Chapter 12
Corporations: Organization,
Capital Structure, and
Operating Rules
Essentials of Taxation
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1
The Big Picture (slide 1 of 3)
• Amber has operated her business for 10 years as a
sole proprietorship, but has decided to incorporate the
business as Garden, Inc.
– She understands that the corporate form offers several
important nontax advantages (e.g., limited liability).
– Also, the incorporation would enable her husband, Jimmy,
to become a part owner in the business.
• Amber expects to transfer her business assets in
exchange for her Garden stock, while Jimmy will
provide accounting and legal services for his interest.
The Big Picture (slide 2 of 3)
• Amber’s sole proprietorship assets available
for transfer to the new corporation are:
The Big Picture (slide 3 of 3)
• Aware of the double taxation problem associated with
operating as a regular corporation, Amber is
considering receiving some corporate debt at the time
of incorporation.
– The interest expense on the debt will then provide a
deduction for Garden, Inc.
• Amber’s main concern, however, is that the
incorporation will be a taxable transaction.
– Can the transaction be structured to avoid tax?
• Read the chapter and formulate your response.
Various Business Forms
• Business operations can be conducted in a
number of different forms including
–
–
–
–
–
Sole proprietorships
Partnerships
Trusts and estates
S corporations
Regular corporations (also called C corporations)
Sole Proprietorship
• Not a separate taxable entity
• Income reported on owner’s Sch. C
Partnership (slide 1 of 2)
• Separate entity, but does not pay tax
– Files information return (Form 1065)
• Most income and expense items are
aggregated in computing the ordinary business
income (loss) of the partnership
– Certain income and expense items are reported
separately to the partners
– e.g., Interest and dividend income, long term
capital gain, charitable contributions and
investment expenses
Partnership (slide 2 of 2)
• Partnership ordinary business income (loss)
and separately reported items are allocated to
partners according to their profit and loss
sharing ratios
– Each partner receives a Schedule K–1
• Reports partner’s share of partnership ordinary business
income (loss) and separately stated items
– Each partner reports these items on his or her own
tax return
S Corporation
• Separate entity, only pays special taxes (e.g., built-in
gains)
– Files information return Form 1120S
• Similar to partnership taxation
– Ordinary business income (loss) flows through to the
shareholders to be reported on their separate returns
– Certain items flow through to the shareholders and retain
their separate character when reported on the shareholders’
returns.
• The S corporation ordinary business income (loss)
and the separately reported items are allocated to the
shareholders according to their stock ownership
interests
C Corporation
• C corporations are subject to an entity-level Federal
income tax which results in what is known as a
double taxation effect.
– C corporation reports its income and expenses and
computes tax on the taxable income reported on its Form
1120
• Uses tax rate schedule applicable to corporations
– When corporation distributes its income, the corporation’s
shareholders report dividend income on their own tax
returns
• Thus, income that has already been taxed at the corporate level is
also taxed at the shareholder level
Dividends
• Double taxation stems, in part, from the fact that
dividend distributions are not deductible by the
corporation
• To alleviate some of the double taxation effect,
Congress reduced the tax rate applicable to dividend
income of individuals for years after 2002
– Generally, dividends are taxed at same marginal rate
applicable to a net capital gain
• Thus, individuals otherwise subject to the 10% or 15% marginal tax
rate pay 0% tax on qualified dividends received
• Individuals subject to the 25, 28, 33, or 35 percent marginal tax
rates pay a 15% tax on qualified dividends
Corporate Income Tax Rates
Nontax Issues in Selecting
Entity Form (slide 1 of 3)
• Liability
– Sole proprietors and some partners have unlimited
liability for claims against the entity
• Capital-raising
– Corporations and partnerships to a lesser extent
can raise large amounts of capital for entity
ventures
Nontax Issues in Selecting
Entity Form (slide 2 of 3)
• Transferability
– Corporate stock is easily sold, but partners must
approve partnership interest transfer
• Continuity of life
– Corporations exist indefinitely
Nontax Issues in Selecting
Entity Form (slide 3 of 3)
• Centralized management
– Corporate actions are governed by a board of
directors
– Partnership operations may be conducted by each
partner without approval by other partners
Limited Liability Companies (LLC)
• LLCs have proliferated since 1988 when IRS
ruled it would treat qualifying LLCs as
partnerships
– Major nontax advantage
• Allows owners to avoid unlimited liability
– Major tax advantage
• Allows qualifying business to be treated as a partnership
for tax purposes, thereby avoiding double taxation
associated with C corporations
Entity Classification
After 1996 (slide 1 of 2)
• Check-the-box Regulations
– Allows taxpayer to choose tax status of entity
without regard to corporate or noncorporate
characteristics
– Entities with > 1 owner can elect to be classified as
partnership or corporation
– Entities with only 1 owner can elect to be
classified as sole proprietorship or as corporation
Entity Classification
After 1996 (slide 2 of 2)
• Check-the-box Regulations (cont’d)
– If no election is made, multi-owner entities treated
as partnerships, single person businesses treated as
sole proprietorships
– Election is not available to:
• Entities incorporated under state law, or
• Entities required to be corporations under federal law
(e.g., certain publicly traded partnerships)
Corporation Formation Transaction
Formation Example
Ron will incorporate his donut shop:
Asset
Tax Basis
Cash
$10,000
Furniture & Fixtures
20,000
Building
40,000
Total
$70,000
Fair Mkt
Value .
