Chapter 4
Corporations:
Organization and Capital
Structure
Corporations, Partnerships,
Estates & Trusts
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Big Picture (slide 1 of 3)
• Emily has operated her business for 10 years as a sole
proprietorship, but has decided to incorporate the
business.
– She understands that the corporate form offers several
important nontax advantages (e.g., limited liability).
– Also, the incorporation would enable her husband, David,
to become a part owner in the business.
• Emily expects to transfer her business assets in
exchange for her corporate interest, while David will
provide services for his interest.
The Big Picture (slide 2 of 3)
• Emily’s sole proprietorship assets available for
transfer to the new corporation are:
Accounts receivable
Building
Other assets
Adjusted
Basis
$
–0–
50,000
150,000
$200,000
Fair Market
Value
$ 25,000
200,000
275,000
$500,000
The Big Picture (slide 3 of 3)
• Aware of the double taxation problem associated with
operating as a regular corporation, Emily is
considering receiving some corporate debt at the time
of incorporation.
– The interest expense on the debt will then provide a
deduction for the corporation.
• Emily’s main concern, however, is that the
incorporation will be a taxable transaction.
– Can her fears be allayed?
• Read the chapter and formulate your response.
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 4
Stock Transferred (slide 1 of 2)
• Return to the facts of The Big Picture on p. 4-2.
• Assume the proposed transaction qualifies
under § 351
– i.e., The transfer of property in exchange for stock
meets the control test
– However, Emily decides to receive some
corporate debt along with the stock.
The Big Picture – Example 4
Stock Transferred (slide 2 of 2)
• If she receives stock worth $450,000 and corporate
debt of $50,000 in exchange for the property
transferred,
– Emily realizes gain of $300,000 [$500,000 (value of
consideration received) – $200,000(basis in the transferred
property)].
– However, because the transaction qualifies under § 351,
only $50,000 of gain is recognized—the $50,000 of
corporate debt is treated as boot.
– The remaining realized gain of $250,000 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 9
Transfers for Property and Services
(slide 1 of 2)
• Return to the facts of The Big Picture on p. 4-2.
• Assume Emily transfers her $500,000 of
property to the new corporation and receives
50% of its stock.
• David receives the other 50% of the stock for
services rendered (worth $500,000).
The Big Picture – Example 9
Transfers for Property and Services
(slide 2 of 2)
• Both Emily and David have tax consequences
from the transfers.
– David has ordinary income of $500,000 because he
does not exchange property for stock.
– Emily has a taxable gain of $300,000
• $500,000 (fair market value of the stock in the new
corporation) - $200,000 (basis in the transferred
property).
• As the sole transferor of property, she receives only
50% of the corporation’s stock.
The Big Picture – Example 10
Transfers for Property and Services
(slide 1 of 2)
• Assume the same facts as in Example 9 except
that David transfers property worth $400,000
(basis of $130,000) in addition to services
rendered to the corporation (valued at
$100,000).
• Now David becomes a part of the control
group.
– Emily and David, as property transferors, together
receive 100% of the corporation’s stock.
The Big Picture – Example 10
Transfers for Property and Services
(slide 2 of 2)
• Consequently, § 351 is applicable to the
exchanges.
– As a result, Emily has no recognized gain.
– David 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.
– David has current taxable income of $100,000.
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
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 2)
Property transferred has:
Fair market value =
Basis
=
Realized Gain
=
$150,000
100,000
$ 50,000
Formation with Liabilities Example
(slide 2 of 2)
Liabilities assumed by corp. (independent facts):
Business Business
No Business
Purpose Purpose
Purpose
Liability:
$80,000 $120,000
$120,000
Boot
None
$ 20,000
$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)
Shareholder’s basis in stock:
Adjusted basis of transferred assets
+ Gain recognized on exchange
- Boot received
-Liabilities transferred to corporation
-Adjustment for loss property (if elected)
= Basis of stock received by shareholder
Basis Computation for §351 Exchange
(slide 2 of 2)
Corporation’s basis in assets:
Adjusted basis of transferred assets
+ Gain recognized by transferor shareholder
- Adjustment for loss property (if required)
= Basis of assets to corporation
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
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
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
Losses on Investment in Corporation
(slide 1 of 5)
• Stock and security losses
– If stocks and bonds are capital assets, losses from
worthlessness are capital losses
• Loss is treated as occurring on last day of tax year in
which they become worthless
• No loss for mere decline in value
Losses on Investment in Corporation
(slide 2 of 5)
• Stock and security losses
– If stocks and bonds are not capital assets, losses
from worthlessness are ordinary losses (e.g.,
broker owned)
– Sometimes an ordinary loss is allowed for
worthlessness of stock of affiliated company
Losses on Investment in Corporation
(slide 3 of 5)
