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This course covers the basic types of corporate entities for tax purposes, with a focus on the types subject to corporate income tax. Topics include double taxation, tax rates for corporations and individuals, and reasons for choosing or not choosing a C corporation.
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Introduction • Personal Introductions • Course objective • Class approach: Problems • Reading materials/Bittker&Eustice • Attendance • Grades • Homework: Solving problems • Quizzes/Special Project • Tests/ Practice Tests
To Begin With … • What are the basic types of corporate entities for tax purposes? • What type of corporation is subject to a corporate income tax? • That’s where we will focus our attention
Problem 1 • B&E Revised Study Problems • Lesson 1, Problems (1) and (2)(a) through (d)
Universe of Business Orgs • Partnerships --- Flow thrus for tax purposes • General • Limited • S Corps --- Flow thrus for tax purposes • C Corps --- Separate entities for tax purposes • See also Publicly Traded Partnerships, Regulated Investment Companies, REITS, REMICs. • NOTE: LLCs may elect to be treated as partnerships or S/C Corps
Current corporate versus individual ordinary income tax rates Married Filing Jointly 10% 15% 25% 28% 33% 35% 39.6% $470M & above Corporate 15% $0- $50M 25% $50M - $75M 34% $75M - $100M 39% $100M - $335M 34% $335M - $10,000M 35% $10,000M & above (subject to 38% rate between $15,000M& $18,333,333)
Current corporate versus individual long capital gains tax rates
Problem 2 • Individual in 35% bracket wants to start up new business by himself and expects business to earn $100,000 taxable income in first year. Strictly from a federal income tax standpoint, is he better off operating business as sole proprietor or inside C corporation?
The concept of double taxation • Tax at corporate level on net earnings. • Tax (again) at the shareholder/individual level on qualified dividend distribution of earnings, albeit at 0%, 15% or 20% (plus 3.8%) --- NOT at shareholder’s individual income tax rate. (Note: definition of qualified dividend to be examined later in course.) • The same earnings amount (minus what is paid out in taxes at corporate level) is taxed TWICE.
Disappearance of Double Tax • BUT…. Distribution of compensation (not earnings) to employees is deductible at the corporate level, provided that the compensation is reasonable. • In that situation, no double tax. Why? • FICA tax still applies at corporate and indiv. level • What is reasonable? Fact specific. • What if shareholder and employee are one and the same? Is the distribution earnings or compensation? Fact specific, and source of a lot of litigation.
Factors used to determine reasonableness of compensation • Employee’s role and qualification in the company • Character and condition of company • Comparison of employee’s compensation with compensation paid elsewhere for comparable services • Salary policy of company for all employees • Whether any conflict of interest, e.g., where employee is company’s sole shareholder.
Limit on public corporation’s deduction for compensation in excess of $1 million • Compensation must be reasonable, PLUS • Cannot exceeds $1 million per year UNLESS • The compensation meets one of several exceptions, including “performance based compensation” (PBC). • An example of PBC would be stock options
Problem 3 Assume C Corp in 35% tax bracket earns $200 taxable income and pays after-tax amount to sole shareholder/employee in highest-tax bracket as a qualified dividend. What is total federal income tax paid at corporate and shareholder level? How is the result different if after-tax amount is paid out as “reasonable compensation” to shareholder/employee?
Problem 4 • Assume C corporation taxed at 35% generates $500,000 of earnings the after-tax amount of which it will distribute as a qualified dividend to its shareholder in the 39.6% ordinary income tax bracket. What is the net amount left to the shareholder after all federal income taxes are paid? • How is the answer different if the shareholder is an employee and the distribution is considered reasonable compensation? • For answers, ignore FICA and Obamacare taxes
What are tax reasons business would choose to form a C corporation? • Publicly traded business; can’t meet requirements to qualify as pass-thru. • Desire to retain earnings inside corp. when there is a substantial differential between corporate and individual rates. Caveat: Restrictions apply. • Double tax “sting” is lessened with relatively low qualified dividend tax rate. • Retirement benefits sometimes more attractive • Big non-tax reason: raise capital from public at large i.,e., IPO
What are tax reasons business would choose NOT to form a C corporation? • Avoid double tax altogether • Avoid double tax altogether • Avoid double tax altogether • No preferential corporate capital gains tax rate inside C Corporation • Reap immediate tax benefits from entity losses, subject to: (i) basis in entity (ii) limitations on passive losses
Problem 5 • Complete problem 1 (parts (a) and (c)) in Lesson 2A of B&E’s Revised Study Problems, including the C Corp scenario where $500,000 paid as compensation and $500,000 paid as qualified dividend. Assume A is taxed at 39.6% rate, C corporation at 35% and all compensation constitutes reasonable compensation. Qualified dividends are taxed at 20%.Ignore all employment and Obamacare tax and S corporation issues.
Respecting corporate form as separatefrom its shareholders • Minimal test: Must be business purpose or activity
Paymer vs. Commissioner • Taxpayers formed two corporations: Raymep and Westrich. • Parcel of real estate conveyed to each • After start-up, no meetings held by either; no books or records; sole purpose of corporate formation to deter creditors. • One difference: Raymep secured loan and as security assigned rights to property to lender. • Question: Which corporations recognized for tax purposes?
Even if corporate form respected, IRS has tools to ignore transaction form • Statutory rules that police transactions between related or affiliated parties • Judicial authority • Substance over form • Economic substance • New statutory authority • Codification of economic substance
Subchapter S • Flow-through corporation • Limited application because of requirements such as no more than 100 shareholders and those (with exceptions) must be individuals • Tax rules a combination of those that apply to C corporations AND partnerships; also some unique to S corporations • FICA vs. SECA
Limited liability company (LLC) • Flow-through entity that does not have to meet Sub S requirements. • Liabilities of entity “walled off” from that of its owners – unlike general partnerships • Can elect to be treated as corporation for tax purposes but usually elects partnership status because of tax advantages. • Entity of choice for start-ups and small businesses
Professional Corporations • C Corporations limited to licensed practitioners of professional services. • Only licensed professionals can qualify as owners • Created by state statutes. • Flat 35% tax bracket.
Problem 7 • B&E Revised Study Problems • Lesson 2A, Problem 2. Assume that both the corporate and individual tax rates are 35% and that no dividends or other distributions made by the corporation.
