Corporate Taxation

Topics

  • Pass-Through Entities
  • Corporate Income Tax
  • Preferential Tax Treatment of Debt
  • Tax Avoidance

Pass-Through Entities

  • Definition: A business entity with no tax liability; income is passed through to the owners, who pay personal income taxes on distribution.
  • Examples:
    • Sole Proprietorship
    • General Partnership
    • Limited Partnership
    • Limited Liability Company (LLC)
  • No Double Taxation: Profits or losses incurred by the partnership pass through to the partners, who pay taxes on their share of the profits.
  • Partnership Responsibilities: The partnership itself pays no taxes but is responsible for filing an information return (Form 1065) each year with the IRS.

IRS Form 1065 Partnership Form

  • Partnership reports total net income and all other relevant financial information using Form 1065.
  • There is no tax reported on Form 1065 because the partnership is a pass-through entity; partners report and pay taxes on their personal income tax returns.

Schedule K-1 Partnership Form

  • Separate Schedule K-1 forms are distributed to each partner.
  • It identifies each partner’s allocated profits and losses for the reporting period.
  • Partners are not employees and do not receive a W-2 tax form.

IRS Form 1040 Individual Form

  • Individual 1040 tax returns will carry respective K-1 amounts as part of total income for the year.
  • The partner pays tax on this amount equal to their personal income tax rate.

Personal Income Tax Rate

  • Maximum personal income tax rate for 2023 is 37%.
  • Tax brackets vary based on income and filing status (single vs. married filing jointly).

Historical Context

  • The highest federal marginal individual income tax rate has varied significantly over time (1913-2020).

State Income Tax Rates

  • Top marginal state income tax rates vary widely by state.

Pass-Through Business Statistics

  • Prevalence: In 2014, 95% of businesses (26 million total) were pass-through entities, while only 5% were C-corporations.
  • Size: Almost 99% of all businesses had 10 million or less in sales or receipts in 2014.
  • Income: In 2013, only 44% of business owners' income was earned through C-corporations.

Corporate Income Tax

  • Corporate profits are subject to federal and state corporate income tax.
  • The Tax Cut and Jobs Act (TCJA) reduced the federal corporate income tax rate from 35% to 21%.

Corporate Income Tax Over Time

  • The statutory rate for federal corporate taxes has declined over time.

State Corporate Tax Rates

  • State corporate tax rates vary.

Corporate Tax Rates in Context

  • The combined federal and state statutory corporate income tax rates in the United States are generally in line with those of other G7 economies.

Taxes on Corporate Payouts

  • Corporate profits are taxed by federal and state governments, and dividends distributed to shareholders are taxed again on the shareholder’s personal income tax returns.
  • This double taxation can be seen as the price paid by a corporation for full limited liability.

Corporate Earnings

  • Corporations can either distribute profits to shareholders as dividends or retain profits as retained earnings.
  • Retained earnings, if invested properly, can yield higher corporate profits and, in turn, a higher stock price.
  • Shareholders reap the benefits of retained earnings in the form of future capital gains from the sale of stock.

Dividends Distribution

  • Payment by a corporation to a shareholder depending on the number of shares owned.
  • Payment to shareholders by a corporation out of its retained earnings in proportion to the number of shares owned.
  • Salary is not a distribution because the payment does not depend on the number of shares owned.

Taxation of Dividends

  • The maximum tax rate for qualified dividends is 20%.
  • Distribution is taxed at the corporate level (at 21%) and again at the individual level (at 20%).
  • Effective Tax Rate on Dividends ≈ 37% = 1 – (79% x 80% ≈ 63%)
    Effective Tax Rate on Dividends ≈ 37% = 1 – (79\% x 80\% ≈ 63\%)

Capital Gains

  • Profit realized on the sale of a non-inventory asset (stock).
  • Tax on individual capital gains.
  • Corporate Income Tax ≠ Capital Gains Tax

Taxation of Capital Gains

  • Maximum tax rate for capital gains is 20%, which is lower than the maximum personal income tax rate of 37%.
  • Profit is taxed at the corporate level (at 21%) and again at the individual level (at 20%).
  • Effective Tax Rate on Capital Gains ≈ 37% = 1 – (79% x 80% ≈ 63%)
    Effective Tax Rate on Capital Gains ≈ 37\% = 1 – (79\% x 80\% ≈ 63\%)

Preferential Tax Treatment for Debt

  • Debt receives preferential tax treatment: interest payments are deductible, but dividends are not.
  • Dividend payments are NOT tax deductible.
  • Retained Earnings = Net Income − Dividends

Tax Avoidance

  • To Avoid Double Taxation:
    • Form an S-corporation
    • Zero-out shareholder payments

S-Corporation (S-Corp) Characteristics

  • Taxation: S-corporation is a pass-through entity and pays no income tax at the corporate level.
  • Liability: Stockholders are also insulated from personal liability.

