LLM Corporate Tax Instructor: Dwight Drake Taxation of Corporations and Shareholders Law T 501 University of Washington School of Law LLM Program in Taxation Instructor: Dwight Drake Fall 2007

LLM Corporate Tax Instructor: Dwight Drake Contact Info – Office Hours Phones: , , , URL: CorpTaxindex.shtml Office Hours: Room Tuesday 3:30 p.m to 5:00 p.m. - By Appointment. Whenever else you can catch me!

LLM Corporate Tax Instructor: Dwight Drake Course Objectives Substantive knowledge base – Corporate Taxation Develop, hone tax learning skills Internalize the “Concepts” Strengthen analytical, problem-solving skills Introduce the planning process Your role – design, not default

LLM Corporate Tax Instructor: Dwight Drake Some Tips… First: Beat Up Code. Learn to talk Code Find the “Concept” of each section. Then Text and Regs. to fill gaps for you. First work Problems hard on your own. Download PP Slides in advance of class – reconcile with your own answers. This is key learning moment. Think and mentally prepare your pitch. Track class discussion. Write personal summary following class. Get ahead – Stay ahead!

LLM Corporate Tax Instructor: Dwight Drake Grade Criteria 100% final No tricks or gimmicks Focus on problems and class discussion Short essay based on fact patterns Can use any non-living thing Key is to have your reminder aids well organized Premium on knowing scope of materials well Completely “Ace-Able” by all!

LLM Corporate Tax Instructor: Dwight Drake Federal Tax Sources Pers. Income 1, Corp. Income Social Insurance Estate & Gift Misc Total Revenue 2, , , , , ,153.9 All in billions

LLM Corporate Tax Instructor: Dwight Drake America’s Privately-Owned Businesses 25 Million 99 % of all employers 75% of all new jobs 53% of private workforce 70% of all first jobs 50% of all sales Largest client base for professionals Badly under-serviced by Bar

LLM Corporate Tax Instructor: Dwight Drake The Lawyer’s Role as an Advisor to Business Owners, Professionals and Entrepreneurs Flash Presentation (20 Min. approx) by Dwight Drake Note: It takes a few minutes to load

LLM Corporate Tax Instructor: Dwight Drake Business Entity Forms C Corporations - Subchapter C (§§ ) S Corporations - Subchapter S (§§ ) Unincorporated Single Owner - Individual Proprietorship General Partnerships – Subchapter K (§§ ) Limited Partnerships – Subchapter K (§§ ) Limited Liability Companies - Subchapter K (§§ )

LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com US Businesses Projected Revenues 2007 Corporations $ Trillion (84.2%) Sole Proprietorships $ 1.23 Trillion (4.8%) Partnerships $ 1.35 Trillion (5.3%) Limited Liab. Companies $ 1.45 Trillion (5.7%) Total $ Trillion

LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Duncan and Sandy Smith Plan Daughter Trust Son Trust Daughter Trust GC Trust – 1 GC Trust – 2 GC Trust – 3 GC Trust – 4 GC Trust – 5 GC Trust – 6 Duncan and Sandy Living Trust Personal Residence Trust Family L.L.C. (Growth) Family L.L.C. (New) Dynasty Insurance Trust Charitable Remainder Trust C Corporation Holding S Corp (Parent) Alma Mater Qualified Retirement Plan QSSS Corp (One) QSSS Corp (Two) Income Charitable Deduction Assets Remainder Contributions Distributions Compensation Distributions Home Term Use Assets Cash Remainder Income Units Income, support

LLM Corporate Tax Instructor: Dwight Drake Our Focus Issues – The Big Picture Taxation of Corporations Entity Formation Tax Issues Capital Structure Tax Issues Dividends and Other of Non-Liquidating Distributions Transactions Between the Corporation and Its Shareholders Corporate Liquidations Taxable Transfers of Corporate Assets or Stock Brief Introduction to Corporate Tax-Free Reorganizations

LLM Corporate Tax Instructor: Dwight Drake The Big Overriding Traps Sham Transaction Business Purpose Step-Transaction Substance Over Form Section 482 Section 269 Section 269A

LLM Corporate Tax Instructor: Dwight Drake Trap One: Sham Transaction Business Entity Phony Off Shore Operation Common Owner Service Fees Cash Transfers Note: No Business Purpose

LLM Corporate Tax Instructor: Dwight Drake C Corp Shareholder Trap Two: Form Over Substance 10k for stock 500k loan - Deductible interest - No repayment plan What’s wrong here?

LLM Corporate Tax Instructor: Dwight Drake Trap Three: Step Transaction Business Entity Child of ownerOwner Cash proceeds sale of asset Asset Gift Note: No Business Purpose Cash Gift

LLM Corporate Tax Instructor: Dwight Drake Trap Four: Section 482 C Corp A Common owners C Corp B Bargain sale Imputed Income Imputed Dividend Imputed Contribution

LLM Corporate Tax Instructor: Dwight Drake Calculating the Entity’s Taxable Income Section 63: Taxable income equals gross income minus allowable deductions. Section 61: Gross income “means all income from whatever source”. Section 162: Deduction for “all ordinary and necessary expenses paid or incurred in carrying on any trade or business.” The “Big 13” comparisons to individuals: 1. No personal expenses. 2. No exemptions. 3. No non-business deduction limitations. 4. Huge dividends exclusion on dividends from other corps. 5. Capital losses only to extent of capital gains.

