TAX II Chapter 15 solutions

List four basic tax planning strategies that corporations and shareholders can use to mitigate double taxation of a taxable corporation's taxable income.

1. Pay reasonable salaries to shareholders. 2. Lease property from shareholders. 3. Defer or eliminate dividend payments. 4. Defer capital gains taxes on shares by making lifetime gifts of appreciated stock.

What are the differences, if any, between the legal and tax classification of business entities?

A business entity may be legally classified as a corporation, limited liability company (LLC), a general partnership (GP), a limited partnership (LP), or a sole proprietorship under state law. However, for tax purposes a business entity can be classified as either a separate taxpaying entity or as a flow-through entity. Separate taxpaying entities pay tax on their own income. In contrast, flow-through entities generally don't pay taxes because income from these entities flows through to their business owners who are responsible for paying tax on the income. C corporations are separate taxpaying entities and if elected some flow-through entities may be treated as separate taxpaying entities. Flow-through entities are usually taxed as either partnerships, sole proprietorships, or disregarded entities.

How do corporations protect shareholders from liability? If you formed a small corporation, would you be able to avoid repaying a bank loan from your community bank if the corporation went bankrupt? Explain.

A corporation is solely responsible for its liabilities. One exception to this is for payroll tax liabilities. Shareholders of closely-held corporations may be held responsible for these liabilities. If a corporation were to go bankrupt, the bank may have priority in the corporation's assets but it could not come to the shareholders to satisfy the outstanding bank loan. The shareholders may lose their investment in the corporation but their personal assets would be safe from the bank.

How does a corporation's decision to pay dividends affect its double-tax rate?

A corporation's double-tax rate includes the corporate tax rate on its income and the tax rate paid by shareholders on either distributed earnings or stock sales. Therefore, the double-tax rate increases with the proportion of earnings distributed as dividends to shareholders. The shareholder may choose to delay recognizing the second level of tax if it relates to stock sales because the shareholder can control the timing of that tax.

Who pays the second level of tax on a C corporation's income? What is the tax rate applicable to the second level of tax and when is it levied?

A corporation's shareholders are responsible for the second level of tax on corporate income. The applicable rate for the second level of tax depends on whether corporations retain their after-tax earnings and on the type of shareholder(s). The shareholders pay tax either when they receive dividends at the dividend tax rate or when they sell their stock at the capital gains tax rate (either long- or short-term, depending on how long they held the stock). Corporate shareholders may be eligible for a dividends received deduction on dividends received from stock ownership. This deduction reduces the dividend tax rate for corporate shareholders. Institutional and tax-exempt shareholders also have special rules on the taxation of dividends and capital gains.

What types of business entities does our tax system recognize?

Although there are more types of legal entities, there are really only four categories of business entities recognized by our tax system: C corporations, treated as separate taxpaying entities, and S corporations, partnerships, and sole proprietorships, treated as flow-through entities.

What is an operating agreement for an LLC? Are operating agreements required for limited liability companies? If not, why might it be important to have one?

An operating agreement is a written document among the owners of an LLC specifying the owners' legal rights and responsibilities for dealing with each other. Generally, operating agreements are not required by law for limited liability companies; however, it might be important to have one to spell out the management practices of the new entity as well as the rights and responsibilities of the owners.

Explain why the IRS would be concerned that a closely held C corporation only pay its shareholders reasonable compensation.

Closely held corporations may have incentives to reduce the double tax on income by paying large salaries to its shareholder/employees. By classifying distributions as salary rather than dividends, the overall double tax rate decreases because the salary is tax deductible at the corporate level. The IRS would be concerned that the closely-held corporation would be classifying too much as salary thereby reducing the corporate level tax by more than it would be entitled.

How many levels of taxation apply to corporate earnings paid out as qualified fringe benefits? Explain

Corporate earnings paid to shareholders in the form of medical insurance, group-term life insurance or other qualified fringe benefits are never taxable because they are deductible by the corporation paying for the benefits and are not taxable to the shareholder receiving them.

Why are C corporations still popular despite the double tax on their income?

Corporations have an advantage in liability protection compared to sole proprietorships and partnerships. In addition, corporations have an advantage if owners ever want to take a business public. As a result, corporations remain desirable legal entities despite their tax disadvantages.

What are the more common legal entities used for operating a business? How are these entities treated similarly and differently for state law purposes?

Corporations, limited liability companies (LLCs), general and limited partnerships, and sole proprietorships. These entities differ in terms of the formalities that must be observed to create them, the legal rights and responsibilities conferred on them and their owners, and the tax rules that determine how they and their owners will be taxed.

Why is it a nontax advantage for corporations to be able to trade their stock on the stock market?

