FEDERAL CORPORATE TAX PROFESSOR STEVEN BANK UNIVERSITY OF CALIFORNIA LOS ANGELES SCHOOL OF LAW

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1 FEDERAL CORPORATE TAX PROFESSOR STEVEN BANK UNIVERSITY OF CALIFORNIA LOS ANGELES SCHOOL OF LAW CHAPTER 1: DOUBLE TAXATION, DEBT VS. EQUITY A crpratin is treated as a taxable entity. This results in taxatin: Earnings are taxed at the crprate level and distributins t sharehlders as dividends are als taxed. Crpratins are taxed differently frm individuals. There is n preference fr crpratins, althugh capital lsses are still limited. Crpratins can chse either a calendar r fiscal year fr taxatin, while individuals must use the calendar year. Individuals are frequently under the cash methd f accunting. Crpratins are typically required t use the methd f accunting. Debt and equity (stck) are treated differently: Debt results in payments, which are deductible, but payments are nt deductible. This means duble taxatin fr equity and single taxatin fr debt. Businesses wuld therefre like t recharacterize their equity as debt, rather than get nndeductible dividends. Distinguishing debt and equity Laundry list apprach: Instrument is evaluated fr whether it has mre debt r equity factrs. Factrs: Whether the cntract is a legally enfrceable instrument; Whether the bligatin is subrdinate t r has precedence ver ther bligatins f the crpratin; Typically, a stckhlder is the residual claimant whatever is left after paying ff all the creditrs ges t the stckhlders (debt is repaid first, preferred stck secnd, cmmn stck third); If a particular instrument entitles smene t be paid as part f the creditrs and befre the residual claimant, it is mre likely t be debt than equity; Rati f debt t equity;

2 If it is a thinly capitalized crpratin, where mst f the capital cmes frm debt, it suggests that sme f the debt may be equity. Whether the debt is int the stck f the crpratin; The relatinship between the stck hldings f the crpratin and the debt and interest hldings f the crpratin; If the debt and equity are held prprtinally, it lks mre likely that the debt is really equity. Other factrs the IRS cnsiders: The name given t the instrument (is it called debt); Whether there is an prmise t pay (usually the traditinal definitin f debt); Whether there is a maturity date (equity desn't usually expire); Whether there is a right t enfrce payment; Whether there is a right t participate in management; Factrs identify the level f risk r whether the instrument is likely t becme debt r stck upn certain ccurrence Cre test: Lks t whether an independent third-party lender wuld have laned mney n the same terms. If debt has unreasnable terms (i.e., tend tward the equity side), curt may say it is nt really debt Themis Bar Review, LLC Federal Crprate Tax

3 CHAPTER 2: SECTION 351 EXCHANGES Sectin 351 exchange Sectin 351 prvides that nn-recgnitin treatment (defer, rather than recgnize currently) t the sharehlder and the crpratin n a transactin between them under a limited set f circumstances. Requirements fr nn-recgnitin Sharehlder must transfer (e.g., mney, securities, etc.), nt Example 1: Yu frm a crpratin with a partner and want t cntribute nly yur labr (services). Receipt f stck is taxable t yu as if it were cmpensatin. Services can be cnverted t prperty (e.g., draft and cntribute a business plan in exchange fr stck that is "prperty") Transfer must be slely in exchange fr (nt cash) S if a taxpayer transfers prperty in exchange fr cash r debt, it is a taxable transactin. prperty (cash r ther prperty) received in additin t stck, is permitted but taxable. Gain is recgnized with respect t the bt prperty. Lsses are nt recgnized n receipt f bt. Example 2: Yu cntribute prperty wrth $100 in exchange fr $80 f stck and $20 in cash. The $20 in bt is recgnized, but nt the $80 f stck. Assumptin f debt is nt recgnized as lng as it is nt dne fr purpses and the amunt f debt des nt exceed basis in the prperty cntributed. Example 3: Yu cntribute prperty wrth $100 that has $20 mrtgage. Crpratin takes prperty subject t agreement t repay liability. Assumptin f debt wuld nrmally be treated as $20 in cash, but it is exempt under 351. Example 4: Yu take ut a lan n prperty and then immediately cntribute it t a crpratin. Yu keep the cash and the crpratin takes the prperty subject t debt. This is cnsidered a tax avidance purpse. Must receive enugh stck t be in Cntrl: 80% f vting stck and 80% f all ther classes f stck Cntrl grup: Mre than ne persn can grup tgether and aggregate interests as lng as each cntributes prperty and gets stck Themis Bar Review, LLC Federal Crprate Tax

