Education Inc Publishing as Prentice Hall CORPORATE FORMATIONS amp CAPITAL STRUCTURE 1 of 2 Organization forms available Legal requirements for forming a corporation Checkthebox regulations ID: 288593
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©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide2
CORPORATE FORMATIONS & CAPITAL STRUCTURE
(1 of 2)
Organization forms availableLegal requirements for forming a corporationCheck-the-box regulationsTax considerations in forming a corporation
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide3
CORPORATE FORMATIONS & CAPITAL STRUCTURE
(2 of 2)
§351: Deferring gain or loss upon incorporationsChoice of capital structureWorthless stock or debt obligationsTax planning considerationsCompliance & procedural considerations
Financial statement implications
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide4
Organization Forms Available
Sole proprietorships
PartnershipsCorporationsC CorporationsS Corporations
Limited liability companies
Limited liability
partnerships
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide5
Sole Proprietorship
(1 of 3)
One ownerNot a separate legal entityIncome reported on Sch. C of 1040No limited liability
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide6
Sole Proprietorship
(2 of 3)
Tax advantagesProfits taxed onceProprietor’s marginal tax rate may be lower than if business were taxed as a corporationNo tax on contributions or withdrawalsLosses offset other income (with limitations)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide7
Sole Proprietorship
(3 of 3)
Tax disadvantagesProfits taxed as earned, not as receivedCorporate tax rates may be lower than proprietor’s marginal tax rate
Owner not employee
Profits subject to SE tax
Not eligible for some tax-exempt fringe benefits
Compensation to owner not deductible
No fiscal year deferral
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide8
Partnerships
(1 of 3)
Two or more ownersConduit entityReports, but does not pay income taxNo limited liabilityExcept for limited partners
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide9
Partnerships
(2 of 3)
Tax advantagesNo partnership-level taxesIncome only taxed at partner level
Losses offset other income (with limitations)
Contributions and withdrawals generally not subject to taxation
Income retains its character
Income/gain increases basis
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide10
Partnerships
(3 of 3)
Tax disadvantagesProfits taxed as earned, not when receivedPartners not employees
Profits subject to SE tax
Not eligible for some tax-exempt fringe benefits
Fiscal year deferral difficult to
obtain
Cannot use fiscal year-end to defer income
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide11
C Corporations
(1 of 3)
Separate taxpaying and legal entityLimited liabilityTaxation at corporate levelRates 15% - 35%Dividend distributions taxed to owners at lower capital gains tax rates
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide12
C Corporations
(2 of 3)
Tax advantagesCorp’s marginal tax rate may be lower than owners’ tax ratesShareholders may be employees
No SE tax
Eligible for tax-exempt fringe benefits
Compensation to owners deductible
May choose fiscal
year
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide13
C Corporations
(3 of 3)
Tax disadvantagesDouble taxation of incomeCorporate and shareholder levelHowever, tax rate at shareholder level is at capital gains rates (generally 15% through 2010)
Withdrawals (dividends) taxable
NOLs cannot be used in current year
Capital losses cannot offset ordinary income
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide14
S Corporations
(1 of 3)
Conduit entitySimilar to a partnership, butLess flexible than a partnershipMust file an election to be an S corp.Subject to rules under Subchapter SFollows same rules as a C Corp except for specific items addressed in Subchapter S
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide15
S Corporations
(2 of 3)
Tax advantagesGenerally exempt from taxationLosses flow through to shareholdersIncome retains its character
Contributions and withdrawals generally not subject to taxation
Income/gain increases basis
Shareholders may be employees
S Corp net income not subject to SE tax
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide16
S Corporations
(3 of 3)
Tax disadvantagesProfits taxed as earnedS Corp shareholders generally not eligible for tax-exempt fringe benefitsS Corp cannot choose a fiscal year to obtain income deferral
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide17
Limited Liability Companies
Limited liability for all owners
No ownership restrictionsMay be taxed as partnership or corporation©2011 Pearson Education, Inc. Publishing as Prentice HallSlide18
Limited Liability Partnership
Partners liable for only their own actions
No liability for negligence or misconduct of other partnersMay be taxed as either a partnership or corporation©2011 Pearson Education, Inc. Publishing as Prentice HallSlide19
Check-the-Box Regulations
(1 of 2)
Unincorporated entities choose to be taxed as partnership or corpSole proprietor or corp if one ownerEntity must choose tax status orAccept default statusPartnership (sole proprietor if one owner)
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide20
Check-the-Box Regulations
(2 of 2)
Change in status results in a deemed liquidation/reincorporationPartner electing corp status is nontaxableCorp electing to be disregarded is taxable
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide21
Legal Requirements for
Forming
a CorporationDependent on state lawMinimum capital requirementsFiling articles of incorporationIssuing stockPaying state incorporation feesMay be assessed franchise taxes
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide22
Tax Considerations in
Forming
a CorporationItems affecting tax consequences of forming a corporationProperty to be transferredServices to be provided
Liabilities transferred
How property should be transferred
E.g., contribution,
sale
See Table 1 for overview of
corp
formation rules
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide23
§351 Deferring Gain or Loss upon Incorporation
(1 of 2)
No gain or loss recognized if:PROPERTY transferred in exchange for stock andTransferors have control (80%) of corp immediately after the exchangeTransfers may be for new or existing corporations
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide24
§351 Deferring Gain or Loss upon Incorporation
(2 of 2)
Property requirementControl requirementStock requirementExchange solely for stock
Effect of §351 on transferors
Effect of §351 on transferee
corp
Assumption of the transferor’s liabilities
Other considerations in a §351 exchange
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide25
Property Requirement
Property does not include:
