Tax 4022/5022 Tax 4022/5022 Federal Income Tax IIFederal Income Tax II

Dr. Robert R. OlivaProfessor and ChairpersonDepartment of Accounting

University of Arkansas at Little Rock

How to obtain class files:How to obtain class files:

http://www.cba.ualr.edu/rroliva/indexrr.html

Corporate Income Taxation Corporate Income Taxation

Miscellaneous TopicsMiscellaneous Topics

Copyright, 1996 © Dale Carnegie & Associates, Inc.

TIP For additional advice seeDale Carnegie Training® Presentation Guidelines

I. The Corporation as an Entity: Types

II. Corporate Taxation

III. Corporations v. Other Entities

I. The Corporation as an I. The Corporation as an Entity: TypesEntity: Types

“C” corporations: Regular corporations “S” corporations Why “C” v. “S”?

Organization of USC Title 26Organization of USC Title 26

Subtitle– Chapter

Subchapter– Part

• Subpart

SUBTITLESSUBTITLES

A: INCOME TAXES B: ESTATE AND GIFT F; PROCEDURE AND

ADMINISTRATION

Subtitle A (divided into Subtitle A (divided into CHAPTERS)CHAPTERS)

1: NORMAL TAXES 2: SELF EMPLOYMENT TAXES 6: CONSOLIDATED RETURNS

Chapter 1 (divided into Chapter 1 (divided into Subchapters)Subchapters)

– A: TAX LIABILITY– B: COMPUTATION OF TAXABLE INCOME– C: CORPORATE DISTRIBUTIONS AND

ADJUSTMENTS– K: PARTNERS AND PARTNERSHIPS– S: TAX TREATMENT OF S

CORPORATIONS AND THEIR SHAREHOLDERS

Defining the “C” corporationDefining the “C” corporation

State law Federal law

– Check the Box Regulations

State lawState law

De jure v. de facto Define responsibilities Define dissolution events

Federal law: Federal law:

IRC: 7701(a)(1)-(3) Check the box regulations Morrisey v. CIR

IRC 7701(a)(1)-(3)IRC 7701(a)(1)-(3)

IRC: corporations includes associations What does that mean?

– Treas. Regs– Cases

Treas. Reg. 301-7701-4Treas. Reg. 301-7701-4

Applicable to resolve issues of whether the business entity should be taxed as one of the following:– Sole proprietorship– Partnership– Corporation

Types of corporate entitiesTypes of corporate entities

“Per se” corporations Not ‘per se” corporations = associations

““Per se” corporationsPer se” corporations

De jure Specifically included foreign corporations

– Generally not closely held, publicly traded

Not “per se” corporations = Not “per se” corporations = associations associations

AKA: eligible entities – Domestic– Unincorporated

Partnerships LLC

– Nonpublicly traded May choose classification Failure to choose: default rules

Choosing classificationChoosing classification

Membership > 2: corporation or partnership Membership = 1: corporation or sole

proprietorship

Default rules:Default rules:

Incorporation on or after 1/1/97:– Membership > 2: partnership– Membership = 1: sole proprietor

Incorporation before 1/1/97:– Membership > 2 : use old regulations– Membership = 1: sole proprietorship

Choosing statusChoosing status

Form 8832

II. Corporate TaxationII. Corporate Taxation

Corporate rates: IRC 11Corporate rates: IRC 11

15%; 25%, 34%, and 35%– 15%: >$0 to $50K– 25%: >$50K to $75K– 34%: >$75K to $10MM– 35%: >$10MM

But also: two surtaxes to eliminate savings from lower brackets:– Add 5%when TI >$100k up to $11,750

Creates a rate “bubble”: 39% MTR between $100K-$335K

– Add 3% when TI> $15MM up to $100K Creates a rate “bubble” of 35% when TI >$18.3MM:

