class outline: corporate taxation (sjsu bus 223c)
I. Evaluation Process
A. Does this transaction make economic sense? Evaluate stock received vs. economic contribution, or consideration received vs. FMV.
B. Realized Gain (economic): FMV – AB
C. Recognized Gain (tax) and type of gain
1. Corporation’s gain
a) Sec. 1032: No g/l to corp on giving stock for property.
b) Sec. 355: No g/l on distribution of a company’s stock in its subsidiary to its shareholders, if not a device for distributing E&P (turns subsidiary into a brother/sister corp).
c) Sec. 361: No g/l to corp in reorg on exchange of property for stock. No g/l on distribution of property to s/h unless appreciated.
d) Sec. 118: Gross income does not include contributions to capital.
e) Sec. 1239: On transfer of property between related (more than 50% of value of stock, or close family members) parties, gain on depreciable property is ordinary income, because purchaser will have A/B of FMV and take depreciation deduction. Otherwise, capital gain to transferor.
(1) Sec. 707(b): Transfer to partnership from partner with more than 50% partnership interest – losses disallowed, gains are ordinary income.
2. Shareholder’s gain
a) General rule: Gain or loss on all dispositions of assets is taxable unless exception (Sec. 1001)
b) Sec. 351: No g/l on transfer of property (including cash and intangibles, but not services) to corporation in exchange for stock, if contributing shareholder(s) has 80% ownership in corp immediately after transfer.
(1) Mandatory provision, but N/A to investment company (80% of value in securities).
(2) No new stock needs to be issued if s/h already 80% owner (“meaningless gesture”).
(3) Control: 80% owner of voting stock and 80% owner of each other class of non-voting stock.
(4) Accommodating transfer: If transferring s/h doesn’t have 80% ownership, other shareholders can transfer in property to reach 80%, but accommodating s/h must transfer in at least 10% of the value of their interest (i.e. 10% of total contribution) Rev. Proc. 77-37.
(5) Some intangibles may be services, not property (Rev. Rul. 64-56 & DuPont case). Ex: Contract to do architectural drawings is a service, but the drawings themselves are property.
(a) No attribution of ownership between family members.
(b) Attribution of ownership within consolidated groups does exist.
(7) Tax planning: If 351 N/A because 80% ownership is not met, have transferor form a corp, put property or cash into the corp, then do a “B” stock for stock reorg with the other company. Still ends up with gain at sale of stock, but that is deferred until sale.
(8) Transfer of appreciated property (FMV > A/B): Results in gain to corporation and gain to shareholder, so lease or sale instead of contribution. If A/B greater than FMV, loss to both corporation and shareholder.
(a) SH: A/B in stock is usually low under 358, therefore big gain at sale because FMV of stock = FMV of appreciated property when given.
(b) Corp: Takes S/H’s low A/B in property (362) therefore large gain at sale.
(9) Sec. 356: If there is boot present, that counts as gain.
(a) Gain = lesser of boot received or realized gain.
(b) Anything given as consideration other than stock is boot, and taxable, but that does not bust the 351.
(c) Sec. 357: When s/h liabilities are relieved it is generally the same as getting cash, but 357 says that in a 351 transaction if s/h is relieved of liabilities, no gain so long as:
(i) Liabilities are less than the a/b of all property transferred (if greater, the excess is gain); and
(a) If liabilities > A/B, avoid gain by having S/H write a promissory note to the corp (Parachi 9th Circuit). Avoids corp relieving liability.
(b) Liabilities include accounts payable.
(ii) Liability wasn’t created just to get cash out of the corporation (i.e. bona fide business liability). If non-bona fide liability, all liabilities are tainted, and full amount of liability is gain
(a) Example: CEO uses corp charge card to buy personal items. Fix by holding out that debt or paying it off.
(iii) If both 1 and 2 apply, 2 trumps.
c) Sec. 354: No g/l in stock-for-stock exchange in a reorg.
