Chapter 2: Corporate Formations and Capital Structure

1. Chapter 2:Corporate Formationsand CapitalStructure Chapter 2: Corporate Formations and Capital Structure

2. CORPORATE FORMATION • Alternative business forms • Check-the-box regulations • Legal requirements for forming a corporation • §351 deferrals • Choice of capital structure • Worthless stock or debt obligations

3. Forms of Business • Sole proprietorships • Partnerships • Corporations • C Corporations • S Corporations • Limited liability companies • Limited liability partnerships

4. Sole Proprietorship(1 of 2) • One owner • Not a separate entity • Income reported on Sch. C of 1040 • No limited liability • Tax advantages • Profits taxed once • No tax on contributions or withdrawals • Losses offset other income (with limitations)

5. Sole Proprietorship(2 of 2) • Tax disadvantages • Profits taxed as earned • Owner not employee • Profits subject to SE tax • Not eligible for some tax-exempt fringe benefits • No fiscal year deferral

6. Partnerships(1 of 3) • Two or more owners • Conduit entity • Reports, but does not pay income tax • No limited liability • Except for limited partners

7. Partnerships(2 of 3) • Tax advantages • Losses offset other income (with limitations) • Income retains its character • Income/gain increases basis

8. Partnerships(3 of 3) • Tax disadvantages • Profits taxed as earned • Partners not employees • Profits subject to SE tax • Not eligible for some tax-exempt fringe benefits • Fiscal year deferral difficult to obtain

9. C Corporations(1 of 2) • Separate taxpaying entity • Limited liability • Tax advantages • Tax rates start at 15% • Shareholders may be employees • No SE tax • Eligible for tax-exempt fringe benefits • May exclude 50% of gain on stock sale if certain requirements met

10. C Corporations(2 of 2) • Tax disadvantages • Double taxation of income • Corporate and shareholder level • However, tax rate at shareholder level is at capital gains rates (generally 15%) • Withdrawals (dividends) taxable • NOLs cannot be used in current year • Capital losses cannot offset ordinary income

11. S Corporations(1 of 3) • Conduit entity • Similar to a partnership, but • Less flexible than a partnership • Must file an election to be an S corp. • Subject to rules under Subchapter S • Follows same rules as a C Corp except for specific items addressed in Subchapter S

12. S Corporations(2 of 3) • Tax advantages • Generally exempt from taxation • Losses flow through to shareholders • Income retains its character • Income/gain increases basis • Shareholders may be employees • S Corp net income not subject to SE tax

13. S Corporations(3 of 3) • Tax disadvantages • Profits taxed as earned • S Corp shareholders generally not eligible for tax-exempt fringe benefits • S Corp cannot choose a fiscal year to obtain income deferral

14. Limited Liability Companies • Limited liability for all owners • No ownership restrictions • May be taxed as partnership or corporation

15. Limited Liability Partnership • Partners liable for only their own actions • No liability for negligence or misconduct of other partners • May be taxed as either a partnership or corporation

16. Check-the-Box Regulations • Unincorporated entities choose to be taxed as partnership or corp • Sole proprietor or corp if one owner • Entity must choose tax status or • Accept default status • Partnership (sole proprietor if one owner)

17. Requirements to Incorporate • Dependent on state law • Minimum capital requirements • File of articles or incorporation • Granting of charter by state • Issue of stock • Pay state incorporation fees

18. §351 Deferrals(1 of 2) • No gain or loss recognized if: • PROPERTY transferred in exchange for stock and • Transferors have control of corp immediately after the exchange • Transfers may be for new or existing corporations

19. §351 Deferrals(2 of 2) • Stock requirement • Tax effects on transferors • Tax effects on transferee corp • Assumption of liabilities • See Table C2-1 for a summary of corporate formation rules

20. §351 Deferrals:Property Requirement • Property does not include: • Services • Indebtedness of transferee not evidenced by a security • Interest on indebtedness of transferee that accrued on or after beginning of transferor’s holding period for the debt

21. §351 Deferrals:Control Requirement • Transferors must own at least: • 80% of total combined voting power of all classes of stock and • 80% of total number of shares of all other classes of stock • Contribution of services & property • Stock of transferor counted towards 80% if FMV of property  10% of service’s value

22. §351 Deferrals:Tax Effects on Transferors (1 of 3) • General rules • No gain or loss recognized • Basis in stock same as basis in property (substituted basis) • Holding period of stock includes holding period of assets

23. §351 Deferrals:Tax Effects on Transferors (2 of 3) • When boot received • Gain recognized lesser of gain realized or FMV of boot received • Gain recognized when liabilities transferred exceed basis in assets transferred • Basis in stock increased by gain recognized

24. §351 Deferrals:Tax Effects on Transferors (3 of 3) • When boot received (continued) • Basis in boot property is FMV • Holding period of boot begins day after exchange

25. §351 Deferrals: Tax Effects on Transfee Corp (1 of 2) • No gain or loss recognized • Basis in property received • Transferor’s adjusted basis plus • gain recognized • Basis = total FMV of property transferred when basis in property transferred > FMV • If all s/h agree, s/h that contributed property can reduce her basis in stock instead of corp reducing basis in assets

26. §351 Deferrals: Tax Effects on Transfee Corp (2 of 2) • Depreciation recapture potential transfers to transferee corporation • Holding period includes transferor’s holding period • Holding period begins day after transfer when basis reduced to FMV

27. Choice of Capital Structures Debt Interest deductible by corp Repayment of debt not taxable to s/h Debt received in §351 is boot to s/h Worthless debt is capital loss to s/h Debt distributed by corp taxable to s/h Equity Dividends not deductible by corp S/h only pays max 15% on dividends received Stock redemption can be taxable dividend to s/h Stock received in §351 not boot to s/h Worthless §1244 stock is ordinary loss to s/h Stock distributed by corp not taxable to s/h

28. Choice of Capital Structures:(1 of 2: Debt) • Interest deductible by corp • Repayment of debt not taxable to s/h • Debt received in §351 is boot to s/h • Worthless debt is capital loss to s/h • Debt distributed by corp taxable to s/h

29. Choice of Capital Structures:(2 of 2: Equity) • Dividends not deductible by corp • S/h only pays max 15% on div. received • Stock redemption can be taxable dividend to s/h • Stock received in §351 not boot to s/h • Worthless §1244 stock is ordinary loss to s/h • Stock distributed by corp not taxable to s/h

30. Worthless Stock or Debt(1 of 3) • Investment evidenced by a security that becomes worthless produces a capital loss on last day of tax year • Securities include: • Stock of a corporation • Rights to subscribe for stock to be issued • Evidence of indebtedness

31. Worthless Stock or Debt(2 of 3) • Ordinary Loss Situations • Securities that are noncapital assets • Securities of affiliated companies • §1244 stock

32. Worthless Stock or Debt(3 of 3) • §1244 stock • Qualifying small business stock • Must be the original purchaser • Ordinary loss up to $50k or $100k if MFJ • Corp must have received $1M or less of property in exchange for stock

33. End of Chapter 2 Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’sKenneth W. Monfort College of Businessrichard.newmark@PhDuh.com