Posts Tagged ‘C corporations’

Tax Roundup, 2/22/2013: Why California refugees might not choose Iowa. And: to C or not to C?

Friday, February 22nd, 2013 by Joe Kristan

 

Enjoying a short Des Moines winter commute.

Enjoying a short winter commute in bicycle-friendly Des Moines.

We aren’t scaring them.  Governor Branstad is making a trip to California to poach some businesses from the failing Golden State.  He’s not scaring one Californian:

Iowa’s top state personal income tax rate is 8.98 percent, compared to 13.3 percent in California. Probably not enough of an improvement to lure millionaires from Pacific Palisades to Dubuque. By contrast, Texas offers zero percent.

The top state corporate income tax rate is 12.5 percent in Iowa, 8.84 percent in California and zero percent in Texas.

Earlier this year, Branstad said he would no longer pursue getting rid of Iowa’s corporate and personal income taxes. Instead, he’s going to focus on cutting property taxes.

Well, California’s property taxes already are fairly low thanks to Proposition 13. Although property prices here are triple those in Iowa and most other states because of our severe restrictions on building.

Bottom line: Iowa doesn’t offer enough incentives to attract many businesses and people to leave California. The Hawkeye State is the Golden State with bad weather.

Ouch.  Well, Iowa’s solvent, too, unlike California, which is a fiscal disaster.  We also have short commutes.  Still, he makes a valid point: it’s not enough to compete with a basket case like California.  Golden State refugees have plenty of places to choose from, many of which have better taxes, better weather, or both.  I have no thoughts on fixing the weather, but The Quick and Dirty Iowa Tax Reform Plan would take care of the tax problems.  With no corporate tax and a 4% individual rate, combined with good employees, education and quality of life, we’d see some Californians.

 

To C or not to C?  The Wall Street Journal reports that taxpayers are revisiting whether to operate businesses as C corporations or pass-through entities.  C corporations face a top rate of 35%, where individuals have top rates over 42% as a result of the ill-concieved fiscal cliff and Obamacare tax increases.  From the article:

“Even though on the surface you’re looking at 35% versus 39.6%, it’s a deceptive comparison,” says Robert W. Wood, a tax lawyer with Wood LLP in San Francisco. “There may be a slight short-term advantage in C-Corporations, but there are a number of negative long-term implications that would outweigh short-term benefit.”

For example, C-Corporation profits can be double-taxed. In addition to the corporate tax on profits, owners also would owe personal taxes on any money they take out of the company as dividends. The double tax kicks in when a business is sold, too.

Another potential problem is that a firm that switches from an S-Corporation generally has to remain a C-Corporation for at least five years. 

At current rates, a switch to C corporation format is probably still unwise, if tempting, because of the double tax issue.  You might have lower tax up front, but getting the money out involves either paying a second tax on the dividends or expensive tax gymnastics, often involving renting to a corporation or potentially “excessive” compensation.  C corporations are the Roach Motels of the tax world: they’re a lot easier to check into than check out of.  But if there is a significant reduction in corporation rates, the current tax savings will be enough to tip the balance for many taxpayers to C corporation status, double tax or no.

Hat tip: TaxProf Blog.

 

When Will Tax Complexity Cause a Collapse? (Jason Dinesen). 

The tax code, as most everyone knows and acknowledges, is ridiculously complex and getting more complex all the time.

When will the complexity cause the system to collapse? And what, exactly, will collapse?

I think it would require a combination of things to “collapse” the tax law.  If the perception becomes widespread that it is impossible to comply with the tax law without unreasonable effort, or the rates get intolerably high, and technical advances allow for cash transfers and banking that the government can’t trace, then the game is over.

Tax Analysts is having a conference today on whether, after 100 years, the income tax has run its race.

Elizabeth Malm, Holy Smokes! Washington Loses $376 Million to Cigarette Tax Evasion in 2012.  Many states have raised tobacco taxes to a point where smuggling becomes attractive.

 

Howard Gleckman, Congress May Not Rewrite the Tax Code in 2013, But It Could Make It Simpler (TaxVox).  If you can’t do everything, you might still do something.

Kay Bell, Education tax credit form, already pushed into February, now causing filer confusion and more delays in processing

Peter Reilly,  Bill Romanowski’s Tax Court Loss Not A Typical Horse Case.  We covered it here yesterday.

TaxGrrrl, About Those Leaked Wal-Mart Emails… Is IRS To Blame For Sluggish Sales?  Are tax refund delays stopping consumer spending?

