C CORPS
C Corp. Operations
A. Gross Income
1. Inclusions – Income from Services
Haag v. Cmsr. – p. 20
Service-Performer Employee Test
Haag v. Cmsr. p. 20
• Facts: Petitioner (physician in Iowa)
• Prior to setting up his corp. on March 16,
1976- GP in Hilltop Medical Clinic (“Hilltop”)
formed in Iowa
• March 16, 1976 incorporated Stanley W. Haag,
M.D., P.C. (the “P.C.”)
– Petitioner was sole director of the P.C.
Haag v. Cmsr. p. 20
• Petitioner assigned his interest in Hilltop to
the P.C.
• He left most of the money in the P.C. and paid
himself (usually a small) salary
• What’s wrong with that from an IRS
perspective under today’s tax rates?
– Corp. 21%
– Indiv. Tax Rate 37%
Haag v. Cmsr. p. 20
• Issues: (1) is the income reported by the
closely-held corp. actually taxable to
Petitioner (individual)
– Why? under IRC 61 and the assignment of income
doctrine
(2) Whether the income should be allocated
to Petitioner (individual) under IRC 482
Haag v. Cmsr. p. 20
• Other relevant facts – top of p. 21
• Neither Petitioner nor his P.C. notified
patients treated at Hilltop of the change
• Notice of deficiency - IRS allocated P.C.’s
income to Petitioner (salary)
Haag v. Cmsr. p. 20
• Analysis:
Assignment of Income Doctrine – Lucas v. Earl
Income is taxed to the one who earns it
1. Actual Earner Test – But inadequate in corp.
context where corp. is earning income only
through personal services of its employees
and agents (physician)
2. Service-Performer Employee Test
Haag v. Cmsr. p. 20
• Analysis:
2. Service-Performer Employee Test
A. Employee of the corp. P.C. direct or control
B. A contract between the corp. and person or
entity using the services (Who?)
Haag v. Cmsr. p. 20
A.
Employee of the corp.
(i). Employment agreement between P.C. and
Dr. Haag-p. 22
(ii). Nothing in record indicated Petitioner
ignored the employment agreement
• Finding: Employment agreement effectively
gave the P.C. the right to control practice
Haag v. Cmsr. p. 20
B. Contract (or other indicia) between Corp. and
Person or Entity using services
• Problems:
i. No K between the P.C. and Hilltop!
ii. Hilltop did not amend its p-ship agreement
• Nevertheless, willing to overlook – Why?
Hilltop listed the P.C., rather than Dr. Haag, on
its p-ship tax return for each year at issue
Finding: Although no formal K – Hilltop
recognized P.C. as entity controlling provision
of services
Haag v. Cmsr. p. 20
Held: Where the service-performer employee
test has been satisfied, the corp. and not the
individual performing services earned the
income, and the corp. will include the amount
earned in its income.
Here, the P.C., rather than Dr. Haag, earned the
income from Hilltop in 1979, 1980, and 1981.
Haag v. Cmsr. p. 20
Issue #2 – Whether the IRS properly allocated
Hilltop income from the P.C. to Petitioner for 3
years under IRC 482?
Haag v. Cmsr. p. 20
Issue #2 – Analysis:
Code: IRC 482
IRS can reallocate income actually earned by
one member of a controlled group to other
members of that group if 3 conditions are
satisfied
Haag v. Cmsr. p. 20
3 Conditions required for Re-allocation under
IRC 482
1. Two or more trades, businesses, or
organizations (What are they?)
2. The enterprises are owned or controlled by
the same interest (Who?)
3. Necessary to clearly reflect income or
prevent evasion of taxes
Haag v. Cmsr. p. 20
Court has held that IRC 482 applies in the oneman personal service corporation context
Main Inquiry: Whether Dr. Haag’s total
compensation after incorporation was around
the same as it would have been absent
incorporation?
Why is that important?
Haag v. Cmsr. p. 20
Court has held that IRC 482 applies in the oneman personal service corporation context
Main Inquiry: Whether Dr. Haag’s total
compensation after incorporation was around
the same as it would have been absent
incorporation?
Haag v. Cmsr. p. 20
•
•
•
•
•
Why is that important?
See top of page 24
Salary in 1979 - $51,159 (45%)
Salary in 1980 - $8,686 (10%)
Salary in 1981 - $85,648 (96%)
Compare to the Hilltop income being received in
those years.
Would you work for those amounts?
Haag v. Cmsr. p. 20
• Finding: A TP dealing at “arm’s length” would
not have accepted employment at such a low
salary than he/she could otherwise earn in
1979 (45%) and 1980 (10%). However, in 1981,
the salary (96%) seemed about right.
• Arm’s Length Charge for Services – amount
that would have been charged for the same or
similar services in a transaction where parties
do not know each other (between unrelated
parties). Treas. Reg. section 1.482-2(b)(3)
Haag v. Cmsr. p. 20
• Rule: Where a corp.’s income is actually
earned by an individual performing services,
the IRS may re-allocate the corp’s income to
the individual (as salary) under IRC 482 to
reflect an arm’s length charge for such
services.
Haag v. Cmsr. p. 20
• Read pages 17-25
C Corp. Operations
A. Gross Income
1. Inclusions – Income from Services
2. Inclusions – Gains from Property p. 27
General Utilities
General Utilities. p. 27
•
•
•
•
Realization Event?
Gain = AR- Basis
Recognition?
Characterization?
General Utilities. p. 27
• Can a C Corp. avoid realizing gain by
distributing property (such as appreciated
stock) to its shareholders and letting them
complete the sale?
General Utilities. p. 27
• Issue: Whether the C Corp. realized taxable
income in declaring a dividend and paying it
in the appreciated stock of another company?
• Rule – No, but overturned.
• Current Rule: A distribution of appreciated
property by a corporation to a shh does
trigger gain to the corp. IRC 311(b)(1)
•
Assignment
Pages 34-37
Next we will cover the Elliots, Inc. v. Cmsr case starting on page 37.
Read Fin Hay Realty – p. 45 and Maxwell, p. 53
C Corp. Operations
Deductions – General Rules
a. Reducing Double Taxation –
(i) Salary - Elliotts & other provisions
(ii) Debt v. Equity - Fin Hay Realty
(iii) Damages - Maxwell
C Corp. Operations
Debt v. Equity - The Service may reclassify purported debt as
equity for tax purposes to prevent shh’s from creating a tax
benefit.
Courts will examine the economic reality of such transactions
between corporations and shareholders.
Generally, this issue arises with closely held corporations
capitalized with excess shh debt.
1. Code –section 385
History/IRC 385(a)
Fin Hay Realty – p. 45
Facts:
• Each contributed $10,000 and received ½ of the corp’s
stock. (Not taxable-1032 nonrecognition)
• Each contributed add’l $15,000 and corp issued an
unsecured promissory note payable on demand and bearing
interest of 6% per year
Corp had $20K +$30K (debt) or 50K total
• Each contributed an add’l $3,000, bringing the totals to $53K
(debt) each and $10K stock subscription each
Fin Hay Realty – p. 45
Finlaw’s daughters became sole shhs.
Corp continued to pay and deduct interest on the notes the
daughters held. In 1962, The Service began to disallow the
interest deductions for prior years.
Issue: Whether funds paid to a close corp by its shhs were add’l
contributions to capital (stock) or loans on which the corp’s
payment of interest was deductible under IRC 163?
Fin Hay Realty – p. 45
What was the economic reality? Corp. used the funds from
the notes to purchase original assets and the advances by the
shhs represented a long term commitment dependent on (1)
future value of the real estate and (2) the ability of the corp. to
sell or refinance it.
An arm’s length relationship between the corp and an outside
lender would not have resulted in this.
The most salient feature of the notes---THEIR RISK---The court said it could not escape the
inference “that a prudent outside businessman would not have risked his capital in six percent
unsecured demand notes in the corp.”