$ 10,000
60,000
100,000
$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 9
Stock Transferred (slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• Assume the proposed transaction qualifies
under § 351
– i.e., The transfer of property in exchange for stock
meets the control test
– However, Amber decides to receive some
corporate debt along with the stock.
The Big Picture – Example 9
Stock Transferred (slide 2 of 2)
• If she receives Garden stock worth $900,000 and
corporate debt of $100,000 in exchange for the
property transferred,
– Amber realizes gain of $600,000
• $1,000,000 (value of consideration received) – $400,000 (basis in
the transferred property).
– However, because the transaction qualifies under § 351,
only $100,000 of gain is recognized.
• The $100,000 of corporate debt is treated as boot.
– The remaining realized gain of $500,000 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
Issues re: Formation
(slide 4 of 7)
• “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
Issues re: Formation
(slide 5 of 7)
• 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
Issues re: Formation
(slide 6 of 7)
• 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”
Issues re: Formation
(slide 7 of 7)
• 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 16
Transfers for Property and Services
(slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• Assume Amber transfers her $1,000,000 of
property to Garden, Inc. and receives 50% of
its stock.
• Jimmy receives the other 50% of the stock for
services rendered (worth $1,000,000).
The Big Picture – Example 16
Transfers for Property and Services
(slide 2 of 2)
• Both Amber and Jimmy have tax
consequences from the transfers.
– Jimmy has ordinary income of $1,000,000 because
he does not exchange property for stock.
– Amber has a taxable gain of $600,000
• $1,000,000 (fair market value of the stock in Garden) $400,000 (basis in the transferred property).
• As the sole transferor of property, she receives only
50% of the corporation’s stock.
The Big Picture – Example 17
Transfers for Property and Services
(slide 1 of 2)
• Assume the same facts as in Example 16
except that Jimmy transfers property worth
$800,000 (basis of $260,000) in addition to
services rendered to Garden, Inc. (valued at
$200,000).
• Now Jimmy becomes a part of the control
group.
– Amber and Jimmy, as property transferors,
together receive 100% of the corporation’s stock.
The Big Picture – Example 17
Transfers for Property and Services
(slide 2 of 2)
• Consequently, § 351 is applicable to the
exchanges.
– As a result, Amber has no recognized gain.
– Jimmy 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.
– Jimmy has current taxable income of $200,000.
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
The Big Picture – Example 21
Assumption of Liabilities (slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• Assume you learn that
– Amber’s husband, Jimmy, has lost interest in becoming a
stockholder in Garden, Inc., and
– Amber’s building is subject to a liability of $70,000 that
Garden assumes.
• Consequently, Amber receives 100% of the Garden
stock and is relieved of the $70,000 liability
– The building has an adjusted basis of $400,000 and fair
market value of $1,000,000.
The Big Picture – Example 21
Assumption of Liabilities (slide 2 of 2)
• The exchange is tax-free under § 351
– The release of a liability is not treated as boot
under § 357(a).
• However, the basis to Amber of the Garden
stock is $330,000
– $400,000 (basis of property transferred) − $70,000
(amount of the liability assumed by Garden).