D. Shareholder’s adjusted basis (358)
1. Sec. 358: S/H’s adjusted basis in stock received in a 351 transaction =
A/B in property
+ gain recognized
– cash received
– FMV of boot
– liabilities relieved of (even if 357 applies)
2. Disregarded liabilities: Contingent environmental liabilities (Rev. Rul. 95-74) and liabilities which will be deductible when paid.
E. Corporation’s adjusted basis (362)
1. Sec. 362: Basis to corp in property received in a 351 stock for property exchange is the carryover basis from transferor, plus any gain recognized by the transferor.
2. If not 351, A/B equals FMV.
F. Holding period
II. Corporation vs. Partnership Features
A. Corporation: Easy to transfer ownership, tax-free reorgs, dividends received deduction, lower marginal rate than K, flexible year end, consolidated groups/NOLs, deduct org and start-up costs, fringe benefits for employees, 1202, 1244.
B. Partnership: Transfer of 50% interest terminates partnership, special allocations available, calendar year end, losses flow through, tax-free property transfer, partners are not employees,
C. Double Taxation
a) Assumes dividend is paid, which is rare in Silicon Valley.
a) General Utilities Doctrine
(1) No G/L on distribution to S/H of property with built-in gain (FMV higher than A/B).
(2) Repealed by Sec. 336(a): Corporation does recognize G/L on liquidation of property to shareholders.
(3) Therefore, better for corporation to lease assets which will appreciate in value (FMV will exceed A/B), rather than putting an appreciating asset into a corporation. Lease expense is deductible.
a) Corporate: 34% (22.25% on income less than $100k, so good to try to get income down to that amount).
b) Shareholder: ~40%
4. Avoidance – Planning Ideas (also deductions), esp. for small family business
a) Increase salary (reasonable) to family members; pension plans and fringe benefits.
b) Lease property from s/h family members
c) Pay off interest on debt used to capitalize company
d) Set up internal travel agency or advertising agency as partnership to handle corporate travel and advertising, children or family members as partners to receive money.
e) Goal is to reduce income to $100k to take advantage of lower 22.25% tax bracket and reduce taxation to one level.
III. Incorporating a Business
1. Reg. 301.7701-2, 3, 4
2. Allows entity with 2+ investors not established as a corporation under state law to be treated for federal tax purposes as a corporation.
3. Election lasts for 5 years – after that, entity can switch back.
B. Capital Structure
a) Preferred stock: Nonvoting; priority on liquidation and dividends
b) Common stock: Dividend payments not deductible
(1) Loan to company
(2) Superior form of capitalization
(a) Interest is a deductible expense, as opposed to a dividend.
(b) Repayment is not a taxable event.
(3) Bank will want to see adequate capitalization, i.e. 3:1 equity:debt.
(4) Sec. 385: Debt vs. Equity characterization.
(a) Would an independent lender make this loan? Lender wants to see good capitalization with stock by owner (i.e. 3:1).
(b) Case law looks at facts and circumstances.
2. Redemption: Not automatically a capital transaction – may be a dividend (ordinary income).
3. Repayment of loan: Automatic return of capital – no g/l. Makes debt more favorable way to capitalize corp. because of interest deduction and no g/l on repayment.
C. Small Business Stock
1. Sec. 1244
a) Qualification: Corp with capitalization under $1M, and more than half of gross receipts in past five years from non-passive activities, and individual s/h received stock for property but not services.
b) Benefits: If a loss on stock occurs, original investor can take ordinary loss of up to $100k ($50k single) per year.
2. Sec. 1202 Qualified Small Business Stock
a) Qualification: Stock of C corp with aggregate gross assets less than $50M and s/h acquired stock for cash, property or services after 8/10/93, and held on to it for more than 5 years.
b) Benefit: Gain to non-corporate s/h taxed at 14% (50% of 28% rate) – excluded portion subject to AMT adjustment.
