Taxation of Corporations—Basic Concepts
SUMMARY OF CHAPTER
Corporation taxation is divided into six areas. They are (1) formation, (2) operation, (3) distributions, (4) redemptions, (5) liquidations, and (6) reorganizations. This chapter focuses on the formation and operation of corporations.
?14,001 Specific Entities
A major concern when forming a business is the type of entity. The three major types are sole proprietorships, partnerships, and corporations. Each entity has certain tax and non-tax advantages and disadvantages. A sole proprietorship is a form of business in which one person owns all the assets and is fully responsible for all the liabilities. A partnership is a form of business in which two or more persons or entities own all the assets and are responsible for the liabilities. It is based on a voluntary contract between these parties. A corporation is a legal entity created by the authority of state law. It is separate and distinct from its owners and may be owned by one or more persons or entities. There are advantages of each type of entity. Corporations have limited liability, owners can have employee status, corporations usually can raise funds more easily than can partnerships and sole proprietorships, and corporations can have a tax year different from their owners. However, regular corporations produce double taxation and do not pass through tax attributes (e.g., losses, credits, etc.) to their owners.
?14,015 Definition of a Corporation
A corporation is a legal entity owing its existence to the laws of the state in which it is incorporated. The state laws define all legal relationships of the corporation. New Regulations to Code Sec. 7701 issued in 1996 and effective January 1, 1997, simplified the entity classification issue. Under the new ‘‘check-the-
box'' system, certain business entities (entities other than trusts or those subject to special rules) automatically will be treated as corporations for federal tax purposes. These entities are: firms incorporated under federal or state law, associations, joint-stock companies or joint-stock associations (as organized under a state statute), insurance companies, banks, business entities wholly owned by a state or political subdivision of the state, business entities taxed as corporations under another Code section, and certain foreign entities. Eligible entities (entities other than trusts or those subject to special rules) that are not automatically treated as a corporation may elect (‘‘check-the-box'') to be treated as a
corporation for federal tax purposes.
Organization of and Transfers to a Corporation
?14,101 Use of Corporate Form
If the corporate form is desired, the owners must be certain they meet all the filing requirements of the state in which the company is organized. Next the owners must decide what type of property to transfer to the corporation and how this property should be transferred. In general, taxpayers who exchange property other than cash for other property recognize a gain or loss. However, Code Sec. 351, a mandatory provision, provides that a transferor recognizes no gain or loss on property transferred solely in exchange for a corporation's stock if the transferor controls the corporation immediately after the exchange.
?14,105 General Requirements
The three major requirements of Code Sec. 351 are (1) transfers of property, (2) solely in exchange for stock, and (3) control by the transferors immediately after the exchange.
?14,111 Transfers of Property
Services, certain debt of the transferee corporation, and certain accrued interest on the transferee's debt are not treated as property. Other than these exceptions, the definition of property is comprehensive and includes all types of property, such as cash, accounts receivable, inventories, patents, installment obligations, equipment, and buildings.
?14,115 Transfers for Stock
Section 351 requires that the transferor receive the corporation's stock. The receipt of securities in exchange for property does not qualify as a Section 351 transfer. If the transferor receives stock and securities, then (assuming other conditions are met) the exchange qualifies under Code Sec. 351 but the securities are treated as boot, regardless of the life of the securities. Nonqualified preferred stock is treated as boot too. Also, receipt of anything else constitutes boot and may cause gain recognition.
?14,125 Control of the Corporation
The transferors must be in control after the exchange, individually or collectively as a group. Control is defined as owning at least 80 percent of the total voting stock and at least 80 percent of each class of non-voting stock. If control is fleeting (i.e., if it is lost after the exchange), then the exchange may be taxable if the disposition was due to a prearranged plan to dispose of the stock. If the transferors receive disproportionate shares of stock or securities (i.e., not in proportion to the value of the property they transfer), then the transaction may be recast as a Section 351 exchange followed by a transfer of some of the stock or securities to the other transferors as a gift, compensation, or loan repayment. Stock received for services rendered is not counted toward control unless the transferor transferred services and property.
