LEARNING OBJECTIVES After studying this chapter, you should be able to D> Identity the types of entities that can be classified as a corporation for federal income tax purposes B> Calculate the corporate income tax liability D> Apply the nonrecognition of gain or loss rules for corporate capitalizations D> Understand the significance of earnings and profits D> Determine the tax consequences of nonmoney distributions and stock redemptions D> Understand the tax implications of a corporate liquidation for the liquidating corporation and its shareholders CORPORATIONS16-2 Individuals ¥ Chapter 16 CHAPTER OUTLINE. Definition ofa Corporation .16-2 Similarities and Differences Between the Taxation of Corporations and individuals..16-3 Specific Rules Applicable to Corporations..164 Computation of Tax.-16-10, ‘Transfers of Property to Controlled Corporations..16-20 Corporate Capital Strucure..16:24 Earnings and Profits..16-25. Nonmoney Distrbutions..16-27 Stock Redemptions..16-28 Corporate Distributions in Complete Liquidation..16-31 ADDITIONAL, COMMENT In 1987, total income tax collec- ‘tons were $568.3 billion. The ‘corporate income tax produced $102.9 bilion of federal income taxrevenues, Corporate income ‘axes were 18.1% of federal income tax revenues. Individual income tax revenues were the Femaining 81.9% of federal Income tax revenues. By 2005, {otal income tax collections were 51,1813 billion. Corporate income taxes deceased to 12.5% of federal income tax Fevenues. Noncorporate (ndivid- al, trust, estate, etc) income taxes increased to 86% of federal A business may be organized and operated as a sole proprietorship, C corporation, S corpo- ration, partnership, limited liability company (LLC), or limited liability partnership (LLP). These business forms fall into two major categories: taxpaying entities and flow-through entities. The latter category also is referred to as tax conduits or pass-through entities. Sole proprietorships and C corporations fall into the taxable category although sole proprietor- ships are subject to a single level of tax, while C corporations are subject to two levels of tax. A sole proprietorship is not taxed directly because it is not considered to be a separate legal entity. Rather, the individual owner is taxed directly and reports the sole proprietor- ship's business income and expenses on Schedule C of Form 1040 (US. Individual Income Tax Return). The C corporation also is taxed directly and reports its tax results on Form 1120 (U.S. Corporation Income Tax Return). In addition, the corporation's shareholders are taxed if the C corporation pays dividends to them or if the shareholders sell their stock at a gain.! In this way, the C corporation organizational form results in two levels of taxa- tion: once at the corporate level and again at the shareholder level. Despite its double taxa- tion and sometimes complicated legal form, the corporation has the dual advantages of facilitating external financing and limiting the shareholders’ legal liability. Flow-through entities, like sole proprietorships, entail only one level of taxation at the ‘ownership level. Accordingly, the entities themselves are not taxed, and the income and losses pass through to the sharcholders of an $ corporation, the partners of a partnership, or the members ofa limited liability company or limited liability partnership. The owners then report the pass-through income or loss items on their individual tax returns. Some of these entities, such as $ corporations, limited liability companies, and limited liability partner- ships, offer the advantage of limiting their owners’ legal liability. Nevertheless, flow-through entities involve certain legal complexities and restrictions, which is one disadvantage of this form of organization. A comparison of the number of tax returns filed and taxable income for the four major business forms for tax year 2006 can be found in Table I:16-1. This chapter explores the basic tax consequences of forming, operating, and liquidat- ing a C corporation. Chapter 1:17 discusses the basic tax rules pertaining to flow-through centities, and Table I:17-2 at the end of that chapter compares the alternative forms of business organizations. Detailed coverage of these two areas of taxation are reserved for this text's companion volume titled Prentice Hall’s Federal Taxation: Corporations, Partnerships, Estates, and Trusts MOND rinirion oF a OBJE iT Identify the types