Fin Hay Realty – p. 45
• Form v. Substance
Rule: Advances by shareholders to a closely held corporation
will not be deemed loans (and thus interest deductions will be
denied) where an outside lender would not have loaned
money to the corporation under the same terms, specifically
where such corp needs the advances to function; repayment
depends on profits; there is no set maturity date; and the
advance is unsecured.
Fin Hay Realty – p. 45
Debt v. Equity Factors:
• The loan is secured by property with a value in excess
of the loan principal;
• There is a fixed maturity date and a market rate of
interest;
• The loan is not subordinated to other liabilities of the
transaction; and
• The return does not depend on profit from the
enterprise
Maxwell v. Cmsr/Hi Life Products v.
Cmsr. p. 53
Facts: Cmsr determined a deficiency of $64,185
in Peter & Helen Maxwell’s Federal income tax
for year ended Dec. 1977. In a separate note of
deficiency, Cmsr determined a deficiency of
458,800 in Federal corporate income tax of Hi
Life Products
Maxwell v. Cmsr/Hi Life Products v.
Cmsr
Facts:
Hi Life- organized by petitioner and his wife—manufactures urethane
foam carpet padding
Petitioner and his wife are controlling shh’s. Two other shareholders
(Sadlers) and the 4 shareholders are the officers
Maxwell v. Cmsr/Hi Life Products v.
Cmsr
Facts:
Mr. Maxwell is caught by and pulled into the mixing machine and
suffers injury. He did not return to work for 6-8 weeks after injury.
May 1977-He reads in the Wall Street Journal about an employee’s
claim against an employer corp which was partly owned by the
employee.
Mr. Maxwell contacts Hi Life’s corporate atty-Floyd Brown-who
recommends that he seek independent counsel. Mr. Maxwell retains
the services of Tristan Pico and paid him a flat retainer
Maxwell v. Cmsr/Hi Life Products v.
Cmsr
Facts:
Oct. 1977-Pico send a demand letter to Brown proposing that hi Life pay
$125K in settlement of petitioner’s claim. Brown contacted Mrs. Maxwell
and recommended that Hi Life settle.
Issue: Whether a payment purported to be in settlement of petitioner’s
personal injury claim is properly deductible by Hi Life under 162(a) and
excludable from petitioner’s gross income under section 104(a)(2) as a
payment for damages received on account of personal injuries
Maxwell v. Cmsr/Hi Life Products v.
Cmsr
Rule: A settlement payment by a closely held corp to its
president/controlling shareholder for on-the-job personal
injuries is properly deductible by such corp under 162(a) as
compensation for personal injuries and excludable from the
president/controlling shh’s gross income under section
104(a)(2) as an amount of damages received on account of
personal injuries where such transaction was arms-length
because both parties had independent counsel and the
taxpayers had a legitimate nontax purpose.
Assignment
Pages - 59-62, 88-93
C Corp. Operations
A.
1.
2.
3.
4.
Gross Income
Inclusions – Income from Services
Inclusions – Gains from Property p. 27
Exclusions – General Rules
Deductions – General Rules
a. Reducing Double Taxation –
Elliots
Exclusions – p. 34
General Rule: All income is included
unless specifically excluded. Generally,
the same statutory exclusions as for
individuals. However, sometimes there
are controversies.
Exclusions – p. 34
Corporate Specific:
• IRC 118 – Contributions to capital (gift)
• IRC 362(a) – basis
• IRC 1032 – nonrecognition provision
Exclusions
Corporate Specific:
• IRC 118 – Contributions to capital (gift)
•
IRC 362(a) – basis
•
IRC 1032 – nonrecognition provision
–
–
–
–
Treasury Stock – What happens upon resale? Sensible?
Stock of a different corporation? Exception: Transfers by a
subsidiary of Parent Stock?
Non-stock consideration
Shareholder level effects?
4.
Scope of Corporate Deductions
Generally same as individuals – IRC 162 (ordinary and
necessary business expenses)
Corporate Specific:
• Interest Expense Deduction – IRC 163(d), (h). No limits.
• Loss Deduction – IRC 165(a). No limits generally, except for
closely-held C corps and personal service corps.
 Closely-held C corps – IRC 542(a)(2) where 5 or fewer indiv.
own directly or indirectly (attribution rules) more than 50%
of the stock (by value) at anytime during the last half of the
tax year
• Bad Debt Deduction – IRC 166(a)
4.
Scope of Corporate Deductions
• Charitable Contribution Deduction – IRC 170(b)(2) 10% of
T.I.
• Some deductions are only for individuals.
• Note: Corps do not need to distinguish between deductions
4.
Scope of Corporate Deductions
a. Reducing Double Taxation – what is deductible? Not
dividends
(1) Compensation – IRC 162
(2) Interest or Rent
Issue: whether payments to a shareholder are deductible
business expenses v. non-deductible dividends
Elliots – p. 37 compensation v. dividend
Assignment
•
Thursday, February 3, 2022
Read Fin Hay Realty – p. 45 and Maxwell, p. 53
C Corp. Operations
A.
1.
2.
3.
4.
Gross Income
Inclusions – Income from Services
Inclusions – Gains from Property p. 27
Exclusions – General Rules
Deductions – General Rules
a. Reducing Double Taxation –
Elliots
Exclusions – p. 34
General Rule: All income is included
unless specifically excluded. Generally,
the same statutory exclusions as for
individuals. However, sometimes there
are controversies.
Exclusions – p. 34
Corporate Specific:
• IRC 118 – Contributions to capital (gift)
• IRC 362(a) – basis
• IRC 1032 – nonrecognition provision
Exclusions
Corporate Specific:
• IRC 118 – Contributions to capital (gift)
•
IRC 362(a) – basis
•
IRC 1032 – nonrecognition provision
–
–
–
–
Treasury Stock – What happens upon resale? Sensible?
Stock of a different corporation? Exception: Transfers by a
subsidiary of Parent Stock?
Non-stock consideration
Shareholder level effects?
4.
Scope of Corporate Deductions
Generally same as individuals – IRC 162 (ordinary and
necessary business expenses)
Corporate Specific:
• Interest Expense Deduction – IRC 163(d), (h). No limits.
• Loss Deduction – IRC 165(a). No limits generally, except for
closely-held C corps and personal service corps.
 Closely-held C corps – IRC 542(a)(2) where 5 or fewer indiv.
own directly or indirectly (attribution rules) more than 50%
of the stock (by value) at anytime during the last half of the
tax year
• Bad Debt Deduction – IRC 166(a)
4.
Scope of Corporate Deductions
• Charitable Contribution Deduction – IRC 170(b)(2) 10% of
T.I.
• Some deductions are only for individuals.
• Note: Corps do not need to distinguish between deductions
4.
Scope of Corporate Deductions
a. Reducing Double Taxation – what is deductible? Not
dividends
(1) Compensation – IRC 162
(2) Interest or Rent
Issue: whether payments to a shareholder are deductible
business expenses v. non-deductible dividends
Elliots – p. 37 compensation v. dividend
Assignment
•
Thursday, February 3, 2022
Read Fin Hay Realty – p. 45 and Maxwell, p. 53
C Corp. Operations
Inhibiting Triple Taxation- DividendReceived Deduction
1. IRC 243-A corporation receiving
dividends is allowed a deduction
equivalent to at least 50% of the
dividends received.
C Corp. Operations
Problem is that dividend income becomes
more desirable to corporations than other
forms of gross income.---Used as a
planning tool
C Corp. Operations
Litton Industries v. Cmsr (US Tax Court)
Facts: Litton Industries and its subs
manufactured and sold its business
systems and equipment, defense and
marine systems, industrial systems and
equip, and microwave cooking equipment
C Corp. Operations
• Oct. 1967-Litton acquired all the outstanding
stock of Stouffer Corp (Stouffer)
• In 1972, the Chairman of Litton’s board of
directors (Charles Thornton) and others
discussed the mechanics of problems of selling
Stouffer.
C Corp. Operations
• As of Aug. 1972, Stouffer’s ACCUMULATED
EARNINGS exceeded $30 mil.