?14,135 Receipt of Boot
The receipt of boot does not disqualify a transfer from Code Sec. 351 treatment. However, gain is recognized to the extent of the lesser of the realized gain or the fair market value of boot received. The boot must be allocated to all properties transferred, and gain is recognized on a property-by-property basis. The character of the gain depends on the property transferred. Losses are never recognized.
?14,141 Transfers of Liabilities
In general, the assumption of liabilities by the transferee corporation is not considered to be boot for gain recognition purposes. However, if the transfer of liabilities has a tax avoidance purpose or no business purpose, then all liabilities are treated as boot. Similarly, if the sum of liabilities transferred exceeds the adjusted basis of all properties transferred, then such excess is recognized as gain by the transferor. The recognized gain is allocated to all the assets transferred. This calculation of liability in excess of basis is on a shareholder-by-shareholder basis. Finally, liabilities that give rise to a deduction (e.g., a cash-basis taxpayer's accounts payable) are not considered liabilities for these purposes.
?14,155 Basis Determination
The shareholder's basis in stock received is equal to the adjusted basis of property surrendered. If boot is received, the basis of the boot is its fair market value and the basis of stocks equals the adjusted basis of property transferred minus the boot received plus the gain recognized by the transferor. The assumption of liabilities is considered boot for purposes of basis determination. If more than one class of stock is received, the basis must be allocated to each type in accordance with relative fair market values. The shareholder's holding period in the stock received includes the holding period in property transferred if these were capital assets or Section 1231 assets. If capital assets or Section 1231 assets and ordinary assets are transferred, then the holding periods must be allocated to the stock and non-boot securities. The holding period for boot received begins with the date of the transaction. The corporation's basis in property received is equal to the transferor's adjusted basis in the property, increased by the gain recognized by the transferor. The corporation tacks on the shareholder's holding period in assets transferred if the assets are capital assets or Section 1231 assets in the corporation's hands.
?14,165 Recapture Rules
Depreciation is not recaptured if no gain is recognized on the exchange. The recapture potential shifts to the corporation. If gain is recognized because boot is received, ordinary income results to the extent of the recapture potential or recognized gain, whichever is less. The un-recaptured portion shifts to
the corporation. Investment tax credit (ITC) might be recaptured if the shareholder does not receive a substantial interest in the corporation. The ITC recapture potential remains with the shareholder, and ITC is triggered if the corporation prematurely disposes of the property or if the shareholder prematurely disposes of a substantial interest.
?14,175 Section 351 Transfer or Taxable Exchange
Code Sec. 351 is a mandatory provision. A shareholder may want to avoid it if the property being transferred has declined in value (to recognize the loss if Code Sec. 267—relating to losses between related
parties—does not apply). Alternatively, the shareholder may be willing to recognize a gain in order to give the corporation a stepped-up basis in the property. In this situation, Code Sec. 1239 must be considered.
?14,185 Reporting Requirements
There are specific reporting requirements that the shareholders and the corporation must adhere to for the year of the exchange.
Corporate Capital Structure?14,201 Equity in the Capital Structure
A corporation recognizes no gain or loss on the receipt of money or property that is received in exchange for its stock or money or property that is a contribution to capital. The corporation's basis in the property is the fair market value if the transaction is a taxable exchange or the carryover basis mentioned earlier if that transaction is a Section 351 transfer or a contribution to capital. The shareholder's basis in the stock is the fair market value if the transaction is a taxable exchange or the carryover basis as mentioned earlier if the transaction is a Section 351 transfer. If the transfer is a contribution to capital, the shareholder increases his or her basis in the stock owned prior to the contribution. The increase equals the amount of cash and adjusted basis of property transferred plus gain recognized by the shareholder on the transfer. A forgiveness of corporate debt by the shareholder is treated as a contribution to capital. Contributions by non-shareholders are excluded from gross income by the corporation if the transfer is not for goods or services. The corporation's basis in such property received is zero. If cash is
received, any property acquired during the next 12-month period is reduced by the amount of cash received.
