Chapter 14 Taxation of Corporations —Basic Concepts

Entity choice • Sole proprietorship • Partnership • Corporation CCH Federal Taxation Comprehensive Topics

Corporation Defined Either an organization incorporated under state law, or an unincorporated association that has “checked the box” for corporate tax treatment on Form 8832 (Entity Classification Election). (Code Sec. 7701; Reg. §301.7701-1 to 3.) Chapter 14, Exhibit 5a CCH Federal Taxation Comprehensive Topics

Corporation Defined Two Classifications of Corporate Entities C Corporations. Taxpaying entities. (This results in what is known as a double tax effect. The corporation computes tax on the net income When a corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns.) S Corporations. Not subject to regular corporate income tax. They are treated in a manner similar to partnerships, i.e., as pass-through entities, in that net profit or loss flows through to the owners to be reported on their separate returns. Chapter 14, Exhibit 5b CCH Federal Taxation Comprehensive Topics

C Corporations—Tax Formula Chapter 14, Exhibit 9 CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 What is the general rule on transferring property to a corporation in exchange for stock? Code Sec. 351 requires that no gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation and immediately after the exchange, such person or persons control the corporation. This non-recognition treatment is mandatory, not elective. Note that Code Sec. 351 protects only the transfer of property. It does not protect the transfer of services. Also, Code Sec. 351 applies even after a corporation has been formed. Chapter 14, Exhibit 38a CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 What was Congress thinking when it enacted Code Sec. 351? There are two reasons for Code Sec. 351. First, as the stockholders receive only stock, they may not have the wherewithal to pay taxes. Second, the incorporation of a going concern is not an economic transaction but rather a change in legal form only. Chapter 14, Exhibit 38b CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 What is “control”? Control is ownership by all transferors of property of 80% or more of BOTH the voting power AND the value of all classes of stock. Do not include the % ownership of transferors of services in this determination. Chapter 14, Exhibit 38c CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 What is “property”? Consistent with Code Sec. 351(d) “property” includes just about everything except services (i.e., cash, inventory, receivables, land, other tangible assets, nonexclusive licenses and industry know-how). Chapter 14, Exhibit 38d CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 Why are “services” NOT “property’? Under Code Sec. 351(d)(1), services are NOT property to ensure that a person who provides ONLY services to a corporation (1) will be taxed immediately (on the FMV of stock received); and (2) will NOT be included in the 80% control computation. Chapter 14, Exhibit 38e CCH Federal Taxation Comprehensive Topics

Formation of Corporations—Overview of Code Sec. 351 How does Code Sec. 351 apply if a person contributes both property and services? The receipt of stock attributable to services will generally be treated as a separate transaction outside the scope of Code Sec. 351. [However, the stock received in exchange for part property, part services will ALL be included in the 80% control computation!] Chapter 14, Exhibit 38f CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contribution of Part Property/Part Services—Example Chapter 14, Exhibit 39a CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contribution of Part Property/Part Services—Example Chapter 14, Exhibit 39b CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contribution of Part Property/Part Services—Example Chapter 14, Exhibit 39c CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Shareholders What is the recognized gain of shareholders in a Code Sec. 351 transfer of property for stock? Code Sec. 351(b) provides that a shareholder’s recognized gain will be the smaller of (1) boot received or (1) realized gain. (Students should not confuse Code Sec. 351 boot with Sec. 1031 “net boot received”—that term applied to like-kind exchanges under Code Sec. 1031) Here, boot is money and the FMV of property other than the common stock of the corporation received in the exchange. Also, under Code Sec. 358(c), a shareholder liability assumed by the corporation is boot if it exceeds the AB of all property contributed by the shareholder. If not, then it’s not boot. Chapter 14, Exhibit 40a CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Shareholders • Transfer of liabilities not normally considered boot for gain recognition purposes, instead it is a normal part of the transaction. • If there is a tax avoidance purpose or no business purpose, then all liabilities are treated as boot. CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Shareholders How is the basis of the stockholder in the stock determined? Code Sec. 358 provides the following formula (referred to as the “front-in” approach): AB in contributed property – Fair market value of boot received, including liabilities assumed by corporation that ARE boot – Liabilities of shareholder assumed by corporation that are NOT boot. Code Sec. 358(d) + Gain recognized by the shareholder (calculated by the lesser of the realized gain or the FMV of the boot received) – Loss recognized by the shareholder = SHAREHOLDER BASIS OF STOCK Chapter 14, Exhibit 40b CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Shareholders How is a shareholder’s holding period in the stock determined? The holding period of the property contributed tacks on to the stock received. If several properties have been contributed, the stock will have a split holding period! Chapter 14, Exhibit 40c CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Shareholders What is a shareholder’s basis and holding period in the boot received? The shareholder’s basis in boot received is generally the corporation’s basis (not FMV). The holding period of boot received does not tack on as does stock received. Instead, it begins on the day AFTER receipt. Chapter 14, Exhibit 40d CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Corporations What is the corporation’s basis in the assets transferred by shareholders? Code Sec. 362 provides that the basis of assets received by a corporation in a Code Sec. 351 transfer will be (a) + (b), where: (a) = Shareholder’s basis in contributed property (b) = Gain recognized by the shareholder, allocated using relative fair market value’s. (a) = (a) + (b) = Corporation’s basis in assets contributed by shareholders Chapter 14, Exhibit 41a CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Tax Effect on Corporations What is the corporation’s holding period in the assets contributed by a shareholder? Same as the holding period of the shareholder. Does the corporation recognize gain or loss on the exchange of its stock for property under Code Sec. 351? No, never. What about property other than stock transferred by the corporation? If a corporation transfers other property to shareholder, then YES, it generally recognizes gain (but not loss) based on [FMV - AB]. Chapter 14, Exhibit 41b CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42a CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Example 1 Question: Compute the following items: • Dennis’ realized gain • Dennis’ boot received • Dennis’ recognized gain • Dennis’ postponed gain • Dennis’ basis in the stock received • Dennis’ holding period in the stock received • The corporation’s basis in the land and building contributed by Dennis • The corporation’s holding period in the land and building Chapter 14, Exhibit 42b CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ realized gain: (a) = Amount Realized – Basis of contributed property = Realized gain (Similar to rules for any disposition) FMV of land………………....... 1 + FMV of bldg..........…….......+ 14 – Mtg. assumed by corporation …(6) = Net value of assets .(i.e., Dennis’ amount realized) ………………9 – Basis of contributed property (2mm land + 3mm bldg)….. 5 = Dennis’ realized gain............…. 4 4 Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42c CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ boot received (b) = Excess debt relief (i.e., debt relief—AB of assets contributed) + FMV of other boot received Dennis’ debt relief.……………... 6 – Basis of contributed property (2mm land + 3mm bldg)……...... (5) = Excess debt relief.…………...... 1 + FMV of other boot received...... 0 = Dennis’ total boot received....... 1 1 Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42d CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ recognized gain: (c) = Lesser of (a) or (b) (Similar to “like-kind” exchange rules) (a) = 4,000,000 (b) = 1,000,000 (c) = 1,000,000 (the lesser amount) 1 Code Sec. 351 Contributions—Example 1 Note: See previous slides for values. Chapter 14, Exhibit 42e CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ postponed gain: (d) = (a) – (c) (d) = $4,000,000 – $1,000,000 = $3,000,000 3 Code Sec. 351 Contributions—Example 1 Note: See previous slides for values. Chapter 14, Exhibit 42f CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ basis in the stock received: Dennis’ stock basis can be determined two ways: • Using the Code Sec. 358 formula, i.e., the “front-in” approach (shown above) • Using the “back-in” approach, as was done for like-kind property received Front-in approach: Stock basis: + AB in cont’d property……… 5 - Boot rec’d……..(1) - Debt relief, nonboot (6-1)….(5) + Gain recog’d…..1 - Loss recog’d….. 0 = Stock basis …... 0 Back-in approach: (Here, the stock’s FMV must first be “plugged” from amount realized): FMV of stock: Amt realized………9 - Debt relief………(6) = Stock FMV…… 3 Stock basis: Stock FMV……. 3 -Postponed gain…. (3) = Stock basis…….. 0 0 Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42g CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s Dennis’ holding period in the stock received: (f) = Same as holding period of the contributed property • Note 1. Since more than one property was contributed for the stock, each share will have a split holding period (HP). • Note 2. The HP rules for Code Sec. 351 stock is similar to HP rules for like-kind assets received under Code Sec. 1031. • HP of 1/15 share begins on 3/21/97; • HP of 14/15 share begins on 8/19/x1. (Thus, as of 12/31/x1, 1/15 of each share is deemed to be long-term, and 14/15 short-term!) Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42h CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s The corporation’s basis in the assets received: The corporation’s basis in the land and building can be determined using the Sec. 362 above. Land Bldg. Dennis’ asset basis + Alloc. of recog. gain: 1 mm x [ 1  (1 + 14)] 1 mm x [14  (1 + 14)] Corporation’s basis 2,000,000 66,667 2,066,667 3,000,000 933,333 3,933,333 Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42i CCH Federal Taxation Comprehensive Topics

Solution: Formula Computation 000’s The corporation’s holding period in assets received: (h) = Same as shareholder’s HP HP beginning date Land Bldg. 3/15/97 8/19/x1 (Same as Dennis’ HP) Code Sec. 351 Contributions—Example 1 Chapter 14, Exhibit 42j CCH Federal Taxation Comprehensive Topics

FACTS: Anu, Ellsworth and Tebessum decided to pool their efforts and form a corporation. They made the following contributions to the corporation: Stockholder Asset FMV AB to S/H # shares issued Anu Services $ 30,000 $ 0 30 Ellsworth Land 70,000 20,000 60 Tebessum Equipment 10,000 11,000 10 TOTALS $110,000 100 The fair market value of the stock is $1,000 per share. Ellsworth’s land is subject to a $10,000 mortgage which the corporation assumed. Code Sec. 351 Contributions—Example 2 Chapter 14, Exhibit 43a CCH Federal Taxation Comprehensive Topics

