2009 Pearson Education Inc Publishing as Prentice Hall
© 2009 Pearson Education, Inc. Publishing as Prentice Hall 2 -1
CORPORATE FORMATIONS & CAPITAL STRUCTURE (1 of 2) ® Organization forms available ® Check-the-box regulations ® Legal requirements forming a corporation ® Tax considerations in forming a corporation © 2009 Pearson Education, Inc. Publishing as Prentice 2 -2
CORPORATE FORMATIONS & CAPITAL STRUCTURE (2 of 2) ® § 351: Deferring gain or loss upon incorporations ® Choice of capital structure ® Worthlessness of stock or debt obligations ® Tax planning considerations ® Compliance and procedural considerations ® Financial Statement Implications © 2009 Pearson Education, Inc. Publishing as Prentice 2 -3
Organization Forms Available ® Sole proprietorships ® Partnerships ® Corporations C Corporations S Corporations ® Limited liability companies ® Limited liability partnerships ® Limited liability limited partnership © 2009 Pearson Education, Inc. Publishing as Prentice 2 -4
Sole Proprietorship (1 of 3) ® One owner ® Not a separate legal entity Income ® No reported on Sch. C of 1040 limited liability © 2009 Pearson Education, Inc. Publishing as Prentice 2 -5
Sole Proprietorship (2 of 3) ® Tax advantages Profits taxed once Proprietor’s marginal tax rate may be lower than if business were taxed as a corporation No tax on contributions or withdrawals Losses offset other income (with limitations) © 2009 Pearson Education, Inc. Publishing as Prentice 2 -6
Sole Proprietorship (3 of 3) ® Tax disadvantages Profits taxed as earned, not as received Corporate tax rates may be lower than proprietor’s marginal tax rate Owner not employee ¬Profits subject to SE tax ¬Not eligible for some tax-exempt fringe benefits ¬Compensation to owner not deductible No fiscal year deferral © 2009 Pearson Education, Inc. Publishing as Prentice 2 -7
Partnerships (1 of 3) ® Two or more owners ® Conduit entity Reports, ® No but does not pay income tax limited liability Except for limited partners © 2009 Pearson Education, Inc. Publishing as Prentice 2 -8
Partnerships (2 of 3) ® Tax advantages No partnership-level taxes ¬Income only taxed at partner level Losses offset other income (with limitations) Contributions and withdrawals generally not subject to taxation Income retains its character Income/gain increases basis © 2009 Pearson Education, Inc. Publishing as Prentice 2 -9
Partnerships (3 of 3) ® Tax disadvantages Profits taxed as earned, not when received Partners not employees ¬Profits subject to SE tax ¬Not eligible for some tax-exempt fringe benefits Fiscal year deferral difficult to obtain ¬Cannot use fiscal year-end to defer income © 2009 Pearson Education, Inc. Publishing as Prentice 2 -10
C Corporations (1 of 3) ® Separate taxpaying and legal entity ® Limited liability ® Taxation at corporate level Rates 15% - 35% ® Dividend distributions taxed to owners at lower capital gains tax rates © 2009 Pearson Education, Inc. Publishing as Prentice 2 -11
C Corporations (2 of 3) ® Tax advantages Corp’s marginal tax rate may be lower than owners’ tax rates Shareholders may be employees ¬No SE tax ¬Eligible for tax-exempt fringe benefits ¬Compensation to owners deductible May choose fiscal year © 2009 Pearson Education, Inc. Publishing as Prentice 2 -12
C Corporations (3 of 3) ® Tax disadvantages Double taxation of income ¬Corporate and shareholder level ªHowever, 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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -13
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 2 -14 © 2009 Pearson Education, Inc. Publishing as Prentice
S Corporations (2 of 3) ® Tax advantages Generally exempt from taxation Losses flow through to shareholders Income retains its character Contributions and withdrawals generally not subject to taxation Income/gain increases basis Shareholders may be employees ¬S Corp net income not subject to SE tax © 2009 Pearson Education, Inc. Publishing as Prentice 2 -15
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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -16
Limited Liability Companies ® Limited liability for all owners ® No ownership restrictions ® May be taxed as partnership or corporation © 2009 Pearson Education, Inc. Publishing as Prentice 2 -17