Teaching by bad example, Nebraska-style.  I examine the tax troubles of a prairie-town lawyer.

 

Jim Maule, How Tax Falsehoods Get Fertilized.  That “70,000-page tax code” really bugs him.

Want to raise the minimum wage?  Then apply it to your interns, Congresscritters. (Donald Boudreaux).

Don’t bug Robert D. Flach with requests for free tax help.

 

It’s probably how he meets girls too.  Berlusconi & The Lure of Tax Refunds (Robert Goulder, Tax.com).

CPA exam tip: Calm Down, This CPA Exam Practice Question Isn’t as Dirty as You Think (Going Concern)

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“Self-Rental rule” trips up trucking company

Thursday, August 9th, 2012 by Joe Kristan

http://www.rothcpa.com/misc/20090115-1.JPGThe perennial tax problem for owners of “C corporations” is getting cash out of the corporation without it being taxed twice.  Unlike “S corporation” income, C corporation income is taxed twice: first under the corporate income tax rules when it is earned, and again as taxable dividend income when distributed to the shareholders.

A common tactic to extract C corporation income without a second tax is to rent property to the corporation.   While the owner has to report the rental payments as income, the corporation gets a rental expense deduction, netting to only one tax.  But this plan has its own risks, as a C corporation owner learned yesterday in Tax Court.  The Tax Court held that the “self-rental” rule kept the taxpayer from deducting rental losses from leases of equipment to his corporation.

Tax Court Judge Wells sets the stage (my emphasis):

Mr. Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a corporation with its principal place of business in Wisconsin. JVT was a C corporation during 2005 but has since elected S corporation status. Petitioners were both employed by JVT during 2005, and Mr. Veriha materially participated in JVT’s business. JVT is a trucking company that leases its trucking equipment from two different entities, Transportation Resources, Inc. (TRI), and JRV Leasing, LLC (JRV). The trucking equipment JVT leases consists of two parts: a motorized vehicle (tractor) and a towed storage trailer (trailer).

     TRI is an S corporation in which Mr. Veriha owns 99% of the stock; his father owns the remaining 1%. TRI is an equipment leasing company with its principal place of business in Wisconsin. TRI owns only the tractors and trailers that it leases to JVT. During 2005, TRI and JVT entered into 125 separate lease agreements, one for each tractor or trailer leased. TRI’s only source of income during 2005 was the leasing agreements with JVT.

     JRV is a single-member limited liability company, and Mr. Veriha is its sole member. JRV is an equipment leasing company that owns only the tractors and trailers that it leases to JVT. During 2005, JRV and JVT entered into 66 separate lease agreements, one for each tractor or trailer leased. JRV’s only source of income during 2005 was the leasing agreements with JVT.

In 2005 TRI had income from its rental, but JRV, the single member LLC, reported a loss.  Rental income and loss is normally “passive,” and passive losses are only deductible to the extent of passive income.

When the passive loss rules were enacted, the IRS feared that business owners would set up deals with their businesses to generate passive income, enabling them to deduct otherwise deferred passive losses.  To combat this, the IRS issued regulations holding that net income from renting to your own business would not be passive if the income from the business isn’t itself passive.  The IRS used these regulations to keep Mr. Veriha from deducting his rental losses against his rental income.  The taxpayer argued the losses of JVT should be lumped together with the income from TRI, with only the net income of the two treated as non-passive.

The Tax Court sided with the IRS:

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes as nonpassive net rental activity income from an “item of property” rather than net income from the entire rental “activity”. Section 469 and the regulations thereunder distinguish between net income from an “item of property” and net income from the entire “activity”, which might include rental income from multiple items of property.

we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI, only TRI’s net income is recharacterized as nonpassive income.2

That last sentence has to be scary to anybody renting multiple properties, like a trucking fleet, to a controlled business.  The Tax Court is saying that the IRS could have required the taxpayer to determine the income from each truck and tractor leased to the business, with all income leases non-passive and all losses passive.  The Tax Court in its footnote spells it out:

We note that this result is necessarily more favorable to petitioners than the result would have been had respondent contended that it was necessary for the income from each tractor or trailer within TRI and JRV to be recharacterized as nonpassive.

That implies that the IRS was just being “nice” this time, and another taxpayer with similar facts could do much worse.

The moral: Taxpayers who rent to their own businesses — at least those in which they “materially participate” —  need to remember that they can’t offset passive losses with that rental income.  If they rent many items to their business, they need to make sure that every lease generates a profit, or the IRS might split them out and disallow all the losses.

Cite: Veriha, 139 T.C. No. 3.

More on the passive loss rules here.

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Tax Court doesn’t let shareholders have their cake and eat it too

Thursday, December 29th, 2011 by Joe Kristan

C corporation shareholders have a problem when it comes time to sell the business. Buyers usually want to buy assets so they can get fresh basis and higher depreciation deduction. Buyers don’t want to by the corporate stock, which comes with any sins of the prior owners.
Sellers, though, get clobbered with two taxes when they sell the assets: the corporation has to pay tax, usually at 35%, on the gain on the asset sale; the shareholders pay a second tax on their gain on liquidating their shares. The same problem applies to S corporations to the extent they have “built-in gains.”
When Wisconsin’s Woodside Ranch Resort, Inc. decided to sell out to a buyer named Zumwalt, they met with representatives of “MidCoast Credit Corp.” and “MidCoast Acquisition Corp.” who claimed they could solve this double-tax problem. The Tax Court explains (my emphasis in bold):

Representatives of MidCoast repeatedly explained to the Woodside Ranch officers that if the Woodside Ranch stock was sold to MidCoast or to a MidCoast-related entity, MidCoast or its related entity would obtain bad debt losses from other companies and use those losses to offset or eliminate the tax liabilities of Woodside Ranch.
The transaction proposed by the representatives of MidCoast was also referred to by the MidCoast representatives as a “no-cost liquidation”. (Emphasis added.) In other words, instead of directly liquidating Woodside Ranch and distributing to the Woodside Ranch shareholders the cash proceeds from the Zumwalt asset sale (less the combined Federal and State tax liability that would have been paid), the MidCoast proposal was designed so that the cash, in effect, still could be “liquidated” or transferred to the Woodside Ranch individual shareholders, but indirectly and via a few additional steps, as follows: A purported or nominal sale of the Woodside Ranch stock to MidCoast; a transfer by MidCoast to the Woodside Ranch individual shareholders of the cash that would have been distributed to the shareholders on a direct liquidation of Woodside Ranch (i.e., the net proceeds available from Woodside Ranch for a liquidating distribution plus a “premium” — one-third of the taxes owed); and MidCoast would avoid paying the tax liabilities the Woodside Ranch shareholders would have had to pay on a direct liquidation. All this allegedly was to be made possible by MidCoast’s use of bad debt losses from other companies to offset the reportable Woodside Ranch gain on the Zumwalt asset sale.

They failed to convince the Tax Court:

Before us in these cases is a purported stock sale between petitioners and MidCoast that lacks both business purpose and economic substance and that we conclude is to be disregarded for Federal income tax purposes. In substance, there was no sale of the stock of Woodside Ranch; rather, Woodside Ranch was liquidated, and the $1,835,209 cash that Woodside Ranch had on hand (after the partial redemption that occurred on July 18, 2002) was distributed to the Woodside Ranch shareholders less a fee of approximately $500,000 that MidCoast retained for facilitating the sham.
The “no-cost liquidation” terminology used by the MidCoast representatives is telling. In substance, it really was a liquidation, not a stock sale. The effort, assisted by MidCoast’s sleight of hand, to reduce the tax cost of the Woodside Ranch liquidation by cloaking the liquidation in the trappings of a stock sale is to be ignored.

The judge held former shareholders liable as “transferees” for the tax that the corporation should have paid on the asset sale.
The Moral? There is no tax fairy. The double tax problem for C corporations, in contrast, is all too real.
Cite: Feldman, T.C. Memo. 2011-297

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Management fees, mismanaged

Friday, September 30th, 2011 by Joe Kristan

The 15% tax rate on the first $50,000 of C corporation taxable income has its attractions, as we mentioned yesterday. It also has a hidden cost: trying to manage income between the personal and corporate return to use the low corporate rates can be tricky. It can tempt taxpayers to play games.
In the dimly-remembered early days of my tax career I encountered practitioners who would allocate income among controlled entities by arranging “management fees” as needed at year-end to get the taxable income to the tax returns where it would do the most good. The Tax Court yesterday shot down a C corporation management-fee arrangement
A taxpayer ran “Top Line,” a hauling business, in a C corporation. The taxpayer owned 30 trucks in a wholly-owned LLC, “Grasshopper,” that he reported on his 1040 Schedule C. in 2004 and 2005 Grasshopper paid management fees of $101,382 and $108,000 to the C corporation — expenses he deducted on his 1040 and added to his C corporation income. The IRS disallowed about $120,000 of the fees over the two years, and the case ended up in Tax Court.
The Tax Court didn’t like the fees. There was no management contract and no detail of the services provided on the intercompany invoices. The taxpayer argued that the C corporation employees spent lots of their time doing work for the single-member LLC, and the fees were fair. The judge didn’t buy it (my emphasis):

According to petitioner’s testimony, then, over half the hours allegedly worked by Top Line employees on behalf of Grasshopper consisted of services in the categories of sales management, safety, and driver relations. Petitioners have not convinced us that it was necessary for Grasshopper to incur expenses for such services. After all, Grasshopper’s business consisted of leasing trucks to other entities, mainly Top Line, that petitioner owned. The sales management services, as described by petitioner, appear to be services that Top Line would have performed on its own behalf in maintaining its own customer base, since Grasshopper had no customers other than Top Line and other related entities. Moreover, the record establishes no reason why Grasshopper would have had any need to recruit, train, test, track, or dispatch truck drivers, since it employed no drivers. In addition, we are not convinced that consulting services that petitioner allegedly provided to Grasshopper were performed in his capacity as an employee of Top Line rather than in his individual capacity as sole owner of Grasshopper. Indeed, because Grasshopper had no other owners and no employees, it is not apparent with whom at Grasshopper petitioner might have consulted, other than himself.

Not only were the fees disallowed, but the Tax Court upheld the 20% “accuracy related” penalty on the taxpayer.
The Moral? They’re “management fees,” not “magic fees.” You can’t freely allocate your income where you want it just by charging arbitrary fees between controlled taxpayers. Management fees for controlled entities are allowed, but they should be charged for services actually provided under an agreement between the entities.
Cite: Fuhrman, T.C. Memo. 2011-236

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Why would you be a C corporation?

Wednesday, September 28th, 2011 by Joe Kristan

While most new businesses are set up as pass-throughs nowadays, C corporations still have a following. Martin Sullivan ponders why taxpayers voluntarily run a business in a way that they know will be subject to two taxes:

Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.

Pass-throughs — S corporations and partnerships — don’t pay taxes on their income. It instead “passes through” to the personal returns of the owners. The top individual and corporate rates are both 35%, but C corporations are taxed at a 15% rate on their first $50,000 of income. If you are in a 35% personal bracket, having additional income taxed at 15% is attractive, even if you have to pay a second 15% tax to withdraw the earnings as as a dividend. C corporations also provide some fringe benefits unavailable to pass-through owners.
So what’s not to like about the C corporation?
- Your corporation can’t grow very big and still use the low rates. Once corporation taxable income exceeds $100,000, a “phase-out” rate of 39% starts to recapture the benefit of the lower brackets. Once taxable income hits $335,000, a flat 35% rate applies to all corporation income.
- You can only get that corporate 15% bracket once. You can’t set up multiple corporations to get multiple 15% brackets.
- Using the 15% rate requires an ability to monitor and control corporate taxable income. That requires time, effort and expense.
-“Personal service corporations,” including law, medical, accounting and consulting practices, don’t get the lower brackets. They pay a 35% rate starting with the first dollar of taxable income.
-Assets inside the corporation are trapped there. The tax law treats distributions of appreciated property as taxable sales, but losses on distributions are normally not allowed.
- If you sell the business, the C corporation can get very expensive. There is no capital gain break in computing C corporation taxes. Most business buyers prefer not to buy stock because they don’t want to inherit any unconfessed sins of the old corporation. If the assets have gone up in value, you probably have a 35% tax on the asset sale, and a 15% capital gain on the liquidation on top of that. In a pass-through, you will have just one tax, and likely it will mostly be at the 15% capital gain rate.
As long as there is a 15% corporate rate bracket and a 15% dividend rate, C corporations will remain tempting. Still, it is wise to ponder the words of tax sages Bittker and Eustice:

Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.


Flickr image of lobster pots courtesy easylocum under Creative Commons license
Related: Corporations: yea or nay?

