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Corporate Tax

Spring 05

I. Formation of a Corporation

1. Types of Corporations

a. C-Corporation: Normal Corporation

1. Taxed like an individual

2. Has income and deductions

3. Corp pays tax on income

4. Shareholders taxed on dividends (15%)

5. Double tax regime b/c Corp taxed on income and shareholder is taxed on dividends.

6. All publicly traded company’s are C-Corps.

b. S- Corporation: Smaller Corporation

1. Less than 100 shareholders

2. Corporation is not taxed

3. Individual shareholder is taxed on their share of the Corp. (Single pass thru tax regime)

  1. Transfers to Corporation: Transferring Property into Corp in Exchange for Shares.

  1. §351(a) Nonrecognition for shareholder: No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation.

    1. Requirements:

  1. One or more persons (including individuals, corporations, partnerships, and other entities) must transfer “property to the corporation; [services is not property, you can’t get stock in exchange for services and be under 351, and this can screw up everyone for the control part. Rev Ruling 77-37 if you get stock for services you have to put up cash = to at least 10% of the value of the stock i.e. get $150,000 worth of stock then you have to put up $15,000]

  2. The Transfer must be solely in exchange for stock of the corporation; [nonqualified preferred stock treated as boot §351(g)] and

  3. The transferor or transferors, as a group must be in “control” of the corporation “immediately after the exchange.”

    1. §368(c) Control Defined: The ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. [transferors of property as a group own 80% of stock]

  1. §358(a)(1) Basis of Stock for Shareholder: The basis of the property permitted to be received under such section §351 without the recognition of gain or loss shall be the same as that of the property exchanged. *Stock basis is the same as the basis of what they gave

  2. §1032(a) Nonrecognition for Corp: No gain or loss shall be recognized by a corporation on the receipt of money or other property in exchange for stock of such corporation.

  3. §362(a) Basis of Property received by Corp: For basis of property acquired by corporation in connection with a §351 exchange, the basis shall be the same as it would be in the hands of the transferor. *Basis is the same as what shareholder had. *look at each thing the corp gets separately. Each asset will have a basis, same as shareholders basis + gain recognized

  4. §1223 Holding Period of Property: The taxpayer’s holding period for property received in an exchange shall include the period for which he held the property exchanged. *Corp will take over the holding period for property exchanged under §351.

3. Treatment of Boot

a. §351(b): If an exchange otherwise would have qualified under §351(a) but for the fact that transferor received “other property or money (boot)” in addition to stock, then the transferor’s realized gain must be recognized to the extent of the boot received.

b. §351(b)(2): No loss to recipient shall be recognized.

c. §358(a)(1) Basis for Shareholder: Basis will be the same as that of property exchanged increased by the recognized gain on the transfer and decreased by the fair market value of the boot.

d. §362(a) Basis for Corp: For basis of property acquired by corporation in connection with a §351 exchange, the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer. *If shareholder gets boot later, then corp’s basis is increased later (when shareholder recognizes gain)

e. If boot is given over time, then divide total amount of gain recognized over total amount of boot

f. If you get boot and there is more than one asset, divide shareholder and each asset is a separate shareholder. Example Use this Way

    • B gets $15,000 in stock and $15,000 in cash. Take B and slice him into “two people.” When you receive boot and transfer more than 1 asset then follow rev ruling 68-55. Treat each asset individually, then allocate what b gets in exchange. 2/3 of the value is in the inventory, 1/3 in the land.

B1 inv.

B2 land

Total

Asset I (Inventory)

Asset II (Land)

Fair market Value of Asset Transferred

$30,000

$20,000

$10,000

% Of Total FMV

2/3

1/3

Fair market value of X stock received in exchange

$15,000

$10,000

$5,000

Cash received in exchange

$15,000

$10,000

$5,000

Amount realized

$30,000

$20,000

$10,000

Adjusted Basis

$7,000

$25,000

Gain (loss) realized

$13,000

(15,000)

No loss recognized under 351(b)(2) so no loss recognized for Asset II (land).

Gain for Asset I (Inventory) is $13,000; Recognized Gain is $10,000 (cash received). Since inventory is an ordinary asset, not a capital asset B would recognize $10,000 ordinary income.

B’s basis in X stock received is $32,000 ($7,000 ab in inv. + $25,000 ab in land)

Holding Period- 2/3 of the stock was exchanged for the inventory and 1/3 of the stock was exchanged for the land.

X corporation basis is adjusted basis 17 + 25 = 42,000 Under §362

4. Assumption of Liabilities/Debt Relief

a. §357(a): The assumption of a liability by a transferee corporation in a §351 exchange will neither constitute boot nor prevent the exchange from qualifying under §351.

b. §358(d) Basis for Shareholder: The assumption of liability shall be treated as money received by the taxpayer on the exchange.

