Module 6 Entity Formation and Start-up

Module Topics n n Transferring assets to a business: general concepts n n Creating the corporate capital structure n n Other transfers to corporations n n Organization costs and start-up expenses n n Accountant's role in business formation

Transferring Assets to a New Business Key Learning Objectives n n Tax implications of transferring assets Sole proprietorship Corporation Partnership

Sole Proprietorship n n Proprietor and business are one entity n n Need business license n n Employer Identification Number u Payroll taxes n n See Module 26 for full discussion

Corporation--Formation Tax Free if §351 Applies GENERAL RULE:No gain or loss recognized by the transferor shareholder u Transfer of property u In exchange for stock u 80% control after transfer

(No Exceptions for Losses) Gain Recognition Exception (No Exceptions for Losses) Stock received for services performed u Always income to shareholder u If stock for property and services, count both for control Boot received u Liabilities assumed are not boot (see next slide) n n If boot, recognized gain is lesser of u Boot received or u Realized gain

(No Exceptions for Losses) Gain Recognition Exception (No Exceptions for Losses) Liabilities assumed by corporation IF >basis of properties transferred in Use aggregate amounts n n If cash basis u Accounts payable not liabilities

Shareholder's Basis in Stock Received n n Substituted basis Basis of property transferred in Plus any gain recognized Minus any boot/money received Liabilities assumed are treated as money here

Corporation's Basis in Property Received n n Basis of property transferred in n n Plus any shareholder gain recognized

Compliance Query: Services Transferred for Stock Taxpayer transferred services for 10 shares of stock valued at $10,000 Calculate: Gain realized Gain recognized Basis in the corporate stock

Compliance Query (con’t): Services Transferred for Stock n n What is Corp’s basis in the services ? n n How should the corporation account for the services rendered if u (1) the services were for installing equipment? u (2) the services were for preparing the corporation’s chart of accounts?

Solution--Compliance Query: Services Transferred for Stock n n Services are not "property" for §351. n n Realize/recognize 10,000 ordinary gain n n Payment is subject to either FICA or self- employment taxes

Solution--Compliance Query: Services Transferred for Stock n n Shareholder’s basis in stock = 10,000 CALCULATION Basis of property transferred in 0 Gain recognized 10,000 Boot received 0 Stock basis 10,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction n n Corp’s basis in services = 10,000 CALCULATION Basis of property transferred to corporation 0 Gain recognized 10,000 Stock basis 10,000

Solution--Compliance Query: Services Transferred for Stock n n Services for installing equipment u Capitalize as part of the equipment's basis and depreciate over useful life n n Services for creating chart of accounts u Capitalize as an organization cost u Amortize it over a period of not less than 60 months

Holding Periods in §351 Transfer n Shareholder’s in stock determined by type of property transferred u If §1221 or §1231 = carryover u Otherwise, starts day after transfer n Corporation always gets carryover

Compliance Query: Inventory Transferred in a §351 Transaction Taxpayer transferred inventory for 50 shares of stock and $6,000 in cash Basis to Transferor Fair Market Value $48,000$56,000 Calculate: Gain or loss realized/recognized Basis/holding period in the corporate stock Corp’s basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred in a §351 Transaction n n Realized gain is 8,000 u 56, ,000 n n Recognized gain = 6,000 u Gain is recognized to the extent of boot received, but never more than the realized gain. u 6,000 of boot was received

Solution--Compliance Query: Inventory Transferred in a §351 Transaction n n Shareholder’s basis in stock = 48,000 CALCULATION Basis of property transferred to corporation 48,000 Gain recognized 6,000 Boot received Stock basis 48,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction n n Corp’s basis in inventory = 56,000 CALCULATION Basis of property transferred to corporation 48,000 Gain recognized 6,000 Stock basis 56,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction n Shareholder’s holding period u Starts day after transfer u Inventory in not §1221 or §1231 n Corp’s holding period is carryover, but since inventory is ordinary income asset, gain will be ordinary regardless of holding period

General Rule: Partnership Formation n n No gain or loss is recognized when property is contributed in exchange for a partnership interest u By a partner u Or the partnership n n No 80% control test n n No limits on type of property

Partnership Formation: Gain Recognition Exceptions n n Services performed n n Capital vs. Profits interest received n n Liabilities assumed by the other partners in excess of partner's (adjusted) basis n n Investment companies n n Disguised sales n n No loss exceptions

Partner's Original Partnership Interest Basis n n Cash contributed n n + basis of non-cash assets contributed F No adjustment for any liabilities > basis n n + other partners' liabilities assumed n n - liabilities assumed by other partners n n + any service gain recognized n n + any investment company gain

Partnership's Basis in Contributed Assets n n Carryover basis for assets transferred n n Add any investment company gain recognized by partner n n No adjustment for liabilities > basis gain recognized n n Depreciation recapture potential and holding periods also carryover