QUESTION 1: Does this transfer of assets qualify for Code Sec. 351 treatment? SOLUTION 1: No, Anu is not a transferor of property. Only Ellsworth and Tebessum can be included in the control computation. Since their combined control is only 70% [(60 + 10) 100], the  80% control requirement has not been met. What would be the result if Anu had also contributed $1.00? Answer would be the same. Anu would have to contribute an asset with a FMV of at least 10% of the value of the services. Code Sec. 351 Contributions—Example 2 Chapter 14, Exhibit 43b CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Example 2 Chapter 14, Exhibit 43c CCH Federal Taxation Comprehensive Topics

Code Sec. 351 Contributions—Example 2 Chapter 14, Exhibit 43d CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Owner Perspective Chapter 14, Exhibit 36a CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Owner Perspective Chapter 14, Exhibit 36b CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Owner Perspective Chapter 14, Exhibit 36c CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Owner Perspective Chapter 14, Exhibit 36d CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Entity Perspective Chapter 14, Exhibit 37a CCH Federal Taxation Comprehensive Topics

Formation of C Corps, S Corps and Partnerships—Entity Perspective Chapter 14, Exhibit 37b CCH Federal Taxation Comprehensive Topics

Corporate Capital Structure • Equity • No gain or loss on the receipt of money or property that is rec’d in exchange for its stock or contributed to capital • Debt • Interest deductibility • Avoid Accumulated Income Tax • Sec. 1244 Stock • Only original holders of the stock eligible • Loss treated as an ordinary loss (S-$50K, MFJ-$100K), gain as capital gain • Sec. 1202 Stock • Original holders of the stock can exclude 50% of the gain, held for > 5 years • Non corporate taxpayers to aid in small business capital formation CCH Federal Taxation Comprehensive Topics

Exclusions Requiring Special Treatment Capital Contributions Pro rata contributions from shareholders are excluded. Whether voluntary or by assessment, shareholder contributions are excluded from corporate income. The corporation carries the property at the same basis as had been reported by the contributing shareholder. That shareholder gets no deduction, but does get an increase in stock basis, equal to the basis in the property contributed. Chapter 14, Exhibit 12c CCH Federal Taxation Comprehensive Topics

Exclusions Requiring Special Treatment Capital Contributions Gifts from nonshareholders are excluded. · Noncash gifts. If a gift is property other than money, the corporation carries it with a zero basis. ·Cash gifts. When cash is contributed, reduce the basis of corporate property in the following order: (i) Property acquired within 1 year after the contribution; (ii) Then depreciable property in proportion to relative bases; (iii) Then, if there is a remaining balance, NON-depreciable property acquired over 1 year after the contribution. Chapter 14, Exhibit 12b CCH Federal Taxation Comprehensive Topics

C Corporations—Tax Years Every newly organized corporation other than a personal service corporations (PSC) has the unrestricted right to select its annual tax year, regardless of the tax years employed by its shareholders. In general, other entities do not have this option. Chapter 14, Exhibit 7 CCH Federal Taxation Comprehensive Topics

C Corporations—Accounting Methods Most corporations must use the accrual method. The cash method MAY be used by C corporations that have average annual gross receipts of $5 million or less in the 3 preceding years, or by PSCs. Chapter 14, Exhibit 8 CCH Federal Taxation Comprehensive Topics

C Corporations—Capital Gains/Losses • Short term and long term gains and losses are kept separate. A corporation determines its net short term and net long term position. If the positions are opposites, then they are netted to obtain an overall net position. If they are not opposite, then they are not netted. Net capital gains are taxed at regular corporate rates. Net losses cannot offset ordinary income and are carried back 3 and forward 5 tax years. If not used, they are lost. CCH Federal Taxation Comprehensive Topics

Deductions Requiring Special Treatment—Capital Gains and Losses Chapter 14, Exhibit 24a CCH Federal Taxation Comprehensive Topics

Deductions Requiring Special Treatment—Capital Gains and Losses Chapter 14, Exhibit 24b CCH Federal Taxation Comprehensive Topics

Comparison Between Corporations and Individuals Corporations Individuals Computing NOL Net capital losses are never part of NOL since they are not deductible. Therefore, no addback to taxable income (TI). Net capital gains are not subtracted from TI (i.e., capital gains reduce NOLs). Net nonbusiness capital losses are added back to taxable income (TI). (Note that they are always  $3,000); Net nonbusiness capital gains are subtracted from NBD to determine the adjustment for NBD in excess of NBI. Deductions Requiring Special Treatment—Capital Gains and Losses Chapter 14, Exhibit 24c CCH Federal Taxation Comprehensive Topics

Chapter 14 Taxation of Corporations —Basic Concepts