4 Previusly wned stck can cunt tward 80% test. Exceptin: Mere accmmdatin transfers are nt permitted. If preexisting hlder nly cntributes prperty t get a few shares t meet 80% Based n whether amunt f stck received is small cmpared t prir hlding Must be in cntrl immediately after exchange Immediate sale f stck after 351 exchange may vilate this test dctrine: Decisin t sell must be discnnected frm 351 transactin Example 5: Yu acquire stck in a 351 transactin and then sld that stck a nansecnd after the transactin. If thse tw transfers are part f the same transactin (the same plan), curts will integrate them under the step transactin dctrine. Curts will say that yu never held the stck immediately after the exchange, because as part f a pre-arranged deal yu were always ging t sell it. Yu acquired enugh t cntrl but were always ging t sell it, s yu never really held it. Example 6: If hwever, sme intervening event ccurred between when yu acquired the stck and when yu sld it, that might suggest that the tw transactins shuld be distinct transactins (i.e., that step transactin shuld nt apply there was n plan). Yu will have satisfied the cntrl immediately after the exchange requirement under 351 and then prceeded t engage in anther transactin. Calculating basis when yu have satisfied the requirements under 351 Sharehlder's basis in stck = ld basis + gain recgnized Example 7: Yu cntribute prperty with a basis f $10 and a fair market value f $100, yu will hld the stck with a basis f $10. Crpratin basis in cntributed prperty = + gain recgnized Example 8: Yu cntribute prperty with a basis f $10 and a fair market value f $100, crpratin hlds the prperty with a basis f $10. Exceptin: Fr lss prperty, crpratin's basis is Example 9: Yu cntribute prperty that yu bught fr $100 that is nw wrth $10. Crpratin's basis is $ Themis Bar Review, LLC Federal Crprate Tax

5 Nte that if bth parties are dmestic taxpayers, the sharehlder can elect t take fair market value basis in the stck and crpratin can take carryver basis Themis Bar Review, LLC Federal Crprate Tax

6 CHAPTER 3: DISTRIBUTIONS OF CASH AND PROPERTY Tax cnsequences f distributin fr crpratin Cash: Nt deductible by the crpratin Prperty: Must recgnize gain fr prperty but may nt recgnize lss prperty Crpratin recgnizes gain as thugh crpratin sld prperty t sharehlder fr its value Distributin f cash r prperty reduces a crpratin's earnings and prfits. Tax cnsequences f distributin fr recipients If earnings and prfits are available, then distributin is taxable as a dividend t the recipient, but a capital gains rates, if they are dividends Qualified dividend incme is incme frm a dmestic crpratin where the parties have held it fr the requisite amunt f time and the incme is cnsidered net capital gains (i.e., subject t a reduced rate the net capital gains rate). Dividends are taxable as net capital gains Disadvantage f dividends vs. capital gains There is n basis fr qualified dividends. The entire amunt is taxable. Example 10: If yu sell stck fr $100 and have basis f $10, then $90 f gain is included in incme. If yu receive $100 in dividends, yu will be taxed n the full $100 even if yu have $10 basis. Dividends/net capital gains cannt be ffset by If crpratin des nt having earnings and prfits, then distributins are return f investment treated as a recvery f capital Taxpayers may try t disguise dividends t eliminate secnd layer f tax Cnstructive dividends: Curts will cnstrue that a distributin is really a dividend even thugh it did nt g thrugh the crprate frmalities f a dividend If crpratin makes distributin that is in effect a dividend and there are earnings and prfits available, it will be taxed as a dividend. Cmpensatin (salary): Deductible by crpratin Crpratin might attempt t pay ut mney t sharehlder as "salary" rather than as a dividend. There is a reasnableness requirement. If crpratin paid ut an amunt as salary that was far in excess f what thers in a cmparable psitin were paid, IRS might recharacterize sme f that salary as a dividend. Advertising: Deductible by crpratin and nt included in incme f recipient Themis Bar Review, LLC Federal Crprate Tax

7 Example 11: If car dealer crpratin gives all sharehlders cars as a dividend, it is duble taxed. If crpratin instead gives sharehlders cars t drive as advertising, it is deductible by the crpratin and nt included in incme f sharehlder. Lans: Nt included in incme f sharehlder Themis Bar Review, LLC Federal Crprate Tax

