2-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall.

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

2-3

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

2-4

Organization Forms Available

Sole proprietorshipsPartnershipsCorporations

C CorporationsS Corporations

Limited liability companiesLimited liability partnerships


2-5

Sole Proprietorship(1 of 3)

One ownerNot a separate legal entity

Income reported on Sch. C of 1040No limited liability


2-6


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

2-7


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

2-8

Partnerships(1 of 3)

Two or more ownersConduit entity

Reports, but does not pay income tax

No limited liabilityExcept for limited partners


2-9


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


2-10


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

2-11

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


2-12


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

2-13


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


2-14

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


2-15


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


2-16


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


2-17

Limited Liability Companies

Limited liability for all ownersNo ownership restrictionsMay be taxed as partnership or

corporation


2-18

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


2-19

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)


2-20

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


2-21

Legal Requirements for Forming a Corporation

Dependent on state lawMinimum capital requirementsFiling articles of incorporationIssuing stockPaying state incorporation fees

May be assessed franchise taxes


2-22

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

2-23

§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


2-24

§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


2-25

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


2-26

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


2-27

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


2-28


(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


2-29


(3 of 4)

Receipt of boot (continued)Basis in boot property is FMVHolding period of boot begins day

after exchange


2-30


(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


2-31

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


2-32


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

2-33


Depreciation recapture potential transfers to transferee corporation

Holding period includes transferor’s holding periodHolding period begins day after

transfer when basis reduced to FMV


2-34

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


2-35

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


2-36

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


2-37

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


2-38

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


2-39

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

2-40


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


2-41


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


2-42


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


2-43

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


2-44


Ordinary Loss SituationsSecurities that are noncapital

assetsSecurities of affiliated companies§1244 stock


2-45


§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


2-46

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

2-47

Compliance and Procedural

Considerations

Attachment to s/hs’ individual tax returns for §351 transactionsMust include all facts pertinent to

the exchange


Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark at University of Northern Colorado’s

Kenneth W. Monfort College of [email protected]

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