Chapter 7 Flashcards
Some issues with using a corp as a tax avoidance device
The Corporation as a Tax Avoidance Device
- From the beginning, Congress has been concerned that individuals would take advantage of corporations in order to reduce their individual income tax obligations
- Today this is not the case, but historically, corporate rates have been substantially lower than individual rates. The text indicates that in 1934, the maximum individual rate was 63% and the maximum corporate rate was 13.75%
- Individuals historically have attempted to hold assets in corporations that should be held at the individual shareholder level – why?
- In this scenario, why not transfer liquid investment assets that will not be needed for years (maybe not needed for decades) to a corporation and minimize the overall drain of taxes?
- Today, there is no such incentive to transfer assets to corporations simply because the rate is lower. However, the rules created in the earlier environment still apply today
- The provisions covered in this chapter are more a trap for the unwary than a meaningful provisions in today’s circumstances
- However, even though the rates are relatively equal, closely held corporations are motivated to avoid the second layer of tax (at the shareholder level)
What is the test to see if a corp will be taxed as a personal holding company?
If there were 5 or fewer owners during the last 6 months of the taxable year owning more than 50% of the value(544 attribution applies)
Then, if 60% or more of the corp’s adjusted ordinary gross income= PHC income
Then, calculate undistributed PHC income( the title is misleading because undistributed PHC income includes many other types of income too
PHC income includes:
- Interest income
- Dividends
- Royalties
- Annuities
- Rents w exceptions
- Doesn’t include capital gains
Personal holding company penalty
- PHC penalty is calculated at the highest individual rate (however, today the rate is 15% since that is the maximum rate on dividends)
- The penalty is roughly equivalent to the tax the shareholder would have paid had the corporation paid a dividend
- Note that shareholders do not get stock basis as if the dividend had been paid and the shareholders had reinvested the dividend
Possible solutions for a PHC
Possible Solutions:
- Actually pay a dividend before year-end
- Pay a “consent dividend” (§565)
- Declare a “deficiency dividend” following a determination (§547)
- Consider liquidating the corporation given the very favorable capital gains rates today – but, don’t forget the §311(b) gain at the corporate level
What is the accumulated earnings tax?
- Applies to corporations “formed or availed of for the purpose of avoiding income tax with respect to its shareholders by permitting E&P to accumulate instead of being divided or distributed”
- This “penalty” is NOT self-assessed
- Does not apply to PHC corporations
Accumulated earnings tax in theory and in practice:
In Theory – equity of corporation should be analyzed for excessive accumulation of earnings
In Practice – in general, the only time excess earnings are an issue is when the corporation has excessive liquid assets (including unrealized appreciation in liquid assets)
What are the facts and issues of the Donruss case:
Facts:
- Donruss was a corporation engaged in the manufacture and sale of bubble gum and candy and in the operation of a farm
- Since 1954, Don B. Wiener has been the sole shareholder
- From 1955 to 1961, Donruss was profitable increasing its undistributed earnings from $1.0 million to $1.7 million
- No loans or other benefits were provided to Wiener other than his salary
- No investments unrelated to the business were made by the corporation
- No dividends were declared during the years in question
- Wiener provided several reasons for accumulating earnings in the corporation (capital and inventory requirements, increasing costs, risks inherent in the particular business, the general economy, desire to expand, desire to invest in major distributor – which Donruss did in 1964 paying $380,000 for 10,000 shares)
- This case is a Supreme Court case – the tax court held for Donruss; the Court of Appeals reversed and remanded for a new trial due to poor instructions to the jury – i.e., the Court of Appeals felt that the jury should understand that “tax avoidance was the “dominant, controlling, or impelling motive” for the accumulation” and that tax avoidance didn’t have to be the “sole” purpose. The Supreme Court granted certiorari due to conflicts between the circuits and the role of tax avoidance in accumulating earnings.
Issues:
Was there an unreasonable accumulation of earnings ?
What was the purpose for accumulating the earnings?
Was tax avoidance a reason?
What is the standard for tax avoidance as it relates to unreasonable accumulations of earnings?
Holdings:
There is no question that there was an unreasonable accumulation of earnings. The Tax Court held so and neither party challenged this holding
The Supreme Court held that tax avoidance must simply be one of what could be many reasons for accumulating earnings beyond the needs of the business
As such, arguing that tax avoidance was not the sole purpose or was not the dominant, controlling, or impelling purpose will not carry the day!!
What are the facts and issues of the Ivan Allen case?
Ivan Allen Co. v. United States
Facts:
Ivan Allen was a corporation incorporated in 1902 and actively engaged in the business of selling office furniture, equipment, and supplies in Atlanta, Georgia
In 1965 and 1966, the corporation owned various marketable securities – principally Xerox stock. These stocks were purchased out of the corporations E&P.
In 1966, the Xerox stock and debentures had a tax basis to the corporation of $130,000 and a FMV of $2,550,000!!
The undistributed earnings of the corporation during this period were approximately $2.3 million
The IRS audited the 1965 and 1966 returns and assessed the accumulated earnings tax in the amount of approximately $150,000.
The courts agreed that if the Xerox assets are considered at their cost, no unreasonable accumulation of earnings has occurred. However, if the Xerox assets are included at their net realizable value (FMV less cost of converting to cash) in the calculation, there has clearly been an unreasonable accumulation of earnings.
Issue:
For purposes of determining whether or not there has been a unreasonable accumulation of earnings, are the Xerox assets to be considered at their costs or net realizable value?
Holding:
Net realizable value
In the face of the accumulated earnings tax, what are some justifications for accumulating liquid assets?
Reasonable Needs of the Business (i.e., justification for maintaining liquid assets)
- Working capital for one complete operating cycle (the Bardahl formula)
- Anticipated repairs/replacements of existing assets
- Anticipated internal financing for growth (expansion of plant, new office building, increases in inventory, increases in accounts receivable, etc.)
- Acquisition of a business through purchase of stock or assets
- Debt retirement
- Investments or loans to suppliers or customers necessary to the maintenance of the corporation’s business
What are some unacceptable grounds for accumulating liquid assets with regard to the acc earnings tax?
- Loans to shareholders and expenditures for their personal benefit
- Loans to relatives or friends of shareholders or to others who have no reasonable connection with the business
- Loans to commonly controlled corporations (brother/sister corporations)
- Investments that are not related to the business (recreational land in Southern Utah)
- Accumulations of funds to provide against unrealistic hazards
- Accumulations of funds to redeem shareholders
How is the penalty for the acc earnings tax calculated?
Accumulated Earnings Tax
Calculation of the Penalty:
Lesser of:
- Accumulated taxable income (adjusted to bring this number more in line with the ability of the corporation to pay dividends) less “reasonable needs of the corporation” (note that “reasonable needs of the corporation” is never less than $250,000)
- Liquid assets less “reasonable needs of the corporation”
Less: Dividends paid
Times: 15% (dividend tax rate – which will likely increase next year)
Once again, there must be a tax avoidance motive but if there is an unreasonable accumulation of liquid assets, such accumulation will be deemed evidence that there was a tax avoidance motive. Such motive is rebuttable.
