Chapter 17
Corporations:
Corporations:
Organization
Organization and
and Capital
Capital Structure
Structure
Eugene Willis, William H. Hoffman, Jr.,
David M. Maloney and William A. Raabe
Copyright ©2004 South-Western/Thomson Learning
Corporation Formation
Transaction
C17 - 2
Formation Example
Ron
Ronwill
willincorporate
incorporatehis
hisdonut
donutshop:
shop:
Asset
Fair
Asset
FairMkt
Mkt
Value
Tax
Value
TaxBasis
Basis
Cash
$10,000
$$ 10,000
Cash
$10,000
10,000
Furniture
20,000
60,000
Furniture&
&Fixtures
Fixtures
20,000
60,000
100,000
Building
40,000
100,000
Building
40,000
Total
$70,000
$170,000
Total
$70,000
$170,000
•• Without
Without§351:
§351:gain
gainof
of$100,000.
$100,000.
•• With
With§351:
§351:no
nogain
gainor
orloss.
loss.Ron’s
Ron’seconomic
economicstatus
statushas
hasnot
not
changed.
changed.
C17 - 3
Consequences of §351
(slide
(slide 11 of
of 2)
2)
•• In
In general,
general, no
no gain
gain or
or loss
loss to
to transferors:
transferors:
–– On
On transfer
transfer of
of property
property to
to corporation
corporation
–– In
In exchange
exchange for
for stock
stock
–– IF
IF immediately
immediately after
after transfer,
transfer, transferors
transferors are
are in
in
control
control of
of corporation
corporation
C17 - 4
Consequences of §351
(slide
(slide 22 of
of 2)
2)
•• IfIf boot
boot (property
(property other
other than
than stock)
stock) received
received
by
by transferors
transferors
–– Gain
Gain recognized
recognized up
up to
to lesser
lesser of:
of:
•• Boot
Bootreceived
receivedor
or
•• Realized
Realizedgain
gain
–– No
No loss
loss isis recognized
recognized
C17 - 5
Issues re: Formation
(slide
(slide 11 of
of 7)
7)
•• Definition
Definition of
of property
property includes:
includes:
–– Cash
Cash
–– Secret
Secret processes
processes and
and formulas
formulas
–– Unrealized
Unrealized accounts
accounts receivable
receivable (for
(for cash
cash basis
basis
taxpayer)
taxpayer)
–– Installment
Installment obligations
obligations
•• Code
Code specifically
specifically excludes
excludes services
services from
from
definition
definition of
of property
property
C17 - 6
Issues re: Formation
(slide
(slide 22 of
of 7)
7)
•• Stock
Stock transferred
transferred
–– Includes
Includes common
common and
and most
most preferred
preferred stock
stock
•• Does
Doesnot
notinclude
includenonqualified
nonqualifiedpreferred
preferredstock
stockwhich
which
possesses
possessesmany
manyattributes
attributesof
ofdebt
debt
–– Does
Does not
not include
include stock
stock rights
rights or
or stock
stock warrants
warrants
–– Does
Does not
not include
include corporate
corporate debt
debt or
or securities
securities
(e.g.,
(e.g., corporate
corporate bonds)
bonds)
•• Treated
Treatedas
asboot
boot
C17 - 7
Issues re: Formation
(slide
(slide 33 of
of 7)
7)
•• Transferors
Transferors must
must be
be in
in control
control immediately
immediately
after
after exchange
exchange to
to qualify
qualify for
for nontaxable
nontaxable
treatment
treatment
–– To
To have
have control,
control, transferors
transferors must
must own:
own:
•• 80%
80%of
oftotal
totalcombined
combinedvoting
votingpower
powerof
ofall
allclasses
classesof
of
stock
stockentitled
entitledto
tovote,
vote,plus
plus
•• 80%
80%of
oftotal
totalnumber
numberof
ofshares
sharesof
ofall
allother
otherclasses
classesof
of
stock
stock
C17 - 8
Issues re: Formation
(slide
(slide 44 of
of 7)
7)
•• “Immediately
“Immediately after”
after” the
the exchange
exchange