(1) S/H can reinvest stock proceeds w/in 60 days of sale in another QSB to defer gain and diversity risk. Holding time tacks on to reach 5 years.
D. Accounting periods and methods
1. Tax Year
a) Regular corp: Any tax year end can be chosen on initial tax return
b) Personal service corp: Calendar year
2. Method: Accrual or cash
a) Corp must use accrual unless:
(2) Farming business
(3) Personal service corp (95% of business is professional services and 95% of stock owned by employees)
(4) Company with average gross receipts for past 3 years of less than $5M, and inventory is not a material producing asset.
3. Sec. 481: Change in method requires spreading adjustment income over 4-6 years. If P converts to C during that period, P has to pick up all adjustment income in final P year.
E. Conversion of Partnership to Corporation (three ways, Rev. Rul. 84-111)
1. Liquidate P and have partners contribute to C.
2. Have partners contribute their interests in P to C, with 1 partner remaining to keep P with 2 partners.
3. P contributes property to C, and P owns C. 357 problem if any partners run up personal liabilities. Corp may also be a PHC.
F. Stock Options
1. Generally when a corporation gives stock for services, they treat the stock as a capital asset, and takes deduction at FMV of stock.
a) Exercise not taxable event and no deduction for corp. For AMT, exercise is an adjustment for the spread amount. If the stock price decreases after exercise, AMT has negative adjustment at sale equal to exercise less sales price.
b) Sale: If TP holds for one year after exercise and two years after grant, gain of FMV less exercise price is long term. If holding period not met, disqualifying disposition results, and gain is ordinary income with deduction to corp.
a) Grant non-taxable.
b) Exercise is a taxable event and deduction for corporation.
4. Restricted stock
a) Grant non-taxable
b) When risk of forfeiture lapses, ordinary income and deduction of entire value.
c) 83(b) election available.
IV. Tax Rates
1. First $50,000: 15%
2. Next $25,000: 25%
3. Next $25,000: 34% (average rate on $100k – 22.25%)
4. $100,000-$335,000: $39%
5. Over $335,000: All income has flat rate of 34%
6. Over $10M: 35% flat rate.
B. Personal Service Corporation
1. Flat 35%
2. Definition: Services (95%) in the fields of accounting, law, architecture, accounting, consulting, engineering, medical, and substantially all (95%) of the stock is held by employees performing services.
C. No special rate for capital gains
D. Installment sales
1. Income from property sold over a multiple-tax-year period must be proportionately recognized over those tax years.
2. Election available to recognize all of the income in the CY.
V. Capital Gains & Depreciation
A. No special rate for long-term capital gains in corporations.
B. Involuntary conversion = capital gain or loss.
C. Gain = Initial basis – accumulated depreciation – amount received.
D. 1221: Capital assets = property, but not inventory, depreciable property, or supplies.
E. 1231: If gains from sale of depreciable property used in a trade or business and held for more than 1 year exceed losses, gain is long-term capital. If losses exceed gains, then ordinary loss. If unrecaptured 1231 losses in prior 5 years is still being carried forward, gain may be offset by that loss.
F. 1245: Depreciation recapture: At disposition of depreciable tangible personal property or intangible property (197), the lower of the depreciation taken or the recognized gain is ordinary income. Excess is capital gain, unless sold to related party, then ordinary income.
G. Small business (<$200k equipment purchases) can expense up to $20k of placed-in-service assets per year. Expense longer-lived assets first, then shorter-lived assets.
H. Installment Sale
1. Automatic provision, unless taxpayer opts out.
2. Not allowed on inventory or marketable securities.
3. Example: Sale of asset, paid part in cash, part with note paid over three year period.
4. For every dollar received, gain =
(FMV – A/B) / (consideration received (FMV) – mortgages assumed)
Remainder is return of capital.
5. First year
a) Depreciation recapture is treated as ordinary income.
b) If liabilities exceed basis, excess is ordinary income.
