Corporate TaxationCorporate Taxation

What is double taxation?What is double taxation?

CorporationsCorporations

Corporation is a separate “TP” from Corporation is a separate “TP” from shareholders (owners)shareholders (owners)

Shareholders must pay tax on Shareholders must pay tax on dividends receiveddividends received

This results in double taxationThis results in double taxation

Double TaxationDouble Taxation

A and B are shareholders of XYZ Corp., A and B are shareholders of XYZ Corp., A and B are equal shareholders , A and B are equal shareholders , each have a basis of $250 in XYZ each have a basis of $250 in XYZ stock. In Y1, XYZ has an income of stock. In Y1, XYZ has an income of $10,000 and distributes $100 to each $10,000 and distributes $100 to each shareholder. What will happen?shareholder. What will happen?

AlternativesAlternatives

What will happen is XYZ is a sole What will happen is XYZ is a sole proprietorship?proprietorship?

What will happen is XYZ is a What will happen is XYZ is a partnership?partnership?

An LLC?An LLC?

A Sub S Corporation?A Sub S Corporation?

A Sub S Corporation?A Sub S Corporation?

Same facts: $10,000 income?Same facts: $10,000 income?

$5,000 OI each$5,000 OI each

A & B will each reduce their basis by A & B will each reduce their basis by $100$100

(the distribution)(the distribution)

Why incorporate?Why incorporate?

Raising capital is easier (price of Raising capital is easier (price of shares reflects the PV of Future shares reflects the PV of Future Prospects)Prospects)

Multiple classes of stock are possibleMultiple classes of stock are possible

Limited liability to investorsLimited liability to investors

Lenders may REQUIRE incorporation Lenders may REQUIRE incorporation (usury laws)(usury laws)

Shareholders can be employees Shareholders can be employees (fringes are excludable from income(fringes are excludable from income—deductible for corporation—deductible for corporation

Pension flexibility (historically—not Pension flexibility (historically—not since 1982)since 1982)

Why incorporate?Why incorporate?

Avoiding Double TaxationAvoiding Double Taxation

Avoid C FormAvoid C Form

Retain EarningsRetain Earnings

Treat distributions as deductible Treat distributions as deductible paymentspayments

(particularly in a closely held corp, where shareholders can be (particularly in a closely held corp, where shareholders can be employees or creditors of the corporation)employees or creditors of the corporation)

Avoid the corporate form, instead useAvoid the corporate form, instead use

PartnershipPartnership

LLCLLC

To Avoid Double TaxationTo Avoid Double Taxation

1. Partnership1. Partnership

““Flow Through” paradigmFlow Through” paradigm

BUT there are limitations on “pass BUT there are limitations on “pass through” expense, which must be through” expense, which must be allocated to keep the expenses from allocated to keep the expenses from being used by partners to whom they being used by partners to whom they would be particularly beneficialwould be particularly beneficial

2. LLCs2. LLCs

Partnership Taxation (default)Partnership Taxation (default)

Vs. Corporation TaxationVs. Corporation Taxation

To distinquish, use “Kintner To distinquish, use “Kintner Regulations”Regulations”

Kintner RegulationsKintner Regulations

US v. Kintner (1954) US v. Kintner (1954) 1.1. AssociatesAssociates2.2. Carry on business/ divide gainsCarry on business/ divide gains

3.3. Continuity of lifeContinuity of life4.4. Centralization of managementCentralization of management5.5. Liability for corporate debts Liability for corporate debts

limited to corporate propertylimited to corporate property6.6. Free transferability of interestsFree transferability of interests

If entity had 3 or more like a If entity had 3 or more like a corporation, it was TAXED as a corporation, it was TAXED as a corporationcorporation

If it lacked 2 it was taxed as a If it lacked 2 it was taxed as a partnershippartnership

Kintner RegulationsKintner Regulations

““Check the box” rules Check the box” rules

LLCs then began to flourishLLCs then began to flourish

Under “check the box” rules, a Under “check the box” rules, a business entity with 2 or more business entity with 2 or more “members’ is either a corporation or “members’ is either a corporation or a partnership.a partnership.

