The student should: 1.Understand the tax treatment of shareholder contributions to equity, as well as contributions by non- shareholders. Page 16+. 2.Understand the role of debt in capital structure. Page 18. 3.Understand the tax treatment of losses by stockholders, including §1244 losses. Page 23. 4.Explain §1202 and §1044. Page 23+.
Other Considerations in a Sec. 351 Exchange. Characterization of Obligations as Debt or Equity Capital. The tax laws provide an incentive for closely held corporations to use as much debt as possible. Where debt financing resembles equity obligations, the form of the transaction will be ignored and debt will be reclassified as common or preferred stock. No single factor is controlling in determining when reclassification will occur.
Determine the tax consequences of worthless stock or debt obligations.
Debt Capital. If assets are exchanged for debt, whether part of an otherwise tax-free transaction or not, the FMV of the debt received is treated as boot. Interest paid on debt is deductible by the payor. Dividends paid on stock are not deductible by the corporation. Noncorporate investors who borrow funds in order to make an investment in a C corporation will find that the interest expense incurred to carry such an investment is generally subject to the investment interest limitation; unless the investment is a passive activity and the interest expense comes under the passive activity limitation rules.
Debt Capital. Repayment of a debt is not considered an exchange transaction. Repayment by corporation of an obligation does not result in a gain or loss being recognized by the creditor. The satisfaction of a debt instrument (e.g., note, bond, or a debenture) is an exchange for the holder of a debt instrument and gain or loss will be recognized if the amount received is different from the asset's basis.
Capital Contributions by Shareholders. A corporation does not recognize any income when it receives money or property as a capital contribution from a shareholder. §118 If additional contributions are made without additional stock being issued, the payments are regarded as an additional price paid for the existing stock.
The basis of property contributed by a nonshareholder is zero. If money is contributed, the basis of any property acquired with such money during a 12- month period is reduced by the amount of the contribution used for the purchase. Money contributed by nonshareholders that is not spent to purchase property during the 12-month period reduces first the basis of depreciable property, then amortizable property, depletable property and all other property. Basis is not reduced below zero.
Worthlessness of Stock or Debt. A debt or equity investment that is evidenced by a security and that becomes worthless results in a capital loss for the investor on the last day of the tax year in which the worthlessness occurs. Ordinary loss can be reported in some situations. An example of this would be securities that are held by dealers as inventory. A domestic corporation is also permitted to claim an ordinary loss in connection with the worthlessness of a security of an affiliated corporation.
Worthlessness of Stock or Debt -1244- 1 of 3 Sec. 1244 permits an ordinary loss to be claimed for qualifying stock issued by a small business that is sold, exchanged or becomes worthless. Ordinary loss treatment is only allowed an individual who was originally issued the stock, or by a partner in a partnership that was originally issued the stock, and whose distributive share includes the losses for the corporate stock.
Worthlessness of Stock or Debt-1244- 2 of 3 If a shareholder contributes additional money or property to a corporation after acquiring Sec. 1244 stock, the amount of ordinary loss recognized upon the sale, exchange, or worthlessness of the Sec. 1244 stock is limited to the shareholder's capital contribution at the time the shares were issued.
Worthlessness of Stock or Debt-1244- 3 of 3 The ordinary loss is limited to $50,000 (or $100,000 if the taxpayer is married and files jointly). Losses in excess of the dollar ceiling are capital losses. The ordinary loss can be carried back or forward as part of a net operating loss.
Worthlessness of Stock or Debt – 1 of 2 Shareholders may make loans to corporations. The type of loss that can be claimed on these advances depends on the nature of the loan. If the advance is treated as paid-in capital, the amount of the loan increases the worthless securities loss on the stock.
Worthlessness of Stock or Debt – 2 of 2 A loan made to a corporation that is not evidenced by a security can be deducted under either the business or nonbusiness bad debt rules. Most unsecured advances are considered to be made outside the shareholder's trade or business. If a noncorporate shareholder makes the loan, it will generally be considered a nonbusiness bad debt that is a short- term capital loss, and is limited to a $3,000 deduction per year.
Character of Investor’s Losses What is the impact of Section 165(c) for worthless Stock? What is the impact of Section 166?
Character of Investor’s Losses Sec. 165. Losses (a) There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance..
Character of Investor’s Losses Sec. 165. Losses (b) Amount of Deduction. For purposes of subsection (a), the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.
Character of Investor’s Losses Sec. 165. Losses (c) In the case of an individual, the deduction under subsection (a) shall be limited to — (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into for profit, though not connected with a business; and (3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft
Character of Investor’s Losses Sec. 165. Losses (f) Capital Losses. Losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212.