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)
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 3)
Property transferred has:
Fair market value =
$150,000
Basis
=
100,000
Realized Gain
=
$ 50,000
Liabilities assumed by corp. (independent facts):
Liability:
Business Business
Purpose I Purpose II
$80,000
$120,000
No Business
Purpose
$120,000
Formation with Liabilities Example
(slide 2 of 3)
Business Purpose I
FMV of stock
received
Business Purpose II
No Business Purpose
$70,000
$30,000
$30,000
80,000
120,000
120,000
Amount realized
$150,000
$150,000
$150,000
Basis of property
transferred
100,000
100,000
100,000
Gain/Loss realized
$50,000
$50,000
$50,000
Liabilities assumed
Formation with Liabilities Example
(slide 3 of 3)
Liabilities assumed by corp. (independent facts):
Business Business
No Business
Purpose I Purpose II
Purpose
Boot
None
None
$120,000
Gain
Recognized
None
$20,000
$ 50,000*
*(Gain is lesser of $50,000 realized gain or boot)
Basis Computation for §351 Exchange
(slide 1 of 2)
Basis Computation for §351 Exchange
(slide 2 of 2)
Basis in Stock in Last Example
Adjusted Basis of transferred assets:
$100,000
Liabilities assumed by corp. (independent facts):
Liability:
Basis in assets
Transferred
+ Gain recognized
- Liab. Transferred
Basis in stock
Business
Purpose
$ 80,000
Business
Purpose
$120,000
$100,000 $ 100,000
None
20,000
(80,000) (120,000)
$ 20,000
-0-
No Business
Purpose .
$120,000
$100,000
50,000
(120,000)
$ 30,000
Corporation’s Basis in Assets
Received in Last Example
Liabilities assumed by corp. (independent facts):
Business Business
Purpose
Purpose
Liability:
$ 80,000 $120,000
Basis of transferred assets:
$100,000 $100,000
Gain recognized
by shareholder
None
20,000
Basis to Corp.
$100,000 $120,000
No Business
Purpose
$120,000
$100,000
50,000
$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
The Big Picture – Example 32
Stock Issued for Services Rendered
(slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• Amber transfers her $1,000,000 of property to
Garden, Inc. and receives 50% of the stock.
• In addition, assume that, in exchange for 50%
of the stock, Jimmy
– Transfers property worth $800,000 (basis of
$260,000), and
– Agrees to serve as manager of the corporation for
one year (services worth $200,000).
The Big Picture – Example 32
Stock Issued for Services Rendered
(slide 2 of 2)
• Amber’s and Jimmy’s transfers qualify under § 351.
– Neither Amber nor Jimmy is taxed on the transfer of his or her
property.
• Jimmy recognizes income of $200,000
– Equal to the value of the stock received for the services he will render
to Garden, Inc.
• Garden has
– Basis of $260,000 in the property it acquired from Jimmy, and
– A compensation expense deduction under § 162 for $200,000.
• Jimmy’s stock basis is $460,000
– $260,000 (basis of property transferred) + $200,000 (income
recognized for services rendered).
The Big Picture – Example 33
Stock Issued for Services Rendered
• Assume the same facts as in Example 32 except that Jimmy
provides legal services (instead of management services) in
organizing the corporation.
– The value of Jimmy’s legal services is $200,000.
• Jimmy has
– No gain on the transfer of the property, but
– Income of $200,000 for the value of the services rendered.
• Garden, Inc.
– Has a basis of $260,000 in the property it acquired from Jimmy, and
– Must capitalize the $200,000 as an organizational expenditure.
• Jimmy’s stock basis is $460,000
– $260,000 (basis of property transferred) + $200,000 (income
recognized for services rendered).
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
The Big Picture – Example 35
Selecting Assets To Transfer (slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• If Amber decides to retain the $50,000 of cash
basis accounts receivable rather than
transferring them to the newly formed
corporation
– She will recognize $50,000 of ordinary income
upon their collection.
The Big Picture – Example 35
Selecting Assets To Transfer (slide 2 of 2)
• Alternatively, if the receivables are transferred
to Garden as the facts suggest, the corporation
will recognize the ordinary income.
– However, a subsequent corporate distribution to
Amber of the cash collected could be subject to
double taxation as a dividend
• Given the alternatives available, Amber needs
to evaluate which approach is better for the
parties involved.