–– Does
Does not
not require
require simultaneous
simultaneous transfers
transfers ifif more
more
than
than one
one transferor
transferor
–– Rights
Rights of
of parties
parties must
must be
be outlined
outlined before
before first
first
transfer
transfer
–– Transfers
Transfers should
should occur
occur as
as close
close together
together as
as
possible
possible
C17 - 9
Issues re: Formation
(slide
(slide 55 of
of 7)
7)
•• After
After control
control isis achieved,
achieved, itit isis not
not
necessarily
necessarily lost
lost upon
upon the
the sale
sale or
or gift
gift of
of
stock
stock received
received in
in the
the transfer
transfer to
to others
others not
not
party
party to
to the
the initial
initial exchange
exchange
•• But
But sale
sale might
might violate
violate §351
§351 ifif prearranged
prearranged
C17 - 10
Issues re: Formation
(slide
(slide 66 of
of 7)
7)
•• Transfers
Transfers for
for property
property and
and services
services
–– May
May result
result in
in service
service provider
provider being
being treated
treated as
as aa
member
member of
of the
the 80%
80% control
control group
group
•• Taxed
Taxedon
onvalue
valueof
ofstock
stockissued
issuedfor
forservices
services
•• Not
Nottaxed
taxedon
onvalue
valueof
ofstock
stockreceived
receivedfor
forproperty
property
contributions
contributions
–– Service
Service provider
provider should
should transfer
transfer property
property
having
having more
more than
than “a
“a relatively
relatively small
small value”
value”
C17 - 11
Issues re: Formation
(slide
(slide 77 of
of 7)
7)
•• Subsequent
Subsequent transfers
transfers to
to corporation
corporation
–– Tax-free
Tax-free treatment
treatment still
still applies
applies as
as long
long as
as
transferors
transferors in
in subsequent
subsequent transfer
transfer own
own 80%
80%
following
following exchange
exchange
C17 - 12
Assumption of Liabilities
(slide
(slide 11 of
of 2)
2)
•• Assumption
Assumption of
of liabilities
liabilities by
by corp
corp DOES
DOES
NOT
NOT result
result in
in boot
boot to
to the
the transferor
transferor
shareholder
shareholder for
for gain
gain recognition
recognition purposes
purposes
–– Liabilities
Liabilities ARE
ARE treated
treated as
as boot
boot for
for determining
determining
basis
basis in
in acquired
acquired stock
stock
–– Basis
Basis of
of stock
stock received
received isis reduced
reduced by
by amount
amount of
of
liabilities
liabilities assumed
assumed by
by the
the corp
corp
C17 - 13
Assumption of Liabilities
(slide
(slide 22 of
of 2)
2)
•• Liabilities
Liabilities are
are NOT
NOT treated
treated as
as boot
boot for
for gain
gain
recognition
recognition unless:
unless:
–– Liabilities
Liabilities incurred
incurred for
for no
no business
business purpose
purpose or
or
as
as tax
tax avoidance
avoidance mechanism
mechanism
•• Boot
Boot==Entire
Entireamount
amountof
ofliability
liability
–– Liabilities
Liabilities >> basis
basis in
in assets
assets transferred
transferred
•• Gain
Gainrecognized
recognized==Excess
Excessamount
amount(liabilities
(liabilities--basis)
basis)
C17 - 14
Formation with Liabilities
Example(slide
(slide 11 of
of 2)
2)
Property
Property transferred
transferred has:
has:
Fair
Fair market
market value
value
Basis
Basis
Realized
Realized Gain
Gain
==
==
==
$150,000
$150,000
100,000
100,000
50,000
50,000
C17 - 15
Formation with Liabilities
Example (slide
(slide 22 of
of 2)
2)
Liabilities
Liabilities assumed
assumed by
by corp.
