A collapsible corporation was a type of corporation—commonly a C corporation—formed primarily to manufacture, construct, or acquire property with the anticipation of quickly “collapsing” the corporation through liquidation or stock sale before it earned significant income. The goal was to receive capital gains tax treatment on distributions or stock sales instead of higher ordinary income rates. This structure allowed shareholders to potentially pay taxes at lower capital gains rates rather than ordinary income taxes on business profits.
Origin and Purpose
The concept originated in the mid-20th century, notably among Hollywood producers who formed corporations to produce a single film. Prior to the film generating substantial box office revenue (ordinary income), shareholders would liquidate the company or sell their shares. This maneuver recharacterized business income as capital gains, which historically had a significantly lower tax rate.
How It Operated
The key was the “view to collapse”—forming a company with the specific intention to dissolve it before earning substantial income. For example, a corporation builds an apartment complex; shareholders liquidate the company before rental or sales income begins. They then report gain from the dissolution or stock sale as a capital gain, paying lower tax rates. The IRS viewed this as a tax avoidance scheme.
IRS Response: Section 341 of the Internal Revenue Code
To combat this, Congress enacted Section 341 in 1950 which treated gains from stock sales or liquidations in collapsible corporations as ordinary income, regardless of the holding period. This provision blocked the attempt to convert ordinary income into capital gains via these corporate structures.
Changes Following the American Jobs Creation Act of 2004
Section 341(a) was largely repealed for C corporations by the American Jobs Creation Act of 2004. This repeal reflected a tax environment where the long-term capital gains rates were significantly lowered, narrowing the tax advantage of collapsible corporations. Additionally, other anti-abuse tax provisions remain in place to prevent similar avoidance schemes.
Modern Relevance
While the specific designation of collapsible corporations is mostly obsolete, the principle remains important—tax authorities scrutinize transactions designed to reclassify income improperly. Other tax rules, such as the personal holding company rules and accumulated earnings tax, continue to target abusive tax avoidance.
Common Misconceptions
Forming a company with the intent to eventually sell it is not illegal nor inherently a collapsible corporation. The critical issue is the intent to sell or liquidate before substantial corporate income is realized to gain a tax benefit improperly. The repeal of Section 341(a) does not open a free pass to convert ordinary income to capital gains; current anti-abuse rules still apply.
Frequently Asked Questions
Is forming a collapsible corporation illegal?
No. It was not illegal to form such corporations, but the IRS reclassified gains to ordinary income for tax purposes under Section 341.
Do collapsible corporation rules still apply?
For most C corporations, the specific Section 341 collapsible provisions were repealed in 2004, though other anti-abuse provisions remain active.
**How can businesses minimize taxes today?
**Modern strategies include choosing the right entity, utilizing the Qualified Business Income deduction, retirement plan contributions, capital gains harvesting, Opportunity Zones investments, and like-kind exchanges under Section 1031.
For detailed tax planning, consulting a qualified professional is essential.
For more on related tax topics, see Domestic Production Activities Credit and Expatriation Tax.
External Resource:
For comprehensive IRS guidance on business income and capital gains, visit IRS.gov.