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
(slide 2 of 3)
• Capital contributions of property by
nonshareholders
– Not taxable to corporation
– Basis of property received from nonshareholder is
-0-
Capital Contributions
(slide 3 of 3)
• 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
Dividends Received Deduction
(slide 1 of 3)
– If corporation owns stock in another corporation
and receives dividends, a portion of dividends may
be deducted from income:
% owned
Deduction Percent
Less than 20%
70%
 20% but < 80%
80%
80% or more, and affiliated
100%
Dividends Received Deduction
(slide 2 of 3)
• The dividends received deduction is limited to a
percentage of the taxable income of a corporation
– For this purpose, taxable income is computed without
regard to
•
•
•
•
The NOL
The domestic production activities deduction
The dividends received deduction, and
Any capital loss carryback to the current tax year
– The percentage of taxable income limitation corresponds to
the deduction percentage
Dividends Received Deduction
(slide 3 of 3)
The following steps are useful in calculating the
dividends received deduction
1. Multiply dividends received by deduction
percentage
2. Multiply taxable income by deduction
percentage
3. Subtract 1. from taxable income
-If entity has income before DRD, but DRD creates NOL,
amount in 1. is DRD (the NOL rule)
-If DRD does not create NOL, deduction is limited to lesser
of 1. or 2.
DRD Examples
Z Corp owns 60% of X Corp’s stock in years 1, 2 & 3. Dividend of $200 is
received each year. Limit (Step 1) is 80% × $200 = $160.
1
2
3_
Income
400
301
299
Dividend rec’d
200
200
200
Expenses
(340)
(340)
(340)
Income before DRD
260
161
159
80% of income
208
129
127
Year #1 $208 > $160, so $160 DRD
Year #2 $129 < $160, so $129 DRD
Year #3 DRD causes NOL ($159-$160), so $160 DRD is used.
$2 less income results in $31 more DRD.
Organizational Expenditures
(slide 1 of 2)
• A corporation may elect to amortize
organizational expenses over a 180-month
period beginning with the month in which the
corporation begins business
• A special exception allows the corporation to
immediately expense the first $5,000 of these
costs
• Phased out on a dollar-for-dollar basis when these
expenses exceed $50,000
Organizational Expenditures
(slide 2 of 2)
• Organizational expenditures include the following:
– Legal services incident to organization
– Necessary accounting services
– Expenses of temporary directors and of organizational
meetings of directors and shareholders
– Fees paid to the state of incorporation
• Expenditures connected with issuing or selling shares
of stock or other securities or with the transfer of
assets to a corporation do not qualify
– Such expenditures reduce the amount of capital raised and
are not deductible at all
Organizational Expenditures Example
• Wren Corp. incurs $53,000 of
organizational costs
– Wren can expense $2,000 of this amount
[$5,000 - ($53,000 - $50,000)]
– The $51,000 balance is amortized over 180
months
Start-up Expenditures
(slide 1 of 2)
• Start-up expenditures include:
– Various investigation expenses involved in
entering a new business
• e.g., Travel, market surveys, financial audits, legal fees
– Also includes operating expenses, such as rent and
payroll, that are incurred by a corporation before it
actually begins to produce any gross income
Start-up Expenditures
(slide 2 of 2)
• At the election of the taxpayer, such
expenditures can be treated in the same
manner as organizational expenditures
– Up to $5,000 can be immediately expensed
(subject to the dollar cap and excess-of-$50,000
phaseout)
– Any remaining amounts are amortized over a
period of 180 months
Corporate Tax Formula
Gross income
Less: Deductions (except charitable, Div. Rec’d, NOL
carryback, STCL carryback)
Taxable income for charitable limitation
Less: Charitable contributions (< = 10% of above)
Taxable income for div. rec’d deduction
Less: Dividends received deduction
Taxable income before carrybacks
Less: NOL carryback and STCL carryback
TAXABLE INCOME
The Big Picture – Example 43
Corporate Income Tax Liability (slide 1 of 2)
• Return to the facts of The Big Picture on p. 12-1.
• Assume that Amber incorporates her business
as a calendar year C corporation and that for
2015, the corporation has taxable income of
$51,500.
