Corporate Taxation

Fall Semester 2012

Professor William P. Streng

Relevance of this Corporate Taxation Course

Federal income tax planning concerns:

1.  Choice of business enterprise form

2.  Capital structure of the enterprise, e.g., debt or equity (or both)

3.  Dividend/profits distribution policy

4.  Compensation policy

5.  Disposition of corporate interests

6.  Estate planning/wealth transfers

BUSINESS ENTITY CHOICES

Corporation - “C” or “S” status

Partnership  - general or limited

Limited Liability Company (LLC)

Trust or Estate (available?)

Sole Proprietorship

Disregarded Entity  (DRE)

RICs & REITS & other flow-throughs

Fundamental Corporate Tax Technical Issues

1.  Contributions to the corporation - gain recognition to either party?

2.             Arrangements between owners & the entity –

                e.g.,  "assignment of income” permitted?

3.  Distributions of appreciated property.

4.  Corporate liquidations, including sales in conjunction with a corporate liquidation.

5. Corporate reorganizations - possible postponement of gain recognition.

“Cradle to Grave” Approach
in this Course

1.         What is a “corporation”?

2.         Organization - §351    Note:  Code §61.

3.         Tax on corporate level income?

            Entity level tax or flow-through treatment?

4.         Capital structure - Debt vs. equity

            Is an interest expense deduction available?

            Tax-free repatriation of debt available?

5.         Dividends – income tax treatment?   continued

“Cradle to Grave”,   cont.

6.         Significant interim distributions:

            - Redemptions & partial liquidations

            - Stock dividends

            - § 306 stock (indirect dividend?)

7.         Terminating the stock ownership interest

8.         Taxable complete or partial liquidation

9.         Corporate tax-free reorganizations

Corporation/Shareholder Tax Policy Issues           p.5

1)  Double taxation, i.e., at the corporate and  the shareholder level; but, 2003 Act.

How moderate:

-  Interest expense for debt financing

-  Other deductions, e.g. payment to insiders

-  Retain earnings inside corporation (including as internal funding source).

Incidence of Corporate Tax
p.5

Who bears the burden of the corporate tax?

1) The corporation?

2) Shareholders/owners?

3) Employees?

4) Corporate managers?

5) Consumers of the corporation’s output?

6) Other investors?  The community?

Corporation/Shareholder Tax Issues, cont.         p.5

2)            Tax rates on ordinary income -  p.7 corporation and shareholder;

                Dividends equalized after with other ordinary income after 2003 Act?

      What happens in 2013? & Medicare tax?

3)  Preferential capital gains rates.  p.9

4)  Non-recognition possible upon asset & ownership shifts. Formation & reorgs. p.9

Concepts of  “Tax Common Law”                              p.10

Non-codified federal income tax rules (particularly relevant in the corporate income tax context):

1)  The “sham transaction” rule.

2)   Economic substance doctrine (p.12)

3)  “Substance over form” analysis (p.12).

4)            The “business purpose” doctrine (p.13).

5)   The “step transaction” doctrine (p.13).

Income Taxation of the Corporation                  p.14

1) Code §11- graduated tax rate structure.

- Code §11(b)(2) - no lower initial brackets for personal service companies.

2) Determination of the corporation’s taxable income –

   no “above the line” vs. “below the line”;  why?

   - dividends received deduction is available.

   - deduction for domestic production - §199.  p.16

3) Accounting period – is the calendar year required?

4) Accrual method of accounting?  §448(a).  p.18; exception for a qualified PSC.

Income Taxation of the Corporation, cont.        p.18

5) Code §267 – limitations on transactions between corp. & owners, i.e., potential “gaps.”

6) Corporate Alternative Minimum (ALTMIN) Tax – p.19    Flat rate tax on broader tax base.

Repealed for small corporations.

7)  Multiple corporations - §1561 limit on controlled group multiple tax benefits – p.22.

Consolidated tax returns for an affiliated group of corporations - §§1501-1504.

8)  The “S” corporation alternative – p.23 (next slide).

S Corporation comparison p.22

S Corp. vs. Partnership vs. LLC

1)  Basis increase for partnership debt;  not S Corp debt re S Corp shareholders.

2)  More income allocation flexibility re partnerships.

3)  Employment tax planning – pay no compensation to S corporation shareholder/employee

Problem - page 26
C Corporation Scenario

(a)      Determining corporate level gross income:

            Inventory sales                       2,600,000

            Capital gains                    200,000

                                                                2,800,000

Exclusion under §103 for $10,000 muni-bond interest received

                                                                   continued

Problem - page 26
Deductions Against GI

Operating expenses                                800,000

Depreciation (ACRS)                                800,000

Capital loss (220, but limit to gain)  200,000

            Total deductions                   1,800,000

Equals:    Taxable income               1,000,000

                                             continued

Problem - page 26
Determining Tax Liability

§ 11(b)(1) tax calculation on $1 million taxable income (2.8 less 1.8):

15% of 50,000                                             7,500

25% of 25,000                                             6,250

34% of 925,000                                 314,500

Plus:  lesser of $45,000

   (5% of 900,000) or 11,750            11,750

          Total regular tax liability     340,000   

Problem (b) - page 27
Dividend distribution

Distribution of $660,000 after-tax profit

§61(a)(7) dividend income

20% (15%?) percent of $660,000 = $132,000

Total taxes: (340 + 132)                    $472,000

Amount for shareholders:                $528,000

Effective tax rate:                        47.2 percent

(is a 47.2% effective tax rate too much?)

Problem (c) - page 27
Deductible (?) payments

1)  $500,000 salaries paid - to eliminate all corporate level income.

     Reasonable compensation amount?

     Then net $300,000 to each shareholder.