Organization of USC Title 26Organization of USC Title 26

Subtitle– Chapter

Subchapter– Part

• Subpart

SUBTITLESSUBTITLES

A: INCOME TAXES B: ESTATE AND GIFT F; PROCEDURE AND

ADMINISTRATION

Subtitle A (divided into Subtitle A (divided into CHAPTERS)CHAPTERS)

Chapter 1: NORMAL TAXES

Chapter 1 (divided into Chapter 1 (divided into Subchapters)Subchapters)

– Subchapter A: TAX LIABILITY– Subchapter B: COMPUTATION OF TAXABLE

INCOME– Subchapter C: CORPORATE DISTRIBUTIONS

AND ADJUSTMENTS– Subchapter K: PARTNERS AND PARTNERSHIPS– Subchapter S: TAX TREATMENT OF S

CORPORATIONS AND THEIR SHAREHOLDERS

SUBCHAPTER C divided into SUBCHAPTER C divided into Parts Parts

PART I: DISTRIBUTIONS BY CORPORATIONS

PART II: CORPORATE LIQUIDATIONS PART III. CORPORATE

ORGANIZATION AND REORGANIZATIONS

PART I: DISTRIBUTIONS BY PART I: DISTRIBUTIONS BY CORPORATIONSCORPORATIONS

SUBPART A: EFFECT ON RECIPIENTS: IRC 301-307

SUBPART B: EFFECT ON CORPORATION: IRC 311 AND 312

PART II: CORPORATE PART II: CORPORATE LIQUIDATIONSLIQUIDATIONS

SUBPART A: EFFECT ON RECIPIENTS: IRC 331-334

SUBPART B: EFFECT ON CORPORATION: IRC 336-338

PART III. CORPORATE PART III. CORPORATE ORGANIZATION AND ORGANIZATION AND REORGANIZATIONSREORGANIZATIONS

SUBPART A: CORPORATE ORGANIZATION: IRC 351

SUBPART B: EFFECT ON SHAREHOLDERS: IRC 354-358

SUBPART C: EFFECT ON CORPORATION; IRC 361-362

CORPORATE TAX CORPORATE TAX FORMULAFORMULA

Corporate Tax FormulaCorporate Tax FormulaCorporate Tax FormulaCorporate Tax FormulaGross incomeLess: Deductions (except charitable, Div. Rec’d, NOL carryback,

STCL carryback) Taxable income for charitable limitationLess: Charitable contributions (< = 10% of above)Taxable income for div. rec’d deductionLess: Dividends received deductionTaxable income before carrybacksLess: NOL carryback and STCL carrybackTAXABLE INCOME

SUBCHAPTER B: SUBCHAPTER B: COMPUTING TAXABLE COMPUTING TAXABLE

INCOMEINCOME IRC 63(a):

– TAXABLE INCOME = GROSS INCOME LESS DEDUCTIONS

GROSS INCOME: IRC 61– SPECIFIC INCLUSIONS: IRC 71-86– SPECIFIC EXCLUSIONS: IRC 101-135

DEDUCTIONS: IRC 161-197

CORPORATE DEDUCTIONSCORPORATE DEDUCTIONS

IRC 162: ORDINARY AND NECESSARY DIFFERENCES SPECIAL CORPORATE DEDUCTIONS

DIFFERENCES FROM DIFFERENCES FROM INDIVIDUALSINDIVIDUALS

– NO FLOOR ON MISCELLANEOUS DEDUCTIONS [IRC 167: 2% OF AGI]

– NO STANDARD DEDUCTIONS

– NO DEPENDENT

– NO HOBBY LOSS LIMITATIONS

– NO INVESTMENT INTEREST LIMITATIONS

– NO CASUALTY LOSSES LIMITATIONS

– CHARITABLE. CAPITAL GAINS/LOSSES, AND NOL DEDUCTIONS COMPUTED DIFFERENTLY

Capital gains/losses:Capital gains/losses:

Corp: Capital gains taxed as all other income

Corp: Capital losses cannot be reduce other income but it can reduce capital gains.