Restrictions on Use (Aside)

  • S-Corporations must satisfy the following conditions:
    • Domestic
    • Entity must be stand-alone (i.e., not a member of an affiliated group of corporations).
    • Have only 1 class of stock.
  • Shareholders must:
    • Be individuals, estates, or certain trusts and tax-exempt organizations.
    • Be equal to, or less than, 100 in number.
    • Not include a non-resident alien.

Zero-out Shareholder Payments

  • Corporations with relatively few shareholders (e.g., close corporations) can distribute profits to shareholders as salaries rather than as dividends (or capital gains).
  • Salaries (expense) are tax-deductible.
  • If a corporation distributes all profits as salaries, then there is no profit and no income tax.
  • Only tax paid is the personal income tax shareholder-employees pay on salaries from the corporation.

Too Much of Good Thing

  • If compensation is not reasonable (i.e., not reasonably related to the value of services rendered), then the IRS will treat compensation as non-deductible dividends.

Amazon’s Tax Avoidance

  • How Amazon Paid $0 in Federal Income Tax
    • Reinvesting Revenue (Lowers Net Taxable Income)
    • Tax Credits (primarily for R&D)
    • Stock-Based Compensation (Lowers Net Taxable Income)
    • Off-Shore Tax Havens?

Why Corporate Finance?

  • Corporate Finance is considered a valuable skill for law students.

Topics

  • Financial Statements
  • Financing a Business

Financial Statements

  • 4 Main Financial Statements
    • Balance Sheet
    • Income Statement
    • Statement of Shareholder Equity
    • Cash Flow Statement
    • Interconnected
  • Fundamental Equation: Assets = Liabilities + Owner’s Equity
  • Double Entry Accounting: All assets have economic claims against them by either: o Debtholders or o Equityholders

Balance Sheet

  • Assets = Liabilities + Equity
  • Asset: Probable future economic benefits owned by firm.
    • Examples: Physical plant, property, and equipment (PP&E), intellectual property, cash.
  • Historical Cost Principle: Virtually everything a company owns or controls (assets) must be recorded at its value at the date of acquisition.
    • Exceptions: Financial instruments (e.g., stock, bonds) might be recorded at fair market value.
    • This is called mark-to-market accounting (or fair value accounting).
  • Liabilities: Probable future economic sacrifices.
    • Examples: Bonds and notes payable, deposits held by banks, contractual obligation to perform service in the future.
  • Equity: Owner’s Equity = Assets – Liabilities
    • Business Organizations:
      • Partnership: Partner’s capital account
      • LLC: Member’s interest
      • Corporation: Shareholder’s equity

Statement of Shareholder Equity

  • Authorized Shares: Maximum number of shares a corporation can issue (per articles of incorporation).
  • Issued Shares: Shares a corporation does, in fact, issue.
  • Outstanding Shares: Issued shares that a corporation has not reacquired (a corporation can buy stock back).
  • Treasury Stock: Reacquired shares (e.g., if a corporation issues 40K shares and buys back 10K, then this 10K is treasury stock and 30K are outstanding shares).
  • Par Value: Minimum price for which a corporation can issue its shares.
    • Par value is the minimum issuance price, not the actual price paid for stock.
    • Par value impacts only issuance price and has no effect on resale price.
  • Contributed Capital Formula: Contributed Capital = Stated Capital + Capital Surplus
  • Stated Capital: Aggregate par value of all issued shares of par value stock.
    • Cannot be distributed to shareholders
  • Capital Surplus (or Additional Paid in Capital): Received funds for its issuance in excess of par value.
    • Can be distributed to shareholders in dividends.

Problem Set

  • Shareholders' Equity Formula: Shareholders' Equity = Contributed Capital + Retained Earnings - Treasury Stock
  • Key Formulas
    • Retained Earnings = Net Income – Dividends
    • Net Income = Revenue – Expenses
  • Fundamental Theorem of Accounting (Restated)

Problem 1

  • Question: If assets minus liabilities equal equity, then how would you interpret negative equity?
  • Answer: INSOLVENCY.
  • Equity is merely placeholder that balances assets and liabilities: this placeholder can be negative.

Problem 2

  • Question: If a firm adds more money to retained earnings, then what entry would the firm make on the left-side of the balance sheet?
  • Answer: Cash (or some other asset) would increase by a corresponding amount.