corp. (independent
(independent facts):
facts):
Business
No
Business Business
Business
No Business
Business
Purpose
Purpose
Purpose Purpose
Purpose
Purpose
Liability:
$80,000
$120,000
Liability:
$80,000 $120,000
$120,000
$120,000
Boot
None
$$ 20,000
$120,000
Boot
None
20,000
$120,000
Gain
Gain
Recognized
None
$20,000
$$ 50,000*
Recognized
None
$20,000
50,000*
*(Gain
*(Gain isis lesser
lesser of
of $50,000
$50,000 realized
realized gain
gain or
or boot)
boot)
C17 - 16
Basis Computation for §351
Exchange (slide
(slide 11 of
of 2)
2)
•• Shareholder’s
Shareholder’s basis
basis in
in stock:
stock:
Adjusted
Adjusted basis
basis of
of transferred
transferred assets
assets
++ Gain
Gain recognized
recognized on
on exchange
exchange
-- Boot
Boot received
received
-- Liabilities
Liabilities transferred
transferred to
to corporation
corporation
== Basis
Basis of
of stock
stock received
received by
by shareholder
shareholder
C17 - 17
Basis Computation for §351
Exchange (slide
(slide 22 of
of 2)
2)
•• Corporation’s
Corporation’s basis
basis in
in assets:
assets:
Adjusted
Adjusted basis
basis of
of transferred
transferred assets
assets
++ Gain
Gain recognized
recognized by
by transferor
transferor shareholder
shareholder
== Basis
Basis of
of assets
assets to
to corporation
corporation
C17 - 18
Basis in Stock in Last Example
Adjusted
$100,000
AdjustedBasis
Basisof
oftransferred
transferredassets:
assets:
$100,000
Liabilities
Liabilitiesassumed
assumedby
bycorp.
corp.(independent
(independentfacts):
facts):
Business
Business Business
Business No
NoBusiness
Business
Purpose
Purpose
Purpose
Purpose
Purpose Purpose
Liability:
$$ 80,000
Liability:
80,000 $120,000
$120,000 $120,000
$120,000
Basis
Basisin
inassets
assets
Transferred
$100,000
Transferred
$100,000 $100,000
$100,000 $100,000
$100,000
++Gain
None
20,000
50,000
Gainrecognized
recognized
None
20,000
50,000
--Liab.
(80,000)
(120,000) (120,000)
(120,000)
Liab.Transferred
Transferred
(80,000) (120,000)
Basis
$$20,000
-0$$30,000
Basisin
instock
stock
20,000
-030,000
C17 - 19
Corporation’s Basis in Assets
Received in Last Example
Liabilities
Liabilitiesassumed
assumedby
bycorp.
corp.(Independent
(Independentfacts):
facts):
Business
Business Business
Business No
NoBusiness
Business
Purpose
Purpose
Purpose Purpose
Purpose
Purpose
Liability:
$$ 80,000
Liability:
80,000 $120,000
$120,000 $120,000
$120,000
Basis
Basisof
oftranstransferred
$100,000
ferredassets:
assets:
$100,000 $100,000
$100,000 $100,000
$100,000
Gain
Gainrecognized
recognized
by
None
20,000
50,000
byshareholder
shareholder
None
20,000
50,000
Basis
$100,000
Basisto
toCorp.
Corp.