• Business versus nonbusiness bad debts
– General rule: Losses on debt of corporation
treated as business or nonbusiness bad debt
– If noncorporate person lends as investment, loss is
nonbusiness bad debt
• Short-term capital loss
• Only deductible when fully worthless
Losses on Investment in Corporation
(slide 4 of 5)
• Business versus nonbusiness bad debts (con’t)
– If corporation is lender, loss is business bad debt
• Ordinary loss deduction
• Deduction allowed for partial worthlessness
• All bad debts of corporate lender qualify as business
bad debts
Losses on Investment in Corporation
(slide 5 of 5)
• Business versus nonbusiness bad debts (con’t)
– Noncorporate lender may qualify for business bad
debt treatment if:
• Loan is made in some capacity that qualifies as a trade
or business, or
• Shareholder is in the business of lending money or of
buying, promoting, and selling corporations
§1244 stock
(slide 1 of 4)
• Treatment of §1244 stock:
– Ordinary loss treatment for loss on stock of “small
business corporation” (as defined)
– Gain still capital gain
§1244 stock
(slide 2 of 4)
• §1244 stock:
– Applies to the first $1 million of corp.'s stock
• If > $1 million of stock issued, entity designates which
shares qualify for § 1244 treatment
• Property received in exchange for stock is valued at its
adjusted basis, reduced by any liabilities assumed by
the corporation
– The fair market value of the property is not considered
§1244 stock
(slide 3 of 4)
• Annual loss limitation:
– $50,000 or
– $100,000 if married filing joint return
– Any remaining loss is a capital loss
• Only original holder of §1244 stock (whether
an individual or a partnership) qualifies for
ordinary loss treatment
– Sale or contribution of stock results in loss of
§1244 status
§1244 stock
(slide 4 of 4)
• If §1244 stock is issued for property with basis
> fair market value
– For determining ordinary loss, stock basis is
reduced to fair market value on date of exchange
Gain from Qualified
Small Business Stock (slide 1 of 2)
• Noncorporate shareholders may exclude 50%
of gain from sale or exchange of such stock
– Must have held stock for > 5 years and acquired
stock as part of original issue
– 50% exclusion can be applied to the greater of:
• $10 million, or
• 10 times shareholder’s aggregate adjusted basis of
qualified stock disposed of during year
Gain from Qualified
Small Business Stock (slide 2 of 2)
• Qualified Small Business Corp
– C corp with gross assets not greater than $50 million on
date stock issued
– Actively involved in a trade or business
• At least 80% of corporate assets are used in the active conduct of
one or more trade or businesses
• Under ARRTA of 2009, the exclusion increases to
75% for qualified stock acquired after February 17,
2009, and before 2011
• From legislation in 2010, the exclusion increases to
100% for qualified stock acquired after September
27, 2010, and before 2012
The Big Picture – Example 35
Selecting Assets To Transfer (slide 1 of 2)
• Return to the facts of The Big Picture on p. 4-2.
• If Emily decides to retain the $25,000 of cash
basis accounts receivable rather than
transferring them to the newly formed
corporation
– She will recognize $25,000 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 the corporation as the facts suggest, the
corporation will recognize the ordinary
income.
– However, a subsequent corporate distribution to
Emily of the cash collected could be subject to
double taxation as a dividend
• Given the alternatives available, Emily needs
to evaluate which approach is better for the
parties involved.
Refocus On The Big Picture (slide 1 of 5)
• Emily, the sole property transferor, must
acquire at least 80% of the stock issued by the
new corporation in order for the transaction to
receive tax-deferred treatment under § 351.
– Otherwise, a tremendous amount of gain (up to
$300,000) will be recognized.
• As a corollary, David must not receive more
than 20% of the corporation’s stock in
exchange for his services.
Refocus On The Big Picture (slide 2 of 5)
• However, even if § 351 is available, any
corporate debt issued by the corporation will
be treated as boot and will trigger gain
recognition to Emily.
– Therefore, she must evaluate the cost of
recognizing gain now versus the benefit of the
corporation obtaining an interest deduction later.
Refocus On The Big Picture (slide 3 of 5)
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.
• Instead of having the corporation issue debt on
formation, Emily 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 the corporation.
Refocus On The Big Picture (slide 4 of 5)
What If?
• An additional benefit results if Emily does not
transfer the cash basis receivables to the
corporation.
– This approach avoids a tax at the corporate level
and a further tax when the receipts are distributed
to Emily in the form of a dividend.
– If the receivables are withheld, their collection is
taxed only to Emily.
Refocus On The Big Picture (slide 5 of 5)
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 Emily
to transfer them to the corporation.
– The subsequent corporate payment of the liability produces
a corporate deduction that will reduce any corporate tax.
• Double taxation can be mitigated in certain situations
with a modest amount of foresight!
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
© 2012 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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