Friday April 26, 2024
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4.2.1 Double Taxation of C Corporations
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Double Taxation of C Corporations
C Corporation Characteristics: The C corporation is an entity that is a separate taxpayer.
Basis Rules: When assets are transferred to a corporation, the basis flows through.
Double Tax Problem: Tax is due at the corporate and shareholders level.
Redemption: Since dividends are distributed and reported as ordinary income under Sec. 316(a), many shareholders prefer to receive capital gain payouts.
Redemption to Pay Death Taxes: If the value of the C corporate stock is more than 35% of a shareholder's estate, after deducting expenses and taxes, a redemption of stock, with capital gain treatment, is permissible.
Accumulated Earnings Tax: Since the dividends distributed from a corporation are subject to tax at ordinary income rates, some owners of closely held C Corporations prefer to retain cash and other securities in the corporation.
Charitable Contributions: C Corporations are permitted charitable deductions under Sec. 170.
Gifts of Inventory: The basic rule for a gift of inventory is that the corporation is permitted to deduct its cost basis.
Valuation and Appraisal: If public stock is transferred to a charity or to a charitable trust, then the rules for deductions of public securities apply.
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Permanent Charitable Tax Extenders
In December of 2015, both the Senate and House passed the Protecting Americans From Tax Hikes Act of 2015 (H.R. 2029). The bill makes permanent four charitable tax extenders.
The four permanent charitable provisions include the following:
1. Conservation Gift Limits – Gifts of property for conservation purposes benefit from increased deduction limits. The normal 30% limit for appreciated property gifts is increased to 50% and the carry-forward limit is extended from five years to 15 years.
2. Food Inventory Gifts – An enhanced deduction for contributions of "apparently wholesome" food will be available for all donors. The deduction is the lesser of twice the basis or basis plus one-half of the appreciation.
3. IRA Charitable Rollover – Each IRA owner may make a transfer of up to $100,000 per year to a qualified charity. The IRA charitable rollovers are tax-free and not included in adjusted gross income.
4. S Corporation Appreciated Gifts – A Subchapter S corporation may give appreciated stock or land to charity. Only the basis of the S corporation in the donated asset will be used to reduce the shareholder basis, even though the full fair market value deduction is claimed by the shareholder.
C Corporation Characteristics
The C corporation is an entity that is a separate taxpayer. It is frequently created to shield the shareholders from liability. Under Sec. 351(a), it is permissible to transfer assets to corporations without payment of tax.
A C corporation must report its income on Form 1120 and pay tax at the flat corporate tax rate of 21%.
In addition to the federal taxes, most corporations also pay state income taxes. After payment of tax, the corporation may distribute dividends to shareholders. The dividends are subject to a second tax at the shareholder level.
Basis Rules
When assets are transferred to a corporation, the basis flows through. The corporation takes the basis of the shareholder in the asset, and the shareholder transfers the asset basis to the stock received. Sec. 358(a).
Therefore, there is both an inside basis and an outside basis. For example, if shareholder owns land with basis of $50,000 and fair market value of $200,000 and transfers it to a corporation in return for stock, the shareholder will hold stock with basis of $50,000 and value of $200,000. Similarly, the corporation now holds an asset with basis of $50,000 and value of $200,000.
Double Tax Problem
Tax is due at the corporate and shareholders level. If the corporation with substantial operating income sells the land for $200,000, there would be a flat tax of 21% on the $150,000 of gain. In addition, if the corporation then distributes the after-tax cash proceeds to the shareholder, the shareholder will pay a dividend tax.
Alternatively, the shareholder who liquidates or sells the entire assets of the C corporation and terminates the existence of the corporation could pay capital gains tax at both levels. In either case, there have been two taxes. One tax is paid at the corporate level and one tax is paid at the shareholder level. The cumulative double federal and state tax rate can approach 30% or more of the value of the asset.
Redemption
Since dividends are distributed and reported as ordinary income under Sec. 316(a) (to the extent that there are earnings and profits under Sec. 316(a)(2)), many shareholders would prefer to receive capital gain payouts. However, there are stringent requirements for distribution to qualify for capital gain payouts. Only if redemption is not equivalent to a dividend or a termination of shareholder interest under Sec. 302(b)(3) will there be capital gain recognition upon distribution to a shareholder. But with the new 15% dividend rate, this is not a major issue.
