Tax Recognition of the Corporate Entity
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A corporation is generally taxed as a separate entity. However, the Service may question the tax validity of any corporation regardless of the legality of the corporation’s existence under its state laws. Although the greatest danger is the professional corporation, no entity is truly safe from such scrutiny.
In general, when a corporation carries on any business, it will be recognized as a separate entity (Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943)).
However, when a corporation does virtually nothing except hold title and serves no business purpose other than to obtain limited liability for the shareholder, the corporation will be ignored (Paymer v. Commissioner, 150 F.2d 334 (2d Cir.1945)).
Nominee & Agency Corporations
Often real estate investors use corporations to borrow money and hold title to land to avoid usury limits. Some cases 6 have held that avoiding usury laws is a business purpose and borrowing money is business activity. However, the Supreme Court’s decision in IRS v. Bollinger, 485 US 340 (1988, S Ct), creates an apparent safe harbor for agency relationships between a corporation and its shareholders, when the corporation holds property as a nominee.
Having Income Attributed to the Corporation
In Jerome J. Roubik, 53 T.C. Several radiologists formed no. 36 (1969), a professional corporation under Wisconsin law. Initially, all of the formalities of corporate existence were observed. However, records were maintained to show the individual billing and expenses of each of the doctors. Stationery and billings were still personalized with the names of each doctor and, some of the doctors continued to operate as though they were not incorporated as evidenced in court by their hiring and supervision habits. Also, leases and other expenses remained in the names of the individuals rather than the corporation. The Tax Court held that the existence of the corporation was not always clearly communicated and that, in substance, the doctors had continued their former practices as self-employees (See also Epperson v. U.S. 490 F.2d 98 (7th Cir. 1983)).
Section 482 Reallocation
“Where it is necessary to clearly show income or to prevent evasion of taxes, the IRS may reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests (§482).”
Section 482 of the Code permits the Service to reallocate income, expenses, and other items between commonly managed businesses to prevent evasion of taxes or to reflect taxable income. Although it is possible to prove that the Service abused its discretion in making a §482 allocation, it is difficult to do so. In general, the test is that a transaction between related entities 7 must be at “arm’s length.” If it is not, the transaction will be restructured so that it is at arm’s length (Eli Lilly & Co. v.U.S., 372 F.2d. 990 (Ct. Cl.1967).
Corporation & Shareholder
Section 482 has been used to reallocate income between a corporation and shareholder if the shareholder is not receiving sufficient compensation (Rubin v. Commissioner, 429 F. 2d 650 (2d Cir. 1970)). The corporation must compensate the employee-shareholder adequately.
However in Frederick A. Foglesong, 82-2 USTC 85, 370 (7th Cir. 1982) rev’g 77 T.C. 1102 (1981), the Seventh Circuit held that §482 should not apply to an employee who works exclusively for his corporation 8.
If one related corporation permits another to make use of its goodwill and trade name, it must make an appropriate charge for the use of these assets (Hamburgers York Road, Inc. v. Commissioner, 41 TC 821 (1964)).
If an interest-free loan is made within a controlled group (§1563), the
Service can charge the lender with interest income 9 and thereby give a
corresponding deduction to the borrower (Forman v. Commissioner, 453
F.2d 1144 (2d Cir. 1972)).
Another area of concern to closely held corporations is §269A. Section 269 explains that if substantially all of the services of a professional service corporation. Performed for one other corporation, partnership or other entity, and the principal purpose of incorporating is the avoidance or evasion of taxes, then the IRS may reallocate the income and expenses of the business between the corporation and its employee-owners (i.e., employees who own or control more than 10%). Thus, if the corporation is used primarily for purposes of avoidance or evasion of taxes, all items of deduction and credit are disallowed. The IRS has applied this provision to disallow NOL deductions after the acquisition of a corporation.
Capital Gains & Losses
An entity, other than an S corporation, can deduct capital losses only up to its capital gains. In other words, if a corporation has a net capital loss, the loss cannot be deducted in the current tax year. It is carried to other tax years and deducted from capital gains that occur in those years (§1212(a)(1)). Excess losses may be moved back three years and carried forward for five years.
Net Capital Loss Carryovers & Carrybacks – §1212
A net capital loss is first carried back 3 years. It is deducted from any total net capital gain that occurred in that year. If the loss is not completely used up, it is carried forward one year (two years back) and then one more year (1 year back). If it is still not used up, it is carried over to future years, one year at a time, for up to five years. When a net capital loss is moved to another tax year, it is treated as a short-term loss do not retain its original identity as long-term or short-term (§1212(a)(1)).
Example from Pub. 542 Rev. ’06
A calendar year corporation has a net short-term capital gain of $3,000 and a net long term capital loss of $9,000. The short-term gain offsets some of the long-term loss, leaving a net capital loss of $6,000. The corporation treats this $6,000 as a short-term loss when carried back or forward. The corporation carries the $6,000 short-term loss back 3 years. In year 1, the corporation had a net short-term capital gain of $8,000 and a net long-term capital gain of $5,000. It subtracts the $6,000 short-term loss first from the net short term gain. This results in a net capital gain for year 1 of $7,000. This consists of a net short-term capital gain of $2,000 ($8,000 – $6,000) and a net long-term capital gain of$5,000.
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