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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -18
Check-the-Box Regulations (1 of 2) ® 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) © 2009 Pearson Education, Inc. Publishing as Prentice 2 -19
Check-the-Box Regulations (2 of 2) ® Change in status results in a deemed liquidation/reincorporation Partner electing corp status is nontaxable Corp electing to be disregarded is taxable © 2009 Pearson Education, Inc. Publishing as Prentice 2 -20
Legal Requirements for Forming a Corporation ® Dependent on state law ® Minimum capital requirements ® Filing articles of incorporation ® Issuing stock ® Paying state incorporation fees May be assessed franchise taxes © 2009 Pearson Education, Inc. Publishing as Prentice 2 -21
Tax Considerations in Forming a Corporation ® Items affecting tax consequences of forming a corporation Property to be transferred Services to be provided Liabilities transferred How property should be transferred ¬E. g. , contribution, sale © 2009 Pearson Education, Inc. Publishing as Prentice 2 -22
§ 351 Deferring Gain or Loss upon Incorporation (1 of 2) ® No gain or loss recognized if: PROPERTY transferred in exchange for stock and Transferors have control (80%) of corp immediately after the exchange ® Transfers may be for new or existing corporations © 2009 Pearson Education, Inc. Publishing as Prentice 2 -23
§ 351 Deferring Gain or Loss upon Incorporation (2 of 2) ® Property requirement ® Control requirement ® Stock requirement ® Effect of § 351 on transferors ® Effect of § 351 on transferee corp ® Assumption of the transferor’s liabilities ® Other considerations in a § 351 exchange © 2009 Pearson Education, Inc. Publishing as Prentice 2 -24
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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -25
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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -26
Effect of § 351 on Transferors (1 of 4) ® 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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -27
Effect of § 351 on Transferors (2 of 4) ® Receipt of boot 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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -28
Effect of § 351 on Transferors (3 of 4) ® Receipt of boot (continued) Basis in boot property is FMV Holding period of boot begins day after exchange © 2009 Pearson Education, Inc. Publishing as Prentice 2 -29
Effect of § 351 on Transferors (4 of 4) ® Computing shareholder’s basis Adjusted basis of property transferred + Gain recognized by transferor - Money received - Liabilities assumed by transferee corp = Shareholder’s basis in corp stock © 2009 Pearson Education, Inc. Publishing as Prentice 2 -30
Effect of § 351 on Transferee Corp (1 of 3) ® No gain or loss recognized Transferor’s adjusted basis plus + Gain recognized by transferee (if any) - Reduction for loss property (if applicable) = Transferee corp’s basis in property © 2009 Pearson Education, Inc. Publishing as Prentice 2 -31
Effect of § 351 on Transferee Corp (2 of 3) ® Loss property limitation When basis > FMV of prop transferred ¬Corp’s basis = FMV AND ªReduction in basis allocated to other assets OR ªContributing s/h reduces her basis in corp stock ® Corp recognizes gain if appreciated property transferred to transferor in § 351 exchange © 2009 Pearson Education, Inc. Publishing as Prentice 2 -32
Effect of § 351 on Transferee Corp (3 of 3) ® 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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -33
Assumption of the Transferor’s Liabilities (1 of 2) ® General rule - § 357(a) Assumption of liabilities by transferee corp not considered receipt of money Does not trigger gain Increases amount realized by transferee Decreases transferee’s basis in stock ® If no bona fide business purpose Assumption of liabilities considered receipt of money © 2009 Pearson Education, Inc. Publishing as Prentice 2 -34
