Corporate Tax
1/17/06
A corporation is a separate taxpayer. It pays taxes on its earnings, and its shareholders also pay tax on dividends.
There is a four step process.
1. GI 61
2. TI – all deductions taken here (no personal deductions) – 63a
There is a 243 dividends received deduction – 70 to 100% of the dividends received from another corporation are deductible. This is central to tax planning. Corporate taxpayers prefer dividends to sales of exchanges of stock. Corporations have no capital gain preference.
3.
The 2004 jobs act put in 199 – congress tries to favor domestic production to export abroad. This violates the trade agreements we have with other countries. DISC, FISC, ETI – all struck down. 199 replaced the ETI. It gives a deduction for a certain amount of qualified production activities income. It starts at 3% and goes up to 9%. They wanted to favor domestic production without tying them to exports. It indirectly reduces the tax on domestic manufacturing. It can apply to corporations and individuals. Peroni hates this section because it is not transparent and has not created any domestic jobs.
If you want to reduce tax rates, you go to section 11 and do it directly.
Since 1913, individual tax rates have historically been higher than corporate rates. This encouraged people to use corporations to accumulate income (even though they were double taxed.) In 1986, the corporate rates were higher than the individual rates. Now, corporate rates are down to 35% and the top individual rate is also 35%. In 2010, the Bush tax cuts may phase out and then the corporate rate will again be lower.
Capital gains/losses – there is no gains preference for corporations. They are subject to a capital loss limit. They can only deduct capital losses up to capital gains. They get three years carryback to use first, then 5 years of carry forward.
In 2003, Bush proposed a corporate integration system. It was killed in the Senate. So, instead he gave dividends a preferential rate in 1h11. It applies from 2003-08.
1h11 means that the planning to avoid dividends is not as important. They are still relevant though. 1h11 does not mean that dividends are capital income. They are ordinary income.
AMT – it is a side by side system that cannot help you, only hurt you. You pay the greater tax. So, every corporation has to keep two sets of books. The AMT is a flat 20% rate. The base is much broader for then AMT. The 56g ACE adjustment brings the AMT tax base closer to your financials.
There is an AMT exemption for small corporations.
Consolidated returns – income, credits, etc. can be combined.
1/23/06
Partnerships and C corps cannot be shareholders in S corps. An S corp can own stock in a C corp, if it meets the definition of a qualified subsidiary.
An S corp is a less flexible pass-through entity than a partnership.
Entity level borrowings and the effect on the basis of the investor – inside vs. outside basis. Whenever you hold a business or investment activity through an entity, rather than directly, you will run into this concept. The entity has its own basis in properties. When an entity purchases property that is inside basis. Outside basis refers to the investors basis in their ownership entity. A shareholder’s basis in stock is an example. Once you own something through an entity, we have two bases to consider. Does a transaction effect inside basis, outside basis or both? In a C corp context we will also run into this issue. When a person transfers property to a C corp for stock, you have now created two bases in that asset. The C basis is determined by 362, and the shareholder basis by 358. If the C sells the property, they might have gain. If the shareholder sells stock, he might have gain. You also have to worry about pre-incorporation appreciation.
Comparatively, the effect of an enitity borrowing money on these bases – if a C borrows a trillion dollars, it does not affect the borrowers outside basis in stock. It only affects the inside basis. The borrowed funds produce only one basis. Given that we treat a C as a separate taxpayer, this makes sense. Moline Properties is a SC decision that is important in this area. If you have a valid C, it will be treated as a separate taxpayer, provided it is formed for a business purpose or conducts any business activity. This is a low standard test. This is taxpayer friendly. A C is a legal fiction. These legal fictions don’t pay taxes – people do! Who actually bears the tax? Shareholders, consumers, employees, suppliers, creditors, etc. do. Economists don’t like this, but politicians love it because people don’t know who pays the tax.
Something that also follows from Moline Properties is that losses over years stay at the corporate level. They cannot flow through to the shareholders. You need a pass-through entity to get these losses to the shareholder.
A Partnership is not a separate taxpayer. It cannot bear income tax. There are no exceptions. They file a return, but it is solely an information return. For tax purposes a P is a quasi-entity. It can engage in transactions, etc. but its profits flow through to the partners for tax purposes without regard to actual distribution. Losses also flow through. But 704d has a limit on the losses a partner can deduct. It is limited to the outside basis the partner has in the P. There is no free lunch.
With a P, when it borrows money, it can get an inside basis, sometimes under the Crane doctrine. Under 752, entity level borrowing can create inside and outside bases. This means that you can write off more losses earlier under 704d.
There have been proposals to get rid of all the different pass-through models and just have one. But Peroni thinks nothing will happen.
CHECK THE BOX
This started during the Clinton administration. The attribute of limited liability used to be the main factor separating corporations and partnerships. Even before check-the-box, it was an elective system if you were well advised by lawyers and accountants. The government wanted to get rid of these high transaction cost and to make it easy to elect tax treatment.
301.7701-1 to -4
Step one – is there an entity? Federal law overrides local law. Mere co-ownership of property is not an entity. You need to provide services as well to get entity treatment. A joint undertaking to share expenses is not an entity. A Sole Proprietor probably cannot elect to check the box for corporate tax treatment, but it is not clear. This is because an SP is not an entity. An unincorporated branch of a C is conducted as if it were a separate corporation. Can it check the box? It is not clear, but probably not. It is probably not an entity.
Step two – once you have an entity, you have to state if it is a trust or estate for tax purposes. Look to the r
nce they are not a state law corporation, can they still get S treatment? Probably. If they really want S, then why not just set this up as a C and then elect for sub S treatment. You might not want to set up a state law corp so that you can keep flexibility, but still be treated as a C or S corp. One of the troubles with S corps is there are lot of limits. You always have to worry about overstepping these limitations. But sub K is more complex than sub S.
2. The default rule is partnership.
3. Yes, there only choice is to be a corporation, but they can try to get pass-through treatment as a S corp.
4. The answers would not change because the company was an LLC. LLC are made for limited liability under state law and pass through tax treatment.
5. If in year 1, they chose to be taxed at a C, and in year 4 they want to change to pass through, then it is permitted. Do we start the 16 month period at year 1 for the intitial classification? It the initial classification considered a change? 301.7701-3c1iv – the initial classification choice is not a change of election. So they can change from C to P, and the IRS will treat it as a liquidation of the C and then the shareholders contribute the proceeds to the formation of a partnership. Under state law, nothing happens. This check the box elections separate the tax consequences from the other legal consequences of state law, except for corporations.
6. In year 7, now they want to change back to a C. Now they can’t change without IRS permission because it was within 60 months of the last change. The IRS may permit it if there has been more than a 50% change in ownership, but it is up to the IRS.
7. Does the change in the number of members change the entity classification? No. It will never change it from being a C or K. If the new partner wants to change, then he would have to get the agreement of Sam and Susan. But you have to look to state partnership law to see who has authority. There is nothing in the check the box rules that spells out the procedure for this. The regs only say that you either have to have all the members sign or an executive officer who has the power to sign. Even if you get an agreement to change, if you are in the 60 months, you cannot be certain the IRS will grant the change.
8. A SP is the most common way one person would operate a business. It is not an entity at all. But Aretha sets up an LLC, which is an entity. Does it make a difference that there is only one person for check the box rules? No, it is still an entity. There may have been some doubt early on, but the issue is resolved now. She can either choose C or disregarded entity.
9. If there is no affirmative election, then the default is disregarded entity.
