the tax imposed by subsection (a) shall be the sum of—
(a) (A) 15 percent of so much of the taxable income as does not exceed $50,000,
(b) (B) 25 percent of so much of the taxable income as exceeds $50,000 but does not exceed $75,000,
(c) (C) 34 percent of so much of the taxable income as exceeds $75,000 but does not exceed $10,000,000, and
(d) (D) 35 percent of so much of the taxable income as exceeds $10,000,000.
[Bubble Rates:] In the case of a corporation which has taxable income in excess of $100,000 for any taxable year, the amount of tax determined under the preceding sentence for such taxable year shall be increased by the lesser of (i) 5 percent of such excess, or (ii) $11,750.
In the case of a corporation which has taxable income in excess of $15,000,000, the amount of the tax determined under the foregoing provisions of this paragraph shall be increased by an additional amount equal to the lesser of (i) 3 percent of such excess, or (ii) $100,000.
(2) (2) Certain personal service corporations not eligible for graduated rates.–Notwithstanding paragraph (1), the amount of the tax imposed by subsection (a) on the taxable income of a qualified personal service corporation (as defined in section 448(d)(2)) shall be equal to 35 percent of the taxable income.
(1) Corporations are an easy target of taxation b/c it is unclear who bears the tax burden (consumers, shareholders, employees). Only people can pay taxes. This is a nontransparent method of taxation.
(2) Reasons for Integration of Tax (Elimination of the Double-Tax):
(a) The incentive to retain earnings was eliminated by § 1(h)(11) b/c dividends are now taxed at the capital gains rate. Note: When corp. retains earnings, the shareholder decides when to realize gain.
(b) *Bias for debt financing as opposed to equity. Interest is deductible under § 163(a) and dividends are not deductible. The increased value of the debt is capped, but it may be convertible.
(3) Ways to Integrate to attain one level of tax: (not tested)
(a) Attribute everything to the shareholders.
(b) Deduction for dividends paid – Incentive to distribute earnings.
(c) Dividend exemption
(d) Shareholders receive a tax credit for tax paid by corporation.
(e) 2003: GWB’s Dividend Exclusion Proposal
1. Proposed to exclude dividends altogether at the shareholder level, if they had been taxed once at the corporate level.
2. The proposal was not passed due to complexity and revenue effect. § 1(h)(11) was enacted to reduce the tax rate on dividends.
b. S Corporation
i. Limited liability.
ii. Treated as a corporation for tax purposes. The C Corporation rules apply but are are overridden in Subchapter S.
iii. Subchapter S provides a pass-through taxation regime, so that it is not treated as a separate taxpayer (treated as a partnership or LLC).
i. Limited Liability
ii. Subchapter K treats LLCs as a pass-through entity, not treated as a separate entity (unless publicly traded – § 7704). Income is included in partners’ returns.
B. Corporate Classification
1. An entity may have to organize as a C-Corp, to obtain outside or venture capital financing, to obtain certain loans.
2. § 7704: Anything that is publicly-traded (even LLCs) is taxed as a C-Corporation. Subjection (c) provides an exception for partnerships with passive-type income.
3. Reg. § 301.7701-1(a): Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
4. Reg. § 301.7701-2(a). Definitions.
i. Business entity: any entity recognized for federal tax purposes (including a disregarded entity) that is not properly classified as a trust.
ii. Business entity w/ two or more members: classified for tax purposes as either a corporation or a partnership
iii. Business entity with one owner: Classified as a corporation or disregarded.
(1) There can be no one-member partnership or LLC for tax purposes
iv. (b): The term corporation means (1) a business entity formed under state law as a “corporation” or (2) an association (determined under § 301.7701-3).
5. Reg. § 301.7701-3: Classifications.
a. (a) An eligible entity with two or more members can elect to be taxed as an association or a partnership. (b) If they do not make an election, they will be taxed as a partnership. Default = Partnership
b. (a) An eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. (b) The default classification is to be disregarded, and income will be reported on schedule C of the owner’s tax return.
6. Hypo: 2 people form an LLC (or LLP or general partnership) for state law purposes. § 7701-2(a) provides that it will be taxed as a corporation or a partnership. If they do not elect to be taxed as an association, it will be taxed as a partnership.
a. Accountants can form LLCs but not corporations. They can form an LLC, make the S Corporation election, and elect to be taxed as a corporation. Corporations also get a deal on employment taxes. An LLC protects shareholders from creditors – creditor only has an economic right (not managerial right) in interest in LLC given to them in bankruptcy of shareholder.
