Corporate Taxation

Fall Semester 2011

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.4

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

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

                Equalized after 2003 Act? 2011/2013?

3)  Preferential capital gains rates.  p.8

4)  Non-recognition possible upon asset/ownership shifts.   p.9

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?

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)  “Substance over form” analysis.

3)             The “business purpose” doctrine.

4)   The “step transaction” doctrine.

Codified § 7701(o) – re:  economic substance

Income Taxation of the Corporation                  p.14

1) Code §11- graduated tax rate structure.

- Code §11(b)(1) - 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.17

3) Accounting period – is the calendar year required?

4) Accrual method of accounting?  §448(a).  p.19

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.20      repealed for small corporations.

7)  Multiple corporations - §1561 – p.23.

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

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

Problem - page 24
C Corporation Scenario

(a)        Determining corporate level gross income:

            Inventory sales                 2,500,000

            Dividends                                        100,000

            Capital gains                       200,000

                                                                2,800,000

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

Problem - page 24
Deductions Against GI

Operating expenses                          600,000

Depreciation                                      800,000

Passive leasing activity loss              130,000

   §469(a)(2)(B) &  §469(e)(2)

Capital loss (limit to gain)                200,000

Dividends received deduction            70,000          Total deductions                   1,800,000

continued

Problem - page 24
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 tax liability                          340,000

Problem (b) - page 25
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 25
Deductible (?) payments

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

     Reasonable compensation amount?

2)  Other corporate level deductions available for this purpose?

                §79 - group term insurance

                §§105 & 106 - health benefits

Corporate Tax Shelters
p.25

Concept of “tax sheltering” - claiming tax losses without economic losses, including questionable economic substance.

Possible use of “tax indifferent” parties.

Aggressive marketing, coupled with secrecy.

Tax law opinions which are “aggressive.”

Playing the “audit lottery.”  Appropriate?

Note the applicability of “Circular 230.”

Attempts to Limit Corporate Tax Shelters

1)  IRS litigation strategy.

2)  Disclosure of tax shelter investments, including registration of tax shelters.  Notice 2009-59 list.

3)  An increased “substantial understatement” penalty.

4)  Penalties for failure to disclose.

5)  Enhanced requirements on the conduct of professionals re opinions.  Treasury Circular 230.

UPS case                           p.27
Economic substance?

UPS organized offshore subsidiary (OPL) to provide reinsurance for excess value insurance on shipments.  Why National Union in the deal?

OPL shares distributed to UPS shareholders.

Issue re income for “excess value” net amount -  economically realized by OPL or UPS?

Real economic substance to this arrangement?

Held:  Not a “sham” transaction;  adequate business purpose;  but is §482 applicable?

Economic Substance &
Codification   §7701(o) (2010)

Economic substance doctrine satisfied only if:

1) A meaningful change (other than income tax) occurs in the taxpayer’s position, and

2) A substantial non-tax purpose exists for entering into the transaction

“Angel list” of transactions not invalidated by economic substance doctrine?

Strict liability penalty for tax underpayment where no economic substance to transaction.

Corporation/Shareholder Tax System Integration

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

Who pays the corporate tax:               

     the corporation or the shareholders?

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

(1) imputation and (2) 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 2011, then?)

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

Special concerns about  integration proposals   p.40

1.  Extension of corporate tax preferences to shareholders.

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.39

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

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

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

Definition of “Corporation” Code §7701(a)(3)         p.45

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.45

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.

“Check the Box” Regulations                 p.47

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

1)  But, automatic classification of certain entities as corporations - per se treatment; including 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.48

1)  The “tax nothing” or disregarded entity

                See Rev. Proc. 2002-69 – p. 48, community property shareholder status (either DE or PTN).

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

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

                a)  Partnership (or DE) to corporation?

                b)  Corporation to partnership?

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 deferral (for U.S. income tax) of E&P retained in foreign subsidiary (i.e., CFC).

Is legislation necessary?  Check-the-box adopted by regulation.

The “Publicly Traded Partnership”                 p.50

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

What is “publicly traded”?

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

See §7704(d)(1)(E).

Corporations vs. Partnerships vs. Trusts

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

Types of trusts:

 -  personal wealth management

 - oil royalty trusts

 - equipment leasing/airplane trusts

Trust Income Taxation 
p.51           Subchapter J

1)  Grantor trusts:  Subchapter J, Subpart E, § 671 et. seq., treated as “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.

Recognition of the Corporate Entity           p.52

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.

Held:  Agency status permitted &, therefore, losses were directly allowable to the individual investors as individuals - (also being shareholders of the corporate agency).

National Carbide Factors
p. 55

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 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.