VI. Deductions & Credits
A. Charitable - §170
1. Limited to 10% of taxable income (or AMTI for AMT), calculated before charitable contributions, DRD, and C/B of NOL and capital losses.
2. Excess c/f for five years.
3. Computer equipment donated for research (i.e. university) is deductible to the adjusted basis plus ½ of the appreciation amount, up to 2x of a/b.
1. C/B 2 years, c/f 20 years.
2. Can elect to forego C/B if lower tax bracket in past years, to use NOL in higher tax bracket future years.
C. Capital losses
1. Cannot offset ordinary income.
2. C/B 3 yaers, C/F 5 yaers.
1. Purpose is to avoid triple taxation on income. Effect is a 10.5% max tax rate on dividends.
2. Deduction rates
a) < 20% of stock: 70% of dividends deductedc
b) 20% < 80%: 80% deduction
c) > 80%: 100% deduction
a) Must hold stock for at least 46 days.
b) Can’t borrow money and directly buy the stock (i.e. debt financed portfolio)
c) Corporate shareholders must hold stock for more than 2 years otherwise extraordinary dividends may reduce basis.
E. Personal Service Corporation
1. Passive losses can only be offset against passive income.
F. Below Market Loans
1. §7872: If loan is more than $10k, interest imputed as though lender paid borrower cash and borrower paid lender the interest. May be compensation income to employee, or dividend to shareholder.
G. Related party (combined 50% s/h of corp and close relatives)
1. Loss (267): Buy or sell property at a loss, loss is disallowed. Buyer reduces eventual gain by the disallowed loss (so it’s a deferred loss).
2. Expense matching - §267: If A is cash basis and B is accrual, and B owed A this year but paid next year, B cannot deduct until next year.
H. Officer Comp
1. No deduction for publicly held companies for top five officers if salary is greater than $1M, unless compensation is tied to performance (prevents loss companies from paying high salaries).
2. For closely held companies, officer comp must be reasonable. Not an issue for larger public companies.
I. Foreign Tax Credit
1. Maximum amount by which foreign taxes paid can reduce US tax liability = (foreign source taxable income / world-wide taxable income) x U.S. tax.
2. Excess foreign tax paid carries back 2 years and 5 forward.
3. If you cannot take the credit, it can be used as a deduction to c/f as an NOL.
4. Cannot reduce regular tax below AMT.
J. General Business Credit
1. Taken before FTC.
2. R&D – 280C election:
a) Taxpayer can either deduct full amount of R&D activities, and reduce credit by highest tax rate; or
b) Take full credit and reduce deduction by amount of credit (default). If this applies, for AMT there is no AMT credit, but also no add-back to the AMT deduction – taxpayer gets screwed.
c) For corp in highest tax bracket, both options have same result. If corp in <35% bracket, default option (full credit) is best.
3. Rehab, Watts, etc.
4. Applied to regular tax after FTC, up to 25k plus 75% of excess tax liability.
5. C/B 1, C/F 20
6. Credits cannot reduce regular tax below AMT.
K. Taxes & Interest
1. State taxes are not deductible. Federal taxes are deductible.
2. Interest on bonds is the opposite: State interest is deductible (nontaxable), federal is not.
3. Interest expense deduction = (taxable interest / total interest) x interest expense
L. Life Insurance - Officers
1. Proceeds not taxable; premiums not deductible. No tax, no deduction.
VII. Distributions & Dividends
A. Constructive dividends
1. Renting property to corp w/higher than normal rent, or below market rentals from corporation.
2. Sale to/from co at above or below price.
3. Unreasonable compensation: Constructive dividend in amount above reasonable amount. Taxable to individual to extent of current and accumulated E&P. If none, then it’s a return of capital. No deduction to corp.
1. 301 Cash: No deduction to corp.
2. 311 Property
a) No g/l unless property is appreciated, then gain as if property was sold at FMV. Therefore, if corp has loss property, sell to taxpayer at loss and distribute the cash to shareholder. That allows corp benefit of the loss.
b) Basis in property received = FMV net of liabilities.
