Chapter 4 presentation

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporations, Partnerships,Estates & Trusts

Chapter 4Corporations: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. – 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.


• Emily’s sole proprietorship assets available for transfer to the new corporation are:

Adjusted Fair Market Basis ValueAccounts receivable $ –0– $ 25,000Building 50,000 200,000Other assets 150,000 275,000

$200,000 $500,000


• 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.

Corporation Formation Transaction

Formation Example

Ron will incorporate his donut shop: Asset Fair Mkt

Tax Basis Value .Cash $10,000 $ 10,000Furniture & Fixtures 20,000 60,000Building 40,000 100,000Total $70,000 $170,000

• Without §351: gain of $100,000.• With §351: no gain or loss. Ron’s economic status has not

changed.

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

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

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

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

The Big Picture – Example 4 Stock 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.

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.

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


• “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


• 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


• 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”


• Subsequent transfers to existing corporation– Tax-free treatment still applies as long as

transferors in subsequent transfer own 80% following exchange

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).


• 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.


• 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.


• 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.

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

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)

Formation with Liabilities Example (slide 1 of 2)

Property transferred has:

Fair market value = $150,000Basis = 100,000Realized Gain = $ 50,000

Formation with Liabilities Example (slide 2 of 2)

Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose

Liability: $80,000 $120,000 $120,000Boot None $ 20,000 $120,000GainRecognized None $20,000 $ 50,000*

*(Gain is lesser of $50,000 realized gain or boot)

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

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

Basis in Stock in Last Example

Adjusted Basis of transferred assets: $100,000Liabilities assumed by corp. (independent facts):

Business Business No Business Purpose Purpose Purpose .Liability: $ 80,000 $120,000 $120,000Basis in assetsTransferred $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

Corporation’s Basis in Assets Received in Last Example

Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose PurposeLiability: $ 80,000 $120,000 $120,000Basis of trans-ferred assets: $100,000 $100,000 $100,000Gain recognized by shareholder None 20,000 50,000Basis to Corp. $100,000 $120,000 $150,000

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

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

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

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

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

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


• Capital contributions of property by nonshareholders– Not taxable to corporation– Basis of property received from nonshareholder is

-0-


• 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

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

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

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

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

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

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


• 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


• 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


• 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


• 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

§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


• §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


• 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


• 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

Gain from Qualified Small Business Stock (slide 1 of 2)

• Noncorporate shareholders may exclude 50% 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

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 stock acquired after February 17, 2009, and before 2011

• From legislation in 2010, the exclusion increases to 100% for qualified stock acquired after September 27, 2010, and before 2012

The Big Picture – Example 35Selecting Assets To Transfer (slide 1 of 2)

• Return to the facts of The Big Picture on p. 4-2. • If Emily 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.

The Big Picture – Example 35Selecting 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

Emily of the cash collected could be subject to double taxation as a dividend

• Given the alternatives available, Emily needs to evaluate which approach is better for the parties involved.

Refocus On The Big Picture (slide 1 of 5)

• Emily, the sole property transferor, must acquire at least 80% of the stock issued by the new corporation in order for the transaction to receive tax-deferred treatment under § 351.– Otherwise, a tremendous amount of gain (up to

$300,000) will be recognized. • As a corollary, David must not receive more

than 20% of the corporation’s stock in exchange for his services.


• However, even if § 351 is available, any corporate debt issued by the corporation will be treated as boot and will trigger gain recognition to Emily. – Therefore, she must evaluate the cost of

recognizing gain now versus the benefit of the corporation obtaining an interest deduction later.


What If?• Can the § 351 transaction be modified to further

reduce personal and business tax costs, both at the time of formation and in future years? – Several strategies may be worth considering.

• Instead of having the corporation issue debt on formation, Emily might withhold certain assets. – If the building is not transferred, for example, it can be

leased to the corporation. • The resulting rent payment would mitigate the double tax problem

by producing a tax deduction for the corporation.


What If?• An additional benefit results if Emily does not

transfer the cash basis receivables to the corporation. – This approach avoids a tax at the corporate level

and a further tax when the receipts are distributed to Emily in the form of a dividend.

– If the receivables are withheld, their collection is taxed only to Emily.


What If?• No mention is made as to the existence of any

accounts payable outstanding at the time of corporate formation. – If they do exist, which is likely, it could be wise for Emily

to transfer them to the corporation.– The subsequent corporate payment of the liability produces

a corporate deduction that will reduce any corporate tax.• Double taxation can be mitigated in certain situations

with a modest amount of foresight!

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61

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SUNY Oneonta

Chapter 4 presentation

Business

thin capitalization

purpose purpose

nonbusiness

qualified

qualifiedsmall

gain recognized

ordinary loss

double taxation