Taxation of Corporations and Shareholders Law T 501 University of Washington School of Law LLM Program in Taxation Instructor: Dwight Drake Fall 2009 LLM Corporate Tax Instructor: Dwight Drake

LLM Corporate Tax Instructor: Dwight Drake Contact Info – Office Hours Email: djdrake@u.washington.edu Phones: 425.281.1493, 425.222.5988, 360.778.1862 URL:http://faculty.washington.edu/djdrake/ CorpTaxindex.shtml Office Hours: Room 416 - Thursday 11:30 a.m. to 1:00 p.m. - By Appointment. Whenever else you can catch me! LLM Corporate Tax Instructor: Dwight Drake

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

America’s Privately-Owned Businesses 29 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

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

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

LLM Corporate Tax Instructor: Dwight Drake Grade Criteria 100% final No tricks or gimmicks Focus on problems and class discussion 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

LLM Corporate Tax Instructor: Dwight Drake Federal Tax Sources 2001 2002 2003 2004 2005 2006 2007 Pers. Income 994.3 858.3 793.7 809.0 927.2 1,043.9 1,163.5 Corp. Income 151.1 148.0 131.8 189.4 278.4 353.9 370.2 Social Insurance 694.0 700.8 713.0 733.4 794.1 837.8 869.6 Excise Taxes 66.2 67.0 67.5 69.9 73.1 74.0 65.1 Estate & Gift 28.4 26.5 22.0 24.8 24.8 27.9 26.0 Misc. 57.2 52.5 54.4 53.9 56.4 74.0 65.1 Total Revenue 1,991.2 1,853.2 1,782.3 1,880.3 2,153.9 2,407.3 2,567.7 All in billions LLM Corporate Tax Instructor: Dwight Drake

LLM Corporate Tax Instructor: Dwight Drake Business Entity Forms C Corporations - Subchapter C (§§301-385) S Corporations - Subchapter S (§§1361-1379) Unincorporated Single Owner - Individual Proprietorship General Partnerships – Subchapter K (§§701-777) Limited Partnerships – Subchapter K (§§701-777) Limited Liability Companies - Subchapter K (§§701-777) LLM Corporate Tax Instructor: Dwight Drake

US Businesses Projected Revenues 2007 Corporations $ 21.58 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 $ 25.61 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 Remainder Duncan and Sandy Living Trust Income Charitable Deduction Son Trust Term Use Assets Home Daughter Trust Charitable Remainder Trust Personal Residence Trust Remainder Alma Mater Daughter Trust Compensation Assets Income GC Trust – 1 Contributions Family L.L.C. (Growth) C Corporation Units GC Trust – 2 Qualified Retirement Plan Assets Distributions GC Trust – 3 Family L.L.C. (New) Distributions Holding S Corp (Parent) Units GC Trust – 4 Income, support QSSS Corp (One) Distributions GC Trust – 5 Cash Dynasty Insurance Trust QSSS Corp (Two) GC Trust – 6 LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

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 LLM Corporate Tax Instructor: Dwight Drake

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

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

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

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

LLM Corporate Tax Instructor: Dwight Drake Calculating the Entity’s Taxable Income Taxable Income = Gross income - Allowable Deductions Section 63 Gross Income = “all income from whatever source”. Section 61 Deductions = “all ordinary and necessary expenses paid or incurred in carrying on any trade or business” + Special Deductions Section 162 LLM Corporate Tax Instructor: Dwight Drake

Compared to Personal Income Taxes… No personal expenses. No exemptions. Capital losses only to extent of capital gains. 10% charitable contribution limitation vs. 50% for personal Any tax year, except for “personal service C corps” and S corp. Must use accrual accounting method unless farm, personal service corps or gross receipts under 5 mill. Deductions and loss limits on transactions between C Corp and more- than-50% owner per 267. LLM Corporate Tax Instructor: Dwight Drake

Select Corp Deduction Provisions Section 162(m) $1 mill executive comp limit for public C corps Section 243 Dividend Deduction - 70%, 80%, or 100% Section 199 Domestic Production Deduction - % of lesser of taxable income or “qualified production income”. - 6% 2007-09, 9% after 09. - Key limitation: 50% of w-2 wages. - Key definitions related to “qualified production income” 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

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

LLM Corporate Tax Instructor: Dwight Drake C Corp Alternative Minimum Tax Good New! Not apply: In first year of corp In first three years if average gross receipts under 5 mill In any year if gross receipts in preceding three years less 7.5 mill. Bottom Line: All Small C corps Safe. AMT Burden: Add back Section 56 adjustments Add back 75% of Adjusted Current Earnings account AMT rate is 20% The “Push to Kill It” is on! LLM Corporate Tax Instructor: Dwight Drake

LLM Corporate Tax Instructor: Dwight Drake C Corp Losses Losses Carry Back Carry Forward C Corp Never Pass Thru Shareholders LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

Basis Game Corporation’s Inside Basis in Assets Contributions Distributions Shareholder’s Outside Basis in Assets LLM Corporate Tax Instructor: Dwight Drake

C Corp Non-Basis Booster LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

S Corp, Partnership, LLC Loss Hurdles: Basis limitations (704(d) and 1366(d)) At-risk limitations (465) Passive activity limitations (469) S Corp Pass Thru Owners LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

S Corp, Partnership, LLC Income Impacts: No entity level tax 1366(a) separately stated items Entity level accounting period & elections Generally calendar year S Corp Pass Thru Owners LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

LLM Corporate Tax Instructor: Dwight Drake S Corp Basis Adjustments Per 1367 Basis Up Basis Up Contributions Distributions Income Losses Basis Down Basis Down LLM Corporate Tax Instructor: Dwight Drake

Pass-Thru Entity Basis Booster LLM Corporate Tax Instructor: Dwight Drake Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 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

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 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

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 (b) Dividends totaling $660,000 distributed: Shareholders tax @ 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 $264k @ 40% combined rate and total tax hit goes to 60.4%. LLM Corporate Tax Instructor: Dwight Drake

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 (c) Compensation of $1 million paid to Emil and Betty Shareholders tax @ 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

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 Payroll Tax: 15.3% of first 106.8k per person (2009 Amount). 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

LLM Corporate Tax Instructor: Dwight Drake Problem P. 24 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 dividends @ 20% = 20,000 967k @ 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 22,250 0 0 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% LLM Corporate Tax Instructor: Dwight Drake