?14,215 Debt in the Capital Structure
The use of debt to raise funds has certain advantages. Interest payments are deductible, whereas dividend distributions are not deductible. Sometimes a debt instrument may be re-characterized as equity by the IRS. The substance will have precedence over the instrument's legal form. Thus, the characteristics of the instrument (e.g., fixed principal, due date, interest payments, etc.) and the corporation's capital structure (e.g., debt-to-equity ratio) are important.
?14,235 Section 1244 Stock
Shareholders are permitted to deduct as ordinary losses any losses incurred on the worthlessness or sale of Section 1244 stock. Ordinary loss treatment is limited to $50,000 per year, $100,000 per year on a joint return. Gains are treated as capital gains. The corporation must be a domestic small business corporation at the time the stock is issued. The special treatment applies only to original holders of the Section 1244 stock. The shareholders and the corporation must keep good records and meet certain reporting requirements. Sometimes it is better to use Section 1244 stock instead of debt in the capital structure because of the loss treatment.
?14,245 Section 1202 Stock
Within limits, non-corporate shareholders are eligible to exclude 50 percent of the gain from the sale or exchange of qualified small business stock originally issued after August 9, 1993, and held for more than five years. The corporation must be a domestic small business corporation at the time the stock is issued and must be actively engaged in a trade or business during substantially all of the time the taxpayer held the stock. Since this provision applies to stock issued after August 9, 1993, and the stock must be held for more than five years to qualify, gains are not eligible for exclusion until the stock is sold on or after August 10, 1998. Under certain conditions, taxpayers may roll over gains from the sale of publicly traded securities
into a specialized small business investment company. Also, under certain conditions, taxpayers may roll over gains from the sale of qualified small business stock into other qualified small business stock.
Determination of Corporate Taxable Income
?14,301 General Rules
There are many similarities between the rules used to determine taxable income for individuals and those used for corporations. Corporations, like individuals, are entitled to exclusions. There are, however, many differences as well; for example, corporations do not have personal deductions and do not distinguish between for AGI and from AGI deductions.
?14,305 Accounting Periods
Regular corporations may elect any tax year, regardless of the tax years of its owners. In general, other entities do not have this option.
?14,311 Accounting Methods
Most corporations must use the accrual method of accounting.
?14,315 Capital Gains and Losses
Short-term and long-term gains and losses are kept separate. A corporation determines its net short-term position and its net long-term position. If these positions are opposites (e.g., a net short-term capital loss and a net long-term capital gain), then they are netted to obtain an overall net position. If they are not opposites (e.g., a net short-term capital gain and a net long-term capital gain), then they are not netted. Net capital gains do not receive special treatment. They are added to ordinary income and taxed at regular corporate rates. Net capital losses cannot offset ordinary income. Instead, they are carried back three tax years and then forward five tax years to offset net capital gains. When carried back or forward, all such losses are considered to be short-term losses. Losses carried forward are lost forever if they are not used within the five-year period.
?14,325 Depreciation Recapture
In addition to Section 1245 and 1250 recaptures, Code Sec. 291 requires that corporations also recapture as ordinary income 20 percent of the excess of the amount that would be treated as ordinary income if the property were Section 1245 property over the amount treated as ordinary income under Section 1250.
?14,335 Net Operating Loss
The net operating loss (NOL) of a corporation may be carried back two years and forward 20 years. A corporation may elect to carry the NOL forward only. Since all expenses of a corporation are business expenses, the only adjustment a corporation has to make to compute an NOL is to eliminate an NOL carryover if it had been used to compute taxable income. Also, there are restrictions on the amount of an NOL that a corporation may carry back to the extent that interest deductions associated with a corporate equity reduction transaction (CERT) are included in the NOL.
?14,345 Charitable Contributions
The maximum deduction permitted in any taxable year is 10 percent of adjusted taxable income (i.e., taxable income without regard to the charitable contribution deduction, the dividends-received deduction, any NOL carry back, and any capital loss carry back). If charitable contributions exceed the 10 percent limit, such excess can be carried forward for five years.