The Big Picture – Example 43
Corporate Income Tax Liability (slide 2 of 2)
• Its income tax liability is $7,875, determined
as follows:
Tax on $50,000 at 15%
Tax on $1,500 at 25%
Tax liability
$7,500
375
$7,875
Tax Liability of Related Corporations
• Subject to special rules for computing income
tax
– Limits controlled group’s taxable income in tax
brackets below 35% to amount corporations in
group would have if they were one corporation
• Controlled group includes:
– Parent-subsidiary groups
– Brother-sister groups
– Combined groups
Parent-Subsidiary
Controlled Group
• Consists of one or more chains of corporations
connected through stock ownership with a
common parent
– Ownership is established through either:
• Voting power test: requires ownership of stock with at
least 80% of total voting power of all classes of stock
entitled to vote
• Value test: requires ownership of at least 80% of total
value of all classes of stock
79
Parent-Subsidiary Controlled Group
80
Application of §482
• §482 permits IRS to reallocate income,
deductions, and credits between two or more
businesses owned or controlled by the same
interests
• Used to prevent avoidance of taxes or to reflect
income properly
– Controlled groups of corps are especially
vulnerable to §482
81
Corporate Filing Requirements
(slide 1 of 2)
• Must file Form 1120 on or before the 15th day
of 3rd month following close of tax year even
if it has no taxable income
– Automatic 6 month extensions are available by
filing Form 7004
Corporate Filing Requirements
(slide 2 of 2)
• Must make estimated tax payments equal to
lesser of:
– 100% of corporation’s tax for the current year, or
– 100% of tax for preceding year
• No estimated tax payments required if tax
liability expected to be less than $500
Schedule M-1
• Corporations must reconcile financial
accounting income with taxable income on Sch
M-1, Form 1120
– Common reconciling items include:
• Federal income tax per books
• Net capital losses
• Income reported for tax but not book income (e.g.,
prepaid income) and vice versa
• Expenses deducted for book income but not tax (e.g.,
excess charitable contributions) and vice versa
Schedule M-2
• Corporations must reconcile retained earnings
at beginning of year with retained earnings at
end of year using Sch M-2, Form 1120
– Schedule L (balance sheet), Schedules M–1 and
M–2 of Form 1120 are not required for
corporations with less than $250,000 of gross
receipts and less than $250,000 in assets
Schedule M-3
• Corporate taxpayers with total assets of $10 million
or more are now required to report much greater
detail regarding differences in financial accounting
income (loss) and taxable income (loss)
– Reported on Schedule M–3
• Schedule M–3 should
– Create greater transparency between corporate financial
statements and tax returns
– Help the IRS identify corporations that engage in
aggressive tax practices
Refocus On The Big Picture (slide 1 of 6)
• Amber, the sole property transferor, must
acquire at least 80% of the stock issued by
Garden, Inc. in order for the transaction to
receive tax-deferred treatment under § 351.
– Otherwise, a tremendous amount of gain (up to
$600,000) will be recognized.
• As a corollary, Jimmy must not receive more
than 20% of Garden’s stock in exchange for
his services.
Refocus On The Big Picture (slide 2 of 6)
• However, even if § 351 is available, any
corporate debt issued by the corporation will
be treated as boot and will trigger gain
recognition to Amber.
– Therefore, she must evaluate the cost of
recognizing gain now versus the benefit of Garden
obtaining an interest deduction later.
Refocus On The Big Picture (slide 3 of 6)
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.
• Have Jimmy transfer some property along with the
services rendered to Garden.
– As long as Jimmy transfers property with more than a
relatively small value compared to the value of services
performed, Jimmy will be considered part of the control
group.
– This would allow Amber to own less than 80% of the new
corporation and still qualify under § 351.
Refocus On The Big Picture (slide 4 of 6)
What If?
• Instead of having Garden issue debt on
formation, Amber 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 Garden.
Refocus On The Big Picture (slide 5 of 6)
What If?
• An additional benefit results if Amber does not
transfer the cash basis receivables to Garden.
– This approach avoids a tax at the corporate level
and a further tax when the receipts are distributed
to Amber in the form of a dividend.
– If the receivables are withheld, their collection is
taxed only to Amber.
Refocus On The Big Picture (slide 6 of 6)
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 Amber to transfer them to the corporation.
– The subsequent corporate payment of the liability
produces a corporate deduction that will reduce
any corporate tax.
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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