Having the ability to issue stock in the stock market provides corporations with a source of capital typically not available to other types of entities. In addition, going public provides a mechanism for shareholders of successful closely-held corporations to sell their stock on an established exchange.

How can leasing property to a corporation be an effective method of mitigating the double tax on corporate income?

Lease payments to shareholders are deductible by the corporation and taxable by shareholders. Because they are deductible at the corporate level, corporate earnings paid to shareholders as lease payments are only taxed once at the shareholder level. This is a particularly useful strategy when shareholder marginal rates are lower than corporate marginal rates.

How many levels of taxation apply to corporate earnings paid out as nonqualified fringe benefits? Explain

Paying corporate earnings out as nonqualified fringe benefits produces one level of tax. The corporation receives a deduction for the fringe benefit and the shareholder/employee pays tax at ordinary rates on the benefit.

How can fringe benefits be used to mitigate the double taxation of corporate income?

Paying fringe benefits can be used to mitigate the double taxation of corporate income in the same way as paying salaries to shareholder/employees. That is, paying fringe benefits produces a corporate tax deduction, reducing the corporate level tax. The shareholder may be taxed on the benefit (if it is non-qualified); however, the tax is just a single-level tax. In some cases when the fringe benefit is qualified, the shareholder would not pay tax on the benefit and it would escape tax altogether.

Explain why paying a salary to an employee-shareholder is an effective way to mitigate the double taxation of corporate income.

Paying salary (to the extent it is reasonable) to an employee/shareholder is an effective way to mitigate the double taxation of corporate income because it allows the corporation to take a deduction for the salary paid thereby reducing the first level of tax on corporate income. The employee reports the salary as income and pays tax at ordinary rates. This tax rate is generally higher than the dividend tax rate but the salary is taxed only once rather than twice. However, both the employer and employee must pay FICA tax on the salary.

{Research}When a corporation pays salary to a shareholder-employee beyond what is considered to be reasonable compensation, how is the salary in excess of what is reasonable treated for tax purposes? Is it subject to double taxation? [Hint: See Reg. §1.162-7(b)(1).]

Reg. §1.162-7(b)(1) indicates that unreasonable salary payments will be treated as constructive dividends to shareholders. The corporation loses the tax deduction for the unreasonable salary. The shareholder has dividend income taxed at the lower dividend tax rate. Any payroll tax paid on the unreasonable salary can be refunded.

What limits apply to the amount of deductible salary a corporation may pay to an employee-shareholder?

Salary payments to employee-shareholders are only deductible to the extent they are "reasonable." The definition of reasonable salary depends on the facts and circumstances, but typically takes into account such factors as the nature of the shareholder's duties, time spent, amounts paid to employees performing similar duties within the industry, etc.

If XYZ corporation is a shareholder of BCD corporation, how many levels of tax is BCD's before-tax income potentially subject to? Has Congress provided any tax relief for this result? Explain.

Taxes are paid first by BCD and then by XYZ when it receives BCD's dividends. XYZ shareholders will also pay taxes on dividends received from XYZ. Thus, the before-tax income of BCD will be taxed at least three times if both BCD and XYZ pay out all of their after-tax earnings as dividends. This potential for triple taxation is mitigated somewhat by the dividends received deduction XYZ would receive on BCD's dividends.

Who pays the first level of tax on a C corporation's income? What is the tax rate applicable to the first level of tax?

The C corporation files a tax return and pays taxes on its taxable income. The marginal tax rate depends on the amount of the corporation's taxable income. The current marginal tax rates range from a low of 15 percent to a maximum of 39 percent. The most profitable corporations are taxed at a flat 35 percent rate.

If a corporation borrows money from a shareholder and pays the shareholder interest at a greater than market rate, how will the interest in excess of the market rate will be treated by the IRS?

The IRS is likely to argue that the interest paid in excess of a market rate should be treated as a constructive dividend. As such, it would not be deductible by the corporation and would be treated as dividend income by the shareholder.

Assume Congress increases individual tax rates on ordinary income while leaving all other tax rates constant. How would this change affect corporate overall or double-tax rates? How would this change affect overall tax rates for owners of flow-through entities?

The corporate after-tax rate of return would remain constant because Congress did not change the corporate rate, dividend rate, or capital gains rate. The after-tax rate for flow-through entities would increase because their individual owners would have a higher tax liability on the business income.

Assume Congress increases the dividend tax rate to the ordinary income rate while leaving all other tax rates constant. How would this change affect the overall corporate or double-tax rate?

The corporate tax rate would not change. However, the double-tax rate would increase because individual shareholders would be taxed at a higher rate due to the increase in the dividend rate..

