Ch 15 LO-3 DQs

List four basic tax planning strategies that corporations and shareholders can use to mitigate double taxation of a C 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.

How does a corporation's decision to pay dividends affect its overall tax rate [(corporate level tax + shareholder level tax)/taxable income]?

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). Individual shareholders may also be required to pay the 3.8% net investment income tax on capital gains and dividends, depending on their income level. 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.

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.

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.

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.

Assume Congress increases the dividend tax rate to the ordinary tax rate while leaving all other tax rates unchanged. How would this change affect the overall tax rate on corporate taxable income?

The overall corporate income tax rate would increase because the second level tax to shareholders on the dividend distributions would increase. The overall tax rate would also increase because individual shareholders would be taxed at a higher rate due to the increase in the dividend rate.

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

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

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.

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. However, if a corporation retains earnings with no business purpose for doing so, it may be subject to the accumulated earnings tax. This is a penalty tax that eliminates the tax incentive for retaining earnings to avoid the double tax

Is it possible for the overall tax rate on corporate taxable income 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.