3. Tax treatment
a) Distribution is a dividend if there are current E&P, even if accumulated E&P is negative. Look at current first, and only if current is negative look at accumulated. If no E&P, distribution reduces basis, then treated as capital gain. Current E&P is allocated amongst the payments pro rata. Accumulated E&P is allocated FIFO.
(1) On distribution, corp’s E&P is reduced by any amount distributed, at the higher of FMV or A/B of property, but never below 0. If FMV > A/B (appreciated), for purposes of measuring E&P to determine character of distribution, add excess of FMV over A/B to E&P, take measurement, then reduce E&P by FMV. If distributed property is subject to a mortgage, add amount of mortgage to E&P.
b) Corporate s/h wants dividend treatment for DRD. Individual s/h wants capital gain treatment for lower tax rate.
(1) For our companies, they would rather reinvest the money into the corporation, generating higher capital gains (with lower tax rates for shareholders).
(2) Good for corporations, bad for shareholders, because of the tax rates.
4. 305: Distribution of Stock to S/H
a) Distribution of stock to existing s/h (i.e. stock split) is not a dividend, and is not taxable, unless s/h has choice between taking cash or stock and chooses stock, or stock is a dividend on preferred stock.
C. Effect on Shareholder
1. Amount received = cash plus liabilities assumed plus FMV of property received.
2. Taxable: Amount which is a dividend (extent of current or accumulated AMT). That which is not a dividend reduces adjusted basis of stock (return of capital). Once A/B is zero, excess is a capital gain in character of the stock (LT or ST).
3. If S/H redeems stock but still owns the same % of the corp (i.e. 100%) after the sale, gain is capital (therefore reduced tax rate).
4. Capital gain treatment applies only if (302(b)):
a) Redemption is not equivalent to a dividend;
b) Substantially disproportionate redemption of stock; or
c) Complete redemption of stock
D. Stock Redemption
1. Redemption treated as distribution of property unless 302(b) is met.
2. Family attribution: One member of a family is considered to own the stock that the other family members own. If one member redeems all stock, he still constructively owns all the stock of the relatives. No capital gain treatment on redemption b/c no change in percentage of ownership. But 302(b)(3) complete redemption of stock allows for cap. gain if all family members redeem, or redeeming member elects out of attribution. Election requires filing a statement, and that s/h must not have any affiliation or interest w/company.
VIII. 318 Attribution
A. Family members (grandparents own grandchildren, but not vice versa)
1. From entity to owner (entity’s stock treated as owned by S/H): Proportional attribution. No attribution w/corps unless S/H has greater than or equal to 50% ownership of corp. No minimum threshold for partnerships, therefore P could check-the-box to become corp and put threshold in place.
2. From owner to entity (s/h stock treated as owned by entity): No proportionality – 100% is used. 50% threshold between corp and owner.
1. Partners aren’t attributed to partners
2. Sisters aren’t attributed to brothers
3. No double family member attribution (husband to wife to wife’s mother)
4. No block to stringing along entities … i.e. P attributed to P attributed to C attributed to S/H, etc.
D. Total ownership can be greater than 100%.
E. Options treated as stock
F. PHC attribution - 544
IX. Controlled groups
A. Goal: Not to be a controlled group
1. 5 or fewer sh’s with common ownership together control 80% or more of both companies. Ex: 1 person owning >80% of two corps. Therefore, the corps are bro/sis corps.
2. Those S/H’s have identical ownership of >50%. Identical = lower of the %’s.
C. Constructive ownership / attribution does apply between family members and entities (1563(e)). But not bro/sis family member s- just spouses, unless spouses meet exception rules.
D. Moral of the story: Break up family business into small co’s that aren’t controlled and spread the income around to get lower tax rates. Including creating a management company.
1. 3 people can set up 6 companies: 3 owned 100% by individuals, 3 owned 50% by 2 x 2.