Net Capital Losses: Carry Back/Forward (and treat as ST cap. loss) – Method: Carry back to third previous year; 2d

previous; last year; and then for the next 5 years.

NOLsNOLs

Carry Back/Forward May elect to carry-back 2 years, otherwise

carry forward 20 years. – DRD included in NOL computation

The Corporate Income TaxThe Corporate Income Tax

SPECIAL CORPORATE SPECIAL CORPORATE DEDUCTIONSDEDUCTIONS

IRC 243: DRD IRC 246 IRC 248 IRC 267 IRC 291

IRC 243: DRDIRC 243: DRDIRC 243: DRDIRC 243: DRD

70% DRD IF % OWNERSHIP < 20% 80% DRD IF % OWNERSHIP = 20% TO

<80% 100% DRD IF % OWNERSHIP 80% OR

MORE

IRC 246: DRD LIMITATIONS; IRC 246: DRD LIMITATIONS; OWNING < 20%: OWNING < 20%:

DRD LIMITED TO THE LESSER OF– 70% DIV RECEIVED, OR– 70% OF TI BEFORE THE DRD, NOL,

AND/OR CAP. LOSS CARRYBACK BUT NO LIMIT WHEN DRD

GENERATES OR ADDS TO AN NOL

EXAMPLEEXAMPLE

CORP RECEIVES $200 DIV ENTITLED TO A 70% DRD, $300 DEDUCTIONS

IF GROSS INCOME = $400IF GROSS INCOME = $400

TIBDRD: 400 + 200 - 300 = $300 70% OF TIBDRD = .7($300) = $210 70% OF DIV = .7($200) = $140 *

LESSER OF 70% OF TIBDRD OR 70% OF DRD = $140

IF GROSS INCOME = $280IF GROSS INCOME = $280

TIBDRD: 280 + 200 - 300 = $180 70% OF TIBDRD = .7($180) = $126* 70% OF DIV = .7($200) = $140 LESSER OF 70% OF TIBDRD OR 70%

OF DRD = $126

IF GROSS INCOME = $ 220IF GROSS INCOME = $ 220

TIBDRD: 220 + 200 - 300 = $120 70% OF TIBDRD = .7($120) = $84 70% OF DIV = .7($200) = $140* LESSER OF 70% OF TIBDRD OR 70%

OF DRD = $140? $140 BECAUSE IT WILL GENERATE

AN NOL: $120-$140 = ($20)

Other DRD ExamplesOther DRD ExamplesOther DRD ExamplesOther DRD Examples

Z Corp owns 60% of X Corp’s stock in years 1, 2 & 3. Dividend of $200 is received each year. Limit (Step 2) is 80% x $200 = $160.

1 2 3_

Income 400 301 299

Dividend rec’d 200 200 200

Expenses (340) (340) (340)

Income before DRD 260 161 159

80% of income 208 129 127

Year #1 $208 > $160, so $160 is DRD

Year #2 $129 < $160, so $129 DRD

Year #3 DRD causes NOL ($159-$160), so $160 DRD is used. $2 less income results in $30 more DRD

IRC 248: ORGANIZATIONAL IRC 248: ORGANIZATIONAL EXPENDITURESEXPENDITURES

ELECTION– IF NOT MADE WITH FIRST RETURN,

THEN DEDUCT IN LIQUIDATION OVER NOT LESS THAN 60 MONTHS

– STARTING WITH THE FIRST MONTH OF OPERATIONS

EXAMPLE:EXAMPLE:

INCORPORATION ON 7/1 STARTS BUSINESS ON 8/1 ELECTS YEAR END OF 9/30

EXPENSESEXPENSES

(1) 6/10: $2K, CHARTER EXPENSES (2) 7/17: $40K, COMMISSIONS (3) 7/18: $2K, CPA FEES (4) 7/20: $1K, TEMP DIRECTORS (5) 8/25: $2K, REGULAR DIRECTORS (6) 12/31: $1K, MODIFY CHARTER

