Chapter 15
A C corporation has a current year loss of $100,000. The corporation had paid estimated taxes for the year of $10,000 and expects to have this amount refunded when it files its tax return. Is it possible that the corporation may receive a refund larger than $10,000? If so, how is it possible? If not, why not?
Because the C corporation may carry back its current year net operating loss to the prior two tax years, it may request an additional refund of taxes paid in the carry back years to the extent the tax liabilities related to those years are reduced by the net operating loss carryback. Of course, if the C corporation also had net operating losses in the prior two years, it would not be able to carry back its net operating loss and receive an additional refund. It could also carry forward the net operating loss for up to 20 years.
Explain how legal entities differ in terms of the liability protection they afford their owners.
Corporations and LLCs offer owners limited liability. General partners and sole proprietors may be held personally responsible for the debts of the general partnership and sole proprietorship. However, limited partners are not responsible for the partnership's liabilities.
According to the tax rules, how are profits and losses allocated to LLC members? How are they allocated to S corporation shareholders? Which entity permits greater flexibility in allocating profits and losses?
LLC profits and losses are allocated according to the LLC operating/partnership agreement. The LLC operating agreement may provide for special allocations that are different from LLC members' actual ownership percentages. In contrast, S corporation profits must be allocated to shareholders pro rata according to their ownership percentages. Thus, LLCs provide for greater flexibility in allocating profits and losses.
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 [note however, that the rental income received by the shareholder may be subject to the 3.8% net investment income tax, depending on the shareholder's income level].
When a C corporation reports a loss for the year, can shareholders use the loss to offset their personal income? Why or why not?
No. Because C corporations are treated as separate entities for tax purposes, their losses do not flow through to shareholders. Generally, net operating losses of C corporations may be carried back two years and then forward 20 years to offset the income of the C corporations.
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 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.
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 the corporation will pay tax on the deemed excess lease amount, and the shareholder will also pay tax on the deemed dividend.
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.
Conceptually, what is the overall tax rate imposed on a corporation for interest paid on shareholder loans 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) plus an additional 3.8 percent net investment income tax for high-income taxpayers.
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.
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 the entities treated as C corporations. On the other hand, shareholders of certain eligible corporations may elect to have the entities receive flow-through tax treatment as S corporations.
How do shareholder loans to corporations mitigate the double taxation 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.
Compare the entity-level tax consequences for C corporations, S corporations, and partnerships for both nonliquidating and liquidating distributions of noncash property. Do the tax rules tend to favor one entity type more than the others? Explain.
Both C corporations and S corporations recognize gain on nonliquidating distributions of appreciated property. Neither C corporations nor S corporations recognize loss on nonliquidating distributions of depreciated property (the loss disappears unused by anyone). Partnerships do not recognize gain on nonliquidating distributions of appreciated property and they do not recognize loss on nonliquidating distributions of depreciated property (the loss carries over to the partner). Thus, the tax rules associated with nonliquidating distributions of noncash property favor partnerships over C corporations and S corporations. For liquidating distributions, C corporations and S corporations both recognize gain and loss (with certain exceptions) when distributing noncash property. Partnerships do not recognize gain or loss on liquidating distributions on noncash property (the loss carries over the receiving partner). Thus, the tax rules for liquidating distributions of noncash property favor partnerships over C corporations and S corporations.
Does a C corporation gain more tax benefit by (a) carrying forward a net operating loss to offset other taxable income two years after the NOL arises or (b) carrying the NOL back two years? Explain.
C corporations generally prefer to utilize net operating loss carryforwards as soon as possible. From a time value of money perspective, equivalent refunds received sooner are worth more than refunds received later. This suggests a C corporation would prefer to carryback a net operating loss. However, if the corporation's marginal tax rate in the carry back and carry forward years differ, it may be preferable to carry the loss to the tax year with the higher marginal tax rate.
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 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 force 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 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-term 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.
If limited liability companies and S corporations are both taxed as flow-through entities for tax purposes, why might an owner prefer one form over the other for tax purposes? List separately the tax factors supporting the decision to operate as either an LLC or S corporation.
Although LLCs and S corporations are both taxed as flow-through entities, several differences exist between the two types of entities. Advantages of S corporations include the ability for shareholders to work as employees of the business and not pay employment taxes on income allocations (self-employment and FICA tax benefit), and the ease of selling their stock. In contrast, the advantages to operate as an LLC are more numerous and include 1) no restrictions on the number and type of allowable owners, 2) few restrictions on tax-free contributions, 3) special allocations are allowed, 4) owner basis for LLC debt, 5) generally no gain recognition on nonliquidating and liquidating distributions of appreciated property and 6) ease of converting to other entity types.
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.
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.
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 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.
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.
What are the differences, if any, between the legal and tax classifications 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.
What types of business entities does the U.S. tax system recognize?
Although there are more types of legal entities, there are really only four categories of business entities recognized by the U.S. tax system: C corporations (treated as separate taxpaying entities), 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.
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 the earnings are eventually distributed out of the retirement fund to the retiree.
Which entity types are generally allowed to use the cash method of accounting?
The tax laws restrict the entities that may use the cash method. C corporations are generally required to use the accrual method of accounting (smaller C corporations may use the cash method). S corporations and entities taxed as partnerships generally may use the cash method of accounting. The cash method provides a tax advantage for entities because it allows the entities to have better control of when they recognize income and expenses.
