Taxation of Entities – Index of Major Topics Title
Tax Administration
Federal, state and local governments
levy taxes in the United States. The federal government imposes income taxes,
excise taxes, and estate and gift taxes. Most states and other local
jurisdictions levy franchise, income and/or capital-based taxes as well as
sales, use, property, estate and gift taxes.
Filing Procedures and Tax Payments
Tax systems within the United States are based on the principle of
self-assessment. That is, if minimal thresholds are met, federal and various
state and local tax laws require taxpayers to file annual returns to report
their taxable income, determine their tax liability, compare this tax liability
to any taxes withheld or estimated taxes paid, and reconcile any balance due or
overpayment. Corporate tax returns are generally due by the 15th day of the 3rd
month following the close of a tax year (i.e., March 15th for a calendar year).
A corpo-ration is not required to have the calendar year as its tax year.
Corporations are generally required to make quarterly estimated tax payments
based on their current year's projected federal tax liability. Most states also
require the payment of estimated tax. Failure to make these estimated payments
can result in fines and penalties.
Statute of Limitations
Generally, the IRS must assess a deficiency in income tax within three years
after the return is filed. The statutory period for assessment is extended to
six years, however, for taxpayers that have omitted an amount of gross income
representing more than 25% of the gross income stated in the return. If no
return has been filed, the IRS may assess tax at any time -- in other words, the
statute of limitations never begins.
Taxation of Resident Corporations
In the United States, taxable income
of corporations is ultimately subject to two levels of taxation: first at the
corporate level and again at the shareholder level when earnings are
distributed. A resident corporation is a corporation incorporated under the laws
of the United States.
Tax Rates
Regular Corporate Tax Rates
For the 2002 tax year, taxable income up to $75,000 is subject to graduated
marginal rates of taxation: 15% on the first $50,000 and 25% on the next
$25,000. Amounts in excess of $75,000 are taxed at a marginal effective rate of
34%; however, corporations with taxable income between $100,000 and $335,000
receive only partial benefit of the lower 15% and 25% rates, because an
additional 5% is added (for a total applicable rate of 39%) to phase out the
benefit of the lower rates. Amounts in excess of $10 million are taxed at a
marginal effective rate of 35%; an additional 3% tax, not to exceed $100,000 is
imposed on corporate taxable income over $15 million. This increase in tax
phases out the benefits of the 34% rate. Therefore, corporations with taxable
income over $18.33 million pay a flat rate of 35%.
Alternative Minimum Tax
The alternative minimum tax (AMT) is designed to prevent a corporation with
substantial economic income from using preferential deductions, exclusions and
credits to reduce significantly or eliminate its U.S. tax liability. To achieve
this goal, the AMT is structured as a separate tax system with its own allowable
deductions and credit limitations. The tax is imposed at a flat rate of 20%. It
is an "alternative tax" because, after computing both the regular tax and the
AMT, a corporation pays the higher of the two.
Alternative minimum taxable income (AMTI) is computed by making adjustments
to regular taxable income. To that result certain tax-preference items are added
back. The required adjustments are intended to convert preferential deductions
allowed for regular tax (for example, accelerated depreciation) into the less
favorable deductions allowed under the AMT system. In addition, the "adjusted
current earnings" adjustment requires AMTI to be increased by 75% of the excess
of adjusted current earnings over AMTI before this adjustment. A corporation’s
Adjusted current earnings is determined by increasing AMTI by certain items of
income that are not otherwise recognized for AMT purposes but are included in
determining earnings and profits. Interest income on tax-exempt obligations is
an example of such an item. AMT net operating losses and, generally, AMT foreign
tax credits may not be utilized to reduce the AMT by more than 90%.
Taxation of S Corporations
A domestic corporation that satisfies certain requirements may be exempt from
federal income tax, including AMT and most other taxes, if its shareholders make
an election for the corporation to be treated as an S corporation. S
corporations are generally treated as nontaxable conduit entities. Regardless of
whether any distributions are made, the shareholders of an S corporation are
taxed currently on their share of the corporation's income. Similarly, current
operating losses of an S corporation are generally passed through and deductible
at the shareholder level, subject to certain limitations. Because the
corporate-level tax is eliminated (and individual tax rates are generally lower
than the corporate rates), S corporation status is often desirable.
To be eligible to make an S corporation election, the domestic corporation
must have only one class of stock outstanding and its stockholders must:
-
Number no more than 35 (for purposes of this limitation, a husband and wife
are counted as one shareholder, regardless of how they hold title to their
shares);
-
Be individuals, estates or certain trusts; and
- Not include any nonresident alien individuals.