• Later that month, Stouffer declared a $30 mil
dividend (which it paid to Litton in the form of a
$30 mil negotiable promissory note)
C Corp. Operations
• 2 weeks later Litton publicly announced Stouffer
was for sale (Sept. 1972)
• Over 6 mths after the dividend was declared March 1973, Nestle, a Swiss corp, offered to buy
all of Stouffer’s stock for $105 million and paid
Litton approx. $75 million in cash for all of
Stouffer’s outstanding stock and $30 million in
cash for the promissory note
Litton Industries
• Issue: Whether Litton Inds received a $30 mil
dividend from Stouffer Corp (its wholly owned
subsidiary) or whether that sum represented
proceeds from the sale of Stouffer stock to Nestle
corp.
Litton Industries
• If the $30mil is a dividend= petitioner may deduct
100% of that amount under IRC 243
Litton Industries
• If instead it represents part of the selling price of
Stouffer stock, as Respondent contends, the
entire amount will be added to the proceeds of
the sale and taxed to Litton as capital gain.
Litton Industries
• The declaration of the dividend and the sale of
the stock are substantially separated in time.
• A dividend may be paid by a note. Thus, the $30
mil distribution by Stouffer would constitute a
dividend even if there was no subsequent sale of
Stouffer. That result does not change just
because there was a subsequent sale that was
tax advantageous to Stouffer’s parent.
Litton Industries
• Rule: Where a subsidiary has declared a dividend
to a parent corp (i.e., issued a promissory note)
before the announcement of its sale, such presale dividend will not constitute part of the
subsidiary’s sales price and will retain its
character as a dividend.
Dividend Received Deduction
• IRC section 243
• If owns less than 20% = 50% deduction taken by
receiving corp.
• If owns 20% or more = 65% deduction taken by
the receiving corp.
Dividend Received Deduction
• Certain small business investment companies
may take a 100% deduction
• US corps receiving dividends from foreign corps.
Bollinger
• Commissioner v. Bollinger, Supreme Court (6th
Cir on appeal)
• Facts: To avoid KY usury laws, Bollinger (who
wanted to purchase certain real estate in p-ship
with others) formed a corp. The partners were the
only shhs. The corp held title to real estate—
understood that the corp. would hold bear legal
title as agent for the p-ship.
Bollinger
• For each apt, there was an agency agreement
(providing that the corp would hold the property
as nominee and agent for the p-ship)
• P-ship was identified as the principal owner
during financing, construction, and operation (the
parties on the other side---lenders, contractors,
mgrs, etc. all knew that the corp was merely an
agent of the p-ship)
Bollinger
• (“6 National Carbide Factors”):
• When a corp can be deemed an agent
1. Whether the corp operates in the name and for
the acct of the principal
2. Binds the principal by its actions
3. Transmits money received to the principal
4. Its business purpose must be the carrying on of
the normal duties of an agent
Bollinger
5. Whether receipt of income is attributable to
the services of employees of the principal and
to assets belonging to the principal are some
of the relevant considerations in determining
whether a true agency exists
6.
If the corp is a true agent, its relations with its
principal must not be dependent upon the fact
that it is owned by the principal
Bollinger
• Conclusion: in both form and substance the
relationship between the corp and p-ship was an
agency with the p-ship as principal
Bollinger
• Rule: A corporation may be an agent of its shhs
for tax purposes. If a corp holds property as agent
for a partnership, then for tax purposes the p-ship
is the owner provided that the corp is a truly
separate entity (i.e., serves a legitimate business
purpose apart from tax avoidance consequences,
National Carbide Corp.) Where a corp acts as an
agent for a certain asset for all purposes (and this
is clearly manifested by a writing), there is no
danger for abusive avoidance schemes.
Assignment
pp. 95-100, 100-106
S CORPS
S Corp. Operations
Point 1: Deduction Differences
Example:
Charitable Contributions - An S corp. may make
charitable contributions, but the allowable deduction
is not determined at the corporate level. In other
words, this deduction is “separately stated.”
S Corp. Operations
• The corp’s contributions are allocated
to the shh’s and each shh may deduct
her share subject to the basis
limitations of IRC 1366(d)(1) and the
percentage limitations of IRC
170(b)(1).
S Corp. Operations
• They are known as separately stated
items and they pass through to the
shhs. IRC 1363(b)(2)
S Corp. Operations
• Hypo: Peter’s Coffee, which is an S
corp., makes a charitable contribution
to the Red Cross during the year.
S Corp. Operations
• Since Peter’s Coffee is not allowed a
charitable deduction in computing
taxable income, the 10% limitation on
corporate charitable deductions in
170(b)(2) does not apply.
S Corp. Operations
• Instead, the charitable contribution is a
“separately stated” item, which passes
through to the shhs.
S Corp. Operations
• The shhs combine their share of the
deduction with their personal
charitable deductions before the IRC
170 limits on individual charitable
contributions are applied.
S Corp. Operations
• Point 2: Under IRC 1371(a), subject to certain
exceptions, Subchapter C (301-385) rules apply
to an S Corp.
• S corporation treated as corporation under
certain rules outside of Subchapter C.
S Corp. Operations
a) IRC 118 & 1032 apply to both S Corps and C
corps
b) A contribution of capital is excluded from a
corporation’s gross income, regardless of
whether the recipient is a C Corp or an S
Corp. IRC 118.
c) IRC 1032 applies – Neither a Corp or an S
Corp recognizes gain or loss when it issues
stock in exchange for money or property.
d) NO Dividend Received Deduction for S Corps
S Corp. Operations
Allocation of Income to Shhs
• Rigid Allocation Rule-IRC 1366(a), 1377(a)
• Treas. Reg. 1.1377-1
• There is a rigid, mechanical rule that controls
allocation of S corp income among the corp’s
shhs.
• IRC 1366(a) – Each shh includes his pro rata
share of S corporation income on his individual
tax return.
S Corp. Operations
Allocation of Income to Shhs
• Rigid Allocation Rule:
• How do we determine the pro rata share?
S Corp. Operations
Allocation of Income to Shhs
Page 102
S Corp. Operations
Allocation of Income to Shhs: 3 Steps
• Step 1: How much income to allocate per day?
1377(a)(1)(A)
• Yearly income/# of days
• =$366,000/366
• =$1,000
S Corp. Operations
Allocation of Income to Shhs: 3 Steps
• Step 2: Under (a)(1)(B), we take that number and
divide by the number of total outstanding shares.
• =$1,000/1,000 shares outstanding
• =$1 per share/per day
S Corp. Operations
Allocation of Income to Shhs: 3 Steps
• Step 3: $1 per share/per day x 500shares x366
days
• =$183,000
• Per share/per day x ownership x number of days
S Corp. Operations
• Example 3-C
• The number of days changes from 366 to 183 for
Floyd and Grant.
• Ellen: Same as above
• Floyd: $1 x500 x183=$91,500
• Grant: Same as Floyd
•
What seems odd?
S Corp. Operations
• Example 3-C
• Under taxation for Floyd - Standard earned
$360,000 during the period Floyd was a 50% shh,
but he is taxed on less than half that amount.
• Over taxation for Grant - Even though Standard
only earned $6,000 during the period Grant was a
50% shh, he is taxed on more than 50% of that
amount.
S Corp. Operations
• Example 3-D (Closing of the books)
• When a shh terminates (sells) her interest during
the taxable year, an election may be made to
allocate a share of the income actually earned
through the date the interest terminates to the
terminating shh. Similarly, the share of the
income actually earned during the remainder of
the taxable year is allocated to the person who
receives the transferred shares.
S Corp. Operations
• Example 3-D (Closing of the books)
• When a shh terminates (sells) her interest during
the taxable year, an election may be made to
allocate a share of the income actually earned
through the date the interest terminates to the
terminating shh. Similarly, the share of the
income actually earned during the remainder of
the taxable year is allocated to the person who
receives the transferred shares.
