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Corporate and Partnership Tax
Wayne State University Law School
Beale, Linda

 
CORPORATE TAX BEALE WINTER 2015
 
 
1. General Corporate Tax Concepts
 
Overview of Capital Structure
·         Hierarchy on who gets paid
o    Senior secured debt
o    Senior unsecured debt
o    Junior unsecured debt
o    Preferred shares
o    Common shares
·         Payment on debt (interest) is deductible
·         Payment on equity (dividends) is not deductible
·         Equity –> return of investment is contingent in amount and in timing (subject to risk of enterprise)
·         Debt –> fixed in amount and timing; much more certainty
 
Debt or Equity? (1)
·         Section C requires the issuer and holder to treat debt/equity the same
·         Analysis for determination:
1.       Look at terms of instrument
·         Is it labeled as debt in the K (note, obligation, etc) — is in the “form” of debt?
·         Principal / interest; there are fixed terms for payment
·         Amount of interest (if its too high it looks like equity)
·         Term to maturity
·         Collateral
·         Is there promised convertibility to shares? 
Disallowance if yes; uncertain convertibility may be okay
·         All these items can exist and it can still be equity for federal income tax purposes, if in substance, the instrument is acting like equity
2.       Look at the issuer
·         Adequate cash flows to service the debt
·         How leveraged are they (are they thinly capitalized, meaning have heavy debt capitalization?)
                                                         i.            Credit rating by agencies
3.       Hindsight factors
·         Did the corp pay on the debt based on the terms
·         Was is a loan to a shareholder
4.       Key to this analysis
·         If in substance a financial instrument should be treated as equity even tho it is labeled as debt, everything connected to that instrument will be treated as if it is connected to equity for tax purposes
                                                         i.            For example, recipient of interest, will have to treat that interest payment as a distribution on corporate stock (dividend or return of capital)
                                                       ii.            This is a re-characterization for tax purposes (even tho legal form stays the same)
 
A Way to Avoid Paying Tax on Corp Profits
·         Pay out in compensation, but 162(m)
·         Pay out to shareholders in distribution, but dividends are not deductible to the corporation
·         Claim you are paying interest to shareholders on money that they loaned you, this is deductible
o    But be careful about how it looks with respect to debt/equity analysis above
·         i.e. proportion of interest to loan
o    Tax evasion schemes to make equity look like debt
o    Lots of provisions in the IRC that force certain instruments to be equity
·         IRC will disallow the full or a portion of the interest rate deduction
 
Statutory Disallowance Rules Impacting Deductibility of Interest on Corporate Debt (2)
·         163(e)(5) – no deduction for interest exceeding applicable fed rate +6%
Typical OID
Buy bond with face amount of $100 for $80 ($20 OID paid at maturity)
Income and deduction are taken into account over time – not when paid
AHYDO
A portion of the OID is disqual and the rest of the deduction is deferred until it is paid
OID so high, it is recharacterized and is not considered payment on debt
·         163(l) – no deduction for debt payable in issuer’s stock
·         163(j) – applies to thinly capitalized companies (too high debt to equity ratio)
Disqualified excessive interest expense [paid to related party (sub)] ·         265(a)(2) – disallows interest on debt used to purchase bonds on which the income is exempt
·         267(a)(2) – defers interest expense to “when paid” when recipient is related party that does not have to recognize the income until “when paid”
·         482
·         279 – limits interest deduction on debt incurred to acquire a corp
 
General Judicial Doctrines
·         Step Transaction Doctrine: (based on case law)
·         Multiple transactions to get to one end are treated for tax as one integrated transaction — separate steps are not honored for tax purposes
o    Binding Commitment Doctrine –> when I entered into step 1, I had a binding commitment to take step 2 in order to get the end (sometimes binding commitment is just oral agreement or expression of intent — this might be hard to prove to IRS)
o    End Result Doctrine –> Courts just look to the end result and step together all of the transactions that it took to get there
o    Intermediate Dependency Doctrine –> steps need to be tied together such that you wouldn't have done one without doing the other
 
·         Business Purpose Doctrine: (based on case law)
o    Transaction can't have the sole purpose of tax savings
o    Transaction must be “germane to the ordinary course of business”
 
·         Sham Transaction Doctrine:
o    Transaction must have economic substance
 
2.  Earnings and Profits (E&P) – a measure of the corporation’s ability to pay weather to s/h
 
Code Sections:
·         316 – defines dividend as distribution of property by corp to shareholders out of E&P
·         311 – Corp will not be taxed on a distribution of its stock or property, unless it distributes appreciated property (then gain is recognized)
·         312 – With respect to distribution of property, corp will decrease E&P by the sum of money and the AB of other property.
o   If corp distributes appreciated property, it will increase E&P by the gain and decrease E&P by the FMV of the property
·        

f corp distributes gain property to shareholders, it must:
o   Recognize gain as if it had sold the property [311(b)] o   Decrease E&P by tax paid on gain
o   Increase E&P by amount of gain [312(b)] o   Decrease E&P by FMV of property [312(b)] ·         If corp distributes loss property to shareholders, it must:
o   Not recognize the loss [311] o   Decrease E&P by basis of property [312(a)] ·         Shareholder gets FMV as basis in property distributed
 
What if a corporation distributes a bond to a shareholder?
·         Even if bond is appreciated in value, no 311(b) gain
·         Bond with a face of 10 but FMV of 8 (issue price) (OID bond à issue price is less than face and OID is the difference, under 163 the bond holder is supposed to take that OID income over time)
o   Distro to sh is FMV under 301b
o   How much is EP reduced by?  FMV or face?
Look at 312(a)(2) –> reduce the EP by the issue price (FMV)
 
 
Constructive dividend
·         Making deductible type payments  to shareholders that are, in substance, dividends
·         Corps do this to get deduction for expense that is really a dividend
·         For the shareholder it is treated as income either way, but shareholders prefer dividends b/c they get a net capital gain treatment
·         Constructive dividend example:
Sally owns ACO, son Max owns a warehouse that has a FMV of rent of 10K per year
Sally arranges for Sally and son to enter into a lease K where ACO pays 100K per year
10K can be treated as rent expense and can be deducted on the corp income tax return
90K is considered a distro to Sally from ACO, which Sally needs to recognize as income on her personal tax return
90k gift from Sally to Max
·         Revenue ruling 69-630:
Shareholder is controlling s/h of 2 corps; transaction at issue is a sale btwn the 2 corps
A has property with FMV of 1M and basis 0.3M
A sells property to B for 0.5M
Constructive distribution of 0.5 from A to shareholder
A makes 0.5M contribution to B (tax-free)
B makes constructive additional purchase price of 0.5M to A (which A will have to recognize as gain)
This is a recharacterization according to economic substance —> the tax consequence is not based on the actual transaction but on the recharacterization