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2-1©2011 Pearson Education, Inc. Publishing as Prentice Hall
2-2
CORPORATE FORMATIONS & CAPITAL STRUCTURE (1
of 2)
Organization forms availableLegal requirements for forming
a corporationCheck-the-box regulationsTax considerations in forming a
corporation
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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CORPORATE FORMATIONS & CAPITAL STRUCTURE (2
of 2)
§351: Deferring gain or loss upon incorporations
Choice of capital structureWorthless stock or debt obligationsTax planning considerationsCompliance & procedural
considerations Financial statement implications©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Organization Forms Available
Sole proprietorshipsPartnershipsCorporations
C CorporationsS Corporations
Limited liability companiesLimited liability partnerships
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Sole Proprietorship(1 of 3)
One ownerNot a separate legal entity
Income reported on Sch. C of 1040No limited liability
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Sole Proprietorship(2 of 3)
Tax advantagesProfits taxed onceProprietor’s marginal tax rate may be
lower than if business were taxed as a corporation
No tax on contributions or withdrawalsLosses offset other income (with
limitations)©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Sole Proprietorship(3 of 3)
Tax disadvantagesProfits taxed as earned, not as
receivedCorporate tax rates may be lower
than proprietor’s marginal tax rateOwner not employee
Profits subject to SE taxNot eligible for some tax-exempt
fringe benefitsCompensation to owner not deductible
No fiscal year deferral©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Partnerships(1 of 3)
Two or more ownersConduit entity
Reports, but does not pay income tax
No limited liabilityExcept for limited partners
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Partnerships(2 of 3)
Tax advantagesNo partnership-level taxes
Income only taxed at partner levelLosses offset other income (with
limitations)Contributions and withdrawals
generally not subject to taxationIncome retains its characterIncome/gain increases basis
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Partnerships(3 of 3)
Tax disadvantagesProfits taxed as earned, not when
receivedPartners not employees
Profits subject to SE taxNot eligible for some tax-exempt
fringe benefitsFiscal year deferral difficult to
obtainCannot use fiscal year-end to defer
income©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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C Corporations(1 of 3)
Separate taxpaying and legal entity
Limited liabilityTaxation at corporate level
Rates 15% - 35%Dividend distributions taxed to
owners at lower capital gains tax rates
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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C Corporations(2 of 3)
Tax advantagesCorp’s marginal tax rate may be
lower than owners’ tax ratesShareholders may be employees
No SE taxEligible for tax-exempt fringe
benefitsCompensation to owners deductible
May choose fiscal year©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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C Corporations(3 of 3)
Tax disadvantagesDouble taxation of income
Corporate and shareholder levelHowever, tax rate at shareholder level is
at capital gains rates (generally 15% through 2010)
Withdrawals (dividends) taxableNOLs cannot be used in current
yearCapital losses cannot offset
ordinary income
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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S Corporations(1 of 3)
Conduit entitySimilar to a partnership, butLess flexible than a partnership
Must file an election to be an S corp.
Subject to rules under Subchapter SFollows same rules as a C Corp
except for specific items addressed in Subchapter S
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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S Corporations(2 of 3)
Tax advantagesGenerally exempt from taxationLosses flow through to
shareholdersIncome retains its characterContributions and withdrawals
generally not subject to taxationIncome/gain increases basisShareholders may be employees
S Corp net income not subject to SE tax
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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S Corporations(3 of 3)
Tax disadvantagesProfits taxed as earnedS Corp shareholders generally not
eligible for tax-exempt fringe benefits
S Corp cannot choose a fiscal year to obtain income deferral
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Limited Liability Companies
Limited liability for all ownersNo ownership restrictionsMay be taxed as partnership or
corporation
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Limited Liability Partnership
Partners liable for only their own actionsNo liability for negligence or
misconduct of other partnersMay be taxed as either a
partnership or corporation
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Check-the-Box Regulations
(1 of 2)
Unincorporated entities choose to be taxed as partnership or corpSole proprietor or corp if one owner
Entity must choose tax status orAccept default status
Partnership (sole proprietor if one owner)
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Check-the-Box Regulations
(2 of 2)
Change in status results in a deemed liquidation/reincorporationPartner electing corp status is
nontaxableCorp electing to be disregarded is
taxable
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Legal Requirements for Forming a Corporation
Dependent on state lawMinimum capital requirementsFiling articles of incorporationIssuing stockPaying state incorporation fees
May be assessed franchise taxes
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Tax Considerations in Forming a Corporation
Items affecting tax consequences of forming a corporationProperty to be transferredServices to be providedLiabilities transferredHow property should be transferred
E.g., contribution, saleSee Table 1 for overview of corp
formation rules©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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§351 Deferring Gain or Loss upon Incorporation
(1 of 2)
No gain or loss recognized if:PROPERTY transferred in
exchange for stock andTransferors have control (80%) of