S Corp. Operations
• Example 3-D (Closing of the books)
• Year 8 is divided into two tax years for purposes
of allocating income
• Ellen:
• Floyd:
• Step 1: Yearly income/# of days
• =$360,000/183
• =$1,967.21
S Corp. Operations
• Example 3-D (Closing of the books)
• Step 2: Under (a)(1)(B), we take that number and
divide by the number of total outstanding shares.
• =$1,967.21/1,000
• =$1.96721 per share/per day
S Corp. Operations
• Example 3-D (Closing of the books)
• Step 3: Per share/per day x ownership x number
of days
• =$1.96721 x 500 x183
• =$180,000
S Corp. Operations
•
•
•
•
Example 3-D (Closing of the books)
Grant:
Step 1: Yearly income /# of days
=$6,000/183=$32.79
S Corp. Operations
• p. 105: Problem 3-1
Assignment
pp. 111-121
S Corp. Operations
Problem 3-1, p. 106
• 100 shares outstanding
• Henry: 75
• Ilsa: 25 (122nd….$122,000)
• Judy: 25 (244th …..$610,000)
• Days: 366
Problem 3-1 (a)
Step 1 = Yearly income/# of days
$732K/366
=$2K
Step 2 = (Step 1)/# of outstanding shares
$2K/100 shares
=$20 per share/per day
Step 3 = (Per share/per day) x ownership x # of days
Henry = $20 x 75 x 366 = $549,000
S Corp. Operations
Step 3 = (Per share/per day) x ownership x # of days
(a) Henry = $20 x 75 x 366 = $549K
Ilsa = $20 x 25 x 122 = $61K
Judy = $20 x 25 x 244 = $122K
Problem 3-1(b)/Closing of Books (Ilsa)
Step 1 = Yearly income/# of days
$122K/122
=$1K
Step 2 = (Step 1)/# of total outstanding shares
$1K/100 shares
=$10 per share/per day
Step 3 = (Per share/per day) x ownership x # of days
Ilsa = $10x 25 x 122 = $30,500
Problem 3-1(b)/Closing of Books (Judy)
Step 1 = Yearly income/# of days
Step 2 = (Step 1)/# of total outstanding shares
Step 3 = (Per share/per day) x ownership x # of days
Problem 3-1(b)/Closing of Books (Judy)
Judy= $152,500
S Corp. Operations
• Consequences of Operating Loss – p. 111
• When a C Corp incurs a net operating loss that it
cannot use, its shh’s cannot apply the loss
against their personal income, but shh’s of a S
corp can
• IRC 1366(a)(1) – If a S Corp has deductions in
excess of gross income, indiv. shhs may apply
those excess deductions against income derived
from other sources.
S Corp. Operations - Losses
• Example 3 – Linda is a sole shh of Sallo Corp.,
an S Corp. Her Year 1 income exceeds her
deductions by $1 mil before taking into acct Sallo.
Sallo’s Year 1 deductions exceed its gross
income by $1 mil. Provided no other rule limits
her ability to use Sallo’s excess deductions, Linda
may claim all of Sallo’s deductions, and her Year
1 income is zero.
S Corp. Operations - Losses
• Hurdles that must be overcome before S corp
shhs may deduct operating losses:
• (1) Operating loss must be allocated among the
shhs – for both taxable income and operating
losses, shhs must include their “pro rata” share
on their individual tax returns.
S Corp. Operations - Losses
• Pro rata share approach – Same rule as before--(A closing of the books election may be made
with the consent of certain shhs IRC 1377(a)(2)).
• Each shh’s loss is based on the percentage of
ownership of stock owned by that shh.
S Corp. Operations - Losses
• (2) Individual shareholders must satisfy additional
requirements before the deductions may be
claimed on their returns
• 1366(d) – Shh’s share of S corp. losses and
deductions is limited to the shh’s adjusted basis
in (1) stock of the corp and (2) indebtedness of
the corp to the shh.
S Corp. Operations - Losses
• The S corp’s loss first reduces the shh’s basis in
her stock and then the basis in any indebtedness
of the corp. to her but not below zero. IRC
1367(a)(2)
• What happens if the loss exceeds her basis in
stock and in debt? She may not deduct the
excess losses until she establishes additional
basis. IRC 1366(d)(2)
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(a) Pro Rata Share of Loss: $75K, $75 K
• Ben & Carol
• Amount of Loss that can be deducted: same
(b) Currently Deductible amount: Ben-$150K,
Carol-$100K
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(b)
(i)
This is not a sensible result because Ben has
sufficient basis to deduct the excess loss, but the
excess loss is allocated to Carol because she owns
50% of the stock of the corp.
(ii) Ben’s stock basis: 0 ($100,000)
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(c)
Back to original facts:
Pro Rata Share of Loss:
Ben: $150K
Carol: $150K
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(c)
Currently Deductible Amount (use their stock
basis…original facts)
Ben: $100K
Carol:$100K
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(c)
Each shareholder may deduct $100K of the corp’s
deductible expenses even if the expenses are paid
with money borrowed from the Bank. This is a
sensible result. Why?
S Corp. Operations - Losses
• Problem 3-3, p. 112:
• Ben & Carol
(d)
If the corp defaults on the Bank loan, the Bank can
recover the $200K contributed by the shhs
S Corp. Operations - Losses
Estate of Leavitt – p. 117
• Facts: Appellants appeal Tax Court’s
decision holding them liable for deficiencies
for 1979-1981.
• Shhs of VAFLA, subchapter S corp. –
claimed deductions under IRC 1366 to reflect
corp’s losses during three years in question.
S Corp. Operations - Losses
Estate of Leavitt – p. 117
• Cmsr. disallowed deductions above the
$10,000 bases each appellant had from their
original investments (stock basis)
• Appellants argue: adjusted basis in stock
should be increased to reflect a $300,000 loan
which VAFLA obtained from Bank of VA on
Sept. 12, 1979 after the appellants and five
other shhs signed guarantee agreements.
S Corp. Operations - Losses
Estate of Leavitt – p. 117
• Under these guarantee agreements, the
shhs agreed to be jointly and severally liable
for all indebtedness of the corp to the Bank.
They argued the Bank would not have lent the
$300,000 without the personal guarantees.
• VAFLA made all loan payments, principal,
and interest to the Bank.
S Corp. Operations - Losses
• Estate of Leavitt – p. 117
• ISSUE: Whether the guaranteed loan from the
Bank to VAFLA is an economic outlay of any kind
by the Shh-Guarantors. (Must answer the q
whether it was a loan from the Bank to VAFLA or
whether it was a loan to the Shhs-Guarantors
who then gave it to VAFLA, as either a loan or a
capital contribution).
S Corp. Operations - Losses
• Estate of Leavitt – p. 117
• Rule: To increase basis in S corp stock, there
must be an economic outlay on the part of the
shh.
• A guarantee in itself does not fulfill that
requirement. (At the current time, appellants
have not been called upon as guarantors, no
economic outlay, suffered no cost).
S Corp. Operations - Losses
• Selfe– p. 113
• 11th Cir case that court disagrees with here.
Applied a debt-equity analysis and held that a
shh’s guarantee of a loan to a subchapter S corp
may be treated for tax purposes as an equity
investment where the lender looks to the shh as
the primary obligor.
S Corp. Operations - Losses
• Selfe– p. 113
• In disagreeing with Selfe, the Tax Court
distinguished Plantation Patterns (which Selfe
relied upon), noting that Plantation Patterns
involved a C Corp. and reasoning the application
of debt-equity principles to a subchapter S corp
would defeat Congressional intent to limit a shh’s
pass-through deduction to the amount he or she
has actually invested in the corp.
Assignment
pp. 142-149
We will cover pages 128-135 after the
break.
TRANSITIONAL PROBLEMS– p. 142
• Changing from C Corp to S Corp
• If a corp operates as a S corp from its inception,
it is never subject to the double tax regime that
applies to C Corps. There is no corporate level
tax.
