Tax - Ch 2 - Corporate Formation and Capital Structure

- Note that section 351 treatment is not always the desired result. Thus, tax planning may involve failing the requirements for its application. - Sales of shareholder property to the corporation and lease arrangements should also be considered as alternatives.

- Corporations are formed under State law. In most States, an application entitled the ‘Articles of Incorporation’ must be filed. - A number of decisions must be made, including what State to incorporate in, what assets will be transferred by investors to the corporation, and how the assets will be transferred. - In the absence of IRC Section 351, any property transfers to a corporation in exchange for stock would be treated as a taxable transaction

- Section 351 uses the continuity of interest principle to provide an exception to the general rule that transfers of property for stock are a taxable transaction. - For a qualifying transfer, the application of section 351 is mandatory.

- No gain or loss is recognized by the transferor (except that realized gain is recognized to the extent of boot received), and - The transferor substitutes the basis of the property transferred to the corporation as the basis for the stock received (with adjustments for any recognized gains and boot received).

- Property is transferred * Excludes services rendered. * Includes unrealized receivables and installment obligations. - For stock (common and most preferred) * All else received (e.g., corporate bonds) is boot that is taxable to the extent of realized gains. * Stock warrants and rights are not stock. - Transferors are in control of the corporation immediately after the exchange.

- Transferors must own at least 80% of the total combined voting power and at least 80% of the shares of all other classes of stock. - Section 351 treatment is lost for all transferors if too much stock is transferred to persons who contribute services rather than property. - A person who exchanges both property and services for stock is treated as part of the transferor group as long as the fair market value of the property portion is not nominal (per IRS, => 10% of the value of the services). - Section 351 also applies to transfers after a corporation is in operation. - For admission of a new shareholder to an existing corporation, existing shareholders may only be counted towards the control requirement if they contribute property that is not nominal (=> 10% of value of their existing stock). - Simultaneous transfers are not necessary if all the transfers are made pursuant to a prearranged plan that is carried out timely. - “Momentary control” can result in a loss of Section 351 treatment if a prearranged plan to sell or gift shares would result in < 80% ownership.

- Service provider has taxable income. - Corporation has a deduction or a capital expenditure depending on the nature of the services. - Complicates control requirements (see above).

1. Receipt of property from the corporation other than stock constitutes boot (e.g., cash, bonds, etc.) 2. Receiving boot does not disqualify the transaction from section 351 treatment. 3. The transferor recognizes a realized gain to the extent boot is received. 4. Note that the receipt of boot cannot trigger a gain more than realized gain and it never triggers a loss.

Basis of property transferred + Gain recognized - Boot received and liabilities Basis of stock received from corp

Basis of assets in hands of transferor + Gain recognized to shareholder **Depreciation periods, methods, and depreciation recapture potential carry over to the corporation.

Shareholder: If transferred property is a capital asset or section 1231 property, then the holding period of the property "tacks on" to the stock received. Otherwise, the holding period of the stock received starts the day after the exchange. Corporation: Holding period of the transferor carries over to the corporation for property received in a section 351 exchange.

1. General Rule: The assumption of shareholder liabilities by the corporation is not boot (for gain recognition purposes). Instead, the basis of the stock received by the shareholder is simply reduced by the assumed liabilities. An exception to this rule applies for payables of a cash basis taxpayer.

a. Exception 1: All assumed liabilities are considered boot if the principal purpose is to avoid tax or if there is no bona fide business purpose behind the exchange. b. Exception 2: If the sum of the assumed liabilities is greater than the adjusted basis of the properties transferred (so that the shareholder’s stock basis would be < 0 under the general rule), then the excess amount is taxable. This rule ensures that stock basis is never < 0. c. If both exceptions apply, then "Exception 1" above predominates.

1. Noncorporate shareholders may exclude 50 % of gain from sale (with capital gain rate of 28 percent). 2. The stock must have been held for more than 5 years and acquired as part of an original issue. 3. A QSB is generally a domestic C corporation with gross assets of $50 million or less and active business operations. 4. Rollover provision allows deferral of gain recognition if sales proceeds used to purchase other QSB stock.

- Worthless stocks and securities - Bad Debts -Section 1244 stock