What Is a Collapsible Corporation?

by Tom Streissguth
Formed for tax avoidance, the collapsible corporation ended soon after it began.

Formed for tax avoidance, the collapsible corporation ended soon after it began.

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The Internal Revenue Service collects both income taxes and capital gains taxes, but sets varying rates for your earnings, depending on how you earned them. At one time, taxpayers could lower their effective tax rate with the use of a collapsible corporation. Instead of making and selling goods and services, the collapsible corporation was created solely for tax purposes and terminated when its usefulness ended.

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A common method of tax avoidance is to transfer assets and income from one business to another. While the second business remains under the control of the original company, its earnings -- for one reason or another -- enjoy favorable tax treatment. In the past, individuals and organizations formed a collapsible corporation for only one reason: to lower their tax rates. This arose from a quirk in the federal tax guidelines -- which is still present -- in which income earned from wages is taxed at a higher rate than capital gains earned from long-term investments, such as stocks, bonds or the assets of a corporation.

Short-Term and Long-Term Rates

For many years, the federal income tax rates have favored long-term capital gains over ordinary income earned by an individual or a business. As of 2012, individual tax rates range from 10 percent to 35 percent, depending on how much taxable income you have. Short-term capital gains -- which you earn on investments held less than a year -- are taxed at the same rate as wage income and are included in your taxable income for the year. Long-term capital gains, which by the IRS definition are held longer than a year, enjoy a lower tax rate than short-term gains. If you are in the 10 percent or 15 percent tax brackets, you pay no tax on long-term capital gains; in the other brackets you pay tax on long-term capital gains at the rate of 15 percent.

How It Worked

In the past, investors formed collapsible corporations to transform income into long-term gains. One type of business that lent itself to collapsible corporations was residential real estate. Investors formed a company to build homes, bought stock in the company and then liquidated the company before selling the homes. They reported the profit on the sale of their stock as a long-term capital gain, earned from the rise in their investment value. The market value of the homes at liquidation then became the basis for the profit on the home sale -- and the taxable profit became much less than if the corporation had remained in business.

Tax Penalties

Over the years, the IRS has set various penalties and provisions in place that have ended the usefulness of collapsible corporations. As of September 2012, if business owners close down their corporation and liquidate its stock before the company becomes a viable business, the proceeds of that sale are treated as taxable income, even if the assets and stock shares would otherwise qualify for capital gains treatment.