NOT INCLUDED:NOT INCLUDED:

(2): PAID-IN CAPITAL: EXPENSES FOR SELLING SECURITIES AND TRANSFER OF ASSETS

(5): ORDINARY AND NECESSARY DEDUCTION

(6): INCURRED DURING SECOND YEAR

INCLUDED:INCLUDED:

(1); (3); AND (4) = $5,000 $5000 OVER 60 MONTHS =

$83.33/MONTH ONLY TWO MONTHS IN FIRST YEAR:

2 ($83.33) = $$166.66

IRC 267: LOSSES, IRC 267: LOSSES, EXPENSES, AND INTEREST EXPENSES, AND INTEREST

BETWEEN RELATED BETWEEN RELATED TAXPAYERSTAXPAYERS RELATED?

EFFECT

RELATED TAXPAYERSRELATED TAXPAYERS

>50% OWNERSHIP CONSTRUCTIVE OWNERSHIP

CONSTRUCTIVE CONSTRUCTIVE OWNERSHIP: IRC 267(c)OWNERSHIP: IRC 267(c)

– A.F.E. %: ATTRIBUTION FROM ENTITY = PROPORTIONATELY

STOCK OWNED BY A CORP, PART, EST, OR TRUST OWNED PROPORTIONATELY BY SHAREHOLDERS, PARTNERS, OR BENEFICIARIES.

– INDIVIDUAL CONSIDERED OWNING STOCK OF BROTHERS/SISTERS, SPOUSE, ANCESTORS, AND LINEAL DESCENDANTS, AS WELL AS HIS PARTNER.

REATTRIBUTION REATTRIBUTION

STOCK OWNED DUE TO A.F.E., CONSIDERED AS OWNED BY SHAREHOLDER, PARTNER, OR BENEFICIARY, TO REATTRIBUTE TO OTHERS.

STOCK OWNED DUE TO PARTNERSHIP OR FAMILY RELATIONSHIP CANNOT BE RE-ATTRIBUTED TO OTHERS.

IRC 267(d): SUBSEQUENT IRC 267(d): SUBSEQUENT RESALE TO A THIRD PARTYRESALE TO A THIRD PARTY REDUCE SUBSEQUENT GAIN FROM

RESALE BY PREVIOUSLY DISALLOWED LOSS

IRC 1239: GAINS BETWEEN IRC 1239: GAINS BETWEEN RELATED TAXPAYERSRELATED TAXPAYERS

COVERT CAPITAL GAINS INTO ORDINARY INCOME

USES IRC 267 CONSTRUCTIVE OWNERSHIP RULES

III. Other business entitiesIII. Other business entities

Sole propietorships Pass-Through Entities

– Partnerships– S corporations– LLCs

Sole propietorshipSole propietorship

One owner No separate existence

– No independent tax significance or consequence Income and expenses retain their character

– Owner contributes and withdraws property without tax effect

Reported: Form 1040; Sch. C Business MTR = individual’s MTR

AdvantagesAdvantages

No independent taxation Losses serve as tax shelter to other income

DisadvantagesDisadvantages

Net profit taxed to owner when reported whether received or not– Taxed on re-invested profits

Owner is not an employee– Self-employment tax

Same tax year No liability shield

Pass-Through EntitiesPass-Through Entities

Partnerships S Corporations LLCs

Partnerships: DefinitionPartnerships: Definition

State law Federal law

Partnership definition: UPA Partnership definition: UPA (local law):(local law):

“… an association of two or more persons...”

“… to carry on as co-owners ….” It is not sufficient:– to have a mere co-ownership, particularly a

passive activity investments– sharing profits: needs co-ownership

“… a business for profit”

Partnership definition: Federal Partnership definition: Federal tax law: IRC 761(a)tax law: IRC 761(a)

“.. Includes a syndicate, group, pool, joint venture or other unincorporated organization …”

“… through of by ... Which any business, financial operation, or venture is carried on ….”