1. Basis is reduced by the debt relief.

2. If your debt relief is greater than your basis, the excess debt relief results in a recognized gain [§357(c)].

c. §357(b): The assumption of liability is treated as boot if the taxpayer’s “principal purpose” in transferring the liability was the avoidance of federal income taxes or was not a bona fide business purpose.

d. If shareholder doesn’t want to recognize gain they can just put in a promissory note equaling the amount of debt relief

5. Incorporation of a Going Business:

a. §357(c)(3) Accounts Receivables and Accounts Payable: Amount of liability is excluded in determining the amount of liabilities assumed.

*Rosenberg Def: The income and deductions balance out when the Corp would assume accounts payable so ignore it. Ignore it for gain and ignore it for basis.

b. Tax Benefit Rule: If an amount has been deducted and a later event occurs that is fundamentally inconsistent with the premise on which the deduction was initially based, the earlier deduction must be effectively “cancelled out” by the recognition of income equal to the amount previously deducted.

c. Organizational Expenses:

1. §248(a): A corporation can elect to amortize certain qualifying “organizational expenditures” over a period of sixty months or more beginning with the month in which the corporation commences business.

2. §248(b) Organizational Expenditures Defined: Any expenditure which-

a. is incident to the creation of the corporation

b. is chargeable to capital account; and

c. is of a character which, if expended incident to the creation of a corporation having a limited life, would be amortizable over such life.

3. Specifically Excluded: Costs of issuing or selling stock and expenditures connected with the transfer of assets to the corporation.

II. Capital Structure of Corporations (NOT ON FINAL)

Ex.

S and T form Company w/ 2 million

Should they put in the money in exchange for equity (stock) or debt?

  • Equity (stock)- you get to share profits, ownership of company, voting rights, more risk

  • Debt- fixed interest, priority, no voting rights

Tax Consequences

  • Debt- Corp has to pay, and paying interest is a cost of doing business so Corp. gets a deduction. Individual’s who receive the interest payments are taxed at 40%.

  • Stock- Paying dividends not deductible (not a cost of doing business), Shareholders who get dividends are taxed at 15% rather than 40%.

Seemingly better for a Corp to issue debt than to issue stock…but people want right to vote, share profits, share risk. So corp’s came up w/stuff like convertible debt, voting debt. Often hard to tell the difference between debt and equity b/c corp. wanted to say it’s debt but they had the same rights as shareholders. Corp would pay and still get a deduction.

Section 385 authorized the Treasury Dept to make regulations to differentiate between debt and equity, but there are no regulations.

Section 385(b) gives factors

Section 351(g) nonqualified preferred stock is treated as debt

Cases where stock is treated as debt is rare, what has developed:

Ex.

Oracle worth 300 billion

Makes profit 10%/yr (30 billion)

Taxes = 12 billion/yr

Net profit 18 billion/yr

John buys Company for 300 billion

What is John’s next step? Get 300, so go to investors to borrow

John Co will take over all of Oracles assets; lenders will lend John Co 300 billion. (Leveraged buyout)

Now Oracle has assets worth 300 billion, but 300 in debt, so net value is 0

Instead of the shareholders, now debt-holders and will get paid more in interest.

After all the interest is paid, net profit is 3 billion, 1.8 after taxes, and that is all Johns.

*President changed the dividend rate at 15% instead of 40% so that companies wouldn’t mind paying the dividends. Lowering the interest rate still isn’t as good as the 40% deduction, but it makes it better for companies to pay more.

III. Non-liquidating Distributions

  • Basically talking about dividends

  • Not every distribution is a dividend- If you’re just getting back your own money it is a return of capital.

  • Dividend is when the Corporation is distributing its profits

  • When a Corporation is distributing its profits then it is taxed as a dividend (15%)

  • If a Corporation is just returning capital then there is no tax, just a reduction in the shareholder’s basis

  1. Dividends

    1. §316 Dividend defined: The term dividend means any distribution of property made by a corporation to its shareholders

    1. out of its earnings and profits accumulated after February 28, 1913, or

    2. out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.

3. Regulation 1.316-2(a): In determining the source of a distribution, considerations should be given first, to the earnings and profits of the taxable year; and second, to the earnings and profits accumulated since February 28, 1913.

    1. §301(c)(1) Amount constituting dividend: That portion of the distribution which is a dividend is included in gross income.

    2. §301(c)(2) Amount applied against basis: That portion of the distribution which is not a dividend shall be applied against and reduce the adjusted basis of the stock.

    3. §301(c)(3) Amount in excess of basis: That portion which is not a dividend, to the extent that it exceeds the adjusted basis of the stock, shall be treated as gain from the sale of or exchange of property

  1. Earnings and Profits: Measuring devise used to determine the extent to which a distribution is made from a corporation’s economic income as opposed to its taxable income or paid in capital.