When a corporation leases property from a shareholder and pays the shareholder at a higher than market rate, how is the excess likely to be classified by the IRS?

The excess lease payment is likely to be classified as a dividend. That means that the corporation will not receive a deduction for the excess lease payment, so it will pay tax on the excess, and the shareholder will also pay tax on the deemed dividend.

How many times is income from a C corporation taxed if a retirement fund is the owner of the corporation's stock? Explain.

The income from a C corporation owned by a retirement fund is taxed twice: once at the corporate level and another time at the retirees' level. The retirement fund isn't taxed on the earnings received, but those earnings are taxed to the retirees when they receive the benefits.

Conceptually, what is the overall tax rate imposed on interest paid on loans from shareholders to corporations?

The overall effective tax rate imposed on interest paid on loans from shareholders to corporations is the shareholder's marginal tax rate on ordinary income (as long as the interest is deemed to be reasonable in amount).

How do business owners create legal entities? Is the process the same for all entities? If not, what are the differences?

The process of creating legal entities differs by entity type. Business owners legally form corporations by filing articles of incorporation in the state of incorporation while business owners create limited liability companies by filing articles of organization in the state of organization. General partnerships may be formed either with or without written partnership agreements, and they typically can be formed without filing documents with the state. However, limited partnerships are usually organized by written agreement and must typically file a certificate of limited partnership to be recognized by the state.

Evaluate the following statement: "When dividends and long-term capital gains are taxed at the same rate, the overall tax rate on corporate income is the same whether the corporation distributes its after-tax earnings as a dividend or whether it reinvests the after-tax earnings to increase the value of the corporation."

This statement is incorrect because it ignores the time value of money. Although dividends and long-term capital gains are currently taxed at the same rate for individual shareholders, this does not mean the present value of capital gains taxes paid when shares are sold will equal dividends taxes paid when dividends are received. As shareholders increase the holding period of their shares, capital gains taxes on share appreciation attributable to reinvested dividends are deferred, and the present value of these capital gains' taxes will decline relative to taxes paid currently on dividends.

Can unincorporated legal entities ever be treated as corporations for tax purposes? Can corporations ever be treated as flow-through entities for tax purposes? Explain.

Treasury regulations permit owners of unincorporated legal entities to elect to have them treated as C corporations. On the other hand, shareholders of certain eligible corporations may elect to have them receive flow-through tax treatment as S corporations.

In general, how are unincorporated entities classified for tax purposes?

Unincorporated entities are taxed as either partnerships, sole proprietorships, or disregarded entities (an entity that is considered to be the same entity as the owner). Unincorporated entities (including LLCs) with more than one owner are taxed as partnerships. Unincorporated entities (including LLCs) with only one individual owner such as sole proprietorships and single-member LLCs are taxed as sole proprietorships.

Is it possible for shareholders to defer or avoid the second level of tax on corporate income? Briefly explain.

Yes. The second level of tax can be avoided entirely to the extent shareholder payments such as salary, rents, interest, and fringe benefits are tax deductible. The second level of tax is deferred to the extent corporations don't pay dividends and shareholders defer selling their shares.

How do shareholder loans to corporations mitigate the double tax of corporate income?

When shareholders lend their money to their corporations, the corporations are allowed to deduct the interest they pay on the loan. Shareholders are taxed at ordinary rates on the interest income they receive from the corporation. As a result, shareholder loans to corporations provide yet another vehicle for corporations to get earnings out of the corporation and into shareholders' hands while avoiding a double tax on earnings. As with salary and rent payments, interest paid to shareholders in excess of market rates may be reclassified by the IRS as nondeductible dividend payments.

Is it possible for the overall or double-tax rate on corporate income for corporations to be lower than the tax rate on flow-through entity taxable income? If so, under what conditions would you expect the overall corporate tax rate to be lower?

Yes, it is possible for the overall corporate tax rate to be lower than the tax rate on flow-through entity income under certain conditions. When corporate marginal rates are substantially lower than individual shareholder marginal rates and dividends are taxed at preferential rates, the combined effect of low corporate marginal rates and preferential dividend rates can produce an overall tax rate less than the individual shareholder's marginal rate.

Other than corporations, are there other legal entities that offer liability protection? Are any of them taxed as flow-through entities? Explain.

Yes. Limited liability companies provide their members with liability protection similar to that provided by corporations to their shareholders. Limited partnerships protect limited partners, but not general partners, from partnership liabilities. All of these alternatives to corporations are taxed as flow-through entities. Limited liability companies are either taxed as partnerships (if there are at least two members), sole proprietorships (if there is only one individual member), or as disregarded entities (if there is only one corporate member). Limited partnerships are generally taxed as partnerships.