corp immediately after the exchange
Transfers may be for new or existing corporations
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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§351 Deferring Gain or Loss upon Incorporation
(2 of 2)
Property requirementControl requirementStock requirement
Exchange solely for stockEffect of §351 on transferorsEffect of §351 on transferee corpAssumption of the transferor’s
liabilitiesOther considerations in a §351
exchange
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Property Requirement
Property does not include:ServicesIndebtedness of transferee not
evidenced by a securityInterest on indebtedness of
transferee that accrued on or after beginning of transferor’s holding period for the debt
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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 stockContribution of services &
propertyStock of transferor counted
towards 80% if FMV of property 10% of service’s value
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Effect of §351 on Transferors
(1 of 4)
General rulesNo gain or loss recognizedBasis in stock same as basis in
property (substituted basis)Holding period of stock includes
holding period of assets
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Effect of §351 on Transferors
(2 of 4)
Receipt of bootGain recognized lesser of gain
realized or FMV of boot receivedGain recognized when liabilities
transferred exceed basis in assets transferred
Basis in stock increased by gain recognized
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Effect of §351 on Transferors
(3 of 4)
Receipt of boot (continued)Basis in boot property is FMVHolding period of boot begins day
after exchange
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Effect of §351 on Transferors
(4 of 4)
Computing shareholder’s basisAdjusted basis of property transferred
+ Gain recognized by transferor- Money received- Liabilities assumed by transferee
corp= Shareholder’s basis in corp stock
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Effect of §351 on Transferee Corp (2 of 3)
Loss property limitationWhen basis > FMV of prop
transferredCorp’s basis = FMV AND
Reduction in basis allocated to other assets OR
Contributing s/h reduces her basis in corp stock
Corp recognizes gain if appreciated property transferred to
transferor in §351 exchange©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Effect of §351 on Transferee Corp (3 of 3)
Depreciation recapture potential transfers to transferee corporation
Holding period includes transferor’s holding periodHolding period begins day after
transfer when basis reduced to FMV
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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 gainIncreases amount realized by
transfereeDecreases transferee’s basis in
stockIf no bona fide business purpose
Assumption of liabilities considered receipt of money
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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
transferredGain recognized
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Other Considerations in a §351 Exchange (1 of 2)
Depreciation recaptureTransferee corp inherits
transferor’s depreciation recapture potential
Computing depreciationTransferee corp must use same
method and recovery period as transferor
Allocate depreciation expense for year of transfer based on # of months held
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Other Considerations in a §351 Exchange (2 of 2)
Assignment of income doctrineTransferee generally recognizes
income when A/R collected and deductions when pays A/P of cash-basis transferor
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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 (through 2010)
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
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Choice of Capital Structures:
Debt
Interest deductible by corpDebt repayment not taxable to
s/hDebt received in §351 is boot to
s/hWorthless debt is capital loss to
s/hDebt distributed by corp taxable
to s/h©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Choice of Capital Structures:
Equity
Dividends not deductible by corpS/h only pays max 15% on div.
receivedThrough 2010
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 dist. by corp not taxable to s/h
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Choice of Capital Structures:
Contributions by Nonshareholders (1 of 2)
Eg., state, local, and city governmentsContributions of money and/or
property to encourage a corporation to move to a particular location
Basis of property acquired by is zero
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Choice of Capital Structures:
Contributions by Nonshareholders (2 of 2)
Property purchased w/in 12 months of cash contribution reduced by cash receivedBasis of other non-cash assets
reduced by remaining cash at end of 12-month period
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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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 corporationRights to subscribe for stock to be
issuedEvidence of indebtedness
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Worthless Stock or Debt(2 of 3)
Ordinary Loss SituationsSecurities that are noncapital
assetsSecurities of affiliated companies§1244 stock
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Worthless Stock or Debt(3 of 3)
§1244 stockQualifying small business stockMust be the original purchaserOrdinary loss up to $50k or $100k
if MFJCorp must have received $1M or
less of property in exchange for stock
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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Tax Planning considerations
Avoiding §351
Mandatory provision, not elective
Avoid if transferring loss property to corpNeed to also avoid §267 related
party loss limitation as wellAvoid if transferring gain
property and want corp to have stepped-up basis©2011 Pearson Education, Inc. Publishing as Prentice
Hall
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Compliance and Procedural
Considerations
Attachment to s/hs’ individual tax returns for §351 transactionsMust include all facts pertinent to
the exchange
©2011 Pearson Education, Inc. Publishing as Prentice Hall
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2-48©2011 Pearson Education, Inc. Publishing as Prentice Hall