“… and which is not … a corporation, or a trust or estate….”

Partnerships: Subchapter KPartnerships: Subchapter K

2 or more persons Independent entity from owner

– Income & Expenses to partners in K-1’s: Non-separately Stated and Separately Stated

– Partner liable for share for allocable share, irrespective of distribution

Conduit/flow through: does not pay taxes– Exceptions: BIG and PAI– Must file an Information Return: Form 1065

Advantages of a PartnershipAdvantages of a Partnership

Entity is tax exempt– Entity’s MTR = partner’s MTR; good if

partner’s MTR < corp’s MTR Partners able to withdraw and contribute

affecting only adjusted basis Partners’ basis increases by allocable share

– Reduces gain on sale Debt basis

DisadvantagesDisadvantages

Net profit taxed to owner when reported whether received or not– Taxed on re-invested profits

Owner is not an employee– Self-employment tax

Effect of “Check the Box” Effect of “Check the Box” regulationsregulations

Business entities with > 1 member may elect to be taxed as partnership or corporation.

But if there is a failure to elect, classification is pursuant to the default rules. – If >1 member: partnership

Types of partnershipTypes of partnership

– General – Limited– Family partnerships– Publicly traded partnership

taxed as corporations unless > 90% of gross from qualifying passive income

traded in public markets

– Electing large partnerships partners > 100 Not in service business; not commodity trading

Family PartnershipsFamily Partnerships

Real or sham?– Two kinds of partnerships based on what is the

material income producing factor capital services

In service partnership, a partner family member must provide substantial services

In capital intensive partnerships: no as much of a problem

LLCs: Limited Liability LLCs: Limited Liability CompaniesCompanies

State created entity Taxation (as a partnership)

– Elect to be taxed as a partnership under “check the box”

Unlike partnerships (and similar to corporations): members have limited liability

Unlike limited partners: LLC members may participate in management

Advantages of LLC’s (versus Advantages of LLC’s (versus S)S)

not limited to a specific number of members– <2005: 75– > 2005: 100

not limited to one class of stock not limited to kinds of shareholders Non-shareholder debt basis

Additional advantages of Additional advantages of LLC’s (versus S)LLC’s (versus S)

LLC able to make disproportionate allocations and distributions [IRC 704]

LLC able to distribute appreciated property to members without recognition of gain [IRC 731(b)]

Has similar provision as IRC 351, without the need of control and can be used at anytime without concern for control [IRC 721].

Advantages of LLC’s (v. LP’s) Advantages of LLC’s (v. LP’s)

No need for GP with personal liability All members have limited liability All members may participate in

management

Advantages of LLC’s (v. GP’s)Advantages of LLC’s (v. GP’s)

LLC members do not have personal liability

Advantages of LLC’s (v. Sub Advantages of LLC’s (v. Sub C’s)C’s)

LLC’s may be taxed as pass through entities by electing under “check the box” to be taxed as a partnership

Has similar provision as IRC 351, without the need of control and can be used at anytime without concern for control [IRC 721].

Conversion to LLCConversion to LLC

From partnership: no tax consequences From corporation: requires liquidation and

tax event

Other similar entities: Other similar entities:

Limited Liability Partnership Publicly traded partnerships

Limited Liability PartnershipLimited Liability Partnership

Like GP: severally and jointly liable for LLP’s liabilities arising out of other than malpractice.

From partnership to LLC: no tax consequences

Publicly traded partnershipsPublicly traded partnerships

PTP avoided double tax because not taxable at entity level

PTP’s classified/taxed as associations– Exception: When > 90% of gross derived from

passive-type income

S CorporationsS Corporations

Hybrid Advantages/disadvantages

– Very similar to partnerships– Very similar to corporations