$100,000 $120,000
$120,000 $150,000
$150,000
C17 - 20
Holding Period
•• Holding
Holding period
period of
of stock
stock received
received
–– For
For capital
capital assets
assets or
or §1231
§1231 property,
property, includes
includes
holding
holding period
period of
of property
property transferred
transferred to
to
corporation
corporation
–– For
For other
other property,
property, begins
begins on
on day
day after
after
exchange
exchange
•• Corp’s
Corp’s holding
holding period
period for
for property
property acquired
acquired
in
in the
the transfer
transfer isis holding
holding period
period of
of transferor
transferor
C17 - 21
Capital Contributions (slide
(slide 11 of
of 3)
3)
•• No
No gain
gain or
or loss
loss isis recognized
recognized by
by corp
corp on
on
receipt
receipt of
of money
money or
or property
property in
in exchange
exchange
for
for its
its stock
stock
–– Also
Also applies
applies to
to additional
additional voluntary
voluntary pro
pro rata
rata
contributions
contributions of
of money
money or
or property
property to
to aa corp
corp
even
even though
though no
no additional
additional shares
shares are
are issued
issued
C17 - 22
Capital Contributions (slide
(slide 22 of
of 3)
3)
•• Capital
Capital contributions
contributions of
of property
property by
by
nonshareholders
nonshareholders
–– Not
Not taxable
taxable to
to corporation
corporation
–– Basis
Basis of
of property
property received
received from
from nonshareholder
nonshareholder
isis -0-0-
C17 - 23
Capital Contributions (slide
(slide 33 of
of 3)
3)
•• Capital
Capital contributions
contributions of
of cash
cash by
by
nonshareholder
nonshareholder
–– Must
Must reduce
reduce basis
basis of
of assets
assets acquired
acquired during
during 12
12
month
month period
period following
following contribution
contribution
–– Any
Any remaining
remaining amount
amount reduces
reduces basis
basis of
of other
other
property
property owned
owned by
by the
the corp
corp
•• Applied
Appliedin
inthe
thefollowing
followingorder
orderto
todepreciable
depreciable
property,
property,amortizable
amortizableproperty,
property,assets
assetssubject
subjectto
to
depletion,
depletion,and
andother
otherremaining
remainingassets
assets
C17 - 24
Debt Vs. Equity
(slide
(slide 11 of
of 2)
2)
•• Debt
Debt
–– Corporation
Corporation pays
pays interest
interest to
to debt
debt holder
holder which
which
isis deductible
deductible by
by corporation
corporation
–– Interest
Interest paid
paid isis taxable
taxable as
as ordinary
ordinary income
income to
to
individual
individual or
or corporate
corporate recipient
recipient
–– Loan
Loan repayments
repayments are
are not
not taxable
taxable to
to investors
investors
unless
unless repayments
repayments exceed
exceed basis
basis
C17 - 25
Debt Vs. Equity
(slide
(slide 22 of
of 2)
2)
•• Equity:
Equity:
–– Corporation
Corporation pays
pays dividends
dividends which
which are
are not
not
deductible
deductible
–– Taxable
Taxable as
as ordinary
ordinary income
income to
to recipient
recipient to
to
extent
extent corp
corp has
has EE &
& PP
•• Corporate
Corporateshareholder
shareholdermay
mayreceive
receivedividends
dividends
received
receiveddeduction
deduction
C17 - 26
Reclassification of Debt As
Equity
•• IfIf corp
corp isis “thinly
“thinly capitalized”,
capitalized”, i.e.,
i.e., has
has too
too
much
much debt
debt and
and too
too little
little equity
equity
–– IRS
IRS may
may argue
argue that
that debt
debt isis really
really equity
equity and
and
deny
deny tax
tax advantages
advantages of
of debt
debt financing
financing
–– IfIf debt
debt has
has too
too many
many features
features of