8 CHAPTER 4: DISTRIBUTIONS OF STOCK Stck dividend r stck split: crpratin may distribute a stck dividend (e.g., each share is split in half and the price is divided between the tw shares) Generally nt taxable ( 305) Basis is split between the split shares Example 12: Yu have stck yu bught fr $50 and it is nw wrth $100. After a stck split, yu have tw shares wrth $50 each. Each share nw has a basis f $25. The aggregate gain is $50 bth befre and after split. Sectin 305 Exceptins Distributins in Sharehlders have chice t elect stck r cash r ther prperty Ratinale: Sharehlders have a meaningful change in wnership Taxable even if all sharehlders elect stck distributin Sme sharehlders get stck and sme get cash r ther prperty (withut electin) Distributins f stck and stck Sme sharehlders get cmmn while thers get preferred Ratinale: Because preferred stck is different in kind (preferred stckhlders have a prir and greater claim t the crpratin's assets and earnings and prfits than cmmn stckhlders), there is a change in the wnership interest Distributin t preferred stckhlders Any distributin f stck t preferred stckhlders is cnsidered disprprtinate and therefre taxable because preferred stckhlders have limited interest Distributins f preferred stck Only when it is likely that sme sharehlders will sell and sme will keep stck and cnvert it t cmmn stck Deemed distributin Crpratin buys back stck f sme sharehlders but nt thers If a series f distributins are made as part f a plan t give sme sharehlders cash and thers a greater interest in the crpratin, it is deemed a distributin even if there was n actual distributin Preferred stck bailut Distributin is received and then immediately sld in attempt t avid dividend rules Themis Bar Review, LLC Federal Crprate Tax

9 Under 306, taxable under rdinary incme rates if it is tainted stck Tainted stck: Preferred stck that is distributed tax-free and then sld sn after Ratinale: Sharehlder can sell preferred stck withut diluting interest in the underlying residual Exceptins t taxatin n preferred stck bailuts (i.e., when we wn't apply the 306 taint) Terminatin f a sharehlder's interest r sale back in cmplete liquidatin transactin (e.g., recapitalizatin) IRS determines it is nt part f a maneuver Themis Bar Review, LLC Federal Crprate Tax

10 CHAPTER 5: REDEMPTIONS Redemptin: Crpratin buys back sharehlder's stck Lks similar t the distributin f a dividend, but is treated the same as a t an unrelated third party (i.e., entitled t basis ffset, capital lss ffset) Dividend vs. redemptin Redemptin requires a reductin in the sharehlder's interest in the crpratin Interest in earnings and prfits Interest in vting Interest in liquidatin Safe harbrs fr redemptin Substantially reductin Sharehlder's vting pwer must be reduced belw 50% Sharehlder must wn less than 80% f the vting pwer and less than 80% f the cmmn stck that sharehlder held pre-redemptin Family attributin rules: Stck wned by clse relatives cunts tward the shares relevant under the substantially disprprtinate test Includes spuse, children, grandchildren, and parents (nt siblings) Example 13: A wns 90 f the crpratin's 300 shares, r 30% f the ttal shares. Crpratin redeems 20 f A's shares. A nw wns 70 f 280 shares, r 25%. A has less than 50% f the ttal shares, but his pst-redemptin wnership percentage is nt less than 80% f his pre-redemptin share. If, hwever, the crpratin redeemed 50 shares, A wuld wn 40 f the 250 shares, r 16%, and wuld meet the substantially disprprtinate test. Example 14: A wns 90 f the crpratin's 300 shares. The ther 210 shares are wned by A's spuse. On a redemptin, there wuld be n meaningful change in A's wnership percentage because A's spuse's shares are attributed t A and cunt tward the shares relevant under the substantially disprprtinate test. Exceptin: If sharehlder cmpletely terminates interest in crpratin, the family attributin rule is waived Cannt retain any interest in crpratin except as Eliminates prblems family attributin rule creates fr clsely held crpratins Partial, r crprate cntractin dctrine Themis Bar Review, LLC Federal Crprate Tax

11 Size f the pie has drpped There is 20% r greater reductin in grss revenues, emplyees, r net asset values f the crpratin treated as meaningful reductin and nt classified as a dividend Example 15: Crpratin wns a big building with aspects f the business n all flrs. The tp flr burns dwn and the crpratin des nt rebuild it, but instead cntracts the size f the crpratin. The crpratin sends ut sme f the insurance prceeds t sharehlders t reflect the fact that the crpratin is nw smaller. Thse payments are nt classified as dividends Themis Bar Review, LLC Federal Crprate Tax

12 CHAPTER 6: LIQUIDATIONS Cmplete liquidatin: Distributin f assets f a crpratin in cmplete terminatin f all the stck f the crpratin Cmplete liquidatin f a nn-cntrlled subsidiary Tax treatment fr sharehlder ( 331) Treated as a sale f stck Value f what sharehlder receives is taxable t the extent it exceeds sharehlder's basis in her stck Basis f prperty received is fair market value Tax treatment fr crpratin ( 336) Treated as selling prperty t sharehlder and crpratin can recgnize gain r lss n the prperty Limits n recgnitin f lss fr crpratins Lsses are disallwed fr certain distributins t persns (fr sharehlder wh hlds 50% r mre f the crpratin's stck) if: Distributin is nn- Example 16: Crpratin has gain prperty wrth 80% f crpratin and lss wrth 20%. Crpratin has 80% sharehlder and 20% sharehlder. Distributin has t be pr rata, with 80% f lss prperty and gain prperty ging t the majrity sharehlder. Or, if the prperty had been acquired in a transactin in the last five years (i.e., prperty cnstitutes disqualified prperty) This an anti-lss stuffing rule (cncern that liquidatin is a sham) Pre-cntributin lss prperty Cmplete liquidatin f a cntrlled subsidiary ( 332) Parent des nt recgnize a gain r lss, and takes assets f the subsidiary with a carryver basis Parent crpratin must hld 80% r mre f by vte and value f stck Themis Bar Review, LLC Federal Crprate Tax

