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Chapter 4 presentation

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  • 1. Chapter 4 Corporations: Organization and Capital Structure
  • 2. 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.
  • 3. The Big Picture (slide 2 of 3)
    • Emily’s sole proprietorship assets available for transfer to the new corporation are:
    • Adjusted Fair Market
    • Basis Value
    • Accounts receivable $ –0– $ 25,000
    • Building 50,000 200,000
    • Other assets 150,000 275,000
    • $200,000 $500,000
  • 4. 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.
  • 5. Corporation Formation Transaction
  • 6. Formation Example
    • Ron will incorporate his donut shop:
    • Asset Fair Mkt
    • Tax Basis Value .
    • Cash $10,000 $ 10,000
    • Furniture & Fixtures 20,000 60,000
    • Building 40,000 100,000
    • Total $70,000 $170,000
    • Without § 351: gain of $100,000.
    • With § 351: no gain or loss. Ron’s economic status has not changed.
  • 7. 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
  • 8. 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
  • 9. 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
  • 10. 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
  • 11. 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.
  • 12. 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.
  • 13. 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
  • 14. 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
  • 15. 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
  • 16. 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”
  • 17. 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
  • 18. 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).
  • 19. 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.
  • 20. 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.
  • 21. 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.
  • 22. 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
  • 23. 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)
  • 24. Formation with Liabilities Example (slide 1 of 2)
    • Property transferred has:
    • Fair market value = $150,000
    • Basis = 100,000
    • Realized Gain = $ 50,000
  • 25. 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)
  • 26. 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
  • 27. 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
  • 28. Basis in Stock in Last Example
    • Adjusted Basis of transferred assets: $100,000
    • Liabilities assumed by corp. (independent facts):
    • Business Business No Business
    • Purpose Purpose Purpose .
    • Liability: $ 80,000 $120,000 $120,000
    • Basis in assets
    • Transferred $100,000 $ 100,000 $100,000
    • + Gain recognized None 20,000 50,000
    • - Liab. Transferred (80,000) (120,000) (120,000)
    • Basis in stock $ 20,000 -0- $ 30,000
  • 29. Corporation’s Basis in Assets Received in Last Example
    • Liabilities assumed by corp. (independent facts):
    • Business Business No Business
    • Purpose Purpose Purpose
    • Liability: $ 80,000 $120,000 $120,000
    • Basis of trans-
    • ferred assets: $100,000 $100,000 $100,000
    • Gain recognized
    • by shareholder None 20,000 50,000
    • Basis to Corp. $100,000 $120,000 $150,000
  • 30. 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
  • 31. 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
  • 32. 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
  • 33. 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
  • 34. 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
  • 35. 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
  • 36. Capital Contributions (slide 2 of 3)
    • Capital contributions of property by nonshareholders
      • Not taxable to corporation
      • Basis of property received from nonshareholder is -0-
  • 37. 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
  • 38. 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
  • 39. 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
  • 40. 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
  • 41. 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
  • 42. 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
  • 43. 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
  • 44. 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
  • 45. 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
  • 46. 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
  • 47. 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
  • 48. §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
  • 49. §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
  • 50. §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
  • 51. §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
  • 52. 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
  • 53. 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
  • 54. 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.
  • 55. 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.
  • 56. 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.
  • 57. 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.
  • 58. 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.
  • 59. 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.
  • 60. 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!
  • 61.
    • If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
    • Dr. Donald R. Trippeer, CPA
    • [email_address]
    • SUNY Oneonta