of stock,
stock, principal
principal
and
and interest
interest payments
payments may
may be
be treated
treated as
as
dividends
dividends
C17 - 27
Thin Capitalization Factors
(slide
(slide 11 of
of 2)
2)
••
••
••
••
Debt
Debt instrument
instrument documentation
documentation
Debt
Debt terms
terms (e.g.,
(e.g., reasonable
reasonable rate
rate of
of interest
interest
and
and definite
definite maturity
maturity date)
date)
Timeliness
Timeliness of
of repayment
repayment of
of debt
debt
Whether
Whether payments
payments are
are contingent
contingent on
on
earnings
earnings
C17 - 28
Thin Capitalization Factors
(slide
(slide 22 of
of 2)
2)
••
••
••
••
Subordination
Subordination of
of debt
debt to
to other
other liabilities
liabilities
Whether
Whether debt
debt and
and stock
stock holdings
holdings are
are
proportionate
proportionate
Use
Use of
of funds
funds (if
(if used
used to
to finance
finance initial
initial
operations
operations or
or to
to acquire
acquire capital
capital assets,
assets, looks
looks
like
like equity)
equity)
Debt
Debt to
to equity
equity ratio
ratio
C17 - 29
Losses on Investment in
Corporation (slide
(slide 11 of
of 5)
5)
•• Stock
Stock and
and security
security losses
losses
–– IfIf stocks
stocks and
and bonds
bonds are
are capital
capital assets,
assets, losses
losses
from
from worthlessness
worthlessness are
are capital
capital losses
losses
•• Loss
Lossisistreated
treatedas
asoccurring
occurringon
onlast
lastday
dayof
oftax
taxyear
yearin
in
which
whichthey
theybecome
becomeworthless
worthless
•• No
Noloss
lossfor
formere
meredecline
declinein
invalue
value
C17 - 30
Losses on Investment in
Corporation (slide
(slide 22 of
of 5)
5)
•• Stock
Stock and
and security
security losses
losses
–– IfIf stocks
stocks and
and bonds
bonds are
are not
not capital
capital assets,
assets, losses
losses
from
from worthlessness
worthlessness are
are ordinary
ordinary losses
losses (e.g.,
(e.g.,
broker
broker owned)
owned)
–– Sometimes
Sometimes an
an ordinary
ordinary loss
loss isis allowed
allowed for
for
worthlessness
worthlessness of
of stock
stock of
of affiliated
affiliated company
company
C17 - 31
Losses on Investment in
Corporation (slide
(slide 33 of
of 5)
5)
•• Business
Business versus
versus nonbusiness
nonbusiness bad
bad debts
debts
–– General
General rule:
rule: Losses
Losses on
on debt
debt of
of corporation
corporation
treated
treated as
as business
business or
or nonbusiness
nonbusiness bad
bad debt
debt
–– IfIf noncorporate
noncorporate person
person lends
lends as
as investment,
investment, loss
loss
isis nonbusiness
nonbusiness bad
bad debt
debt
•• Short-term
Short-termcapital
capitalloss
loss
•• Only
Onlydeductible
deductiblewhen
whenfully
fullyworthless
worthless
C17 - 32
Losses on Investment in
Corporation (slide
(slide 44 of
of 5)
5)
•• Business
Business versus
versus nonbusiness
nonbusiness bad
bad debts
debts
(con’t)
(con’t)
–– IfIfcorporation
corporationisislender,
lender,loss
loss isis business
business bad
bad debt
debt
•• Ordinary
Ordinaryloss
lossdeduction
deduction
•• Deduction
Deductionallowed
allowedfor
forpartial
partialworthlessness
worthlessness
•• All
Allbad
baddebts
debtsof
ofcorporate
corporatelender
lenderqualify
qualifyas
asbusiness
business
bad
baddebts
debts
C17 - 33
Losses on Investment in
Corporation (slide
(slide 55 of
of 5)
5)
•• Business
Business versus
versus nonbusiness
nonbusiness bad
bad debts
debts
(con’t)
(con’t)
–– Noncorporate
Noncorporate lender
lender may
may qualify
qualify for
for business
business
bad
bad debt
debt treatment
treatment if:
if:
•• Loan
Loanisismade
madein
insome
somecapacity
capacitythat
