© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporations, Partnerships, Estates & Trusts Chapter 4 Corporations: Organization and Capital Structure

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Corporation Formation Transaction

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Formation Example Ron will incorporate his donut shop: AssetFair Mkt Tax BasisValue. Cash$10,000$ 10,000 Furniture & Fixtures 20,000 60,000 Building 40, ,000 Total$70,000$170,000 Without §351: gain of $100,000. With §351: no gain or loss. Ron’s economic status has not changed.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Consequences of §351 (slide 1 of 2) In general, no gain or loss to transferors: –On transfer of property to corporation –In exchange for stock –IF immediately after transfer, transferors are in control of corporation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Consequences of §351 (slide 2 of 2) If boot (property other than stock) received by transferors –Gain recognized up to lesser of: Boot received or Realized gain –No loss is recognized

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Issues re: Formation (slide 1 of 7) Definition of property includes: –Cash –Secret processes and formulas –Unrealized accounts receivable (for cash basis taxpayer) –Installment obligations Code specifically excludes services from definition of property

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Issues re: Formation (slide 2 of 7) Stock transferred –Includes common and most preferred stock Does not include nonqualified preferred stock which possesses many attributes of debt –Does not include stock rights or stock warrants –Does not include corporate debt or securities (e.g., corporate bonds) Treated as boot

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Issues re: Formation (slide 3 of 7) Transferors must be in control immediately after exchange to qualify for nontaxable treatment –To have control, transferors must own: 80% of total combined voting power of all classes of stock entitled to vote, and 80% of total number of shares of all other classes of stock

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 Issues re: Formation (slide 4 of 7) “Immediately after” the transfer –Does not require simultaneous transfers if more than one transferor –Rights of parties should be outlined before first transfer –Transfers should occur as close together as possible

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Issues re: Formation (slide 5 of 7) After control is achieved, it is not necessarily lost upon the sale or gift of stock received in the transfer to others not party to the initial exchange But disposition might violate §351 if prearranged

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Issues re: Formation (slide 6 of 7) Transfers for property and services –May result in service provider being treated as a member of the 80% control group Taxed on value of stock issued for services Not taxed on value of stock received for property contributions –All stock received by the person transferring both property and services is counted in 80% test –To be considered a member of the 80% control group The service provider should transfer property having more than “a relatively small value”

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Issues re: Formation (slide 7 of 7) Subsequent transfers to existing corporation –Tax-free treatment still applies as long as transferors in subsequent transfer own 80% following exchange

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Assumption of Liabilities (slide 1 of 2) Assumption of liabilities by corp does not result in boot to the transferor shareholder for gain recognition purposes –Liabilities are treated as boot for determining basis in acquired stock Basis of stock received is reduced by amount of liabilities assumed by the corp

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Assumption of Liabilities (slide 2 of 2) Liabilities are not treated as boot for gain recognition unless: –Liabilities incurred for no business purpose or as tax avoidance mechanism Boot = Entire amount of liability –Liabilities > basis in assets transferred Gain recognized = Excess amount (liabilities - basis)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Formation with Liabilities Example (slide 1 of 2) Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = $ 50,000

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Formation with Liabilities Example (slide 2 of 2) Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $80,000 $120,000$120,000 Boot None $ 20,000$120,000 Gain Recognized None $20,000$ 50,000* *(Gain is lesser of $50,000 realized gain or boot)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Basis Computation for §351 Exchange (slide 1 of 2) Shareholder’s basis in stock: Adjusted basis of transferred assets + Gain recognized on exchange - Boot received -Liabilities transferred to corporation -Adjustment for loss property (if elected) = Basis of stock received by shareholder

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Basis Computation for §351 Exchange (slide 2 of 2) Corporation’s basis in assets: Adjusted basis of transferred assets + Gain recognized by transferor shareholder - Adjustment for loss property (if required) = Basis of assets to corporation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Basis in Stock in Last Example Adjusted Basis of transferred assets: $100,000 Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose. Liability: $ 80,000 $120,000 $120,000 Basis in assets Transferred $100,000 $ 100,000 $100,000 + Gain recognized None 20,000 50,000 - Liab. Transferred (80,000) (120,000) (120,000) Basis in stock $ 20, $ 30,000

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Corporation’s Basis in Assets Received in Last Example Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $ 80,000 $120,000 $120,000 Basis of trans- ferred assets: $100,000 $100,000 $100,000 Gain recognized by shareholder None 20,000 50,000 Basis to Corp. $100,000 $120,000 $150,000

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Basis Adjustment for Loss Property (slide 1 of 2) When built-in loss property is contributed to a corporation –Aggregate basis in property may have to be stepped down so basis does not exceed the F.M.V. of property transferred Necessary to prevent parties from obtaining double benefit from losses involved

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Basis Adjustment for Loss Property (slide 2 of 2) Step-down in basis is allocated among assets with built-in loss –Alternatively, if shareholder and corporation both elect, the basis reduction can be made to the shareholder’s stock Built-in loss adjustment places loss with either the shareholder or the corporation but not both

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Stock Issued for Services Rendered Corporation may be able to deduct the fair market value of stock issued in exchange for services as a business expense –e.g., Performance of management services –May claim a compensation expense deduction under §162 If the services are such that the payment is characterized as a capital expenditure (e.g., legal services in organizing the corporation) –Must capitalize the amount as an organizational expenditure