13 CHAPTER 7: CORPORATE ACQUISITIONS Ways t transfer crpratin withut liquidatin Asset sale Crpratin sells all assets t buyer, which prduces a gain t the crpratin, and distributes cash t sharehlders in liquidating distributin, which prduces a gain fr the sharehlders Duble tax: seller crpratin and sharehlders must recgnize gains Buyer gets a in the assets. Buyer hlds the assets at fair market value and can depreciate frm a high basis Buyer must the purchase price amng the assets. Stck sale Sharehlders as a grup sell stck t buyer as a grup fr cash One layer f tax fr seller: Gain t sharehlders, but nt crpratin Crpratin remains intact and becmes subsidiary f new buyer. Basis: Buyer hlds assets f crpratin at same basis as when they were wned by seller Nthing happened; N step up in basis t fair market value Advantageus fr seller, but nt buyer Hw t slve this? Cntrlled subsidiary can make 338(h)(10) electin Buyer can acquire stck and get stepped up basis in assets There is n additinal tax at the crprate level, s n duble tax Under 336(e) yu culd d the reverse and treat an asset sale as a stck sale Acquisitin expenses (e.g., legal fees, investment banking fees) Must, rather than currently deduct, expenses Add expenses t basis and recver at sale r ver time Tax-free rerganizatin Merger r cnslidatin r acquisitin f all prperty f crpratin in exchange fr stck rather than cash N real cashing ut, s taxatin deferred t a later pint in time Must cmply with set f technical rules Themis Bar Review, LLC Federal Crprate Tax

14 CHAPTER 8: SUBCHAPTER S CORPORATIONS An eligible crpratin frmed under state law may make a subchapter S electin. S crpratins are eligible fr pass-thrugh tax treatment (i.e., tax cnsequences flw thrugh t the sharehlders f the S crpratin). Tax benefits and burdens are allcated t sharehlders pr rata t their wnership interest. Crpratin's incme is divided amng sharehlders and sharehlders must reprt it n their returns regardless f whether a distributin is made. S crpratins avid duble tax. Requirements t qualify fr subchapter S electin Must be eligible entity crpratin r limited liability cmpany that has checked the bx fr crprate status fr federal tax purpses (n freign entities) Must have nly f stck (e.g., can't have preferred stck) Prfits and lsses must be allcated t sharehlders in prprtin t that ne class f stck. Must have n mre than sharehlders Spuses and all members f a family (within six generatins f a cmmn ancestr) are treated as ne sharehlder. Sharehlders must be Nn-resident aliens are excluded. Gains and lsses generally pass thrugh t sharehlders. Lss limitatin rules Lsses limited t (utside basis) Example 17: If yu invest $100 in stck f a crpratin, crpratin can nly allcate $100 f lsses t yu. Unused lsses can be carried frward indefinitely until the sharehlder has sufficient basis. A sharehlder's basis can increase if the sharehlder is allcated gains. At-risk rules A sharehlder can nly take lsses t the amunt she has at (e.g., the persnal funds invested and the adjusted basis f unencumbered prperty; nt nn-recurse debt). Passive-activity lss limitatin rules Themis Bar Review, LLC Federal Crprate Tax

15 If a sharehlder has nt materially participated in the activity, lsses are cnsidered passive-activity lsses. Passive-activity lsses cannt be passed thrugh unless there are. Cash distributins Cash distributins are nly taxed t the extent they exceed basis Sharehlders reprted the gains when the mney was earned, even if it was nt distributed. Cash distributins simply reduce the sharehlders' basis. Any cash that exceeds basis is taxed. Exceptins Earnings and prfits frm befre crpratin made the subchapter-s electin prperty distributed t sharehlders S crpratin has t recgnize gains as if the prperty was sld t the sharehlder The sharehlder reduces basis in the stck by fair market value f prperty Exam Tip 1: If yu are asked t frmulate the best entity fr a particular venture, cnsider an S crpratin if the parties are cncerned abut duble taxatin. [END OF HANDOUT] Themis Bar Review, LLC Federal Crprate Tax