Determination of Taxable Income
The computation of taxable income generally begins with income computed
according to generally accepted accounting principles, but is adjusted for
certain statutory tax provisions. As a result, the amount of taxable income
frequently differs from the amount of income stated for financial reporting
purposes.
Territoriality
Domestic corporations are subject to U.S. income tax on their worldwide
income from all sources, including the income of foreign branches, regardless of
whether such income is repatriated. However, domestic corporations are generally
not taxed on the earnings of a foreign subsidiary until the subsidiary remits
its earnings, is sold or is liquidated. Exceptions may apply for certain income
of controlled foreign corporations, foreign personal holding companies and
passive foreign investment companies.
Capital Gains and Losses
Capital gains are taxable at the same rates as ordinary income. Generally,
losses on the sale or exchange of capital assets may offset only capital gains,
not ordinary income. A corporation's unused capital losses may be carried back
for three years and forward for five years to offset capital gains realized in
these other years.
Deductible Expenses
Generally, all ordinary and necessary expenses incurred in carrying on a
trade or business, or with respect to property held for the production of
income, are deductible against gross income. Deductible business expenses
generally include, but are not limited to, salaries and wages, bad debts, rents,
state and local income taxes, foreign income taxes (except where the taxpayer
elects to treat foreign income taxes as a credit), property taxes, interest,
business-related meals and entertainment, pension fund contributions,
depreciation and amortization. These deductions are subject to many statutory
limitations, such as the 50% limitation for deductible meals and entertainment.
Also, many reserves and provisions are not deductible until paid (i.e., they are
deductible on a cash basis). One common example is bad debt reserves.
Depreciation
A depreciation deduction is available for most property, except land, used in
a trade or business. Tangible depreciable property used in the United States is
generally depreciated using accelerated depreciation systems normally under a
200% declining balance method. The most common depreciable lives of depreciable
property includes:
Machinery and Equipment 7 or 12 years
Furniture and Fixtures 7 or 12 years
Commercial Buildings 39 years
Computer Equipment 5 years
In addition, several types of intangible assets are amortizable over 15
years, on a straight-line basis, if they are acquired after August 10, 1993,
such as goodwill, going-concern value, information base, know-how, trademarks,
and covenants not to compete.
Tax Credits and Incentives
Foreign Tax Credit
Domestic corporations may treat foreign income taxes as a deduction against
U.S. taxable income or, alternatively, may elect to credit them against their
U.S. tax liability, subject to limitations. Domestic corporations are also
permitted to claim an indirect ("deemed-paid") foreign tax credit for foreign
income taxes paid by foreign subsidiaries in which they hold a 10% or greater
voting stock interest. The indirect foreign tax credit may be claimed on the
receipt of actual dividends from the subsidiary, or the inclusion of subpart F
income (i.e., deemed dividends).
The foreign tax credit allowable for a taxable year is limited to the lesser
of the following:
-
The foreign taxes paid or accrued; or
-
The taxpayer's U.S. tax on foreign-source taxable income. (This limitation
is determined by the following formula: U.S. tax before credits multiplied by
foreign-source taxable income over worldwide taxable income.)
The foreign tax credit limitation is determined separately for various
categories, or "baskets," of income including passive income,
high-withholding-tax interest, shipping income, financial services income,
dividends from 10%- to 50%-owned foreign corporation, and the general income
basket for all other types of income.
Net Operating Losses
Net operating losses may generally be carried back for two years and forward
for 20 years to offset taxable income in those other years. Significant
limitations on the use of corporate net operating losses may apply, however, if
a change in ownership of more than 50% in value of the stock of the loss
corporation has occurred. Other restrictions may apply to the use of losses of
acquired corporations.
Treatment of Groups of Companies
Consolidated Returns
Domestic corporations that are members of an affiliated group may generally
elect to file a federal consolidated income tax return and determine their U.S.
tax liability on a consolidated (group) basis. If this election is made, losses
sustained by group members may generally be offset against profits earned by
other group members. An affiliated group consists of a parent-subsidiary chain
of corporations connected by stock ownership representing at least 80% of the
voting power and value of all classes of stock outstanding, excluding certain
non-voting, preferred stock.