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Holding Period Holding period of stock received –For capital assets or §1231 property, includes holding period of property transferred to corporation –For other property, begins on day after exchange Corp’s holding period for property acquired in the transfer is holding period of transferor

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Recapture Considerations In a § 351 transfer where no gain is recognized, the depreciation recapture rules do not apply –Recapture potential associated with the property carries over to the corporation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Capital Contributions (slide 1 of 3) No gain or loss is recognized by corp on receipt of money or property in exchange for its stock –Also applies to additional voluntary pro rata contributions of money or property to a corp even though no additional shares are issued

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Capital Contributions (slide 2 of 3) Capital contributions of property by nonshareholders –Not taxable to corporation –Basis of property received from nonshareholder is -0-

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Capital Contributions (slide 3 of 3) Capital contributions of cash by nonshareholder –Must reduce basis of assets acquired during 12 month period following contribution –Any remaining amount reduces basis of other property owned by the corp Applied in the following order to depreciable property, amortizable property, assets subject to depletion, and other remaining assets

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Debt vs. Equity (slide 1 of 2) Debt –Corporation pays interest to debt holder which is deductible by corporation –Interest paid is taxable as ordinary income to individual or corporate recipient –Loan repayments are not taxable to investors unless repayments exceed basis

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Debt vs. Equity (slide 2 of 2) Equity: –Corporation pays dividends which are not deductible Taxable to individuals at low capital gain rates to extent corp has E & P Corporate shareholder may receive dividends received deduction

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Reclassification of Debt as Equity If corp is “thinly capitalized,” i.e., has too much debt and too little equity –IRS may argue that debt is really equity and deny tax advantages of debt financing –If debt has too many features of stock, principal and interest payments may be treated as dividends

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 Thin Capitalization Factors (slide 1 of 2) Debt instrument documentation Debt terms (e.g., reasonable rate of interest and definite maturity date) Timeliness of repayment of debt Whether payments are contingent on earnings

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 Thin Capitalization Factors (slide 2 of 2) Subordination of debt to other liabilities Whether debt and stock holdings are proportionate Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) Debt to equity ratio

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 Losses on Investment in Corporation (slide 1 of 5) Stock and security losses –If stocks and bonds are capital assets, losses from worthlessness are capital losses Loss is treated as occurring on last day of tax year in which they become worthless No loss for mere decline in value

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 Losses on Investment in Corporation (slide 2 of 5) Stock and security losses –If stocks and bonds are not capital assets, losses from worthlessness are ordinary losses (e.g., broker owned) –Sometimes an ordinary loss is allowed for worthlessness of stock of affiliated company

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 Losses on Investment in Corporation (slide 3 of 5) Business versus nonbusiness bad debts –General rule: Losses on debt of corporation treated as business or nonbusiness bad debt –If noncorporate person lends as investment, loss is nonbusiness bad debt Short-term capital loss Only deductible when fully worthless

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 Losses on Investment in Corporation (slide 4 of 5) Business versus nonbusiness bad debts (con’t) –If corporation is lender, loss is business bad debt Ordinary loss deduction Deduction allowed for partial worthlessness All bad debts of corporate lender qualify as business bad debts

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Losses on Investment in Corporation (slide 5 of 5) Business versus nonbusiness bad debts (con’t) –Noncorporate lender may qualify for business bad debt treatment if: Loan is made in some capacity that qualifies as a trade or business, or Shareholder is in the business of lending money or of buying, promoting, and selling corporations

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 §1244 stock (slide 1 of 4) Treatment of §1244 stock: –Ordinary loss treatment for loss on stock of “small business corporation” (as defined) –Gain still capital gain

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 §1244 stock (slide 2 of 4) §1244 stock: –Applies to the first $1 million of corp.'s stock If > $1 million of stock issued, entity designates which shares qualify for § 1244 treatment Property received in exchange for stock is valued at its adjusted basis, reduced by any liabilities assumed by the corporation –The fair market value of the property is not considered

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 §1244 stock (slide 3 of 4) Annual loss limitation: –$50,000 or –$100,000 if married filing joint return –Any remaining loss is a capital loss Only original holder of §1244 stock (whether an individual or a partnership) qualifies for ordinary loss treatment –Sale or contribution of stock results in loss of §1244 status

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 §1244 stock (slide 4 of 4) If §1244 stock is issued for property with basis > fair market value –For determining ordinary loss, stock basis is reduced to fair market value on date of exchange

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 Gain from Qualified Small Business Stock (slide 1 of 2) Noncorporate shareholders may exclude 50% (75% under ARRTA of 2009) of gain from sale or exchange of such stock –Must have held stock for > 5 years and acquired stock as part of original issue –50% exclusion can be applied to the greater of: $10 million, or 10 times shareholder’s aggregate adjusted basis of qualified stock disposed of during year

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 Gain from Qualified Small Business Stock (slide 2 of 2) Qualified Small Business Corp –C corp with gross assets not greater than $50 million on date stock issued –Actively involved in a trade or business At least 80% of corporate assets are used in the active conduct of one or more trade or businesses Under ARRTA of 2009, the exclusion increases to 75% for qualified small business stock acquired after February 17, 2009, and before 2011

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta