Select Page

Business Planning
Wayne State University Law School
Schenk, Alan

TAX

Introduction

Special Rules that Apply to Corporations

Purpose of a corporation – To make a profit

The corporation must then pay a tax on the profit and can do one of two things:

i. Pay it out to the owners (S/H) where it will be taxed again, or
ii. Retain the profits. But it cannot be retained beyond the reasonable needs of the business or else it will be subject to AET which is higher than the regular corporate tax.

Corporate Tax

A corporation is taxed as an individual that chooses its Fiscal year and accounting method
A corporations tax rates reach higher than the individuals tax rates
The capital gains rate is higher
A study shows that 2 out of every 3 corps were not paying a corporate tax

i. Shows that small businesses are striving to avoid this tax.
1. a major way is to push out the profits of the company to the owners in pre tax ways like wages

Undistributed Corporate Income

Many small businesses owners can profit by leaving the profits in to be taxed at a lower corporate rate and have their stock be increased for only capital gains

i. Then it would be helpful to hold the stock until pass at death thus giving the donee a stepped up basis and no gain recognized.

The Service has ways around the above happening

i. Section 482 – allows the Service to shift around income among commonly controlled businesses to get a more accurate income
ii. Section 531 – AET applied on a corporation formed or availed of for the purpose of avoiding the income tax by accumulating profits instead of distributing – covered more in depth below
iii. Section 541 – Can tax the undisbursed amounts in a personal holding company

Distributed Corporate Income

Subject to double taxation.

i. First by the corporation
ii. Then as a dividend to the S/H receiving property

Ways around double taxation

i. Election of S Corporation status – covered below
ii. Payment of salaries to the owners for services provided
iii. Interest paid to S/H for loans to the corporation
iv. Rent on property leased by the S/H to the corporation
v. Royalties on patents owned by S/H and used by Corporation
1. With all of the above, the payments must be justified as bona fide arrangements rather than as disguised dividends

Sales and Exchanges of Corporate Stock and Securities

The sale of corporate securities for cash or notes will result in most likely a capital gain or loss for the person

i. Same if the exchange was for other property

There are some exchanges where there isn’t a recognition and the TP keeps his original basis

i. Section 351 – transfer of business assets to a newly formed corporation in exchange for 80% control of the corporations stock
ii. Section 354 – exchange of one corporations stock for another and the first corporation is merged into the second

Sole S/H exchange of stock to the corporation is considered a dividend.

The Corporation as an entity

Generally it is its own entity but the courts can look past the corporation

i. It is its own tax paying entity

Two groups of statutory exception to the idea of the corporation as its own entity

i. Rules limiting normal tax benefits when the parties to a transaction are related in a certain way
ii. Rules limiting certain tax benefits to a corporation in transactions with its S/Hs

Courts will sometimes ignore a corporation as an entity if it is a sham, dummy, or straw corporation

i. Avoided if there is a business activity or carrying on of a business

To determine if an entity will not be acknowledged, the law is to look at substance of transactions over form

Various Forms of Doing Business

Proprietorship

The business and the owner are one
The individual is taxed through the business

i. the only income splitting would come from paying your family to work there

Taking out and putting money back in to the company doesn’t matter
Gain or loss on the sale of the business comes down to everything that is sold individually
There is no continuality of a proprietorship.

Partnership

All pass through taxation
Some income splitting if a member of your family is actually part of the business. Can only split the income based on the person’s share in it
Allowed to retain profits
Sale of the business is capital gain or loss of your partnership interest except:

i. Substantially increased inventory is ordinary income
ii. Unrealized receivables is ordinary income
iii. Recapture of depreciation is ordinary income

Corporation

Many income splitting opportunities

i. Can give stock to family member and they are taxed on it
ii. Can sell it yourself
iii. Can do things like rent or loan to the company to get income with the corporation getting a tax deduction

Taxation of profits

i. Only taxed at corporate level once if reasonable amount for business is retained
ii. Taxed twice when a dividend is paid out

Sale of stock is a capital gain or loss

i. Unless you get ordinary loss from a 1244 stock

Business has continuality

i. Sale of stock doesn’t stop the corporation
ii. Death causes stock to be passed on with stepped up basis

S Corporation

Corporation with flow through taxation – covered in depth later

When deciding on a business type re

f he got 10K in money, and then the property with a FMV of 10K and a 4K mortgage on it, he would recognize a dividend of 16K

It makes a difference if it is an individual or a corporation receiving the distribution

i. An individual is taxed on the property at the 15% dividend rate
ii. A corporation looks at Section 243 to determine how much of the distribution it is taxed on
1. It depends on how much of the corporation the corporation S/H owns
a. If it owns 80% or more, then it gets a 100% tax deduction from the dividend received
b. If it owns 20% or more, then it gets an 80% tax deduction
iii. So while the individual is taxed at a lower rate, the corporation would be taxed less b/c of the 243 deduction
1. so individual wants the corporation to retain the earnings so it capitalizes, and the corporation wants the payout

Section 316 – Dividends

Section 301(c) says that the individual is receiving a dividend which then puts us to section 316

i. A dividend is to come from a companies earnings and profits
1. there is two sources of earnings and profits
a. Current – the profits from this fiscal year
b. Accumulated – Profits still in the business from prior years
ii. When making a dividend distribution, it first comes out of the current E&P, and when that is used up, it comes from the Accumulated E&P.
1. if there aren’t any E&P, then there cannot be a dividend and the distribution will just be recognized as a return on your basis of stock held and it will be a capital gain

Debt v. Equity

Major Tax effects in holding Debt or Equity

The difference in holding debt to equity does not make much of a difference in a closely held corporation

i. A person holding debt that is an owner will likely not force the company into bankruptcy to get its interest
ii. Therefore, the main decision of debt v. equity will be tax considerations

Setting up the Corporation with Debt or Equity

i. Having debt does not make a difference to a S/H that is an individual or corporation
1. they will both be taxed the same on gain of interest
2. the recovery of their basis in the debt is tax free
ii. Holding equity will make a difference to the S/H that is an individual or corporation