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Module 6 Entity Formation and Start-up

Module 6 Entity Formation and Start-up. Module Topics. Transferring assets to a business: general concepts Creating the corporate capital structure Other transfers to corporations Organization costs and start-up expenses Accountant's role in business formation.

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Module 6 Entity Formation and Start-up

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  1. Module 6Entity Formation and Start-up

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

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

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

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

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

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

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

  9. Corporation's Basis in Property Received • Basis of property transferred in • Plus any shareholder gain recognized

  10. 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

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

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

  13. Solution--Compliance Query: Services Transferred for Stock • 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

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

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

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

  17. 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

  18. Solution--Compliance Query: Inventory Transferred in a §351 Transaction • Realized gain is 8,000 • 56,000 - 48,000 • Recognized gain = 6,000 • Gain is recognized to the extent of boot received, but never more than the realized gain. • 6,000 of boot was received

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

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

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

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

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

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

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

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

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

  28. 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

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

  30. Solution--Compliance Query: Inventory Transferred To A Partnership • Shareholder’s basis in partnership = 42,000 CALCULATION Basis of property transferred to partnership 48,000 Money/debt relief <6,000> Partnership basis 42,000

  31. Solution--Compliance Query: Inventory Transferred To A Partnership • 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

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

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

  34. Choice of Capital Structure • Stock Common Preferred • Debt Debt to equity ratio important Debt issued at transfer treated as boot

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

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

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

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

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

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

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

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

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

  44. Organizational and Start-up Expenditures • Qualifying expenses • Election • Amortization • Distinguish from syndication costs

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

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

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

  48. Research Query:When Does Business Begin? • §248 & §709 allow amortization to start in month business begins • §195 allows amortization to start in month active trade or business begins • Are these the same month? • Hint: • IRS Letter Rulings 9027002 & 9047032

  49. Solution-- Research Query:When Does Business Begin? • The amortization deduction begins when activities have advanced to the extent necessary to establish the nature of the business operation • 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

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

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