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When professional C corporations go bad

Friday, April 1st, 2011 by Joe Kristan

You can operate a professional corporation as a C corporation and get tax-free fringe benefits unavailable to partnerships or S corporations. Sure, C corporations are subject to a flat 35% tax on every dollar of taxable income left at year end, but you just suck out all the earnings as salary at the end of the year. Right?
For an Orland Park, Illinois CPA firm, that failed spectacularly yesterday in Tax Court, and those fringe benefit tax savings are turning out to be quite expensive.
Like many professional C corporations, the firm sucked out all the cash as (purportedly) deductible expenses at year-end to take its taxes down to zero. The Illinois firm did this by paying “consulting fees” to entities controlled by the firm’s owners. Tax Court Judge Morrison explains:

The firm made a number of payments to the related entities that it designated as “consulting fees”. It now claims that these payments were compensation for the services of the founders. It paid PEM, as “consulting fees”, $136,570 in 2001, $147,837 in 2002, and $81,467 in 2003. It paid Financial Alternatives, as “consulting fees”, $755,000 in 2001, $468,306 in 2002, and $610,524 in 2003. And it paid MPS Ltd., as “consulting fees”, zero in 2001, $250,000 in 2002, and $301,537 in 2003.

The IRS took exception:

In a notice dated December 5, 2007, the IRS determined the following deficiencies in tax: $317,729 for 2001, $284,505 for 2002, and $377,247 for 2003. The deficiencies primarily resulted from disallowance of the deductions for “consulting fees”. The IRS also determined that the firm was not entitled to the $34,421 interest expense deduction in 2003. And, as a result of its disallowance of the “consulting fee” deductions for 2001 and 2003, the IRS determined that for 2003 the firm was entitled to neither the credit for prior-year minimum tax nor the deduction for the net operating loss carry forward.
The IRS also determined that the firm was liable for accuracy-related penalties under section 6662 in the following amounts: $63,546 in 2001, $56,901 in 2002, and $73,238 in 2003.

That’s real money. Naturally the firm defended the deductibility of the payments, saying that they were intended to be compensation to firm owners for services, and the compensation amounts were reasonable.
The judge found otherwise. He said even if the payments were intended to be compensation, they were too high. He also said found that they weren’t really intended as compensation:

We find that the firm intended for the payments to the related entities to distribute profits, not to compensate for services. As discussed above, [one of the owners] chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. He did this for tax planning purposes. Each founder’s percentage of the payments to the related entities was tied to hours worked, but the firm’s intent in making the payments was to eliminate all taxable income. The firm did not intend to compensate for services.

This sounds a lot like business as usual for many professional C corporations. This case should put many C corporation law, medical and accounting firms on notice that they need to do more than just suck out their cash at the end of the year; they need to document that they are making reasonable salary payments. That could be a tough circle to square.
Not only were the expenses non-deductible to the corporation, the distributions were presumably taxable as dividends to the owners also. That’s why the IRS likes to win excess compensation cases — the owners still get taxed, but the corporation gets no deduction.
On the other hand, this case could be useful to S corporations. The IRS has an incentive to try to jack up the salaries of S corporation owner, which is the opposite of their goal for C corporation owners. S corporation earnings left in the company pass through without self-employment tax on a K-1; IRS likes to reclass such earnings as salary and subject them to employment taxes. This case makes a good argument that you don’t have to treat all of the earnings of a professional practice as salary.
Cite: Mulcahy, Pauritsch, Salvador & Co. Ltd., T.C. Memo 2011-74

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Dividend rates will rise next year. How high? What to do?

Tuesday, April 27th, 2010 by Joe Kristan

Will the dividend rate rise from 15% this year to 39.6% next year? Or only 20%? Does that mean you should pay a dividend from your C corporation this year? And what about the 3.8% Obamacare tax?
Paul Neiffer explains the stakes:

Let

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You mean when you raise taxes, people just don’t lie down and take it?

Thursday, August 13th, 2009 by Joe Kristan

Leave it to the Congressional Research Service to discover the obvious:

Currently, both the top individual and the top corporate tax rates are 35%. However, President Obama’s FY2010 budget proposes allowing the top individual tax rate to revert to its pre-2001 level of 39.5%. In addition, indications are that legislation similar to H.R. 3970, which was introduced in the 110th Congress by Chairman of the House Ways and Means Committee Charles Rangel and would have lowered the top corporate tax rate from 35% to 30.5%, may be introduced in the 111th Congress. In response to either one of these proposals, economic theory and data would suggest that some pass-through businesses could choose to reorganize as C corporations to take advantage of the more favorable corporate tax schedule.

Imagine that.
I’d link to the report, which provides a very useful summary of the different ways you can organize your business, but the Congressional Research Service has perhaps the most useless web site in the world, with no links to CRS reports. The report is not yet on a private site set up to remedy this deficiency, OpenCRS.com. If you subscribe to Tax Analysts (and you’ll be happy if you do), you can find the report here ($link)
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