1. Parent w/80% ownership in sub, liquidating sub into parent: 332 says no g/l to parent, 337 says no g/l to sub. P’s investment in S disappears. Tax attribution of S go to P (381). Basis in S’s assets carries over to P.
1. Corporation w/shareholders: If no 80% ownership (or the 20% ownership from the 332/337 deal), 336 says gain or loss is recognized by the liquidating corp, and 331 says s/h recognize the gain as if SH sold the stock at FMV. Basis in property = fmv; sub’s attributes disappear. 332: No G/L to corp on receipt of property in complete liquidation of a stock, but no loss to liquidating corp. Forces sub to cash out 20% SH.
A. Target’s sh want to sell stock (cash goes to SH not corp – skips double taxation)
B. Acquiring co wants to buy assets to get step up in basis.
C. Stronger party wins.
D. 338 election: A can elect to treat stock purchase as an asset acquisition. Deemed sale of T’s assets to itself. Creates another gain/loss. Useful if T is foreign, or if T has large NOL’s. Steps up basis without gain because foreign country won’t recognize the gain. Wipes out T’s tax attributes.
E. 338(h)(10) election: Allows a 332 transaction to treat as if T sold assets to itself and liquidated up. Built in gain can be offset w/NOLs.
XII. Estimated taxes
A. §6655 Safe Harbor
B. Non-Large Co. must pay lesser of:
1. 100% of last year’s tax (unless no tax was paid last year); or
2. 100% of current year tax projection
C. Large Co. must pay:
1. Q1: Same as non-large co.
2. Q2-Q4: 25% of current year’s projected tax, plus any make-up from Q1 (if Cy has more tax than PY)
D. Large Co.: More than 1M in taxable income in any of the prior 3 years, exclusive of NOLs.
E. If AMT tax applies, estimates must be paid based on AMT.
a) Payment often required under AMT before regular tax – accelerates income, defers deductions.
2. Minimum tax
a) AMT is only paid if it exceeds regular tax liability, excluding all credits other than FTC.
b) If tax is caused by timing differences, it is basically a prepayment of regular liability via minimum tax credit. If caused by perm differences, it is an additional tax imposed, and no credit carryforward is available.
c) Minimum tax credit carries forward indefinitely, and applies to reduce regular tax when regular tax is next greater than AMT.
d) MTC is applied after other tax credits. Credits reduces regular tax liability to AMT amount.
3. Parallel system
a) AMT has its own tracking for NOL, credits, property basis, charitable contributions, etc.
Taxable income before NOL deduction but after DRD
– AMT NOL (90% of AMTI max)
+ ACE Adjustment
x 20% flat tax rate
-FTC (unless NOL maxed out)
a) Added back to AMT.
b) Section 1202 qualified small business stock exclusion (perm): 42% of excluded gain must be added back.
c) Certain tax-exempt interest income (perm): Private Activity (PA) bonds.
(1) Any interest expense related to PA bonds is deductible for AMT.
a) Substitution of AMT treatment for regular tax treatment.
b) Incentive stock options (temp)
(1) At exercise, adjustment = difference between FMV and exercise price.
(2) AMT basis is adjusted accordingly.
(3) No adjustment for disqualifying dispositions – treated same as regular tax.
c) Excess depreciation on real estate placed in service between 87-98 (temp): AMT uses a different depreciation schedule.
(1) Commercial/Industrial real estate: Regular 39 years; AMT 40 years.
(2) Residential real estate: Regular 27.5 SL; AMT 40 years.
d) Excess depreciation on personal roperty placed in service after 86
(1) Pre-99: See Rev. Proc 87-56 for class lives to use for AMT. AMT generally longer than MACRS.
(2) Post-99: Same life for both regular tax and AMT.
a) May not reduce AMTI by more than 90% of AMTI.
1. Corporate: Flat 20%
a) 26% on first 175,000
28% on excess