Note: the first hour of the class will be a catch-up on Week 11, individual capital gains and losses

Taxing Corporation Income

Overview

A corporation measures income and deductions using the same general rules as a proprietor. Form 1120 p.1 is used to report receipts, subtract the cost of goods sold, deduct "ordinary and necessary" expenses, and take cost recovery allowances for plant & equipment.

Operating income is added to income from investments and from capital gains, net of capital losses. Corporations don't have personal or living expenses, so don't have itemized deductions. Corporations don't marry or have children who depend on them, so there are no personal exemptions. (There are corporate "families", tho -- three types of corporate "groups".)

The "double tax" problem

Corporations are taxed on their income. When the after-tax income is paid to shareholders as a dividend, the shareholders have taxable income but the payor corporation gets no deduction for the payments.

Example: Cea Corporation has taxable income of $100, pays $35 in corporate income tax, and pays the $65 that's left after tax to Sol Shareholder. Cea can't deduct the $65. Sol has $65 of income and at a tax rate of 38% would pay $24.70 in individual income tax. The two income taxes together total $35 + $24.70 = $59.70, and Sol keeps only $40.30 net after tax. If Cea did not exist and Sol were able to earn the $100 of income directly, Sol would pay only personal income tax of $38 and would keep $62.

This treatment is not essential to an income tax system: European countries generally "integrate" the corporate and personal income taxes (eg. by allowing a corporate deduction for dividends, or a shareholder credit for the corporate tax paid.)

Taxpayers' Strategic Responses to double taxation

1) Don't incorporate

But it's hard to run a large/publicly traded business as a partnership (which, like a proprietorship, is not double taxed). People tried, and Congress' answer was to tax publicly traded p'ships as tho they were corps

2) If you're small business, lobby for relief

S-Corps were the answer here. Congress created a new tax treatment, like single-taxed partnerships, for many closely held corporations -- the "S-election" not to be a "C-Corp"

3) Pay dividends in loss years, not when profitable

Congress responded with the "earnings and profits" tracking account -- a hybrid of tax and financial accounting, intended to measure *cumulative* retained after-tax profits

• Slow depreciation: s/line over class lives.
• Adjustments for tax exempt income (and the cost of getting it) -- it may not be taxable to Corp. but it does create ability to pay profits to sh's
• Various timing adjustments, generally unfavorable as compared with measuring taxable income

4) Build in "bailouts" at the time of incorporation

Repayment of debt is not income for creditor, and interest paid on corporate debt is deductible. Therefore, have as much debt and as little equity as possible in initial capital structure. Q how to distinguish debt from equity

5) Replace existing equity with debt

Eg. the tax benefits of the "leveraged buyout" Double tax may turn into no tax if borrowing is from a non-US person or a tax exempt institution

6) If closely held, make alternative types of payouts to owners

Transactions with owners are not arm's length, and may be "disguised dividends"

The "reasonable compensation" question under Sec. 162

Leases of property, licenses of rights, commissions , etc -- the question is the motive and the reasonableness, compared w/ arms length parties

7) Go for growth, not value: retain all earnings

Accumulate at corporate level w/ only 1 tax. MSFT, CSCO, INTC etc pay zero or nominal dividends

Get the $$ to shareholders thru stock buybacks (if publicly traded, only the sellers are taxed, they are only taxed on what they gain above their cost, and it's probably a LT capital gain).

Keep the stock price up & sh can get cash thru margin loans

Or hold lifelong and watch the gains tax go away when basis steps up at shareholder's death.

8) Use the stock option tax rules

These can give the company a deduction = the income to the employee = the value of stock the employee got minus the option price paid. In effect, the company gets a deduction for diluting the non-employee shareholders (and FASB lets you bury it in the footnotes per APB 25.)

Entity choice and entity life-cycles

The available choices

Proprietorship / contract

Partnership (general, limited and LLP)

LLC (Federal tax uses partnership rules)

Corporation with subchapter S-election

Corporation without S-election

Getting it going

Nonrecognition rules for transfers in from owners. Transfers of liabilities create the difficult issues.

Ongoing

C-Corporations (corps without S-election) are taxpaying entities.

All others are "pass-thrus". The entity calculates income but isn't taxed. Owners include their share of current year entity results in determining owner-level income and tax

Issues: need separate calculation of items that different owners might treat differently. How much flexibility is there in allocating various items?

Getting it out

"Double taxation" as to C-corp dividends. Basis tracking for pass-thrus, to determine if distribution has already been included in owner's income.

C-corp issues distinguishing stock buy-backs from dividends. Corporate gain recognition on distribution of appreciated assets.

Getting Out

C- and S-corps both recognize gain on selling or distributing appreciated assets. Shareholders are treated as selling stock for liquidation payments. Partnership results can be inconsistent -- q of basis in the partnership as opposed to basis in a partner's share of particular assets.

The Charitable Contribution Deduction

General rules

Itemized deduction for cash gifts and the value (or cost) of noncash gifts to "501(c)(3) organizations"

Common audit issues

Verifying the contribution

How prove a contribution was made? eg. the church collection plate? IRS Regs expect Tp to keep a "contributions diary" to verify cash gifts

Verification letter required if over $250

Also must subtract benefits received in exchange

Determining Value of non-cash contributions

Generally, deduction is the lower of cost (basis) or market (current FMV)

How determine value of depreciated property given to Goodwill, etc.? Note Form 8323 needed if total noncash gifts over $500

Gifts of Appreciated Capital Gain property:

When deduct cost, and when market value?

Case 1: property is ord income or STCG property or LTCG but tangible and not used by charity in its exempt function. Deduction is lower of basis (usu. cost) or market. (Technically, FMV- appreciation (FMV-AB) = AB )

Case 2: property is LTCG and either intangible (e.g. stock) or tangible but will be used by charity in exempt function (eg painting to art museum). Deduct FMV

This is a major loophole: can deduct unrealized appreciation without ever paying tax on it

The Limits to Charity

• Deduction in any year cannot exceed 50% of AGI.
• carryforward undeducted contributions: 5 yrs to use
• "Nested" sub-limits for capital gains gifts and private charities depending on type of contribution and organization

The Donative Impulse