Assumption of the Transferor’s Liabilities (2 of 2) ® Liabilities in excess of basis - § 357(c) Total liabilities transferred to corp - Total adj basis of property transferred Gain recognized © 2009 Pearson Education, Inc. Publishing as Prentice 2 -35
Other Considerations in a § 351 Exchange (1 of 2) ® Depreciation recapture Transferee corp inherits transferor’s depreciation recapture potential ® Computing depreciation Transferee corp must use same method and recovery period as transferor Allocate depreciation expense for year of transfer based on # of months held 2 -36 © 2009 Pearson Education, Inc. Publishing as Prentice
Other Considerations in a § 351 Exchange (2 of 2) ® Assignment of income doctrine Transferee generally recognizes income when A/R collected and deductions when pays A/P of cashbasis transferor © 2009 Pearson Education, Inc. Publishing as Prentice 2 -37
Choice of Capital Structures ® ® ® Debt Interest deductible by corp® Repayment of debt not taxable to shareholder Debt received in § 351 is ® boot to shareholder Worthless debt is capital ® loss to shareholder Debt distributed by corp ® taxable to shareholder Equity Dividends not deductible by corp Shareholder only pays max 15% on dividends received Stock redemption can be taxable dividend to shareholder Stock received in § 351 not boot to shareholder Worthless § 1244 stock is ordinary loss to shareholder ® Stock distributed by corp not taxable to shareholder 2 -38 © 2009 Pearson Education, Inc. Publishing as Prentice
Choice of Capital Structures: Debt ® Interest deductible by corp ® Debt repayment 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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -39
Choice of Capital Structures: Equity ® Dividends S/h not deductible by corp 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 stk ordinary loss to s/h ® Stock distributed by corp not taxable to 2 -40 s/h © 2009 Pearson Education, Inc. Publishing as Prentice
Choice of Capital Structures: Contributions by Nonshareholders (1 of 2) ® E. g. . , state, local, and city governments Contributions of money and/or property to encourage a corporation to move to a particular location ® Basis of property acquired by is zero © 2009 Pearson Education, Inc. Publishing as Prentice 2 -41
Choice of Capital Structures: Contributions by Nonshareholders (2 of 2) ® Property purchased w/in 12 months of cash contribution reduced by cash received Basis of other non-cash assets reduced by remaining cash at end of 12 -month period © 2009 Pearson Education, Inc. Publishing as Prentice 2 -42
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 © 2009 Pearson Education, Inc. Publishing as Prentice 2 -43
Worthless Stock or Debt (2 of 3) ® Ordinary Loss Situations Securities that are noncapital assets Securities of affiliated companies § 1244 stock © 2009 Pearson Education, Inc. Publishing as Prentice 2 -44
Worthless Stock or Debt (3 of 3) ® § 1244 stock Qualifying small business stock Must be the original purchaser Ordinary loss up to $50 k or $100 k if MFJ Corp must have received $1 M or less of property in exchange for stock © 2009 Pearson Education, Inc. Publishing as Prentice 2 -45
Tax Planning considerations Avoiding § 351 ® Mandatory provision, not elective ® Avoid if transferring loss property to corp Need to also avoid § 267 related party loss limitation as well ® Avoid if transferring gain property and want corp to have stepped-up basis © 2009 Pearson Education, Inc. Publishing as Prentice 2 -46
Compliance and Procedural Considerations ® Attachment to s/hs’ individual tax returns for § 351 transactions Must include all facts pertinent to the exchange © 2009 Pearson Education, Inc. Publishing as Prentice 2 -47
Financial Statement Implications ® SFAS 109 requires recognition of deferred tax asset/liability for difference between financial stmt asset values and tax asset values Difference also requires corp to record goodwill on its books but not for tax ¬Permanent difference results when impairment of goodwill recorded © 2009 Pearson Education, Inc. Publishing as Prentice 2 -48
Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. newmark@Ph. Duh. com © 2009 Pearson Education, Inc. Publishing as Prentice Hall 2 -49
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