Corporate Taxation I
Section 1. What Is A “Corporation” Under The Income Tax?
1. Anne and Bill plan to form a limited liability company to engage in the business of developing and marketing computer software. They have identified between 35 and 50 potential investors who will contribute varying amounts of cash for membership interests totaling approximately 75% – 85% of profits and losses (after Anne and Bill receive handsome salaries). Under the governing state law, the LLC may be member-managed or manager-managed, membership interests may be freely transferable or nontransferable, and the LLC may or may not be dissolved by the death, bankruptcy, retirement, or expulsion of a member, all as provided in the LLC agreement. Anne and Bill want the LLC to be managed by themselves, with the investors having only the minimal rights of members required by state law. Only Anne and Bill will have authority to act on behalf of the LLC. Because of the limited powers that the investor-members will be granted, Anne and Bill think it best that the investors be permitted to sell or assign their membership interests if they so desire, although Anne and Bill think that the actual opportunities for resale will be limited by market forces. Of course, Anne and Bill want the business of the LLC to be uninterrupted by the death, bankruptcy, etc. of an investor-member. Will the LLC be taxed as a corporation if organized in the manner contemplated by Anne and Bill?
What is an LLC for federal tax purposes?
· § 7701(a)(3) – The term “corporation” includes associations, joint-stock companies, and insurance companies.”
· § 7701(a)(2) – The term “partnership” includes a syndicate, group pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.
Since an LLC is not defined in the Code, we must turn to the Regulations to determine whether it is a separate entity, and if so, whether it is a business entity classified as a corporation or partnership.
The first step under the entity classification regulations is to determine whether a separate entity has actually been created for federal tax purposes.
Whether an entity is recognized under local law as a separate entity for federal tax purposes is a question of federal tax law.
· Reg. § 301.7701-1(a)(1) – 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.
· Reg. § 301.7701-1(a)(2) – A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. . . . Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. . . .
· Reg. § 301.7701-1(a)(3) – An entity formed under local law is not always recognized as a separate entity for federal tax purposes.
Once it is established that the organization is a separate entity for tax purposes, the entity must further be classified as a corporation, partnership, or trust – the entities recognized as separate entities for federal tax purposes.
· Reg. § 301.7701-1(b) – Classification of organizations – The classification of organizations that are recognized as separate entities is determined under §§ 301.7701-2, 301.7701-3, and 301.7701-4 unless a provision of the Internal Revenue Code . . . provides for special treatment of that organization.
· Reg. § 301.7701-2(a) Business entities – For purposes of this section and § 301.7701-3, a business entity is any entity recognized for federal tax purposes . . . that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership. . . .
Because a separate entity is a business entity only if it is not properly classified as a trust or otherwise subject to special treatment, it is necessary to establish that the organization is not properly classified as a trust under § 301.7701-4.
· Reg. § 301.7701-4(a) Ordinary Trusts – ” . . . Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.”
· Reg. § 301.7701-4(b) Business trusts – “There are other arrangements which are known as trusts because the legal title to property is condveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Internal Revenue Code because they are not simply arrangement to protect or conserve the property for the beneficiaries. . . . The fact that any organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of person designated as beneficiaries, will not change the real character of the organization if the organization is more properly classified as a business entity under § 301.7701-2”
Having determined that a separate entity is a business entity because it is not properly classified as a trust or otherwise subject to special treatment, it is necessary to determine whether the entity is either a corporation or a partnership.
· Reg. § 301.7701-2(b) Corporations – For federal tax purposes, the term corporation means –
(1) A business entity organized under a Federal or State statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic;
(2) An association (as determined under § 301.7701-3);
(3) A business entity organized under a State statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association;
(4) An insurance company
(5) A State-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, 12 U.S.C. 1811 et seq., or a similar federal statute;
(6) A business entity wholly owned by a State or any political subdivision thereof, or a business entity wholly owned by a foreign government or any other entity described in § 1.892-2T;
(7) A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than section 7701(a)(3); and
(8) Certain foreign entities. – (i) In general – Except as provided in paragraphs (b)(8)(ii) and (d) of this section, the following business entities formed in the following jurisdictions: [See Reg.] · Reg. § 301.7701-2(c) Other business entities – For federal tax purposes –
(1) The term partnership means a business entity that is not a corporation under paragraph (b) of this section and that has at least two members.
Since an LLC is not classified as a corporation under § 301.7701-2(b)(1), (2), (3), (4), (5), (6), (7), or (8), it will be classified as a partnership if there are at least two members. However, the next issue is whether the LLC is an “eligible entity” that may elect to be classified as a corporation.
· Reg. § 301.7701-3(a) – “A business entity that is not classified as a corporation under § 301.7701-2(b)(1), (2), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under § 301.7701-2(b)(2)) or a partnership, and 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. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible e
disavowed. We think the fifth National Carbide factor – so much more abstract than the others – was no more and no less than a generalized statement of the concern, expressed earlier in our discussion, that the separate-entity doctrine of Moline not be subverted.”
· “As noted earlier, it is uncontested that the law attributes tax consequences of property held by a genuine agent to the principal; and we agree that it is reasonable for the Commissioner to demand unequivocal evidence of genuineness in the corporation shareholder context, in order to prevent evasion of Moline. We see no basis, however, for holding that the unequivocal evidence can only consisted of the rigid requirements (arm’s-length dealing plus agency fee) that the Commissioner suggests. ”
· It seems to us that the genuineness of the agency relationship is adequately assured, and tax avoiding manipulation adequately avoided when, the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent and not principal with respect to the asset for all purposes, and the corporation is held out as the agent and not principal in all dealings with third parties relating to the asset.”
1. Written agreement
2. Acts as agent
3. Held out as agent and not principal in dealings with third parties
· In contrast to Strong, where the taxpayer was arguing that the corporation should be completely ignored for federal tax purposes, the taxpayers in Bollinger were not arguing that the corporation should be disregarded because it was a “purely passive dummy,” but only that the corporation should be treated as their agent.
· Recognition of the corporate entity because the corporation conducts sufficient business activity does not preclude a Bollinger type argument that the corporation nevertheless was acting merely as the agent of its shareholders.
· Subsequent decisions have established that no written agreement is fatal to arguing that a corporation was acting only as an agent, but it is not necessarily fatal if the corporation does not hold itself out as agent in dealings with third parties because the corporation may be held liable vis-à-vis third parties under general principals of agency law.
· The continued validity and applicability of National Carbide is not clear. After Bollinger, some courts treated it as the exclusive test for determining whether a corporation was acting as a true agent. However, it appears that more courts have adopted the view that Bollinger established a safe-harbor, and that in the absence of compliance with its three requirements, National Carbide still applies to the question whether a true agency relationship exists.
A. Basic Principles
1. Amy and Ben plan to organize X Corporation to engage in the construction business. Amy will contribute a truck with a basis of $50,000 and a fair market value of $150,000 and a power shovel with a basis of $125,000 and a fair market value of $