ServicesIndebtedness of transferee not evidenced by a securityInterest on indebtedness of transferee that accrued on or after beginning of transferor’s holding period for the debt
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide26
Control Requirement
Transferors must own at least:
80% of total combined voting power of all classes of stock and 80% of total number of shares of all other classes of stockContribution of services & propertyStock of transferor counted towards 80% if FMV of property
10% of service’s value
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide27
Effect of §351 on Transferors
(1 of 4)General rulesNo gain or loss recognizedBasis in stock same as basis in property (substituted basis)Holding period of stock includes holding period of assets
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide28
Effect of §351 on Transferors
(2 of 4)Receipt of bootGain recognized lesser of gain realized or FMV of boot receivedGain recognized when liabilities transferred exceed basis in assets transferredBasis in stock increased by gain recognized
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide29
Effect of §351 on Transferors
(3 of 4)Receipt of boot (continued)Basis in boot property is FMVHolding period of boot begins day after exchange
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide30
Effect of §351 on Transferors
(4 of 4)Computing shareholder’s basis Adjusted basis of property transferred+ Gain recognized by transferor
- Money received
- Liabilities assumed by transferee corp
= Shareholder’s basis in corp stock
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide31
Effect of §351 on Transferee Corp
(1 of 3)
No gain or loss recognized Transferor’s adjusted basis plus+ Gain recognized by transferee (if any)
- Reduction for loss property (if applicable)
= Transferee corp’s basis in property
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide32
Effect of §351 on Transferee Corp
(2 of 3)
Loss property limitationWhen basis > FMV of prop transferredCorp’s basis = FMV ANDReduction in basis allocated to other assets ORContributing s/h reduces her basis in corp stock
Corp recognizes gain if
appreciated property transferred to transferor in §351 exchange
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide33
Effect of §351 on Transferee Corp
(3 of 3)
Depreciation recapture potential transfers to transferee corporationHolding period includes transferor’s holding periodHolding period begins day after transfer when basis reduced to FMV
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide34
Assumption of the Transferor’s Liabilities
(1 of 2)
General rule - §357(a)Assumption of liabilities by transferee corp not considered receipt of moneyDoes not trigger gain
Increases amount realized by transferee
Decreases transferee’s basis in stock
If no bona fide business purpose
Assumption of liabilities considered receipt of money
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide35
Assumption of the Transferor’s Liabilities
(2 of 2)
Liabilities in excess of basis - §357(c) Total liabilities transferred to corp- Total adj basis of property transferred
Gain recognized
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide36
Other Considerations in a §351 Exchange
(1 of 2)
Depreciation recaptureTransferee corp inherits transferor’s depreciation recapture potentialComputing depreciationTransferee corp must use same method and recovery period as transferorAllocate depreciation expense for year of transfer based on # of months held
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide37
Other Considerations in a §351 Exchange
(2 of 2)
Assignment of income doctrineTransferee generally recognizes income when A/R collected and deductions when pays A/P of cash-basis transferor
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide38
Choice of Capital Structures
Debt
Interest deductible by corpRepayment of debt not taxable to shareholderDebt received in §351 is boot to shareholder
Worthless debt is capital loss to shareholder
Debt distributed by corp taxable to shareholder
Equity
Dividends not deductible by
corp
Shareholder only pays max 15% on dividends
received (through 2010)
Stock redemption can be taxable dividend to shareholder
Stock received in §351 not boot to shareholder
Worthless §1244 stock is ordinary loss to shareholder
Stock distributed by
corp
not taxable to shareholder
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide39
Choice of Capital Structures:
Debt
Interest deductible by corpDebt repayment not taxable to s/hDebt received in §351 is boot to s/hWorthless debt is capital loss to s/hDebt distributed by corp taxable to s/h
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide40
Choice of Capital Structures:
Equity
Dividends not deductible by corpS/h only pays max 15% on div. receivedThrough 2010
Stock redemption can be taxable dividend to s/h
Stock received in §351 not boot to s/h
Worthless §1244
stk
ordinary loss to s/h
Stock
dist.
by
corp
not taxable to s/h
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide41
Choice of Capital Structures:
Contributions by
Nonshareholders (1 of 2)Eg., state, local, and city governments
Contributions of money and/or property to encourage a corporation to move to a particular location
Basis of property acquired by is zero
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide42
Choice of Capital Structures:
Contributions by
Nonshareholders (2 of 2)Property purchased w/in 12 months of cash contribution reduced by cash received
Basis of other non-cash assets reduced by remaining cash at end of 12-month period
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide43
Worthless Stock or Debt
(1 of 3)
Investment evidenced by a security that becomes worthless produces a capital loss on last day of tax yearSecurities include:Stock of a corporationRights to subscribe for stock to be issuedEvidence of indebtedness
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide44
Worthless Stock or Debt
(2 of 3)
Ordinary Loss SituationsSecurities that are noncapital assetsSecurities of affiliated companies§1244 stock
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide45
Worthless Stock or Debt
(3 of 3)
§1244 stockQualifying small business stockMust be the original purchaserOrdinary loss up to $50k or $100k if MFJCorp must have received $1M or less of property in exchange for stock
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide46
Tax Planning considerations
Avoiding §351
Mandatory provision, not electiveAvoid if transferring loss property to corpNeed to also avoid §267 related party loss limitation as wellAvoid if transferring gain property and want
corp
to have stepped-up basis
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide47
Compliance and Procedural Considerations
Attachment to s/
hs’ individual tax returns for §351 transactionsMust include all facts pertinent to the exchange
©2011 Pearson
Education, Inc. Publishing as Prentice HallSlide48
©2011 Pearson
Education, Inc. Publishing as Prentice Hall