Corporate Distributions
In general, a corporation distributing property must recognize gain or loss
as if it had sold the property at its fair market value in a taxable
transaction. However, a corporation need not recognize gain or loss on a
liquidating distribution to an 80% or more U.S. corporate shareholder if certain
conditions are met. This exception is not generally available for liquidating
distributions to foreign corporate shareholders unless the distributed property
is a U.S. real property interest.
Dividends Received Deduction
Dividends received from other U.S. corporations generally qualify for a 70%
dividends-received deduction, subject to certain limitations. The
dividends-received deduction is increased to 80% if the recipient corporation
owns at least 20% of the stock in the distributing corporation. Dividend
payments from members of an affiliated group of U.S. corporations to other
members qualify for a 100% dividends-received deduction.
Thin-Capitalization Rules
The U.S. tax law still favors characterization of shareholder contributions
as debt rather than equity because interest expense is generally deductible
against taxable income, and principal repayments can be used to distribute
after-tax earnings with no further U.S. tax cost. No specific statutory limits
are placed on the ratio of debt to equity, however a debt to equity ratio of 3:1
or less is generally acceptable assuming the taxpayer can service this debt on
their own without assistance.
Dividends, Interest and Royalties Paid to Foreign Affiliates
Dividends, interest and royalties paid by domestic corporations to foreign
affiliates are subject to a 30% U.S. withholding tax (or lower treaty rate) to
the extent that the amounts constitute U.S.- source income not effectively
connected with the conduct of a U.S. trade or business.
The earnings-stripping provisions may limit the interest expense deduction of
a foreign-owned U.S. subsidiary or branch of a foreign corporation if it has a
debt-to-equity ratio in excess of 1.5 to 1. This rule disallows otherwise
deductible interest on loans to a related-party lender in a country where a U.S.
treaty reduces the U.S. interest withholding tax to the extent this interest
exceeds 50% of the corporation's adjusted taxable income for the year.
Disallowed interest expense may be carried forward indefinitely and deducted in
a tax year in which the corporation has an excess limitation (i.e., the amount
of its net interest expense is less than 50% of its adjusted taxable income).
The limit can also apply to interest on a loan from an unrelated party (such as
a U.S. bank) if a related foreign person has guaranteed the loan. This guarantee
rule applies whether or not a direct loan from such related foreign person would
have been subject to earnings stripping. U.S. international tax reforms
currently under consideration would materially change the earnings stripping
calculations. Some of the changes under contemplation include the elimination of
the 1.5:1 safe harbor, the elimination of the indefinite carry forward period
for excess interest deductions and the reduction of the adjusted taxable income
percentage.
Intercompany Transactions
U.S. tax law provides the IRS with very broad powers to adjust transfer
prices between related parties to prevent evasion of taxes or to clearly reflect
the income of related parties. The basic standard is that related-party prices
must reflect the arm's length price that would apply between independent parties
in comparable transactions. The arm's length standard applies to all types of
transfers, including transfers of licenses and intangibles. Companies now must
document their intercompany pricing policies or risk penalties upon IRS
examination. In recent years the IRS has enforced these transfer pricing rules
with increased tenacity.
Taxation of Nonresident Companies
Foreign corporations are generally
subject to U.S. income tax on two categories of income:
Income effectively connected with a U.S. trade or business is subject to tax
on a net basis, after deducting expenses incurred to produce such income. Normal
corporate graduated income tax rates apply.
FDAP income not effectively connected with a U.S. trade or business is
generally subject to U.S. income tax on a gross basis -- without allowance for
deductions -- at a 30% or lower treaty rate.
Branch Profits and Interest Tax
In addition to corporate income tax, foreign corporations engaged in a U.S.
trade or business may be subject to branch profits or interest taxes. These
taxes are intended to place U.S. branches of foreign corporations in a position
similar to that of U.S. subsidiaries of foreign corporations vis-a-vis the U.S.
withholding tax on dividends and payments of interest.
The 30% branch profits tax is imposed on the non-reinvested after- tax
earnings, known as the dividend-equivalent amount, of a U.S. branch of a foreign
corporation. The branch profits tax may be reduced or eliminated by treaty if
the foreign corporation is a "qualified treaty resident" of that country.
In addition to the branch profits tax, the United States generally imposes a
branch interest tax. Under the first part of this tax, interest actually paid by
a U.S. branch is treated as if paid by a U.S. corporation. Accordingly, these
interest payments are subject to a 30% withholding tax unless a lower income tax
treaty rate applies or the payments would be exempt from U.S. withholding tax
under regular domestic rules -- for example, as portfolio interest. Under the
second part of the branch interest tax, a foreign corporation is subject to a
30% (or lower income tax treaty rate) "excess branch interest tax" on the excess
of the U.S. branch's interest expense deduction (which is determined pursuant to
an IRS regulatory formula) over the interest actually paid by the branch.