• However, an S corp does not have to operate as
an S corp from its inception to qualify for S corp
status. As the casebook author points out, many
corps operate as C corp for a period and then
change to S corps.
TRANSITIONAL PROBLEMS– p. 142
• Basic idea – When this transition from C corp to
S corp status occurs, all operating income and
gains that accrue after the conversion are
subject only to the indiv. income tax. The same
holds for operating losses that occur after the
conversion---They flow through to the shh.
TRANSITIONAL PROBLEMS– p. 142
• What about corporate income level items
(e.g., assets held at the time) that may exist
when a C corp converts to S corp status?
• Unrealized gains in corporate assets (corporate
level taxes even after converting)
• Accumulated earnings
• Net operating loss carryovers (generally cannot
be used after S corporation status commences)
Built-In Gains – p. 143
• IRC 1374
• Tax on Excessive Passive Investment
Income – interest, dividends, etc.
Pages 145-146, Problem 3-4
Assets
Adj. Basis
FMV
Land
$200,000
$1,400,000
All other assets
$700,000
$1,200,000
Total
$900,000
$2,600,000
a) Year 2, C corp sold the land
GAIN = AR-BASIS
= $1.4 mil. - $200,000
= $1.2 mil. (capital gain) x 21%
= $252k
Taxed again in hands of Y’s shareholders
b) Year 3, S corp sold the land
SAME GAIN AS ABOVE.
NUBG: $1.7 mil.
RBG: $1.2 mil.
NRBG= $1.2 mil. (assume no losses) x 21%
= $252k BUT What about Y’s shareholders?
Pages 145-146, Problem 3-4
Assets
Adj. Basis
FMV
Land
$200,000
$1,400,000
All other assets
$700,000
$1,200,000
Total
$900,000
$2,600,000
Pages 145-146, Problem 3-4
Assets
Adj. Basis
FMV
Land
$200,000
$1,400,000
All other assets
$700,000
$1,200,000
Total
$900,000
$2,600,000
b) Y’s shareholders
The built in gain tax (IRC section 1374) is
treated as a loss that offsets the amount
of Y’s gain that flows through to the
shareholders.
Thus, the net flow through is:
= $1,200,000 - $252,000
= $948,000.
See Treas. Reg. section 1.366-4(b)
Pages 145-146, Problem 3-4
Assets
Adj. Basis
FMV
Land
$200,000
$1,400,000
All other assets
$700,000
$1,200,000
Total
$900,000
$2,600,000
e) No section 1374 tax is imposed because
the sale occurred after the end of the
“recognition period” i.e., 5 year period.
See IRC section 1374(d)(7).
Accumulated C Earnings – p. 146
• IRC section 1375
• Tax on Excessive Passive Investment
Income – interest, dividends, etc.
Accumulated C Earnings – p. 147
TWO CRITERIA FOR 1375 TO APPLY:
1. Accumulated C earnings
2. More than 25% of its gross receipts consist of
“passive investment income”
Result: ENPI taxed at highest rate, i.e., 21%
Accumulated C Earnings – p. 147
What is Passive Investment Income? (PII)
• Gross receipts from royalties, rents, dividends,
interest and annuities, as well as gains from the
sale of stock or securities. 1375(b)(3),
1362(d)(3)
• Generally, it consists of classic forms of
investment income (dividends, interests, rents,
etc.) but not gains from the disposition of
property
Accumulated C Earnings
What are Gross Receipts? (GR)
• Not defined by statute but include virtually all
revenue received, unreduced by the cost of
goods sold or deductions
Accumulated C Earnings
What is Excess Net Passive Income? (ENPI)
• Tax Base to which we apply the highest rate
(21%)
• A portion of the corporation’s net passive
income, which is generally defined as passive
income less directed connected deductions for
the year,
1375(b)(1)
Accumulated C Earnings
What is Excess Net Passive Income? (ENPI)
• This amount is determined by a ratio.
• The amount by which the corp’s passive
investment income exceeds 25% of its GR for
the year OVER Passive Investment Income
Accumulated C Earnings
What is Excess Net Passive Income? (ENPI)
ENPI = Net Passive Income x PII – (.25 x GR)/PII
• All of the other terms have been defined.
However, what is Net Passive Income?
PII reduced by deductions attributable to the
production of such income. 1375(b)(2)
Accumulated C Earnings
What is Excess Net Passive Income? (ENPI)
ENPI = Net Passive Income x PII – (.25 x GR)/PII
• Ceiling: ENPI cannot exceed the corp’s taxable income
(computed with certain changes). 1375(b)
• Waiver: IRS may waive the 1375 tax if the S corp
establishes it determined in good faith that it had no
accumulated earnings and within a reasonable time
distributed such found accumulated earnings to its shhs.
1375(d)
Example 3-N – p. 147
Have the two criteria for the 1375 tax been met?
• PII (interest income) = $10k
• GR = $90k revenue + $10k of interest income
GR = $100k
• PII is only 10% of GR, so the answer is no.
Example 3-O –No looking
Have the two criteria for the 1375 tax been met?
• Accumulated C earnings
• Dividend income = $75k ($15k deductible
expenses in connection with dividend income)
• Revenue = $25k revenue from doorknob sales
Example 3-O – p. 148
Have the two criteria for the 1375 tax been met?
• PII (dividend income) = $75k
• GR = $25k revenue + $75k of dividend income
GR = $100k
• PII ($75,000) >25% of GR ($100,000)
• In other words 75k is greater than $25k.
Example 3-O – p. 148
Have the two criteria for the 1375 tax been met?
1) Accumulated C Earnings
2) Does PII exceed 25% of GR?
• PII (dividend income) = $75k
• GR = $25k revenue + $75k of dividend income
GR = $100k
• PII ($75,000) >25% of GR ($100,000)
• In other words $75k is greater than $25k.
Example 3-O – p. 148
ENPI = Net Passive Income x PII – (.25xGR)/PII
• What is Net Passive Income?
$75k - $15k (see question)
• What is PII?
$75k (dividend income)
• What is 25% of GR?
25% x $100k or $25,000
Plug & Chug = $40,000
Example 3-O – p. 148
ENPI = $40,000
Not Done Yet! ENPI is just the tax base.
What is the section 1375 tax liability?
Section 1375 tax = ENPI x highest corporate rate
= $40,000 x 21%
= $8,400
Example 3-P (Taxable Income Ceiling)
What is Excess Net Passive Income? (ENPI)
ENPI = Net Passive Income x PII – (.25 x GR)/PII
• Ceiling: ENPI cannot exceed the corp’s taxable income
(computed with certain changes). 1375(b). In other words,
the tax base is the lesser amount of TI or ENPI. The excess
amount is not treated as ENPI in the next year.
• Note: This is different from how it works in terms of the Built-In
Gain tax. The excess is treated as RBG the following year.
(See Example 3-M on p.145).
Waiver of the 1375 tax by IRS
• Waiver: IRS may waive the 1375 tax if the S
corp establishes it determined in good faith that
it had no accumulated earnings and within a
reasonable time distributed such found
accumulated earnings to its shhs. 1375(d)
Time Limit on Getting Rid of Accumulated C
Earnings
An S corp. subject to the 1375 tax must distribute
all of its accumulated C earnings before being
subject to the tax in 3 consecutive years.
• If not, what happens?
The S election will terminate at the beginning of
the 4th year.
IRC section 1362(d)(3).
Problem 3-6 on page 149
1. Accumulated C earnings?
2. GR: _______
PII: ________
Is PII > 25% x GR?
Problem 3-6 on page 149
1. Accumulated C earnings?
2. GR: $1,600,000
PII: $400K (interest) + $200K (dividend) = $600K
Is PII > 25% x GR?
Yes!
Problem 3-6 on page 149
GR: _______
PII: ________
Net Passive Income: Same as PII
ENPI =Net Passive Income x PII-(.25%x GR)/PII
Plug & Chug
Problem 3-6 on page 149
GR: $1,600,000
PII: $600K
Net Passive Income: $600K
ENPI =Net Passive Income x PII-(.25%x GR)/PII
Plug & Chug
= $600K x [$600K – $400k]/$600K
= $200K
1375 tax liability = $200K x 21%
Answer = $42K
Problem 3-6 on page 149
What about the shhs?