2)  Other corporate level deductions available for this purpose?  Debt & rents?

                §79 - group term insurance

                §§105 & 106 - health benefits

Definition of “Corporation” Code §7701(a)(3)         p.27

Choices of business entities:  (see chart)

1. Regular corporation

2. S corporation

3. Foreign corporation

4. Limited liability company - LLC

5. Limited partnership, including “MLP”

6. General partnership

7. Sole proprietorship (& the “tax nothing”)

Prior Entity Classification Criteria -Tax Regs.       P.27

1) associates

2) business objective

3) continuity of life

4) centralization of management

5) limited liability for debts of entity

6) free transferability of interests - but buy-sell agreement not limiting transferability.

Regs. had bias towards partnership status (if not more than 2 of last 4 characteristics).

“Check the Box” Regulations                 p.29

Premise:  Regulations make the choice of entity optional to the taxpayer.

1)  But, automatic classification of certain entities as corporations - per se treatment; including domestic & specifically enumerated foreign corporations.

2)  Default partnership status - an "eligible entity" may elect to the contrary (not in the foreign context, where one party must have unlimited liability;  or both must consent).

Additional Entity Classification Issues    p.32

1)  The “tax nothing” or disregarded entity

                See Rev. Proc. 2002-69 re community property shareholder status (either a DE or PTN).

2)  What tax effect of a change in the number of members of an entity? Change in status?

3)  What income tax effect of elective changes in tax classification of the entity?

                a)  From partnership (or DE) to corporation?

                b)  From corporation to partnership?

The “Publicly Traded Partnership”                 p.32

Corporate treatment of a “publicly traded partnership”?  IRC § 7704.  Trading “units.” 

What is “publicly traded”?

Purpose of the exception from corporate status where 90% of more of the entity’s income is “passive”, including income from natural resource activities?

See §7704(d)(1)(E).

Corporations vs. Partnerships vs. Trusts

P. 33.  See Reg. § 301.7701-4  - purpose of a trust is to “protect or conserve” property, but not to conduct a business.  If doing so, partnership or corporate status for the entity.

Types of trusts:

 -  personal wealth management

 -  oil royalty trusts

 -  equipment leasing/airplane trusts

Trust Income Taxation 
p.33        Subchapter J

1)  Grantor trusts:  IRC Subchapter J, Subpart E, § 671 et. seq., grantor treated as the “owner”

   -   income taxation to the grantor

2)  Nongrantor trusts:  Subparts A-D

taxation of (a) trust (if no distribution); or

(b) beneficiaries to the extent of actual distributions (or required distributions), applying the DNI concept, but not to undistributed income.

Recognition of the Corporate Entity           p.34

I.e., is the corporation to be treated as an entity separate from its shareholders?

Bollinger:  corporation holding title to real property as an “agent” for the shareholders of the corporation and not as “owner” (for tax purposes).

Held:  Agency status was permitted &, therefore, losses were directly allowable to the individual investors (although also being shareholders of the corporation which was the agent).

National Carbide Factors
p. 37

1) Corporation operates in the name and for the account of the principal;

2) Corporation binds the principal;

3) Transmits money to the principal;

4) Income is attributable to services of the employees of the principal?

                                      continued

National Carbide, cont.

5) Relations with the principal must not be dependent upon the fact that it is owned by the principal;

(see Bollinger case discussion) and,

6)  Business purpose must be the carrying on of the normal duties of an agent.

Corporation/Shareholder Tax System Integration

U.S. has a classical tax system, i.e., taxation both on (1) the corporation and (2) the shareholder.

Who pays the corporate tax:                 

     the corporation or the shareholders?

How eliminate double taxation (if desired)?

The full integration option:  complete flow-through, e.g., the ALI proposal of:

(1) Income imputation and (2) tax withholding (for U.S. Treasury cash flow acceleration).

Partial corporate shareholder integration

1.  Shareholder credit for tax previously paid on the dividend amount - subject to an income  “gross-up” requirement.

2.  Deduction available to the distributing corporation for the dividend paid.

3.  Shareholder gross income exclusion for all or part of corporate dividend.

      2003 Act -  reduce individual dividend tax to 15%  (extended through 2012 & then?)

                Foreign corps? § 1(h)(11)(C)(i)(II) – re treaty

Special concerns about  integration proposals   p.44

1.  Extension of corporate tax preferences to shareholders (& limited corporate level tax).

2.  Treatment of tax-exempt shareholders (e.g., §401 deferred compensation plans).

3.  Treatment of foreign shareholders (only through tax treaty?) -  30% under 2003 Act.

4.  Treatment of foreign taxes paid by the U.S. corporation. Not creditable?

Distortions Tilting Towards Non-Corporate Status       p.49

1) Higher effective income tax rate on corporate taxable income.

2) Incentive to finance with debt (since deductible interest reduces net income tax amount).

3) Incentive to retain earnings, not pay dividends (and spend earnings for stock buy-backs).

4)  Incentives for corporate tax shelter investments.

Obama Legislative Proposals – 2009   Abandoned in 2010/1

Eliminate check-the-box – at least as to foreign corporations. 

What is the tax policy concern?  Possibility of reducing foreign country income tax liability while enabling U.S. income tax deferral of the E&P retained in foreign subsidiary (i.e., CFC).

Is legislation necessary?  Check-the-box was adopted by regulation (not Code provision).

Simpson-Bowles Fiscal Responsibility Commission

Proposing reduction of corporate tax rate.

Eliminate special business subsidies, i.e. fast depreciation deductions.

How deal with multinationals?   Use a territorial system?

Obama Legislative Proposals – 2012

White House & U.S. Treasury:  “Framework for Business Tax Reform”

         (included in supplemental materials)