Is a current-year net operating loss of a C corporation available to offset income from the corporation in other years? Explain.
While NOLs provide no tax benefit to a corporation in the year the corporation experiences the NOL, they may be used to reduce corporate taxes in other years. Generally, C corporations with a NOL for the year can carry back the loss to offset the taxable income reported in the two preceding years and carry it forward for up to 20 years.
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 most 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.
Explain how liabilities of an LLC or an S corporation affect the amount of tax losses from the entity that limited liability company members and S corporation shareholders may deduct. Do the tax rules favor LLCs or S corporations?
LLC liabilities are included as part of a member's tax basis while S corporation liabilities (other than loans from the shareholder) are not included in an S corporation shareholder's tax basis. This distinction is important because the amount of loss a member or shareholder may deduct is limited to his or her tax basis in either his or her LLC interest or shares. Thus, in this regard tax rules favor LLCs.
What are the tax advantages and disadvantages of converting a C corporation into an LLC?
The major disadvantage of converting a C corporation into an LLC is that the appreciation in corporate assets must be taxed once at the corporate level and again at the shareholder level as part of the conversion to an LLC. After converting to an LLC, the advantage will be that the entity avoids the double tax going forward. In the absence of a large NOL carry forward to absorb the gain, the present value of this advantage is typically overwhelmed by the taxes that must be paid at the time of conversion. Thus, making the S election is typically the only viable method for converting a taxable corporation into a flow-through entity.
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 partner(s), 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.
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 strictly to avoid the double tax
In its first year of existence, KES, an S corporation, reported a business loss of $10,000. Kim, KES's sole shareholder, reports $50,000 of taxable income from sources other than KES. What must you know in order to determine whether she can deduct the $10,000 loss against her other income? Explain.
Because an S corporation is a flow-through entity, the business loss from KES is allocated to Kim. However, the loss must clear certain limitations in order for Kim to deduct this loss against her other income. First, Kim may deduct the loss to the extent of her tax basis in her KES stock. The second limitation is the "at-risk" amount. In general, the at-risk amount is similar to her basis in her KES stock so the at-risk limitation will likely not be any more binding than the basis limitation. If Kim has adequate basis and at-risk amounts she can deduct the loss if she is involved in working for KES. If Kim is a passive investor in KES, the loss is a passive activity loss and Kim may only deduct the loss to the extent she has income from other passive investments (businesses in which she is a passive investor).
Are C corporations or flow-through entities (S corporations and entities taxed as partnerships) more flexible in terms of selecting a tax year-end? Why are the tax rules in this area different for C corporations and flow-through entities?
C corporations provide greater flexibility when selecting tax years-ends. Generally, corporations can choose a tax year that ends on the last day of any month of the year. In contrast, S corporations must typically adopt a calendar year-end while partnerships are generally required to adopt year-ends consistent with the partners' year-ends. The tax laws attempt to require flow-through entities to have the same year-end as their owners to limit the owners' ability to defer reporting income. C corporation income does not flow through to owners so the year-end does not matter from a tax perspective.
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 unreasonably 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 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.
What happens to a C corporation's net operating loss carryover after 20 years?
If a corporation is unable to utilize its NOL carryforwards in the 20 years following its creation, the NOL will expire unused. That is, the corporation will forever lose the benefit of the NOL.
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 corporation would be entitled to a tax deduction for the expense and the shareholder would not pay tax on the benefit and the amount of the fringe benefit 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.
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?
Reg. §1.162-7(b)(1) mandates 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.
Why are S corporations less favorable than C corporations and entities taxed as partnerships in terms of owner-related limitations?
S corporations may not have more than 100 shareholders and they may not have corporations, partnerships, nonresident aliens, or certain trusts as shareholders. The only ownership restriction for C corporations and partnerships is that C corporations must have a least one shareholder and a partnership (or entity taxed as a partnership) must have at least two owners.
Compare and contrast the FICA tax burden of S corporation shareholder-employees and LLC members receiving compensation for working for the entity (guaranteed payments) and business income allocations to S corporation shareholders and LLC members assuming the owners are actively involved in the entity's business activities. How does your analysis change if the owners are not actively involved in the entity's business activities?
Shareholder-employees of S corporations pay FICA tax (and possibly the additional 0.9% Medicare tax depending on the salary level) on the shareholder's salary. However, the shareholder's allocation of the S corporation's business income for the year is not subject to FICA, self-employment tax, or the additional 0.9% Medicare tax. If shareholders materially participate in the entity's business activities, the income allocations are not subject to the 3.8% net investment income tax. Income allocations to shareholders who do not materially participate in the entity's business activities may be subject to the net investment income tax, depending on the shareholder's income level. LLC members pay self-employment tax on any guaranteed payments they receive and on their share of business income from the LLC if they are actively involved in the LLC's business activities. An LLC member may also pay the .9% additional Medicare tax on guaranteed payments and business-income allocations, depending on the member's income level. Further, an LLC member who is does not materially participate in the entity's business activity does not pay self-employment tax on the member's share of operating income from the LLC. However, the member's share of business income may be subject to the net investment income tax, depending on the member's income level.
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.
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 (qualified) 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.
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 only one individual owner such as sole proprietorships and single-member LLCs are taxed as sole proprietorships.