7. For federal tax purposes, the tax liabilities of an LLC, formed by a single owner, are the liabilities of the owner b/c the entity is disregarded if he does not make the election to be taxed as a corporation. (The govt put federal tax liens on owner’s land for failure to pay employment tax.)
a. Under the statute, the party liable for employment taxes is the “employer,” (any entity who employs). Under § 7701(a)(1): a person is anything whose rights and duties are separate for tax purposes.
i. Hellwig: The employer, the LLC, should be liable for employment tax, not the individual owner. The regulations ignore the statute and pretend like the employer does not exist.
ii. The courts have found for the govt, but the IRS amended the employment tax regulations going forward.
b. What could have been done? The owner could check box for a corporation so that it is treated as a separate entity and the liability is the LLC’s liability. Then, elect an S Corp to get the flow-through tax treatment. (but an S Corp. may not be preferred).
c. Note: If it was a partnership, with another person, his personal property would not be attached to a tax lien.
8. Two LLCs: One elects to be taxed as a corp. One is taxed as a partnership.
a. 7701(a)(2) Partnership (def.): Expansive, anything other than a trust or corp.
b. 7701(a)(3) Corporation (def.): Includes associations, joint-stock companies, and insurance companies.
c. Statute purports to have 2 different entities, but the
Union. Clearly, UPS wouldn’t have entered into the contract with National Union if not for the fact that most of the premiums went to its sister off-shore corp.
a. SH à UPS à (premium to) Nat’l Union à (premium to) OPL à (reinsurance to) Nat’l Union
3. Tax court: Transaction has no economic substance. (11th Cir. reversed)
4. Held, UPS’s restructuring had sufficient real economic effects and a business purpose. National Union is in the insurance business and it is common place for an insurance company to reinsure itself.
a. Note: If UPS had set itself up as an offshore ins. co. to begin with, it would not have been subject to US taxation. Bermuda corp. probably has little or no corporate tax. Perhaps the court was influenced by the fact that other corp. are doing this.
5. Dissent: No risk of loss to National Union.
6. Note: The taxpayer could argue that because these doctrines are not codified, that they are not the law. However, the reason they are not codified is because they should remain flexible to enforce the spirit of the law and established tax principles.
IV. Ch. 2: Formation of a Corporation
A. Introduction to § 351 (p.58)
1. What would the tax treatment be without § 351?
a. Under § 1001(a): A/R – A/B
b. A/B = after tax investment or cost basis
c. A/R = FMV of property received
d. If not a capital asset under § 1221(a)(1) (i.e. inventory), then treated as ordinary income.
e. Holding period would be new because this is a taxable exchange.
2. Why would the taxpayer want to be outside of § 351? Get a higher basis for depreciation deductions.
3. Loss would be realized under § 1001(a), recognized under § 1001(c) (“Except as otherwise provided, all realized gains and losses shall be recognized.”), and § 351 is an exception to recognition of gain or loss.
4. § 351(a). [At the shareholder level,] “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person(s) are in control (as defined in § 368(c)) of the corporation.”
5. Reasons for § 351
a. The transfer of (appreciated/depreciated) property to a corporation controlled by the transferor is viewed as a mere change in the form of a shareholder’s investment.
i. Rationale breaks down in the case of a minority shareholder. It looks like a new investment, an interest in a variety of other assets.
b. Eliminate tax obstacle to raising capital in the formation of a corporation.
6. Requirements of § 351(a)
a. One or more persons (including individuals or entities) transfer property to corp. (transferor group)
b. solely in exchange for stock
c. Transferor group must be in control immediately after the exchange
i. control (§ 368(c)): 80% of voting power and 80% of the number of shares of nonvoting stock
ii. Rev. Ruling 59-259: Transferor group must own at least 80% of each class of nonvoting stock.
iii. 80% req. is easy to satisfy by transferor group for new corp. b/c the transfers occur as one transaction. However, some may contribute services instead of property to new corp. It is more difficult to satisfy by older corp.
7. Shareholder Basis & Holding Period
a. § 358(a)(1): the basis of stock (“nonrecognition property”) received in a § 351 exchange shall be the same as the basis of the property transferred by the shareholder to the corporation.
b. § 1223(1): Where a transferor receives property with an exchanged basis (i.e. stock in a § 351 exchange), the holding period of that property is determined by including the period during which he held the transferred property if the transferred property is a capital asset or § 1231 property.