• Entire $100k of gross profit from the sale of
clothing is allocated to the shhs
• The $600k of passive investment income is
reduced by the $42k tax and only $558k of
passive income flows through to the shhs.
IRC section 1366(f)(3)
Assignment for Thursday, 3/10
Read pages 128-135
Eligibility for S corp Status
1) Domestic corp, other than certain ineligible
corps
2) Not More than 100 shhs
Rev. Rul. 94-43 – p. 129
3) No ineligible shhs
4) Not More than 1 class of stock – IRC 1361(b)
Paige – p. 133
*And the corp. must make the requisite “S”
Election
Check the Box Regs.
• Treas. Reg. section 301.7701
• Form 8832
• General Instructions – page 4
Check the Box Regs.
• Eligible entity – business entity not
included in items 1 or 3 through 9, under
the definition of corporation under
“Definitions” (see right column)
• Eligible entities include LLCs and p-ships
• Generally, corps are not eligible entities
(two exceptions)
Check the Box Regs.
• What is a business entity? – “Definitions”
• Any entity recognized for federal tax
purposes that is not a trust under Treas.
Reg. section 301.7701-4 or otherwise
subject to special treatment under the
Code re: the entity’s classification (under
the check the box regs).
Check the Box Regs.
• What are the classification options?
• Corporation – See “Definitions”
• Disregarded Entity – an eligible entity
treated as not separate from its single
owner for federal income tax purposes
• Partnership – a business entity that has at
least two members and is not a
corporation as defined under “Definitions”
Check the Box Regs.
• What about S corporations?
• See page 5 – “Who Must File”
• Retroactive Entity Classification election?
See page 5 – “When to File”
Tax Planning with Check the
Box Regs.
• Dual-Qualified Structures
• Problem? - Territoriality
• Solution – Charitable Deduction in Both
Completing Form 8832 – p. 6
• UK Friends of Tulane University
EIN: 70-0128345
7 Princes Gate Road.
London, SW7 1JA
• Tulane University
EIN: Can you find it online?
6823 St. Charles Avenue,
New Orleans, LA 70118
Who signs the form?
Completing Form 8832 – p. 6
• UK Friends of Tulane University
EIN: 70-0128345
7 Princes Gate Road.
London, SW7 1JA
• Tulane University
EIN: 72-0423889
6823 St. Charles Avenue,
New Orleans, LA 70118
Who signs the form?
Assignment for 3/15
• We will cover pages 106-110 later in the term.
• Read pages 155-164.
PARTNERSHIPS
Operations: Partnerships & LLCs
1. Classification – Check the Box Rules
2. T.I. = Gross Income and Deductions
Gross Income and Deductions
General Rules: Subchapter K
§701 – Partnerships are not subject to income tax;
partners are liable for tax
§702 – Partners account separately
(i) Separately stated items
(ii) Bottom line income or loss
§703 – Generally, a partnership's taxable income
is determined in the same way as the taxable
income of an individual (except denied itemized
deductions)
Gross Income and Deductions
Computation and Reporting
Form 1065 – includes a separate schedule for
each partner (K-1)
• Items reflected on a K-1 must be included on
a partner’s personal tax return
Gross Income and Deductions
Problem 4-1 (P-ship Gross Income) – p. 158
(a) §721 – A p-ship does not recognize gain or
loss when it receives property in exchange for a pship interest. Analogous to §1032.
(b) The p-ship has no income, but the authority is
not apparent. Same rule as §118 – Gross income
does not include capital contributions.
(c) P-ship has $1 million of §61(a) income, but the
p-ship does not pay the tax. Instead, the p-ship’s
income is allocated to the partners and reported on
their personal returns.
Gross Income and Deductions
Problem 4-1 (P-ship Gross Income) – p. 158
(d) No p-ship level tax is recognized when a p-ship
distributes appreciated property to a partner.
This is different from the corporate context.
Operations: Partnerships & LLCs
1. Classification – Check the Box Rules
2. T.I. = Gross Income and Deductions
Gross Income and Deductions
B. Allocation to Partners
1. Taxed When Income Is Earned – p. 158
Burke v. Commissioner – p. 159
Gross Income and Deductions
Similar to S corps – mere accounting entity
• Income and deductions are allocated to partners
and reported on their personal tax returns
Different from S corps
• Partnership form does not constrain the
economic relations that may be established
among owners of the enterprise
Instead of the Rigid Allocation Rule, Flexible
Allocation Rule!
Assignment for
Read Orrisch case on pages 165-170.
Orrisch
Illustrates the SEE Test –
• Substantial Economic Effect
When do you apply the SEE Test?
• When there are partners who have agreed
upon a Special Allocation
Scenario 1 – No Special Allocations
O
C
Initial Contribution
$500
$500
Depreciation
(100)
(100)
Gain
$150
$150
Totals
$550
$550
Scenario 2
Complete blank on handout
Gain Chargeback Provision – All partnership
gain attributable to depreciation taken is allocated
to the partner who was allocated the depreciation
deduction.
What does that mean?
First, Orrisch will take on any gain up to an amount
equal to the depreciation he was given before any
gain is allotted to Crisafi.
How much gain is there?
Scenario 2 –Special Allocation
O
C
Initial Contribution
$500
$500
Depreciation
(200)
(0)
Gain
$250
$50 (1/2 of $100)
Totals
$550
$550
Scenario 3 –Special Allocation and LOSS
O
C
Initial Contribution
$500
$500
Depreciation
(200)
(0)
$300
$500
Sold at $800 or Loss
Totals
Still court did not allow the Special Allocation –
Why?
The court concluded the partners had no
intention of distributing liquidation proceeds
per the capital accounts. (Instead, they
intended that all distributions would be made
equally).
Thurs., 3/24
Read pages 170-174 and pages 176-179
Orrisch
Illustrates the SEE Test –
• Substantial Economic Effect –
• Would the special allocation indeed affect the
dollar amounts the partners might eventually
receive – such as on the sale of the property?
SEE Test Safe Harbor – Ec. Effect
3 Requirements from Treas. Reg. 1.704-1(b)(2)(ii)
1. Capital Account Requirement
2. Liquidation Requirement
3. Deficit Makeup Requirement
SEE Test Safe Harbor
1. Capital Account Requirement – Maintenance of
capital account for each partner pursuant to the
rules set forth in the Regs.
SEE Test Safe Harbor
2. Liquidation Requirement – Liquidating
distributions must be made in accordance with the
positive capital account balances of the partners
SEE Test Safe Harbor
3. Deficit Makeup Requirement – Any partner with a
deficit capital account must restore the deficit upon
liquidation of the p-ship (or upon leaving the p-ship)
SEE Test
Two Tests that must be satisfied:
(1) Whether a special allocation has “economic
effect” – regs/safe harbor
(2) Whether the “economic effect” is substantial –
There must be a reasonable possibility that the
allocation will affect substantially the dollar
amounts received by the p-ship independent of tax
consequences.
SEE Test - Substantiality
• Focuses on whether the economic effect of one
special allocation is neutralized by another one
• Question: Is there a reduction in the total amount
of tax paid by the partners without a change in the
relative economic position of the partners?
– If Yes, the economic effect of the allocations is NOT
substantial
SEE Test - Substantiality
How do we know when substantiality is violated?
(A) Does the special allocation reduce the total
amount of taxes paid by the partners?
AND
(B) Is there no significant change in the balance of
each partner’s capital account (compared to that
which it would be in the absence of the special
allocations)?
