Chapter 4 Corporations Organization and Capital Structure Corporations

Chapter 4 Corporations: Organization and Capital Structure Corporations, Partnerships, Estates & Trusts Copyright © 2010 Cengage Learning Corporations, Partnerships, Estates & Trusts C 4 - 1

Corporation Formation Transaction Corporations, Partnerships, Estates & Trusts C 4 - 2

Formation Example Ron will incorporate his donut shop: Asset Fair Mkt Tax Basis Value. 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. Corporations, Partnerships, Estates & Trusts C 4 - 3

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 Corporations, Partnerships, Estates & Trusts C 4 - 4

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 Corporations, Partnerships, Estates & Trusts C 4 - 5

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 Corporations, Partnerships, Estates & Trusts C 4 - 6

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 Corporations, Partnerships, Estates & Trusts C 4 - 7

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 Corporations, Partnerships, Estates & Trusts C 4 - 8

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 Corporations, Partnerships, Estates & Trusts C 4 - 9

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 Corporations, Partnerships, Estates & Trusts C 4 - 10

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 – Service provider should transfer property having more than “a relatively small value” Corporations, Partnerships, Estates & Trusts C 4 - 11

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 Corporations, Partnerships, Estates & Trusts C 4 - 12

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 Corporations, Partnerships, Estates & Trusts C 4 - 13

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) Corporations, Partnerships, Estates & Trusts C 4 - 14

Formation with Liabilities Example (slide 1 of 2) Property transferred has: Fair market value = Basis = Realized Gain = Corporations, Partnerships, Estates & Trusts $150, 000 100, 000 $ 50, 000 C 4 - 15

Formation with Liabilities Example (slide 2 of 2) Liabilities assumed by corp. (independent facts): Business No Business Purpose Liability: $80, 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) Corporations, Partnerships, Estates & Trusts C 4 - 16

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 Corporations, Partnerships, Estates & Trusts C 4 - 17

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 Corporations, Partnerships, Estates & Trusts C 4 - 18

Basis in Stock in Last Example Adjusted Basis of transferred assets: $100, 000 Liabilities assumed by corp. (independent facts): Liability: Basis in assets Transferred + Gain recognized - Liab. Transferred Basis in stock Business Purpose $ 80, 000 Business Purpose $120, 000 $100, 000 $ 100, 000 None 20, 000 (80, 000) (120, 000) $ 20, 000 -0 - Corporations, Partnerships, Estates & Trusts No Business Purpose. $120, 000 $100, 000 50, 000 (120, 000) $ 30, 000 C 4 - 19

Corporation’s Basis in Assets Received in Last Example Liabilities assumed by corp. (independent facts): Business Purpose Liability: $ 80, 000 $120, 000 Basis of transferred assets: $100, 000 Gain recognized by shareholder None 20, 000 Basis to Corp. $100, 000 $120, 000 Corporations, Partnerships, Estates & Trusts No Business Purpose $120, 000 $100, 000 50, 000 $150, 000 C 4 - 20

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 Corporations, Partnerships, Estates & Trusts C 4 - 21

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 Corporations, Partnerships, Estates & Trusts C 4 - 22

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 Corporations, Partnerships, Estates & Trusts C 4 - 23

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 Corporations, Partnerships, Estates & Trusts C 4 - 24

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 Corporations, Partnerships, Estates & Trusts C 4 - 25

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 Corporations, Partnerships, Estates & Trusts C 4 - 26

Capital Contributions (slide 2 of 3) • Capital contributions of property by nonshareholders – Not taxable to corporation – Basis of property received from nonshareholder is -0 - Corporations, Partnerships, Estates & Trusts C 4 - 27

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 Corporations, Partnerships, Estates & Trusts C 4 - 28

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 Corporations, Partnerships, Estates & Trusts C 4 - 29

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 Corporations, Partnerships, Estates & Trusts C 4 - 30

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 Corporations, Partnerships, Estates & Trusts C 4 - 31

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 Corporations, Partnerships, Estates & Trusts C 4 - 32

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 Corporations, Partnerships, Estates & Trusts C 4 - 33

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 Corporations, Partnerships, Estates & Trusts C 4 - 34

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 Corporations, Partnerships, Estates & Trusts C 4 - 35

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 Corporations, Partnerships, Estates & Trusts C 4 - 36

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 Corporations, Partnerships, Estates & Trusts C 4 - 37

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 Corporations, Partnerships, Estates & Trusts C 4 - 38

§ 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 Corporations, Partnerships, Estates & Trusts C 4 - 39

§ 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 Corporations, Partnerships, Estates & Trusts C 4 - 40

§ 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 Corporations, Partnerships, Estates & Trusts C 4 - 41

§ 1244 stock (slide 4 of 4) • If § 1244 stock is issued for property with basis > fair market value – For determining ordinary loss, stock basis is reduced to fair market value on date of exchange Corporations, Partnerships, Estates & Trusts C 4 - 42

Gain from Qualified Small Business Stock (slide 1 of 2) • Noncorporate shareholders may exclude 50% (75% under ARRTA of 2009) of gain from sale or exchange of such stock – Must have held stock for > 5 years and acquired stock as part of original issue – 50% exclusion can be applied to the greater of: • $10 million, or • 10 times shareholder’s aggregate adjusted basis of qualified stock disposed of during year Corporations, Partnerships, Estates & Trusts C 4 - 43

Gain from Qualified Small Business Stock (slide 2 of 2) • Qualified Small Business Corp – C corp with gross assets not greater than $50 million on date stock issued – Actively involved in a trade or business • At least 80% of corporate assets are used in the active conduct of one or more trade or businesses • Under ARRTA of 2009, the exclusion increases to 75% for qualified small business stock acquired after February 17, 2009, and before 2011 Corporations, Partnerships, Estates & Trusts C 4 - 44

If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta. edu SUNY Oneonta Corporations, Partnerships, Estates & Trusts C 4 - 45