LLM Corporate Tax Instructor: Dwight Drake Calculating the Entity’s Taxable Income C Corps compared to individuals (Con’t): 6. 10% charitable contribution limitation vs. 50% for personal. 7. No at-risk and passive loss limitations. 8. Losses trapped inside corp – carry back or over, but not pass thru. 9. One mill executive comp limit for public C corps. 10. Any tax year, except for “personal service C corps” – must show business purpose for non-calendar year and pay deferral deposit per Must use accrual accounting method unless farm, personal service corps or gross receipts under 5 mill. 12. Deductions and loss limits on transactions between C Corp and more- than-50% owner per 267.

LLM Corporate Tax Instructor: Dwight Drake Calculating the Entity’s Taxable Income C Corps compared to individuals (Con’t): 13. New domestic production deduction under section % of lesser of taxable income or “qualified production income”. 3% for , 6% , 9% after 09. Net tax savings about one- third: 1% building to 3%. Key limitation: 50% of w-2 wages. Key definitions related to “qualified production income” will come from FSC and DISC regs. With repeal of Extraterritorial income (ETI) rules, real winners are manufactures who sell in U.S.

LLM Corporate Tax Instructor: Dwight Drake C Corp Bracket Racquet First 50k 15% Next 25k 25% Next 9 mill, 925k 34% Over 10 mill 35% Plus… First Bubble: If over 100k, lesser of 5% of excess or 11.75k Second Bubble: If over 15 mill, lesser of 3% of excess or 100k. Bad News: If qualified personal service corporation, flat 35%

LLM Corporate Tax Instructor: Dwight Drake C Corp Alternative Minimum Tax Good New! Not apply in first year of corp, not apply in first three years if average gross receipts under 5 mill, not apply if annual gross receipts in preceding three years under 7.5 mill. Bottom line: All small C corps safe. AMT burden: 1. Add back Section 56 adjustments 2. Add back 75% of Adjusted Current Earnings account 3. AMT rate is 20% The “Push to Kill It” is on!

LLM Corporate Tax Instructor: Dwight Drake C Corp Penalty Taxes Good News: They have been de- fanged with 15% rate. Section 531 Accumulated Earnings Tax - 15% tax on excess accumulating earnings in C corp. Minimum of 250k each year (150k for professionals. The game is justifying accumulations. Section 541 Personal Holding Company Tax – 15% tax on undistributed personal holding company income. 50% or more of stock owned by five or fewer and 60% or more of income from dividends, interest, rents, capital gains and certain personal service income. Rescue dividends permitted to avoid tax.

LLM Corporate Tax Instructor: Dwight Drake Two Important C Corp Factors 1. A buys stock for 10k. Company makes millions, keeps most to grow business and pays only minor dividends. Company sold down road for millions and A gets 1.2 mill for his stock. What is A’s basis? What is A’s gain? 2. C Corp A adopts 1/31 tax year and earns 400k for year ending 1/ To reduce taxes, pays Walter a 300k bonus on 1/30/2006. What calendar year is bonus reported by Walter? When must Walter report income? How would this change if C Corp was calendar year and bonus was paid on 12/31/05?

LLM Corporate Tax Instructor: Dwight Drake

Problem P. 23 (a) Boots Inc. Taxable Income and Regular Tax Inventory Sales 2,500,000 Dividends 100,000 Capital Gains 200,000 Gross Income 2,800,000 Operating Expenses 600,000 Depreciation 800,000 Capital Loss (limited to gain) 200,000 Passive activity loss 130,000 Dividend received deduction (243) 70,000 Taxable Income 1,000,000

LLM Corporate Tax Instructor: Dwight Drake Problem P. 23 Tax liability: 15% of 50k = 7,500 25% of 25k = 6,250 34% of 925k = 314,500 First bubble = 11,750 Tax 340,000 (Note: Flat 34% Rate)

LLM Corporate Tax Instructor: Dwight Drake Problem P. 23 (b) Dividends totaling $660,000 distributed: Shareholders 20% = 132,000 Corporate tax = 340,000 Total tax hit 472,000. Combined tax rate 47.2% Note: Without Bush favorable capital gain rate, due to expire at the end of 2010, Shareholder tax goes to 40% combined rate and total tax hit goes to 60.4%.

LLM Corporate Tax Instructor: Dwight Drake Problem P. 23 (c) Compensation of $1 million paid to Emil and Betty Shareholders 40% = 400,000 Corporate tax = 0 Total income tax hit = 400,000. Combined tax rate 40% But this not all - there’s another tax that no one ever wants to talk about: The Payroll Tax.

LLM Corporate Tax Instructor: Dwight Drake Problem P. 23 (c) Payroll Tax: 15.3% of first 97k per person. 2.9% on excess per person. Half deductible by corp. Impact in this situation: Payroll taxes 52,360 Shareholder income 400,000 Corporate tax 0 Total income tax hit = 452,360. Combined tax rate 45.2%

LLM Corporate Tax Instructor: Dwight Drake Problem P. 23 (c) Note impact if S corporation: - No corporate tax - No payroll tax - If passive losses good, total income passed thru to shareholders is 1,067,000 (no 70k 264 dividends deduction, and 3k capital loss). Tax as follows to shareholders: 100k 20% = 20,000 40% = 386,800 Total Tax 406,800 (40.7%)

LLM Corporate Tax Instructor: Dwight Drake Earnings Bailout – The New Math C Corp C Corp S Corp Dividend Bail Comp Bail Owner Bail 100k Income C Corp Tax 22, Shareholder Inc Tax 11,662 20,674 22,627 Payroll Tax 0 13,854 0 Total 33,912 34,528 22,627 Percentage 33.9% 34.5% 22.6%