Incorporating a Business: Maximizing Advantages and Minimizing Taxes

1. Chapter 12 Corporations: Organization, Capital Structure, and Operating Rules

2. The Big Picture (slide 1 of 3) Amber has operated her business for 10 years as a sole proprietorship, but has decided to incorporate the business as Garden, Inc. She understands that the corporate form offers several important nontax advantages (e.g., limited liability). Also, the incorporation would enable her husband, Jimmy, to become a part owner in the business. Amber expects to transfer her business assets in exchange for her Garden stock, while Jimmy will provide accounting and legal services for his interest.

3. The Big Picture (slide 2 of 3) Amber’s sole proprietorship assets available for transfer to the new corporation are:

4. The Big Picture (slide 3 of 3) Aware of the double taxation problem associated with operating as a regular corporation, Amber is considering receiving some corporate debt at the time of incorporation. The interest expense on the debt will then provide a deduction for Garden, Inc. Amber’s main concern, however, is that the incorporation will be a taxable transaction. Can the transaction be structured to avoid tax? Read the chapter and formulate your response.

5. Various Business Forms Business operations can be conducted in a number of different forms including Sole proprietorships Partnerships Trusts and estates S corporations Regular corporations (also called C corporations)

6. Sole Proprietorship • Not a separate taxable entity • Income reported on owner’s Sch. C

7. Partnership (slide 1 of 2) Separate entity, but does not pay tax Files information return (Form 1065) Most income and expense items are aggregated in computing the ordinary business income (loss) of the partnership Certain income and expense items are reported separately to the partners e.g., Interest and dividend income, long term capital gain, charitable contributions and investment expenses

8. Partnership (slide 2 of 2) Partnership ordinary business income (loss) and separately reported items are allocated to partners according to their profit and loss sharing ratios Each partner receives a Schedule K–1 Reports partner’s share of partnership ordinary business income (loss) and separately stated items Each partner reports these items on his or her own tax return

9. S Corporation Separate entity, only pays special taxes (e.g., built-in gains) Files information return Form 1120S Similar to partnership taxation Ordinary business income (loss) flows through to the shareholders to be reported on their separate returns Certain items flow through to the shareholders and retain their separate character when reported on the shareholders’ returns. The S corporation ordinary business income (loss) and the separately reported items are allocated to the shareholders according to their stock ownership interests

10. C Corporation C corporations are subject to an entity-level Federal income tax which results in what is known as a double taxation effect. C corporation reports its income and expenses and computes tax on the taxable income reported on its Form 1120 Uses tax rate schedule applicable to corporations When corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level

11. Dividends • Double taxation stems, in part, from the fact that dividend distributions are not deductible by the corporation • To alleviate some of the double taxation effect, Congress reduced the tax rate applicable to dividend income of individuals for years after 2002 • Generally, dividends are taxed at same marginal rate applicable to a net capital gain • Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received • Individuals subject to the 25, 28, 33, or 35 percent marginal tax rates pay a 15% tax on qualified dividends

12. Corporate Income Tax Rates

13. Nontax Issues in Selecting Entity Form (slide 1 of 3) • Liability • Sole proprietors and some partners have unlimited liability for claims against the entity • Capital-raising • Corporations and partnerships to a lesser extent can raise large amounts of capital for entity ventures

14. Nontax Issues in Selecting Entity Form (slide 2 of 3) • Transferability • Corporate stock is easily sold, but partners must approve partnership interest transfer • Continuity of life • Corporations exist indefinitely

15. Nontax Issues in Selecting Entity Form (slide 3 of 3) • Centralized management • Corporate actions are governed by a board of directors • Partnership operations may be conducted by each partner without approval by other partners

16. Limited Liability Companies (LLC) • LLCs have proliferated since 1988 when IRS ruled it would treat qualifying LLCs as partnerships • Major nontax advantage • Allows owners to avoid unlimited liability • Major tax advantage • Allows qualifying business to be treated as a partnership for tax purposes, thereby avoiding double taxation associated with C corporations

17. Entity Classification After 1996 (slide 1 of 2) • Check-the-box Regulations • Allows taxpayer to choose tax status of entity without regard to corporate or noncorporate characteristics • Entities with > 1 owner can elect to be classified as partnership or corporation • Entities with only 1 owner can elect to be classified as sole proprietorship or as corporation

18. Entity Classification After 1996 (slide 2 of 2) • Check-the-box Regulations (cont’d) • If no election is made, multi-owner entities treated as partnerships, single person businesses treated as sole proprietorships • Election is not available to: • Entities incorporated under state law, or • Entities required to be corporations under federal law (e.g., certain publicly traded partnerships)

19. Corporation Formation Transaction

20. Formation Example Ron will incorporate his donut shop: Asset Fair Mkt Tax BasisValue . Cash $10,000 $ 10,000 Furniture & Fixtures 20,000 60,000 Building 40,000 100,000 Total $70,000$170,000 Without §351: gain of $100,000. With §351: no gain or loss. Ron’s economic status has not changed.

