Tax - Ch 2 - Corporate Formation and Capital Structure Flashcards Table View
Tax Planning with Section 351
- 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.
Incorporation in General
- 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
Transfers to Controlled Corporations (IRC Section 351)
- 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.
If section 351 applies then
- 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).
Three requirements for section 351 to apply
- 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 Section 351
- 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.
Stock Issued for Services Rendered (Section 351)
- 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).
Solely for Stock and the Boot Exception (Section 351)
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 stock received from corporation (formula)
Basis of property transferred+ Gain recognized- Boot received and liabilitiesBasis of stock received from corp
Basis of assets received from shareholder formula)
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.
Assumption of Liabilities (IRC section 357)
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.
Other Exceptions to the General Rule(IRC section 357)
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.
Qualified Small Business (QSB) Stock
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
Worthless Stocks and Securities
Usually capital assets that can only be deducted as a capital loss on the last day of the tax year in which they become completely worthless.
Section 1244 Stock
1. Ordinary loss treatment in any one year permitted for up to $50,000 per year ($100,000 joint return) for losses on the sale or worthlessness of section 1244 stock.2. A gain on the sale of section 1244 stock is capital.3. Section 1244 stock applies to small domestic business corporations (capitalization < $1 million) with stock issued for money or property (does not include stock received for services or convertible securities).4. Only the original individual holder of the stock qualifies.5. If section 1244 stock is received in exchange for loss property, then the ordinary loss is based on the fair market value of property.
1. Business bad debts yield ordinary losses and deductions are allowed for partial worthlessness.2. Nonbusiness bad debts yield short term capital losses and no deductions are allowed for partial worthlessness.3. For corporations, bad debts are always "business". For noncorporate taxpayers, the primary motive for making the loan controls the classification.
Shareholder Contributions to Capital
A. Not taxable to recipient corporation. B. Basis of property received from shareholder as a capital contribution equals basis to shareholder plus any recognized gain.
Nonshareholder Contributions to Capital
A. Not taxable to corporations as long as an inducement and not a payment for goods and services.B. Basis of property received from a non-shareholder as a capital contribution is zero. C. If cash is received from a non-shareholder as a capital contribution, the basis of property purchased within 12 months is reduced by the amount of the cash. At the end of 12 months, any excess cash reduces basis in other property.
Corporation Capital Structure
Stock versus DebtA. In general, the tax laws favor the use of debt rather than stock.IRC Section 385 allows the IRS to reclassify debt as equity. The form of the debt obligation must be proper and the corporation cannot be thinly capitalized.
Advantages of Debt
1. Interest payments are deductible to corporations; dividends payments are not deductible.2. Repayments of debt principal do not create income to shareholders; stock redemptions do create income.3. Retaining earnings to repay debt is a reasonable business need for the accumulated earnings penalty tax; retaining earnings for a redemption of stock is not.