The initial measure of long-term capital gain property contributed by a corporation is its fair market value (FMV). However, if the property is tangible personal property not related to the charity's tax exempt function, then the initial measure is FMV minus the amount of long-term gain that would have been
recognized if the property had been sold. Section 1231 property is considered to be long-term capital gain property. However, the depreciation recapture portion of this property is considered to be ordinary income. The initial measure for contributions of ordinary income property is FMV minus the ordinary income that would have been recognized if the property had been sold. Contributions of qualified inventory to public charities or of scientific research property to educational institutions are deductible to the extent of the adjusted basis of the property plus one-half its appreciation, not to exceed twice the adjusted basis.
?14,355 Related Taxpayers—Losses and Expenses
Losses between related parties are not deductible. The transferee (buyer) is allowed to offset gain on a subsequent sale of the property by the amount of the disallowed loss. Expenses commonly disallowed are interest and compensation payable by an accrual-basis corporation to its cash-basis shareholders. The deduction is taken in the year the corporation makes the payment. Related persons include (1) a corporation and an individual with direct or indirect ownership of more than 50 percent and (2) two corporations, if the same person owns more than 50 percent of each corporation.
?14,365 Organizational Expenditures
A corporation may elect to expense the first $5,000 of expenditures (subject to a phaseout) and then amortize organizational expenditures over a period of 180 months or more. Only expenditures incurred in the first year qualify. If no election is made, the organizational expenditures are capitalized and deducted when the corporation is dissolved.
?14,375 Start-Up Expenditures
Start-up expenditures are different from organizational expenditures. However, the corporation may make a similar election to amortize start-up expenditures.
?14,385 Dividends-Received Deduction
A corporation is entitled to a deduction for dividends received from certain domestic corporations. The size of the deduction depends on the percentage of ownership of the corporate shareholder. Computation of the deduction is summarized below.Ownership Percentage Percentage Deductible
Less than 20 percent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 percent 20 percent but less than 80 percent . . . . . . . . . . . . . . . . . . . . . . 80 percent 80 percent or more . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 percent The deduction equals the applicable percentage (70, 80, or 100) times the lesser of the dividend received or the shareholder corporation's taxable income, computed without regard to the dividends received deduction, any NOL carry back or carry forward, any capital loss carry back, and a dividend paid deduction. However, the taxable income constraint is not applicable if the shareholder corporation has an NOL or would have an NOL if the full dividends-received deduction (i.e., applicable percentage times dividend received) would create an NOL. The dividends-received deduction is not permitted to the extent that a dividend is received on debt-financed stock. Also, the stock must have been held for more than 45 days to be eligible for the dividends-received deduction. Finally, the basis of stock held by a corporation must be reduced by the non-taxed portion of any extraordinary dividend received by the corporation with respect to such stock.
?14,391 Executive Compensation
In general, a corporation and its executives attempt to design a compensation package that maximizes the executives' after-tax cash flows at the least cost and cash outflow to the corporation. Thus, the compensation package usually includes a combination of cash payments (salary and bonus), fringe benefits (nontaxable and taxable), and deferred compensation.
?14,395 Domestic Manufacturer's Deduction
The domestic manufacturer's deduction equals a percentage of the firm's taxable income (computed without regard to this new deduction): some % × lesser of: (1) taxable income (before this deduction) for the taxable year or (2) qualified production activities income for the taxable year. The percent is 3% for 2005 and 2006, 6% for 2007, 2008 and 2009, and 9% for taxable years after 2009. The deduction cannot exceed
50% of the employer's W-2 wages for the taxable year. Qualified production activities income equals domestic production income minus the sum of: (1) cost of goods allocable to these receipts + (2) other deductions, expenses and losses directly allocable to these receipts + (3) a ratable portion of other deductions, expenses and losses that are not directly allocable to these receipts or other classes of income.
Determination of Corporate Income Tax Liability
?14,401 Computation of Tax Liability
A corporation computes a regular tax and an alternative minimum tax. After obtaining its gross tax liability, it reduces this by the amount of tax credits allowed.
