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Chapter 9

Chapter 9. Corporations: Organization, Capital Structure, and Operating Rules. 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.

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Chapter 9

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  1. Chapter 9 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. 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 corporate interest, while Jimmy will provide 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: Adjusted Fair Market Basis Value Accounts receivable $ –0– $ 25,000 Building 50,000 275,000 Other assets 150,000300,000 $200,000 $600,000

  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 the corporation. Amber’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. Various Business Forms 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 • Separate entity, but does not pay tax • Allocates partnership income to partners • Partners report partnership income on personal tax returns • Files information return (Form 1065)

  8. S Corporation • Separate entity, only pays special taxes (e.g., built-in gains) • Allocates entity income to shareholders • Shareholders report entity income on personal tax return • Files information return (Form 1120S)

  9. C Corporation • Separate tax-paying entity • Reports income and expenses on Form 1120 • Income is taxed at corporate level and again at owner level when distributed as a dividend

  10. 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

  11. Corporate Income Tax Rates

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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)

  18. Corporation Formation Transaction

  19. 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.

  20. 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

  21. 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

  22. 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

  23. 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

  24. The Big Picture – Example 11Stock Transferred(slide 1 of 2) Return to the facts of The Big Picture on p. 9-2. 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.

  25. The Big Picture – Example 11 Stock Transferred(slide 2 of 2) If she receives stock worth $550,000 and corporate debt of $50,000 in exchange for the property transferred, Amber realizes gain of $400,000 [$600,000 (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 $350,000 is deferred.

  26. 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

  27. 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

  28. 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

  29. 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”

  30. 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

  31. The Big Picture – Example 17Transfers for Property and Services(slide 1 of 2) Return to the facts of The Big Picture on p. 9-2. Assume Amber transfers her $600,000 of property to the new corporation and receives 50% of its stock. Jimmy receives the other 50% of the stock for services rendered (worth $600,000).

  32. The Big Picture – Example 17Transfers for Property and Services(slide 2 of 2) Both Amber and Jimmy have tax consequences from the transfers. Jimmy has ordinary income of $600,000 because he does not exchange property for stock. Amber has a taxable gain of $400,000 $600,000 (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.

  33. The Big Picture – Example 18 Transfers for Property and Services(slide 1 of 2) Assume the same facts as in Example 17 except that Jimmy transfers property worth $500,000 (basis of $130,000) in addition to services rendered to the corporation (valued at $100,000). Now Jimmy becomes a part of the control group. Amber and Jimmy, as property transferors, together receive 100% of the corporation’s stock.

  34. The Big Picture – Example 18 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 $100,000.

  35. 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

  36. 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)

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

  38. Formation with Liabilities Example (slide 2 of 2) 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)

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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

  44. 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

  45. 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

  46. 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

  47. 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

  48. The Big Picture – Example 36Selecting Assets To Transfer(slide 1 of 2) Return to the facts of The Big Picture on p. 9-2. If Amber decides to retain the $25,000 of cash basis accounts receivable rather than transferring them to the newly formed corporation She will recognize $25,000 of ordinary income upon their collection.

  49. The Big Picture – Example 36Selecting Assets To Transfer(slide 2 of 2) Alternatively, if the receivables are transferred to the corporation as the facts suggest, the corporation will recognize the ordinary income. However, a subsequent corporate distribution to Amber of the cash collected could be subject to double taxation as a dividend Given the alternatives available, Amber needs to evaluate which approach is better for the parties involved.

  50. 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

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