Problem 3

  • Bacall Tin Whistles:
    • Firm has current assets of 5.7millions,fixedassetsofmillions, fixed assets of4.3million,currentliabilitiesofmillion, current liabilities of3.9million,andlong−termdebtofmillion, and long-term debt of1.1 million.
    • Construct simple balance sheet.
    • Question: What is shareholders’ equity?
  • Results:
    • Total Assets = 10
    • Total Liabilities = 5
    • Equity = 5

Income Statement

  • Income Statement: Measures financial performance over a given period.
  • Net Income Formula: Net Income = Revenue – Expenses
  • Note: Net Income is an after-tax number, meaning corporate income tax expense is included as an expense in the above equation.

Terminology

  • Synonyms for Net Income
    • Net Profit
    • Earnings
  • NOT Synonyms for Net Income
    • Gross Profit
    • Operating Profit, EBIT
    • Pretax Profit
    • EBITDA

Components of Income Statement

  • Operations
  • Debt Service
  • Tax Service
  • Residual Profit

Accrual Accounting

  • 2 Principles of Accrual Accounting
    • Revenue Recognition Principal
    • Matching Principal (or Expense Recognition)
  • Comment: Much of the complexity in accounting follows from the use of accrual accounting (as opposed to cash accounting).

Revenue Recognition Principle

  • Revenue is recognized on the income statement when realized and earned—not when cash is received.
  • Example: On December 28, a company completes a service and bills a customer 5Kwithcredittermsofnet30days.OnJanuary29,thecompanyreceiveswith credit terms of net 30 days. On January 29, the company receives5K.OnDecember28,thecompanyrecordsa. On December 28, the company records a5K increase in the income statement account: Revenues Earned.

Matching Principle

  • Expenses on the income statement are reported in the period in which the related revenue is earned.
  • Expenses are recognized on the income statement when incurred—not when cash is paid.

Deferred (Prepaid) Expense

  • Prepaid Rent: Rent paid in advance of the rental period.
  • The journal entries for prepaid rent are as follows:
    • Initial journal entry for Prepaid Rent (Asset, NOT Expense)
    • Adjusting journal entry as Prepaid Rent expires

Capital Expenditures

  • Purchases of new property, plant, and equipment.
  • Accounting Treatment
    • Capital expenditures do not appear immediately as expenses on the income statement: rather, the firm deducts depreciation expenses over time.

To Capitalize vs. To Expense

  • To Capitalize
    • Recognize expense on the balance sheet as an asset (and then regularly reduce the value of that asset over time by depreciation expense in the income statement).
    • Income Statement: Depreciation expense.
  • To Expense
    • Recognize expense in the income statement in the same period incurred (rather than spreading the expense over several periods as in the case of capitalized expenses).
    • Income Statement: Expense

WorldCom's Accounting Fraud

  • Transaction: 3.8bn 2001-02 expenditure on "line costs"
  • What was required as per GAAP: 3.8bn must have been treated as operating expense
  • What WorldCom did: WorldCom capitalized the costs
  • Financial Statement Effects: Pre-tax Income should be deducted by 3.8bn

Depreciation

  • Suppose a company acquires production equipment for 100K$$ that has a projected useful life of 10 years.
  • Revenue recognition dictates that revenue must be recognized over the useful life of the asset.
  • The matching principle dictates that the cost of the asset must be expensed over its useful life while used by the company to produce revenue (depreciation expense “matches” the cost of the equipment with revenue generated by the equipment).
  • Depreciation is an example of a deferred expense.

Accrued Expense

  • Utility Payable: Utility remains unpaid on payment date.
    • Initial journal entry for Utility Payable (Liability, NOT Cash)
    • Adjusting journal entry as the Utility Payable expires

Cash Flow Statement

  • Reports cash inflows and cash outflows that occurred during the same time interval as the income statement.
  • The bottom line of the cash flow statement shows the net increase or decrease in cash for the period.
  • Under accrual-based accounting, the income statement does not measure amounts of cash flowing in and out of the company.
  • The income statement can tell you whether a firm made a profit.
  • The cash flow statement can tell you whether a firm generated cash.

Elements of Cash Flow Statement

  • Operating Activities: Net cash from operating activities.
  • Investing Activities: Includes the purchase or sale of long-term assets (e.g., property, plant & equipment) and investment securities.
  • Financing Activities: Includes cash raised by selling stock or bonds or borrowing from banks.

Consolidated Financial Statements

  • A consolidated financial statement takes the financial results of subsidiaries and includes them in a single financial statement for the parent company (i.e., the parent company and subsidiaries are treated as one entity).
  • Normally, an entity still wants to maintain legal separation to avoid “veil piercing,” etc.