SEE Test - Substantiality
• Two Types of Allocations
1) Transitory Allocations
2) Shifting Tax Consequences
SEE Test - Substantiality
1. Transitory Allocation – (occurs over two or more
tax years)
• Occurs when the neutralizing allocation impacts a
p-ship year subsequent to the year affected by the
original allocation
SEE Test - Substantiality
2. Shifting Tax Consequences (occurs over one tax
year)
• Have the partners allocated types of income or loss
to themselves within a given tax year solely to
reduce their total tax liability?
Look for 2 facts (compared to situation where there is
no special allocation):
(a) No significant change in the balance of each
partner’s capital accounts AND
(b) Total tax liability of all partners will be less than it
would in the absence of the allocation
SEE Test - Substantiality
Example 4-E (Shifting Tax Consequences) p. 178
Year 1
Maurice
Nisa
$10K
$10K
SEE Test - Substantiality
• Are the partners taxed on the distributive share of
tax exempt interest ($5K each)?
• Will Maurice pay more tax on his distributive share
of dividend income than Nisa?
SEE Test - Substantiality
Presence of Special Allocations
Maurice – allocated the first $10K of tax exempt
interest during Year 1
Nisa – allocated the first $10K of dividends generated
during Year 1
• Will the capital accounts looks any different?
• Will the special allocations reduce the collective tax
liability of the partners? If so, why?
SEE Test - Substantiality
Does substantiality exist?
SEE Test - Substantiality
Example 4-E (Transitory Allocations) –p. 177
Operations: Partnerships & LLCs
1. Classification – Check the Box Rules
2. T.I. = Gross Income and Deductions
Gross Income and Deductions
General Rules: Subchapter K
§701 – Partnerships are not subject to income tax;
partners are liable for tax
§702 – Partners account separately
(i) Separately stated items
(ii) Bottom line income or loss
§703 – Generally, a partnership's taxable income
is determined in the same way as the taxable
income of an individual (except denied itemized
deductions)
Gross Income and Deductions
General Rules: Subchapter K
§702 Separately stated items vs. Bottom Line
• Separately stated items: Items of p-ship income
and deduction that may affect each partner
differently depending on his/her tax profile.
• Bottom Line: Items that will affect all partners the
same way, without regard to their tax profiles,
which can be included in “bottom line” income or
loss
Gross Income and Deductions
§702 Separately stated items
Hypo: Partnership AB
Only tax item for the year - $4,000 capital gain
(allocated equally between two partners A&B)
• If A has no other capital gains or losses for the
year
• If B has a $3,000 capital loss
What is the tax effect of the $4k on A and on
B?
Separately Stated Items
The tax effect will be dramatically different?
A: report $2,000 gain
B: report $1,000 loss ($3k loss - $2k gain)
Thus, it is important that the p-ship return
specify $4,000 as capital gain (and not as net
income/bottom line income).
Separately Stated Items
AB Partnership must separately state this capital
gain and any other “variable effect” items.
What are “variable effect” items?
• Items whose tax consequences vary from
partner to partner.
• Listed in IRC 702(a)
Separately Stated Items
“Variable effect” items under IRC 702(a)
• Both short and long term capital gains & losses
• Gains & losses from IRC 1231 property
• Charitable contributions (which will be combined
with each partner’s contributions before applying
the relevant IRC 170 limitations)
• Dividends eligible for the dividend received
deductions – Corporate Partners only
• Qualified dividend income (eligible for capital
gains rate) – Noncorporate partners
Separately Stated Items
This language causes partners & p-ships
(practitioners) to be on the look out for items
that may have a “variable effect.”
The list of “variable effect” items changes.
P-ship Basis
Partner’s Outside Basis https://www.irs.gov/pub/irs-utl/partnersoutside-basis.pdf
“Each partner has a basis in his partnership
interest. The partner’s basis in his partnership
interest is separate from the partnership’s
basis in its assets. Partnership tax law often
refers to “outside” and “inside” basis. Outside
basis refers to a partner’s interest in a
partnership. Inside basis refers to a
partnership’s basis in its assets. Publication
541 contains information on outside basis.”
Separately Stated Items
“Variable effect” items under IRC 702(a)
• Congress authorized Treasury to expand this list
in the Regs. & Treasury did:
Section 1.702-1(a)(8) – Also included broad
language that says each partner must also take
into account separately, his/her distributive share
of any p-ship item if doing so would result in an
income tax liability different from that which would
result if the partner did not take the item into
account separately.
C Corp. Distributions
3 Categories:
1) one-side
2) redemption
3) liquidation
C Corp. Distributions
One-Side Distribution – IRC section 301(a)
• A transfer of property under 317(a) to a shh
in his/her capacity as an owner
C Corp. Distributions – One Side
• What is property under 317(a)?
– Salary, money, securities, and any other
property except stock in the distributor
corporation or rights to acquire that stock.
(It also includes a loan by the corp. but not for
the purposes of 301(c) because a distribution
must be made to a shh in his/her capacity as
an owner).
C Corp. Distributions: One Side
Earnings & Profits – page 220
• Not defined in the Code
• Not Equivalent to Taxable Income
 Broader than Taxable Income because it includes
receipts excluded from gross income (e.g., taxexempt interest).
 Narrower than Taxable Income because it is offset
by disbursements not allowed as deductions (e.g.,
payments of Federal income tax)
C Corp. Distributions: One Side
• Generally, a return on investment but
sometimes a return of investment
C Corp. Distributions: One-Side
• How to Determine the Tax Consequences of
a One-Side Distribution:
1. Dividend – portion that is from E&P
2. Not Dividend – reduce basis to zero, not
below, i.e., received tax-free
3. Excess Over Basis – treated as capital gain
C Corp. Distributions: One-Side
• Dividend
E&P includes:
(1) CURRENT E&P – look there first AND
(2) Accumulated E&P – since Feb. 28, 1913
General Rule: Look to current E&P, and then if
necessary, to accumulated E&P.
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
Page 224
(a) Year 1
Current E&P
($100,000)
Accumulated E&P
0
Benedum distributed $50K to Jacob on May 1
of Year 1. What are the tax consequences to
Jacob?
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(a) Year 1
Current E&P
($100,000)
Accumulated E&P
0
$10K received tax-free (stock basis reduced to
zero), 301(c)(2)
$40K capital gain, 301(c)(3)
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(a)
Benedum’s Accumulated E&P at the end of
each year:
Year 1
($100,000)
Year 2
($40,000)
Year 3
$30,000
Year 4
zero
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(b)
Benedum’s accumulated E&P at the end of
each year:
Year 1
Year 2
Year 3
Year 4
($100,000)
($90,000)
($20,000)
($50,000)
C Corp. Distributions: One-Side
• Qualified Dividend Income – Maximum capital
gains rate of 20%, plus the Medicare
contribution tax rate of 3.8%
• Dividends are not characterized as capital gains.
• Qualified Dividend Income – Shh must have held
the stock for at least 61 days during the 121 day
period specified on page 226.
C Corp. Distributions: One-Side
Camouflaged One-Side Distribution – Jacques
page 228 and Sullivan – page 243
• Dividing Line: Loan v. Distribution?
C CORP DISTRIBUTIONS
C Corp. Distributions
3 Categories:
1) one-side
2) redemption
3) liquidation
C Corp. Distributions
One-Side Distribution – IRC section 301(a)
• A transfer of property under 317(a) to a shh
in his/her capacity as an owner
C Corp. Distributions – One Side
• What is property under 317(a)?
– Salary, money, securities, and any other
property except stock in the distributor
corporation or rights to acquire that stock.
(It also includes a loan by the corp. but not for
the purposes of 301(c) because a distribution
must be made to a shh in his/her capacity as
an owner).
C Corp. Distributions: One Side
Earnings & Profits – page 220
• Not defined in the Code
• Not Equivalent to Taxable Income
 Broader than Taxable Income because it includes
receipts excluded from gross income (e.g., taxexempt interest).