?14,405 Corporate Regular Income Tax Rates
Corporate tax rates are as follows:
Taxable Income Rate
$0 to $50,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15% $50,001 to $75,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25% $75,001 to $100,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34% $100,001 to $335,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39% $335,001 to $10,000,000. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34% $10,000,001 to $15,000,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35% $15,000,001 to $18,333,333 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38% Over $18,333,333 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35% Corporations with over $100,000 in taxable income are subject to a 5 percent tax on such excess between $100,001 and $335,000. The maximum additional tax is $11,250 (($335,000 1 $100,000) × 5%). This figure represents the savings from being in a tax bracket below 34 percent on the first $75,000. At $335,001 of taxable income, the result is the equivalent of a ‘‘flat tax'' of 34 percent. The 34 percent ‘‘flat
tax'' is imposed on corporations whose taxable income ranges from $335,001 to $10,000,000. At $10,000,001 the tax rate increases to 35 percent. Corporations with over $15,000,000 in taxable income are subject to a 3 percent tax on the excess between $15,000,001 and $18,333,333. The maximum additional tax is $100,000 (($18,333,333 1 $15,000,000) × 3%). This figure represents the savings from being in the 34 percent bracket on the first $10,000,000. At over $18,333,333 of taxable income, the result is the equivalent of a ‘‘flat tax'' of 35 percent. These tax rates are shown in the above tax rate schedule. Also, see
the corporate tax rate schedule in the inside back cover of the text book.
?14,415 Corporate Alternative Minimum Tax
The alternative minimum tax (AMT) is designed to ensure that corporations with economic income pay a tax. The AMT is payable to the extent that it exceeds the regular income tax. The corporation's taxable income is modified to obtain its alternative minimum taxable income (AMTI). AMTI is reduced by a $40,000 exemption. The resultant amount is multiplied by 20 percent to obtain the gross AMT. Gross AMT is reduced by the AMT foreign tax credit to obtain the tentative minimum tax (TMT). TMT is compared to the corporation's regular income tax liability before credits but after the regular foreign tax and possessions tax credits. If TMT is greater, the excess is the AMT. The $40,000 exemption is reduced by 25 percent of each dollar by which AMTI exceeds $150,000. Thus, when AMTI equals $310,000 there is no exemption. Small corporations that meet an average gross receipts test are exempt from AMT.
?14,433 Controlled Groups of Corporations
Parent-subsidiary corporations, brother-sister corporations and combined groups are subject to special rules. Members of these groups must share the first two tax rates (15 and 25 percent), as well as the extra 5 percent tax, the AMT exemption of $40,000, the Code Sec. 179 election to expense, and the $250,000 accumulated earnings credit. Parent-subsidiary controlled groups are permitted to file consolidated returns if all members of the group elect to do so. Code Sec. 482 gives the IRS the power to reallocate gross income, deductions, and credits among members of a controlled group. The reallocation is done to prevent evasion of taxes or to clearly reflect
?14,445 Consolidated Returns
Parent-subsidiary controlled groups are entitled to file consolidated returns if all members of the group make an irrevocable election to file a consolidated return. Such an election enables member corporations to offset income and capital gains with other members' losses and capital losses, respectively. However, there are restrictions on these offsets with respect to built-in deductions and losses from a separate return limitation year.
?14,465 Corporate Tax Returns
Corporations must make estimated tax payments if their estimated tax for the year is $500 or more. These payments must be equal to 100 percent of this year's actual tax liability or 100 percent of last year's tax liability (if this was positive and was for a 12-month period), whichever is less. Corporations use Form 1120-A or 1120 to file their annual income tax returns. A balance sheet must be presented on Form 1120. Also, the corporation must reconcile book income with taxable income (Schedule M-1) and provide an analysis of un-appropriated retained earnings (Schedule M-2).
ANSWER TO KEYSTONE PROBLEM—CHAPTER 14
1. The manager could be given 20 percent or less of the stock. Section 351 would be satisfied, but the manager still has gross income equal to value received. (There is an offsetting deduction to the payer. Code Sec. 83 (h).)
2. By investing cash or other property, the manager becomes part of the transferor group. However, the investment must be of ‘‘more than a relatively small value'' compared to the stock received for services. Reg. ?1.351-1(a)(1)(ii). Gross income to the manager equals value received, less the investment. 3. The owner could initially receive at least 80 percent control. After a reasonable time, the manager could be given a stock ‘‘bonus.'' The longer the waiting period, the less likely it is that the bonus would be construed as part of a preconceived plan.