of entities that can be lassified as a corporation for federal income tax Purposes CORPORATION Under Treasury Regulations,? a business entity with two or more owners may be classi- fied as either a corporation or a partnership. An entity having only one owner may be classified as a corporation or a sole proprietorship. A business entity is a corporation if it is organized under a federal or state statute that refers to the entity as incorporated or as a corporation, body corporate, body politic, joint-stock company, or joint-stock associa- tion. Corporations also include insurance companies, state-chartered banks, and business entities wholly owned by a state o political subdivision. In general, with rare exceptions if a business entity incorporates, itis taxed as a corporation. ‘On the other hand, if the business entity has two or more owners and is organized as a partnership, limited liability company, o limited liability partnership, the entity can elect to be taxed as either a partnership or corporation. The “check-the-box” regulations replace prior entity classification rules that involved subjective judgment and opened the door to manipulation. "A corporate liquidation is treated asa sale whereby asharcholder receives tribution generally capital in character (IRC Sec. 331(a). Tis topic is cash andlor othe assets fom the liguiating corporation in exchange for his lore tock The shareholder’ recognized gain of los upon aligudating di ‘later and 3 tom ofthis chapee.EXAMPLE I: > Corporations ¥ Individuals 16-3 Y Table 116-1 Comparison—types of Returns Number of Returns Filed ‘Taxpayer Class 2006 2005 Individuals 177.404 million 177.494 million Partnerships 2.773 milion. 2.665 milion S.corporations 3.825 milion 3.634 milion C corporations’ ® 2.454 milion. 2.494 milion Estates and Trusts 3.697 milion 3.684 milion IRS, Data Boot, 2006. "The number shown includes returns for various types of domestic an foresgn corporations and associations. tarcenempt organizations fed 815,000 Form 990 series returns in 2005 and 833,000 n 2006, Al and Jane incorporate a business entity in Delaware. Because itis legally incorporated, the entity is taxed as a corporation. Bill and Max form a limited liability company in Florida. For fed- eral income tax purposes, the limited liability company can elect to be taxed as a corporation or 8 partnership. < MNS ima ariries AND DIFFERENCES BETWEEN THE TAXATION OF CORPORATIONS AND INDIVIDUALS SIMILARITIES The computation of corporate taxable income is similar to that of a sole proprietorship. For example, under Sec. 162 corporations can deduct ordinary and necessary business expenses. They also may exclude items such as tax-exempt interest and life insurance pro- ceeds from gross income. Corporations also can deduct interest, depreciation, and other business-related expenses in a manner similar to that of unincorporated businesses. In general, the IRC authorizes all taxpayers to use one of three methods of account- ing—the accrual method, the cash method, and the hybrid method. However, with cer- tain exceptions C corporations generally must use the accrual method of accounting unless they meet certain conditions. Sec. 48 permits corporations engaged in a farming business, qualified personal service corporations, and entities having less than $5 million in gross receipts for each of the three prior tax years to use the cash method of account- ing.‘ To simplify recordkeeping requirements for small businesses, Rev. Proc. 2002-28 permits qualified small businesses to adopt the cash method of accounting instead of the accrual method.’ Corporations are entitled to many of the tax benefits available to individuals who operate a sole proprietorship. C corporations can elect to claim the Sec. 179 expensing deduction that is available for sole proprietorships and partnerships. In the past, they also were eligible to claim the 50% first-year bonus depreciation. In addition, owners of small corporations are eligible for a special exclusion of part of their gain on the sale of qualify- ing stock under Sec. 1202. The 2003 Tax Act lowered capital gains rates, thereby reducing 3 Fora more complete discussion of accounting methods, ee Chaper 11). gross receipts of $10 milion or less fr all prior thretaxable year periods 5c 448(b) find not prohibited under Sc. 448 fom otherwise using the cash method of 5 Res, Pros. 2002-28, 2002-1 C-B. 815, An eligible busines is one having acsounting.