 Narrower than Taxable Income because it is offset
by disbursements not allowed as deductions (e.g.,
payments of Federal income tax)
C Corp. Distributions: One Side
• Generally, a return on investment but
sometimes a return of investment
C Corp. Distributions: One-Side
• How to Determine the Tax Consequences of
a One-Side Distribution:
1. Dividend – portion that is from E&P
2. Not Dividend – reduce basis to zero, not
below, i.e., received tax-free
3. Excess Over Basis – treated as capital gain
C Corp. Distributions: One-Side
• Dividend
E&P includes:
(1) CURRENT E&P – look there first AND
(2) Accumulated E&P – since Feb. 28, 1913
General Rule: Look to current E&P, and then if
necessary, to accumulated E&P.
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
Page 224
(a) Year 1
Current E&P
($100,000)
Accumulated E&P
0
Benedum distributed $50K to Jacob on May 1
of Year 1. What are the tax consequences to
Jacob?
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(a) Year 1
Current E&P
($100,000)
Accumulated E&P
0
$10K received tax-free (stock basis reduced to
zero), 301(c)(2)
$40K capital gain, 301(c)(3)
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(a)
Benedum’s Accumulated E&P at the end of
each year:
Year 1
($100,000)
Year 2
($40,000)
Year 3
$30,000
Year 4
zero
C Corp. Distributions: One-Side
• Problem 5-1: One-Side Distribution of Money
(b)
Benedum’s accumulated E&P at the end of
each year:
Year 1
Year 2
Year 3
Year 4
($100,000)
($90,000)
($20,000)
($50,000)
C Corp. Distributions: One-Side
• Qualified Dividend Income – Maximum capital
gains rate of 20%, plus the Medicare
contribution tax rate of 3.8%
• Dividends are not characterized as capital gains.
• Qualified Dividend Income – Shh must have held
the stock for at least 61 days during the 121 day
period specified on page 226.
C Corp. Distributions: One-Side
Camouflaged One-Side Distribution – Jacques
page 228 and Sullivan – page 243
• Dividing Line: Loan v. Distribution?
C Corp. Distributions
3 Categories:
1) One-side – some (but not all) of the corp’s
property is transferred to its shhs in their
capacity as owners where shhs do not
surrender any of their stock to the distributing
corp. IRC 301(a)
2) Redemption – some of the corp’s property is
transferred in exchange for some of the corp’s
outstanding stock.
3) Liquidation – ALL of the corp’s property is
transferred to its shhs.
C Corp. Distributions
1. One-side distributions
p. 220 – “One side distributions
and dividends are not
synonymous.”
C Corp. Distributions
1. One-side distributions
What about one-side distributions that
are dividends?
• “Holding Period” – Capital gains rate?
Qualified Dividend Income – p. 220
• Contrary to capital gains, dividends
received on stock held less than a year
qualify for the 20% capital gains rate.
1(h)(11)(A).
C Corp. Distributions
1. One-side distributions
Qualified Dividend Income – p. 220
• However, to qualify for the 20% tax rate,
the stock must have been held for a
certain amount of time (61 days during a
specified time period), referred to as the
applicable “holding period.”
1. One Side Distributions
a. Camouflaged One-Side Distribution –
Jacques p. 228
Dividing Line: Loan or Distribution?
Withdrawal by sole shh: a loan or a
distribution (dividend)?
• Jacques PC loaned Jacques the private
citizen large amounts of money
1. One Side Distributions
a. Jacques
What is the problem?
Sole shh of a PC can withdraw large sums from
the corp without incurring tax liability. How?
characterize the withdrawals as loans
(not income)
postpone repayment of the loans
indefinitely
rather than characterize the withdrawals
as taxable, non-deductible dividends.
1. One Side Distributions
a. Jacques
5 Important Factors – Withdrawals
(1) Absence of written loan agreement
(2) Jacques did NOT periodically repay
principal or interest
(3) Withdrawals were unsecured and not
subject to a fixed payment schedule
(4) Withdrawals were in proportion to his
holdings as the sole shh
(5) Corp had substantial current earnings but
did not pay any dividends during this period
1. One Side Distributions
a. Jacques
Camouflaged one-side distributions are often
called “constructive dividends.”
• Is every one-side distribution a dividend?
1. One Side Distributions
a. Jacques
Issue: Whether withdrawals by Jacques from
his PC are treated for tax purposes as loans or
dividends?
• Depends on the intention
• Objective factors, including the taxpayer’s
testimony (typically self-serving)
1. One Side Distributions
a. Jacques
Rule: A withdrawal by a sole shh will be treated
as a distribution/dividend, rather than a loan,
unless at the time of the withdrawal, the shh
intends to repay the amount received, and the
corporation intends to require payment. The
mere declaration by a shh that a withdrawal is
intended to constitute a loan is not sufficient
without more reliable loan indicia. (See factors
above). See also pages 231-232:
(2) & (3), (6), (7), (11) & (10), and (14)
1. One Side Distributions
b. Business or Personal Use of Corporate
Property – omitted
1. One Side Distributions
c. Discharge of Corporate or Personal
Obligation – Sullivan, p. 243
Sullivan – sole shh of auto dealership, 62%
Nelson – resident manager, 38%
Sullivan was required to repurchase any stock
Nelson acquired upon his termination of
employment (a “redemption”).
• Under 317(b), the purchase by a corp. of its
own stock is called a “redemption.”
1. One Side Distributions
c. Discharge of Corporate or Personal
Obligation – Sullivan, p. 243
Issue: Whether the payment by the
corporation in redemption of Nelson’s stock
constituted a taxable distribution to taxpayer
Sullivan, again the sole remaining shareholder.
• Personal obligation?
• Purchase out of E&P?
1. One Side Distributions
c. Discharge of Corporate or Personal
Obligation – Sullivan, p. 243
What is the criteria for determining whether a
payment is a constructive dividend?
• Economic benefit
1. One Side Distributions
c. Discharge of Corporate or Personal
Obligation – Sullivan, p. 243
Does it matter that Sullivan’s financial worth in
the corp. was the same before and after the
transaction?
Is the court looking more to substance or to
form?
1. One Side Distributions
c. Discharge of Corporate or Personal
Obligation – Sullivan, p. 243
Rule: An individual shh receives an economic
benefit when a corp relieves him/her of a
personal obligation to purchase stock by
diverting corporate earnings and profits, and
such benefit may be taxed as a constructive
dividend.
QBI DEDUCTION
Deduction for Qualified Business Income
– p. 106
Similar to S corps – Both have the QBI
Deduction! – see p. 106
IRC section 199A
What is QBI? – Essentially, it’s the operating
income of a business. Succinctly, it is the
taxpayer’s ordinary income (less ordinary
deductions) earned from a passthrough entity.
Deduction for Qualified Business Income
What is excluded from QBI? –
• Reasonable compensation received from the
business, capital gains and losses,
dividends, interest and certain other items.
See IRC 199A(c)
QBI Deduction
What is the effect of the QBI deduction on the effective rate of
tax?
The QBI deduction is applied at the shh level.
This means a shh is able to deduct an amount equal to as much
as 20% of the shh’s pro rata share of S corp. income.
If a shh is taxed at the highest rate (37%) and claims a QBI
deduction (20%), the shh will reduce the tax burden from 37%
to 29.6%.
QBI Deduction
There are 2 constraints on a shh’s ability to take the QBI
Deduction:
1) When the shh’s taxable income exceeds the yearly amount
• For 2021, taxable income must be under $164,900 for single
filers or $329,800 for joint filers. (If you are over these
limits, complicated IRS rules determine whether a full or
partial deduction is allowed).
QBI Deduction
2) When the S Corp. conducts a “specified service business” –
see IRC 199A(d).
What is a “specified service business” under IRC 199A(d)?
Includes any business in the following fields:
• Health, law, consulting, athletics, financial services,
brokerage services, or a business whose principal asset is
the reputation or skill of its employees or owners, or certain
investment and investment related services.
• Note: Architecture and engineering are excluded from the
definition of “specified service business.”
Practice Problem
Tina is a shh in the XYZ Corp. Tina’s basis in her stock is $1,000.
She receives a $850 distribution of which only $100 is a
dividend.
What are the tax consequences?