21. 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

22. 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

23. 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

24. 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

25. The Big Picture – Example 9Stock Transferred(slide 1 of 2) Return to the facts of The Big Picture on p. 12-1. Assume the proposed transaction qualifies under § 351 i.e., The transfer of property in exchange for stock meets the control test However, Amber decides to receive some corporate debt along with the stock.

26. The Big Picture – Example 9 Stock Transferred(slide 2 of 2) If she receives Garden stock worth $900,000 and corporate debt of $100,000 in exchange for the property transferred, Amber realizes gain of $600,000 $1,000,000 (value of consideration received) – $400,000 (basis in the transferred property). However, because the transaction qualifies under § 351, only $100,000 of gain is recognized. The $100,000 of corporate debt is treated as boot. The remaining realized gain of $500,000 is deferred.

27. 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

28. 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

29. 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

30. 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”

31. 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

32. The Big Picture – Example 16Transfers for Property and Services(slide 1 of 2) Return to the facts of The Big Picture on p. 12-1. Assume Amber transfers her $1,000,000 of property to Garden, Inc. and receives 50% of its stock. Jimmy receives the other 50% of the stock for services rendered (worth $1,000,000).

33. The Big Picture – Example 16Transfers for Property and Services(slide 2 of 2) Both Amber and Jimmy have tax consequences from the transfers. Jimmy has ordinary income of $1,000,000 because he does not exchange property for stock. Amber has a taxable gain of $600,000 $1,000,000 (fair market value of the stock in Garden) - $400,000 (basis in the transferred property). As the sole transferor of property, she receives only 50% of the corporation’s stock.

34. The Big Picture – Example 17 Transfers for Property and Services(slide 1 of 2) Assume the same facts as in Example 16 except that Jimmy transfers property worth $800,000 (basis of $260,000) in addition to services rendered to Garden, Inc. (valued at $200,000). Now Jimmy becomes a part of the control group. Amber and Jimmy, as property transferors, together receive 100% of the corporation’s stock.

35. The Big Picture – Example 17 Transfers for Property and Services(slide 2 of 2) Consequently, § 351 is applicable to the exchanges. As a result, Amber has no recognized gain. Jimmy does not recognize gain on the transfer of the property He does recognize ordinary income to the extent of the value of the shares issued for services rendered. Jimmy has current taxable income of $200,000.

36. 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

37. The Big Picture – Example 21 Assumption of Liabilities (slide 1 of 2) Return to the facts of The Big Picture on p. 12-1. Assume you learn that Amber’s husband, Jimmy, has lost interest in becoming a stockholder in Garden, Inc., and Amber’s building is subject to a liability of $70,000 that Garden assumes. Consequently, Amber receives 100% of the Garden stock and is relieved of the $70,000 liability The building has an adjusted basis of $400,000 and fair market value of $1,000,000.

38. The Big Picture – Example 21 Assumption of Liabilities (slide 2 of 2) The exchange is tax-free under § 351 The release of a liability is not treated as boot under § 357(a). However, the basis to Amber of the Garden stock is $330,000 $400,000 (basis of property transferred) − $70,000 (amount of the liability assumed by Garden).

39. 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)

40. 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)

41. Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = $ 50,000 Liabilities assumed by corp. (independent facts): Business Business No Business Purpose I Purpose IIPurpose Liability: $80,000 $120,000 $120,000 Formation with Liabilities Example (slide 1 of 3)

42. Formation with Liabilities Example (slide 2 of 3)

43. Liabilities assumed by corp. (independent facts): Business Business No Business Purpose IPurpose II Purpose Boot None None $120,000 Gain Recognized None $20,000 $ 50,000* *(Gain is lesser of $50,000 realized gain or boot) Formation with Liabilities Example (slide 3 of 3)

44. Basis Computation for §351 Exchange (slide 1 of 2)

45. Basis Computation for §351 Exchange (slide 2 of 2)

46. Basis in Stock in Last Example Adjusted Basis of transferred assets: $100,000 Liabilities assumed by corp. (independent facts): Business Business No Business PurposePurposePurpose. 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 $ 20,000 -0- $ 30,000

47. Corporation’s Basis in Assets Received in Last Example Liabilities assumed by corp. (independent facts): Business Business No Business PurposePurposePurpose 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

48. 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

49. 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

50. 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