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Chapter 3

Chapter 3. Corporations: Organization and Capital Structure. The Big Picture (slide 1 of 3). Emily has operated her business for 10 years as a sole proprietorship, but has decided to incorporate the business.

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Chapter 3

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  1. Chapter 3 Corporations: Organization and Capital Structure

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

  3. The Big Picture (slide 2 of 3) Emily’s sole proprietorship assets available for transfer to the new corporation are: Adjusted Fair Market Basis Value Accounts receivable $ –0– $ 25,000 Building 50,000 200,000 Other assets 150,000275,000 $200,000 $500,000

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

  5. Corporation Formation Transaction

  6. 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. Formation Example

  7. 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

  8. 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

  9. 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

  10. 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

  11. The Big Picture – Example 4Stock Transferred(slide 1 of 2) Return to the facts of The Big Picture on p. 4-2. Assume the proposed transaction qualifies under § 351 i.e., The transfer of property in exchange for stock meets the control test However, Emily decides to receive some corporate debt along with the stock.

  12. The Big Picture – Example 4 Stock Transferred(slide 2 of 2) If she receives stock worth $450,000 and corporate debt of $50,000 in exchange for the property transferred, Emily realizes gain of $300,000 [$500,000 (value of consideration received) – $200,000(basis in the transferred property)]. However, because the transaction qualifies under § 351, only $50,000 of gain is recognized—the $50,000 of corporate debt is treated as boot. The remaining realized gain of $250,000 is deferred.

  13. 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

  14. 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

  15. 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

  16. 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”

  17. 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

  18. The Big Picture – Example 9 Transfers for Property and Services(slide 1 of 2) Return to the facts of The Big Picture on p. 4-2. Assume Emily transfers her $500,000 of property to the new corporation and receives 50% of its stock. David receives the other 50% of the stock for services rendered (worth $500,000).

  19. The Big Picture – Example 9Transfers for Property and Services(slide 2 of 2) Both Emily and David have tax consequences from the transfers. David has ordinary income of $500,000 because he does not exchange property for stock. Emily has a taxable gain of $300,000 $500,000 (fair market value of the stock in the new corporation) - $200,000 (basis in the transferred property). As the sole transferor of property, she receives only 50% of the corporation’s stock.

  20. The Big Picture – Example 10 Transfers for Property and Services(slide 1 of 2) Assume the same facts as in Example 9 except that David transfers property worth $400,000 (basis of $130,000) in addition to services rendered to the corporation (valued at $100,000). Now David becomes a part of the control group. Emily and David, as property transferors, together receive 100% of the corporation’s stock.

  21. The Big Picture – Example 10 Transfers for Property and Services(slide 2 of 2) Consequently, § 351 is applicable to the exchanges. As a result, Emily has no recognized gain. David 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. David has current taxable income of $100,000.

  22. 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

  23. 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)

  24. Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = $ 50,000 Formation with Liabilities Example (slide 1 of 2)

  25. Liabilities assumed by corp. (independent facts): Business Business No Business PurposePurpose 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) Formation with Liabilities Example (slide 2 of 2)

  26. 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

  27. 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

  28. 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 Basis in Stock in Last Example

  29. 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 Corporation’s Basis in Assets Received in Last Example

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. Capital Contributions (slide 2 of 3) • Capital contributions of property by nonshareholders • Not taxable to corporation • Basis of property received from nonshareholder is -0-

  37. 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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

  44. 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

  45. 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

  46. 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

  47. 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

  48. §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

  49. §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

  50. §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

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