Chapter
2
Corporate Formations
and Capital Structure
(Day 4)
Capital Structure
Slide D4-3
Equity Capital
Dividends paid are not deductible to the
corporation [IRC §311(a)]
Dividends received are taxable to the
shareholder [IRC §61(a)(7)]
Qualifying dividends are taxed at favorable
capital gains tax rates [IRC §1(h)]
Slide D4-4
Equity Capital
Gains (losses) from sales of stock are
generally capital gains (losses) to the
shareholders [IRC §1221]
Gains (losses) from sales of stocks by
securities dealers are ordinary
Slide D4-5
Equity Capital
Partial exclusion of gain from certain
small business stock:
Qualified small business stock [IRC §1202(c)]
For individual taxpayers, 50% of the gain is
excluded from taxable income if the stock was
held for more than 5 years [IRC §1202(a)(1)]
Remaining gain is taxed at maximum 28% capital gains
tax rate [IRC §1(h)(3)]
7% of excluded gain is a tax preference for AMT
purposes [IRC §57(a)(7)]
IRC §1202 - Example
Slide D4-6
Six years ago, Violet transferred property
with a basis of $100,000 and a FMV of
$300,000 to VCorp (a new corporation) in
exchange for 100% of VCorp stock. This
year, she sold the stock for $600,000.
Violet’s realized gain is $500,000
Violet’s recognized gain is $250,000
(subject to a maximum 28% rate)
Violet has a $17,500 AMT tax preference
Slide D4-7
Equity Capital
Losses on small business stock
IRC §1244 stock defined [IRC §1244(c)]
Up to $50,000 ($100,000 MFJ) of losses
from the sale or exchange of §1244 stock
are ordinary losses [IRC §1244(a)&(b)]
Reduced limit if IRC §1244 stock was issued for
property having basis > FMV [IRC §1244(d)]
Problems C2-51 and C2-52
Slide D4-8
Worthless Securities
If a security is a capital asset to the
taxpayer and it becomes worthless during
the year, it is treated as a capital loss on the
last day of the tax year [IRC §165(g)]
Slide D4-9
Worthless Securities
Exception [IRC §165(g)(3)] :
If a corporation owns worthless securities in an
affiliated corporation, the loss is ordinary
Affiliated corporation must be at least 80% owned and
More than 90% of gross receipts were from active
sources for all tax years
Problem C2-49
Slide D4-10
Capital Structure Choice
Debt
 Interest paid is deductible
 Interest income is ordinary
income to debtholders
 Principal repayments not taxable
 Debt is boot in IRC §351
 Debt distributed is taxable
 Worthless debt is capital loss
Equity
 Dividend paid is not deductible
 Dividend income taxed at lower
rate (15%) to shs
 Stock redemptions are taxable
 Stock is not boot in IRC §351
 Stock dividends are not taxable
 Worthless stock may qualify for
IRC §1244
 Gains from stock sales may
qualify for IRC §1202 exclusion
Slide D4-11
Capital Contributions
A corporation is not taxed on contributions
to its capital [IRC §118(a)]
If a shareholder contributes property to a
corporation:
The corporation’s basis in the property equals the
shareholder’s basis [IRC §362(a)]
 Limitation for built-in losses [IRC §362(e)]
The shareholders’ basis in existing stock increases
[Reg. §1.118-1]
 Election to reduce stock basis instead of corporation’s basis
for built-in losses [IRC §362(e)]
Slide D4-12
Capital Contributions Example
Chad has owned 100% of Chad Corp. for
three years. His basis in the stock was
$100,000 at the beginning of the current
year. During the current year, he contributed
property to the corporation that had a FMV
of $50,000 and a basis of $35,000.
Chad Corp.’s basis in the property is $35,000
Chad’s basis in his stock is $135,000 after the
contribution to capital
Slide D4-13
Capital Contributions
A corporation is not taxed on contributions
to its capital [IRC §118(a)]
If a nonshareholder contributes property to the
corporation, its basis is zero [IRC §362(c)(1)]
If a nonshareholder contributes cash to the
corporation [IRC §362(c)(1)]
the basis of property acquired within 12 months is
reduced by the amount of the cash contribution
any excess cash contribution reduces the basis of
existing property
Problem C2-47