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Monday September 6, 2010
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May - 2007
Gifts of C Corporations Part I – Double Taxation
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Part One of Three Parts - Double Taxation and Asset Sales
I. Double Taxation of C Corporations
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.
The corporation files Form 1120 and pays tax at corporate rates, which may be as high as 35%. 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. 351(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, then 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
With a federal income tax rate on corporations of 34% or 35%, the federal and state combined tax rate may approach approximately 40%. If the corporation holding the land with $200,000 sells the land, there could be a tax of up to 40% on the $150,000 of gain. In addition, if the corporation then distributes the cash proceeds after-tax to the shareholder, there will be a dividend tax paid by the shareholder.
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 tax rate can approach 65% 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(b)), many shareholders prefer to receive capital gain payouts. However, there are stringent requirements for a distribution to qualify as a capital gain payout. Only if there is redemption 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.
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, then 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.
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. In order to force distributions as dividends and taxation of these amounts, there is an accumulated earnings tax on excess accumulations.
Generally, $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 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. The corporation now owns Treasury stock and has reduced the amount of accumulated earnings.
Example A. 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 top personal rate.
Mary transfers stock valued at approximately $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 4 to 8 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 carrybacks and net capital loss carrybacks. Sec. 170(b)(2). If the gift exceeds 10% of taxable income, then it may be carried forward for up to 5 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 then 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.
The rule for the enhanced deduction also applies to gifts of scientific equipment and other qualified research equipment. Sec. 170(e)(4)(B).
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 the high and low on the date of the transfer. However, for closely-held stock with value over $10,000, there will be an appraisal required by a qualified independent appraiser. 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.
II. Asset Sale with Unitrust
C Corporation Double Taxation
The C corporation is a separate taxpayer. It tracks depreciation and basis of all assets at the corporate level and pays tax on income and gains.
Since the shareholder also has a basis in his or her stock, there is the potential to pay a double tax. Particularly when a C corporation is terminating business, there is tax on the corporate gain at the corporate rate and then a second tax on the shareholder at the shareholder's personal rate.
C Corporation Liquidation Options
For many closely-held C corporations, there may come a time when the business assets have been transferred to another entity. Alternatively, the owners may decide to retire and not continue further operations.
After the corporation ceases active operation, there may be substantial liquid assets or appreciated securities within the corporation. This problem creates a challenge. Liquidating the corporation will subject the gain to tax at both the corporate level and a second time at the shareholder level.
Sale of Assets and Unitrust
If the corporation is capable of being sold as an entity, then the preferable alternative is to sell the corporate stock to a new buyer. The shareholder will recognize capital gain at the corporate level. However, due to the nature of corporate assets, many corporations are not saleable as an entity, but purchasers are only willing to buy the assets. By acquiring the assets, the purchasers minimize the risk of assuming liabilities that had been previously created by the corporation.
One option that reduces (but does not eliminate) the tax on gain is to sell the corporate assets, pay the capital gains tax and then transfer the stock into a charitable remainder trust. This solution has the negative result of paying tax at the corporate level, but the positive result of bypassing the shareholder tax and benefiting from a charitable income tax deduction at the shareholder level. The latter two tax benefits may at least offset a substantial portion of the tax that otherwise would be paid on a pure liquidation.
Example B. Timber Sale and Unitrust
John Wilson was involved in the timber industry his entire career. He acquired a parcel of approximately 300 acres of timber. Since he was operating a corporation that was involved in various aspects of the timer industry, he purchased the timber with corporate cash.
When John passed away, he transferred one-third of the corporation to each of his three children, Arnold, Bill and Clara. Arnold, Bill and Clara owned the property for over 30 years and merely maintained the property through minor cutting.
After Arnold, Bill and Clara retired, they thought that it would be appropriate to sell the property. At that time, the timber was between 40 and 50 years old and the value of the property had increased dramatically.
However, the three children had different goals. Two of them wanted to be cashed out and Bill wanted to continue to own the corporation and to use the cash proceeds to engage in other business transactions.
Both the corporation and the timber were offered for sale. Predictably, the bids came in for the timber and not for the corporate entity. The top bid was just in excess of $5 million for the timber and land.
The C corporation sold the timber and land for $5 million. After payment of tax at the federal and state corporate rate, approximately $3 million remained. Clara then took her distribution in cash and paid tax at capital gains rates in the amount of $250,000 on complete redemption of her stock.
Arnold transferred his shares of stock into a charitable remainder unitrust for himself and his wife. The unitrust sold the stock for $1 million cash to the corporation. Arnold bypassed the gain, thus saving approximately $250,000 of federal and state capital gains tax and received a charitable income tax deduction. The income tax deduction saved Arnold an additional $100,000 in tax. Thus, Arnold enjoyed tax savings of approximately $350,000.
Clara ended up paying $916,000 of tax at the corporate and state levels. Arnold was able to reduce that amount by approximately $350,000 to $566,000. This is still a substantial tax, but the charitable trust did cut the tax bill by approximately 40%.
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| April - 2007 - Active Businesses Transferred to Unitrusts
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| March - 2007 - Charitable Life Insurance (CHOLI)
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| February - 2007 - Supporting Organizations After PPA 2006
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| January - 2007 - Donor Advised Funds After PPA 2006
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