Holding Periods in Partnership Transfer n Partner’s in partnership interest is determined by type of property transferred u If §1221 or §1231 = carryover u Otherwise, starts day after transfer n Partnership gets carryover

Tax Avoidance Rules n n 5-year character rule for u Inventory u Capital loss property n n Prevents partnership from converting use of property to avoid u Inventory--ordinary income treatment u Capital loss--limitations on loss deductions

Compliance Query: Inventory Transferred To A Partnership Taxpayer transferred inventory for 50% interest in a partnership and $6,000 in cash Basis to Transferor Fair Market Value $48,000$56,000 Calculate: Gain or loss realized/recognized by partner Basis/holding period in partnership interest P’ship’s basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred To A Partnership n n Realized/recognized gain is 0 n n Partner does not recognized gain on transfer to a partnership unless money/debt relief is more than adjusted basis of property transferred to partnership

Solution--Compliance Query: Inventory Transferred To A Partnership n n Shareholder’s basis in partnership = 42,000 CALCULATION Basis of property transferred to partnership 48,000 Money/debt relief Partnership basis 42,000

Solution--Compliance Query: Inventory Transferred To A Partnership n n Partnership’s basis in inventory = 48,000 CALCULATION Basis of property transferred to partnership 48,000 Investment gain recognized N/A Partnership’s basis 48,000

Solution--Compliance Query: Inventory Transferred To A Partnership n Partner’s holding period u Starts day after transfer u Inventory is not §1221 or §1231 n Partnership’s holding period is carryover, but inventory must retain its character as an ordinary income asset for 5 years

Choice of Corporate Capital Structure Key Learning Objectives n n Debt vs. equity

Choice of Capital Structure n Stock CommonPreferred n Debt Debt to equity ratio important Debt issued at transfer treated as boot

Stock General Rules n n §351 may apply n n Dividend payments are not deductible by corporation n n Corporation does not have to repay equity capital invested n n Stockholder has capital loss if stock becomes worthless or is sold at a loss u Unless it is §1244 stock

Debt General Rules n n Interest payments are deductible by corporation n n Corporation must also repay principal n n Holder of debt has a capital loss if debt becomes worthless or is sold at a loss n n Outside creditors may not like high debt to equity ratio

Special Topics Key Learning Objectives n n Other transfers to corporations n n Related party transactions—§267 n n Losses on §1244 stock

Other Transfers to Corporations n n Contributions without consideration n n Surrendering shares Contributions by nonshareholders n n Generally treated as nontaxable events

Related Party Transactions--§267 n n Related parties include n n Spouse, sibling, ancestor, descendant n n More than 50% owned corporations n n Other complex relationships

Related Party Transactions--§267 n n Disallowed property transaction losses n n Gain offset provision n n Unpaid expenses u Accrual basis payor deducts when cash basis payee includes in income

Related Party Transactions--§707 n n Applies many of §267 rules to partners and partnerships n n More than 50% owned partnerships

Losses on §1244 Stock n n Only first million $ of stock qualifies n n Only original stockholders eligible n n Owned by individuals, but not trusts/estates n n Ordinary loss treatment n n Limited to $50,000 u $100,000 married joint

Capital Costs Incurred in Organizing a Business Entity Key Learning Objectives n n Organizational and start-up costs Deducting organizational and start-up costs n n Syndication costs

Organizational and Start-up Expenditures n n Qualifying expenses n n Election n n Amortization n n Distinguish from syndication costs

Qualifying Expenses Organizational Costs n n §248 & §709 n n All expenses paid in creating a business entity n n Expenses for drafting documents u Organizational minutes, articles, partnership agreements bylaws, and stock certificates

Qualifying Expenses Start-up Costs--§195 n n All expenses incurred before beginning operations u Includes investigating creation or acquisition n Does not include u Interest u Taxes u Research and experimental expenditures

Election and Amortization Organization and Start-Up Costs n n Separate elections are required n n Election to amortize over 60 months n n Starting with month u Business begins--§248 u Active trade or business begins--§195 n n Untimely election will be denied

Research Query: When Does Business Begin? n §248 & §709 allow amortization to start in month business begins n §195 allows amortization to start in month active trade or business begins n Are these the same month? n Hint: u IRS Letter Rulings &

Solution-- Research Query: When Does Business Begin? n The amortization deduction begins when activities have advanced to the extent necessary to establish the nature of the business operation n For start-up expenditures, the IRS follows the standard of carrying on a trade or business found at §162(a) in determining when a trade or business begins

Syndication Costs--Corporations n n The costs paid to issue stock u Underwriter's commissions u Attorney's fees u Printing of stock certificates n n Must be deducted from cost of stock.

Syndication Costs--Partnerships n n Partnership interest sold as investment n n Includes u Printing fees u Brokerage commissions u Mailing expenses n n Must reduce basis in partnership interest by these amounts

Services Accounting Professionals Provide Key Learning Objectives n n Identifying the important filings n n Other tax and accounting assistance