Real Property Income and Gains
Foreign corporations not engaged in a U.S. trade or business that derive
rental income from U.S. real estate are generally subject to U.S. tax on gross
rental income (no deductions are permitted) at a 30% rate. However, a "net
election" may be made to treat such rental income as if it were effectively
connected with the conduct of a U.S. trade or business. If this election is
made, the rental income is taxable on a net basis, at graduated U.S. income tax
rates, with allowance for deductions such as depreciation, interest and
maintenance. Under the Foreign Investment in U.S. Real Property Tax Act (FIRPTA),
when a foreign person sells a U.S. real property interest, any gain or loss
recognized is treated as effectively connected income regardless of whether this
election is made. Unless certain conditions are met, the FIRPTA provisions
generally tax all dispositions of U.S. real property by foreign persons even if
a U.S. transferor would qualify for non-taxable treatment on the transaction.
State and Local Income Taxation
Most states and many municipalities
impose an income tax on corporations that are incorporated within the state or
doing business within the state.
State Corporate Income Tax
A corporation may be subject to the taxing jurisdiction of more than one
state. Although incorporated in only one state, the corporation may be "doing
business" in several other states through branch operations or some other means.
Each of these states may tax the part of the corporation's income that is
apportionable to the particular state.
Most states determine the portion of a corporation's income subject to tax by
multiplying the corporation's federal taxable income, as adjusted for state
modifications, by a three-factor formula based on that portion of the
corporation's property, payroll and sales within the state.
State Consolidated Returns
Some states do not permit the filing of state consolidated returns, even for
affiliated groups that have elected to file a federal consolidated return. In
many states, regardless of intercompany ownership and transactions, each
corporation having a nexus -- taxable contacts -- with the state may be required
to file a separate state tax return. Other states either require or allow
multistate controlled groups to report income on a combined basis if business
operations are "unitary" in nature.
Partnerships - Generally
For U.S. tax purposes, partnerships
are transparent conduit entities not subject to taxation at the entity level.
The partners are taxed currently on their distributive share of partnership
taxable income regardless of whether any distributions are made, and current
losses sustained by the partnership are passed through and deductible at the
partner level.
The amount of a partner's distributive share of partnership loss or deduction
that may be deducted by the partners is limited to the partner's adjusted basis
in the partnership interest. A partner's adjusted basis is generally increased
by the partners share of undistributed partnership income and liabilities of the
partnership.
Trusts - Generally
Trusts are separate taxable entities
in the United States. Business, commercial and investment trusts are generally
considered associations formed to carry on profit-making businesses and are
taxed as corporations. Other types of trusts, which are usually formed to
protect, preserve and manage assets, are generally taxed as trusts.
Almost all trusts are required to adopt a calendar tax year. A trust must
generally report its entire income on Form 1041, which must generally be filed
on or before April 15 following the close of the calendar tax year. In general,
trusts must also make advance estimated tax payments quarterly.
Trusts are treated as conduit entities on income that must be distributed
currently or is distributed properly to beneficiaries. This distributed income
retains its character in the hands of the beneficiaries, who must include it in
determining their incomes.
A trust is considered a simple trust if it is required to distribute all of
its income currently, and a complex trust if not.
Trusts are taxed as separate entities on undistributed income. Trusts
determine taxable income by subtracting allowable deductions (including
deductions for distributed income) and personal exemptions from gross income. In
general, trusts are entitled to the same deductions and credits as individuals,
although some exceptions apply.
Tax rates for trusts are based on individual tax rates and range from 15% to
39.6%.
U.S.-Switzerland Key Treaty Rates
As part of consideration with any
multinational companies with business between the United States and Switzerland,
the United States-Swiss Income Tax Treaty ("Treaty") supplies such companies
with reduced withholding rates on interest, royalties and dividends. Under the
Treaty, withholding on dividends vary from 5 to 15 percent depending upon stock
ownership. Furthermore, withholding on interest and royalties are subject to a 0
percent rate and, thus, exempt from withholding taxation. Please note that
whenever relying on the Treaty for benefits, the Limitation on Benefits Clause
must be analyzed in extreme detail. Generally, a claim for reduced U.S.
withholding under an income tax treaty with the Unites States requires that a
payor receive a specific form prior to the payment to grant the reduced
withholding.
November 2003
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