Income Taxation on Corporations, Part 2




See Also:


The Taxation of Corporations and their Shareholders – Part 2


Taxation of the Operations of a Corporation: Double Taxation


            Taxpayers which are corporations are subjected to tax under section 11 of the Code. In other words, just like individual taxpayers, corporations must recognize their own gross income, take into account their own deductible expenditures, and arrive at a taxable income amount upon which the corporation pays tax at the graduated rates described in section 11.[1] This tax liability is an obligation of the corporation for which the corporation’s shareholders generally have no personal liability, but it does nevertheless affect the shareholders inasmuch as that much less wealth accumulates in the corporation than would otherwise accumulate in the absence of the corporate tax.[2]


            Once a corporation has computed its taxable income and paid (or accrued) its corporate tax, that income less the tax is accumulated in a balance sheet account called “earnings and profits,” or “E&P.” This is roughly the same figure (but is decidedly not exactly the same) as what accountants call “retained earnings.” It is, in other words, the earnings of the corporation that have not yet been distributed (they have so far been “retained”). This is important because once distributed the double-taxation of the corporate tax becomes clear.


            Section 301(c) of the Code describes what is sometimes called the “ordering rules” for corporate distributions. Pursuant to this law whenever a corporation transfers property to a shareholder not in liquidation of the shareholder’s stock, then—

·         First, that portion of the distribution which is a dividend under section 316 of the Code shall be included in the shareholder’s gross income;

·         Second, after accounting for the portion considered to be a dividend, that portion of the distribution that is not greater than the shareholder’s stock basis shall be a tax-free return of capital; and

·         Third, any distribution in excess of the shareholder’s stock basis shall be considered capital gain.


                    For purposes of the first step in these ordering rules, a “dividend” is any distribution of property from E&P.[3] A corporation with no E&P cannot, therefore, pay a dividend. It is only after the corporation recognizes taxable income and accumulates some E&P that a dividend becomes possible, although once E&P accumulates all distributions are generally considered a distribution “from” E&P and therefore are considered dividends.


            Consider the example of the corporation formed by an individual taxpayer contributing a building worth $1,000,000 but having an adjusted basis in the shareholder’s hands of $100,000. The shareholder recognized no gain by reason of the contribution, but rather took a $100,000 basis in the corporate stock received. The corporation also recognized no gain upon receiving the building but rather took a $100,000 carryover basis from the shareholder. If the corporation were to soon thereafter sell the building for $1,000,000, it would recognize $900,000 in taxable gain. Assuming no deductions and assuming (for the sake of simplicity) a 20% corporate tax, the corporation would pay $180,000 in federal tax and accumulate $720,000 in E&P. Recall, however, that it sold the building for $1,000,000, so after paying the tax the corporation should now have $820,000 in cash in the bank. If it were to distribute this $820,000 to the shareholder—

·         The first $720,000 would be considered a distribution from E&P, so a dividend includible in the shareholder’s gross income; and

·         The next $100,000 would be a tax-free return of the shareholder’s capital—i.e., his adjusted basis in his stock.


                Accordingly, although there was just $900,000 of gain built into the building before it was contributed to the corporation, after the building’s sale and the distribution of those sale proceeds to the shareholder, $900,000 has been recognized as taxable income to the corporation and another $720,000 as taxable income to the shareholder.  Not quite double, but still considerably more gain than that with which the shareholder started.[4]


The Tax Effect of Redemptions and Liquidations


            The ordering rules of section 301 only apply to non-liquidating, or operating, distributions. That is, distributions that do not affect a shareholder’s stock. After such a distribution the shareholder’s stake in the corporation is unchanged, thus the distribution is considered a distribution of the corporation’s previously taxed earnings (that is, it’s considered a dividend). Some distributions to shareholders do affect the shareholder’s stake in the business, however. The corporation might distribute property to a shareholder in exchange for all or some of his stock (a “redemption”), or the corporation might dissolve completely and its existence cease (a “liquidation”). Although either one of these events is still a “distribution,” they cannot produce dividends to the shareholder as neither of them is considered “from E&P.” Nevertheless, the double-taxation inherent in corporate taxation persists even in these events.


            When a distribution is considered a “redemption,”[5] it is governed not by section 301 but rather by section 302. Instead of applying ordering rules, the tax effect of a redemption is rather more straightforward: the distribution is simply deemed the consideration for the shareholder’s stock. Thus, if a shareholder is paid $1,000,000 in cash from a corporation in complete redemption of stock in which the shareholder has a $100,000 adjusted basis, the shareholder recognizes $900,000 in gain. Of course, continuing with our example from above, in order for the corporation to make such a distribution of cash to the shareholder it would have had to have sold the building first, in which case it would have recognized income on which a corporate tax would have resulted. Again, double taxation.[6]


            Finally, essentially the same result—recognition of income at both the corporate and shareholder levels—occurs even in the complete liquidation of a corporation. Under section 336 of the Code, a corporation recognizes gain when it distributes property in a complete liquidation “as if such property were sold to the distributee at its fair market value.” Thus, any gain inherent in a liquidating corporation’s assets is first recognized by the corporation itself, triggering a corporate level tax. Thereafter, under section 331, shareholders are deemed to have sold their stock in a liquidation, with the liquidating proceeds (net of any corporate-level tax paid or accrued) deemed the consideration. Once again, double taxation.


            Thus from its very beginning, by function of the concept of inside-outside basis parity, a corporation is set upon a path of double taxation whether it distributes profits to its shareholders, redeems its shareholders’ stock, or completely liquidates.[7] This nearly unavoidable doubling of the potential for tax can make a corporation an unattractive alternative for many taxpayers starting a new business (or continuing an old one in corporate form).




Footnotes

[1] With relatively few specific exceptions, corporations are entitled to the same deductions for business-related expenditures that individual are. (IRC § 162.) Unlike individuals, however, corporations do not get a personal exemption nor are they entitled to a standard deduction. (See, generally, IRC §§ 62 and 63.) If a corporation has gross income but no deductible expenditures, all of its income is taxable.

[2] Indeed, Congress regularly wrestles with this very issue: Whenever the business profits of a corporation are subjected to a tax there is that much less profit to reinvest in the business’s growth (it can hire fewer taxpaying employees, for example) as well as that much less wealth to distribute to the shareholders (who might then re-invest those distributed earnings in other profit-making ventures). Just how much of the corporation’s profits should be redirected to the federal fisc through taxation rather than back into the economy in general is a never-ending debate in Washington.

[3] IRC § 316(a).

[4] Moreover, the character of the gain has changed. Had the shareholder been holding the building for investment and sold it for $1,000,000, the $900,000 in resulting gain would likely have been considered capital gain. When the corporation sells the building, however, the distinction between ordinary income and capital gain is mostly lost at the corporate level as there are no differences in rates for corporations, and the dividend income accruing to the shareholder is considered ordinary. Given the extra taxation at the corporate level and the differences in rates on ordinary income versus capital gain at the shareholder level, the overall amount of tax may have doubled even if the amount of taxable income did not.

[5] In studying redemptions most of a student’s time is typically spent in this aspect of the topic—that is, whether a distribution is a non-liquidating distribution governed by section 301 or actually a redemption governed by section 302.

[6] By reason of the “repeal” of the General Utilities Doctrine represented by section 311 of the Code, essentially the same result would be found to happen even if rather than selling the building the corporation had distributed it back to the shareholder directly.

[7] Indeed, double taxation can even occur whether the corporation distributes its earnings or not. See, e.g.,  the “accumulated earnings tax” of section 531.