*Rosenberg Definition: Net real profit the corporation has made

    1. §312 Effect on Earnings and Profits: On the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation shall be decreased by the sum of-

(a)(1) The amount of money

(a)(2) The principal amount of the obligations of such corporation, or

(a)(3) The adjusted basis of the other property

    1. §312(b) Distributions of Appreciated Property:

  1. The earnings and profits of the corporation shall be increased by the amount of such excess (amount FMV is greater than AB), and

  2. (a)(3) will be applied by substituting FMV for AB

3. Distributions of Cash

a. Cash distributions are taxable as a dividend to the extent of the distributing corporation’s current or accumulated earnings and profits. [§301(c)(3)]

b. Amounts distributed in excess of available earnings and profits are first applied against and reduce the basis of the shareholders stock. [§301(c)(2)]

c. To the extent the distributions exceed the shareholder’s basis, they are treated as gain from the sale or exchange of stock. [§301(c)(3)]

d. When there are insufficient current e&p available to cover all cash distributions made during the year, e&p must be allocated to the distributions in order to determine dividend status under the following rules.

1. Current e&p, determined as of the end of the year, are prorated among the distributions by using the following formula:

Current E&P allocated to distribution = Amount of distribution x Total Current E &P/ Total distributions

2. Next, accumulated e&p are allocated chronologically to the distributions on a first-come, first-served basis.

4. Distributions of Property: When Property is distributed-

a. Corporation is taxed as if it sold the property at its FMV (so taxed on any gain) [§311(b)].

b. Any Gain increases the Earnings and Profits of the Corp. [§312(b)]

c. For Shareholder: The amount of distribution is the net FMV of the property [§301(b)(1)]

d. For Shareholder: The distribution is a dividend to the extent of the earnings and profits. [§301(c)(1)]

e. For Shareholder: The basis is the FMV of the property [§301(d)]

f. Corporations ending earnings and profits is whatever it had minus the dividend distributed. [§312(a)(3), adjusted by §312(b)(2)]

g. §316 tells us to do §312(b) before we do §312(a)

5. Distributions of a Corporation’s Own Obligations

a. §312(a)(2): A corporation’s earnings and profits will be reduced by the amount of the obligations.

b. §7872(a) & (c)(1)(C): If a corporation tries to distribute its earnings and profits in a way that may be deductible at the corporate level, then the IRS will reclassify the distribution as a constructive dividend and the corporate level deduction will be disallowed.

1. Examples of Corporate distribution avoidance schemes:

a. A corporation’s payment of:

1. excessive compensation to shareholders or their relatives;

2. expenses paid for the personal benefit of shareholders;

3. excessive rent for corporate use of shareholder property’

4. interest on shareholder debt that in substance represents equity.

*If these payments are not what they purport to be, they risk being classified as a constructive dividend.

b. Other disguised dividend strategies:

1. Labeling a distribution a loan

2. Bargain sales or rentals of corporate property to shareholders,

3. Interest free loans.

  1. Anti-Avoidance Limits on the Dividends Received Deduction

    1. §243 Dividends received by corporations: A corporation that receives a dividend from another corporation can make a deduction of:

      1. 70% [§243(a)(1)]

      2. 80% if the corporation owns 20% or more of the distributing corporation [§243(c)]

      3. 100% in the case of qualifying dividends.

        1. §243(b)(1) Qualifying Dividends- Any dividend received by a corporation-

          1. if the corporation is a member of the same affiliated group as the corp. distributing the dividend (parent-subsidiary)

    2. §246(c) Holding Requirements- The corporation receiving the dividend must hold the stock for 45 dies during the 90 day period beginning on the exdividend date. Ex. Hold stock for 45 days before exdividend date, or for 15 before and 30 after.

    3. §1059 Extraordinary Dividends Basis Reduction: Corp shareholder receiving an extraordinary dividend must reduce its basis in the underlying stock by the amount of nontaxed (i.e. deductible) portion if the Corp has not held the stock for more than 2 years.

      1. Extraordinary Dividend Definition: A dividend is extraordinary if it exceeds 5% of shareholders preferred stock or 10% shareholders of common stock.

      2. Fair Market Value Test §1059(c)(4): Can elect to substitute FMV for adjusted basis.

      3. §1059(c)(3)(A) and (c)(3)(B): dividends within 85 days are aggregated (treated as one dividend) and dividends within 1 year are aggregated if it exceeds 20% of basis.

    1. §246A Debt-financed Portfolio Stock- A Corporation’s §243 deduction is reduced by the amount the dividends are attributable to debt-financed portfolio stock. If the portfolio stock is entirely debt ridden, then §246 denies any dividends received deduction

  1. Use of Dividends in Bootstrap Sales

    1. Two Factors that the Service will look at to see if it is a dividend or a sale:

      1. What was the intent of the parties? The intent can’t be to make it a disguised sale?

      2. If there is a dividend just prior to the sale, what is the source of the funds?



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