If one “member” it can be a If one “member” it can be a corporation or a sole proprietorship corporation or a sole proprietorship (maybe branch or division of its (maybe branch or division of its owner)owner)

““Check the box” rules Check the box” rules

Entity is taxed as a corporation ifEntity is taxed as a corporation if

1.1. Organized as corporation under state law, andOrganized as corporation under state law, and

2.2. Associations, under Tres. Reg 301.7701-3Associations, under Tres. Reg 301.7701-3

3.3. Joint stock companies (joint ventures)Joint stock companies (joint ventures)

4.4. Insurance companiesInsurance companies

5.5. State chartered banksState chartered banks

6.6. Those wholly owned by a state (or political subdivision)Those wholly owned by a state (or political subdivision)

7.7. Certain foreign entitiesCertain foreign entities

If not above, entity can CHOOSE tax treatmentIf not above, entity can CHOOSE tax treatment

““Check the box” rules Check the box” rules

Introduction of Sub S Introduction of Sub S

All shareholders must consentAll shareholders must consent No more than 75 shareholdersNo more than 75 shareholders All SHs must be (basically) All SHs must be (basically)

individualsindividuals No nonresident aliensNo nonresident aliens One class of stockOne class of stock

Avoiding Subchapter C—Avoiding Subchapter C—Corporation as AgentCorporation as Agent

Where a real estate partnership Where a real estate partnership formed corporation to comply with formed corporation to comply with usury laws, but all parties regarded usury laws, but all parties regarded the partnership as owner, and:the partnership as owner, and:

Corp had no employees, assets, Corp had no employees, assets, Contract specified agency, in form Contract specified agency, in form

and substanceand substance

Disguised DividendsDisguised Dividends

IRS has tests and techniques for IRS has tests and techniques for closely held corporations to closely held corporations to recharacterizing salary as dividends. recharacterizing salary as dividends.

For example, the salary must be For example, the salary must be “reasonable” and “purely for “reasonable” and “purely for services. “ services. “

Distinguishing Capital Gains and Distinguishing Capital Gains and OI in Corporate TaxOI in Corporate Tax

Many Issues in Corporate Tax involve Many Issues in Corporate Tax involve characterization of a transaction as characterization of a transaction as either a distribution taxable as a either a distribution taxable as a dividend or a sale or exchangedividend or a sale or exchange

Distinguishing Capital Gains versus Distinguishing Capital Gains versus

Ordinary IncomeOrdinary Income Which would you rather have?Which would you rather have?

CG are defined by exclusion, only CG are defined by exclusion, only “capital assets” etc.“capital assets” etc.

Capital Losses are disfavored—Capital Losses are disfavored—limited on their deductibilitylimited on their deductibility

Need “appreciation event”Need “appreciation event”Eisner v. Macomber (1920)Eisner v. Macomber (1920)

For example: a sale—”profit” is taxed For example: a sale—”profit” is taxed at CG ratesat CG rates

How is appreciation of stock taxed?How is appreciation of stock taxed?

Backstops to PlanningBackstops to Planning

Substance-Over-Form—avoids abusive Substance-Over-Form—avoids abusive transactions that do not quality for the beneficial transactions that do not quality for the beneficial treatment sought.treatment sought.

This requires that TPs think carefully This requires that TPs think carefully when setting up a corporate formwhen setting up a corporate form

Courts are hesitant to disregard the Courts are hesitant to disregard the form the TP chooses, because it is form the TP chooses, because it is the TPs choicethe TPs choice

The Step-Transaction The Step-Transaction Doctrine—are Doctrine—are steps indeed separate or part of an steps indeed separate or part of an integrated whole that forms one integrated whole that forms one transaction?transaction?

““binding commitment test”binding commitment test” a plan to engage in several a plan to engage in several step simultaneously will collapse transactions to onestep simultaneously will collapse transactions to one

““mutual-interdependence” test—mutual-interdependence” test—are steps so are steps so interdependent that the legal relations created by one would have interdependent that the legal relations created by one would have been fruitless without the other steps?been fruitless without the other steps?

““end-result” end-result” test-are steps prearranged components of a test-are steps prearranged components of a single transaction in which parties from the beginning intended to single transaction in which parties from the beginning intended to reach a particular result?reach a particular result?

BackstopsBackstops