The secondary relationship

Where the shareholder has a secondary relationship with the corporation as a

creditor, supplier, employee, customer, or lessor, the resulting tax consequences
and cash flows between the parties are significantly different from those in the
primary relationship. For example, because the corporation is a separate legal
entity, the corporation can employ the shareholder and provide a salary or other
benefits as compensation. The corporation can deduct the compensation paid from its
pre-tax income, and the compensation is fully taxable when the employee/shareholder
receives it. The result of this treatment is that corporate income paid as
compensation to the employee/shareholder is converted into employment income and
taxed only once within the overall system. Similarly, when a shareholder loans
money to a corporation and receives interest or leases property to a corporation
and receives rents, corporate income is shifted to the individual shareholder and
taxed only once.
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Consider also the situation where the shareholder acts as a supplier and sells
property to the corporation. The sale of property at fair market value may result
in taxable gains to the shareholder, but the cost of the asset to the corporation
is established by the selling price; this reduces corporate income for tax
purposes. The timing of the deduction from corporate income will depend on the
nature of the property acquired (that is, whether it is inventory, depreciable
property, or something else).
The fundamental difference between the primary relationship and the secondary
relationships centres on the tax treatment given to income flows between the
corporation and its shareholders. In the primary relationship, dividends paid by
the corporation are not deductible by the corporation for tax purposes, but are
taxable to the recipient shareholder. In secondary relationships, such payments as
salaries, interest, and rents are deductible by the corporation and are taxable to
the recipient. This difference is particularly important in closely held
corporations, which are controlled by a single shareholder or by a relatively small
group of shareholders. Decisions by such corporations—whether the corporation
should be capitalized with shareholder debt, rather than equity; whether the owners
should take salaries, rather than dividends; and whether property should be owned
by the corporation, rather than leased from the shareholders—all relate back to how
the corporation and its shareholders are taxed in primary and secondary
relationships. In widely held corporations, such as public corporations, secondary
relationships usually do not exist. However, the two-tiered system of tax in the
primary relationship affects such corporations’ decisions concerning whether to
raise capital by debt or by equity. We examine this question in subsequent
chapters.
In order to understand the tax impact of the two-tiered system of tax for
corporations on cash flow, we must first establish the taxa