Redemption to Pay Death Taxes
If the value of the C corporate stock is more than 35% of a shareholder's estate, after deducting expenses, claims, other items and taxes, a redemption of stock with capital gain treatment is permissible. Since the C corporate stock in the estate receives a stepped-up basis, there normally will be minimal capital gain recognition by the estate. See Sec. 303.
Accumulated Earnings Tax
Even though the dividends distributed from a corporation are subject to tax at a favored 15% ordinary income rate, some owners of closely held C corporations prefer to retain cash and other securities in the corporation. In order to force distributions as dividends and taxation of these amounts, there is an accumulated earnings tax on excess accumulations.
Generally, accumulation of $250,000 is permitted ($150,000 for professional service corporations). However, additional accumulations are permitted for reasonably anticipated needs, distributions to pay death taxes and certain stock redemption needs. Sec. 537(a).
An excellent solution for corporations with excess accumulated earnings is for the business owner to transfer stock to charity. While there must be no binding obligation to do so, the charity may then sell the stock back to the corporation. After the redemption, the corporation has reduced its accumulated liquid earnings.
Example 4.2.1A Gift and Redemption
Mary Businessowner owns a company that imports and distributes suits for men and women from foreign suppliers. Mary has accumulated $500,000 in cash in her C corporation. She is concerned that the cash may be subject to an accumulated earnings tax, generally at the 15% rate. Sec. 531.
Mary transfers stock valued at $100,000 to her favorite charity. There is no prearranged obligation for the charity to sell the stock back to the corporation. However, after a period of four to eight weeks, the charity offers to sell the stock back to the corporation at fair market value. The corporation transfers $100,000 and reduces its accumulated earnings from $500,000 to $400,000. Mary and her tax advisor are comfortable that the $400,000 amount can be justified as a "reasonably anticipated need" for the future. If she prefers to reduce the accumulated earnings to an even lower level, the charity has indicated that it would be willing to receive another $100,000 gift.
Charitable Contributions
C corporations are permitted charitable deductions under Sec. 170. However, the deduction is limited to 10% of taxable income. This 10% number must also be calculated by excluding charitable deductions, net operating loss carryback and net capital loss carryback. Sec. 170(b)(2). If the gift exceeds 10% of taxable income, it may be carried forward for up to five years. Sec. 170(d)(2)(A).
Gifts of Inventory
The basic rule for a gift of inventory is that the corporation is permitted to deduct its cost basis. However, if the use of the property by the charity is for the care of the ill, the needy or infants, a different rule may apply. Sec. 170(e)(3)(A). In this case, the gift will be the lesser of twice the basis or basis plus one-half of the appreciation.
Valuation and Appraisal
If public stock is transferred to a charity or to a charitable trust, the rules for deductions of public securities apply. Generally, the deduction will be the mean between high and low on the date of the transfer. However, for closely held stock with value over $10,000, an appraisal by a qualified independent appraiser is required. The appraisal will consider several factors. Among these are the nature of the business, the book value, the earning capacity and dividend-paying capacity, the value of goodwill or other intangibles, any other sales of the stock and the value of comparable closely held corporations. Reg. 25.2512-3(a). Rev. Rul. 83-120,1983-2 C.B.170.
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Case Studies on Double Taxation of C Corporations
Death and Taxes - The Madison Era of Giving, Part 3 of 7:
George Madison, Jr., has definitely become a gift-making machine. Just in the past three months he has gifted $5 million to public charities. George's "ease" into retirement is turning out to be much more exciting than he had ever imagined. Due to the publicity of his two large charitable contributions, George has risen to the top of many gift planners' "people to call upon" list. One such list belongs to Eleanor Jacob, director of development at Education is Power schools. Eleanor consequently called George and asked if she could visit with him. After several visits and trips to the schools, George and Eleanor developed a good relationship. George liked the school's mission and felt he could contribute greatly to its further development. Therefore, George happily pledged a gift of $1 million to help Education is Power upgrade its classrooms and purchase new books for its students.
Decide Now, Deduct Now But Give Later:
Carol Garcia is CEO, President and Founder of Widgets, Inc. After many years of blood, sweat and tears, Widgets, Inc. has become a very strong and established corporation.
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