thatqualifies
qualifiesas
asaa
trade
tradeor
orbusiness,
business,or
or
•• Shareholder
Shareholderisisin
inthe
thebusiness
businessof
oflending
lendingmoney
moneyor
or
of
ofbuying,
buying,promoting,
promoting,and
andselling
sellingcorporations
corporations
C17 - 34
§1244 stock
(slide
(slide 11 of
of 4)
4)
•• Treatment
Treatment of
of §1244
§1244 stock:
stock:
–– Ordinary
Ordinary loss
loss treatment
treatment for
for loss
loss on
on stock
stock of
of
“small
“small business
business corporation”
corporation” (as
(as defined)
defined)
–– Gain
Gain still
still capital
capital gain
gain
C17 - 35
§1244 stock
(slide
(slide 22 of
of 4)
4)
•• §1244
§1244 stock:
stock:
–– Total
Total amount
amount of
of stock
stock at
at initial
initial issuance
issuance cannot
cannot
exceed
exceed $1,000,000
$1,000,000 (based
(based on
on basis
basis of
of property
property
contributed,
contributed, less
less liabilities
liabilities assumed
assumed by
by
company)
company)
C17 - 36
§1244 stock
(slide
(slide 33 of
of 4)
4)
•• Annual
Annual loss
loss limitation:
limitation:
–– $50,000
$50,000 or
or
–– $100,000
$100,000 ifif married
married filing
filing joint
joint return
return
–– Any
Any remaining
remaining loss
loss isis aa capital
capital loss
loss
•• Only
Only original
original holder
holder of
of §1244
§1244 stock
stock
qualifies
qualifies for
for ordinary
ordinary loss
loss treatment
treatment
–– Sale
Sale or
or contribution
contribution of
of stock
stock results
results in
in loss
loss of
of
§1244
§1244 status
status
C17 - 37
§1244 stock
(slide
(slide 44 of
of 4)
4)
•• IfIf §1244
§1244 stock
stock isis issued
issued for
for property
property with
with
basis
basis >> fair
fair market
market value
value
–– For
For determining
determining ordinary
ordinary loss,
loss, stock
stock basis
basis isis
reduced
reduced to
to fair
fair market
market value
value on
on date
date of
of
exchange
exchange
C17 - 38
Gain From Qualified
Small Business Stock (slide
(slide 11 of
of 2)
2)
•• Noncorporate
Noncorporate shareholders
shareholders may
may exclude
exclude
50%
50% of
of gain
gain from
from sale
sale or
or exchange
exchange of
of such
such
stock
stock
–– Must
Must have
have held
held stock
stock for
for >> 55 years
years and
and acquired
acquired
stock
stock as
as part
part of
of original
original issue
issue
–– 50%
50% exclusion
exclusion can
can be
be applied
applied to
to the
the greater
greater of:
of:
•• $10
$10million,
million,or
or
•• 10
10times
timesshareholder’s
shareholder’saggregate
aggregateadjusted
adjustedbasis
basisof
of
qualified
qualifiedstock
stockdisposed
disposedof
ofduring
duringyear
year
C17 - 39
Gain From Qualified
Small Business Stock (slide
(slide 22 of
of 2)
2)
•• Qualified
Qualified Small
Small Business
Business Corp
Corp
–– CC corp
corp with
with gross
gross assets
assets not
not greater
greater than
than $50
$50
million
million on
on date
date stock
stock issued
issued
–– Actively
Actively involved
involved in
in aa trade
trade or
or business
business
•• At
Atleast
least80%
80%of
ofcorporate
corporateassets
assetsare
areused
usedin
inthe
the
active
activeconduct
conductof
ofone
oneor
ormore
moretrade
tradeor
orbusinesses
businesses
C17 - 40
IfIfyou
youhave
haveany
anycomments
commentsor
orsuggestions
suggestionsconcerning
concerningthis
this
PowerPoint
PowerPointPresentation
Presentationfor
forWest's
West'sFederal
FederalTaxation,
Taxation,
please
pleasecontact:
contact:
Dr.
Dr.Donald
Donald R.
R.Trippeer,
Trippeer,CPA
CPA
donald.trippeer@colostate-pueblo.edu
donald.trippeer@colostate-pueblo.edu
Colorado
ColoradoState
StateUniversity-Pueblo
University-Pueblo
C17 - 41