Character of Investor’s Losses Sec. 165. Losses (g) Worthless Securities. (1) If any security which is a capital asset becomes worthless during year, the loss shall …be.. a loss from the sale or exchange, on the last day of year, of a capital asset. (2)..the term “security” means (A) a share of stock in a corporation; (B) a right to subscribe to a share of stock; or (C) a bond or other debt, issued by a corp or by a gov. with interest coupons or in registered form.
Character of Investor’s Losses Sec. 165. Losses (g) Worthless Securities. (3).. any security in a corporation affiliated with a taxpayer which is a domestic corp shall not be treated as a capital asset...a corporation shall be treated as affiliated with the taxpayer only if- (A) the taxpayer owns directly stock in such corp. meeting the requirements of section 1504(a)(2), and (B) more than 90% receipts.. from sources other than royalties, rents … dividends, interest..... gross receipts from sales of stocks and securities are taken into account only to the extent of gains therefrom.
Character of Investor’s Losses Sec. 165. Losses (j) Denial of Losses -Obligations Not Registered. — (1) Nothing in subsection (a) or in any other provision of law shall be.. provide a deduction for any loss on any registration-required obligation unless such obligation is in registered form … (2) Definitions. —For purposes of this subsection — (A) “registration-required obligation” has the meaning given to such term by section 163(f)(2) … (B) Registered form. —The term “registered form” has the same meaning as when used in section 163
Character of Investor’s Losses Sec. 166. Bad Debts (a) General Rule. (1) There shall be allowed as a deduction any debt which becomes worthless within the taxable year. (2) When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. (b) … the basis for determining the amount of the deduction for any bad debt shall be adjusted basis in section 1011 for determining the loss from the sale of property.
Character of Investor’s Losses Sec. 166. Bad Debts (d) Nonbusiness Debts. (1) In the case of a taxpayer other than a corporation (A) subsection (a) shall not apply to any nonbusiness debt; and (B) where any nonbusiness debt becomes worthless, the loss shall be a loss from the sale or exchange of a capital asset held for not more than 1 year. (2) the term “nonbusiness debt” means a debt other than- (A) a debt created or acquired in a trade or business or..
Character of Investor’s Losses Sec. 166. Bad Debts (e) Worthless Securities. This section shall not apply to a debt which is evidenced by a security as defined in section 165(g)(2)(C). (f) Cross References. (1) For disallowance of deduction for worthlessness of debts owed by political parties and similar organizations, see section 271. (2) For special rule for banks with respect to worthless securities, see section 582.
Character of Investor’s Losses Sec. 1211. Limit on Capital Losses (a) Corporations. In the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.
Character of Investor’s Losses Sec. 1211. Limit on Capital Losses (b) Taxpayer other than a corp,-- losses from sales or exchanges of capital assets are allowed only to the extent of gains from such sales or exchanges, plus (if such losses exceed such gains) the lower of (1) $3,000 ($1,500 separate return), or (2) the excess of such losses over such gains.
Outside Loans Guaranteed by S/H If the shareholder loans money to a corp. and the corporation does bankrupt, how is the loss treated? Is the answer different if the shareholder guarantees a bank loan for the corporation and (after the corporation goes bankrupt) the shareholder has to pay the bank?
Jan’s only income is her salary of $200,000 per year from IBM. In 2004, Jan invested $10,000 in stock of Local Corp, which was organized by a neighbor. Later, Jan loaned $20,000 to Local Corp. In 2007, she sold the Local Corp stock to her neighbor for $10,000. In 2014, Local Corp began to fail and was not able to make any interest payment on the note payable to Jan. On December 31, 2014, Jan learned that Local Corp had filed for bankruptcy and the note receivable is worthless. What is Jan’s AGI for 2014?
Section 1244 Stock-1 What if the basic message of Section 1244? Make a list of the requirements that must be met for Section 1244 to apply. Name some limits on the ordinary loss deduction.
Section 1244 Stock-2 Sec. 1244., Losses on Small Business Stock (a) General Rule. In the case of an individual, a loss on section 1244 stock issued to such individual or to a partnership which would (but for this section) be treated as a loss from the sale or exchange of a capital asset shall, to the extent provided in this section, be treated as an ordinary loss.
Section 1244 Stock-3 Sec. 1244. … Small Business Stock (b) Maximum Amount for Any Taxable Year. For any taxable year the aggregate amount treated … by reason of this section as an ordinary loss shall not exceed (1) $50,000, or (2) $100,000, in the case of a husband and wife filing a joint return for such year under section 6013.
Section 1244 Stock-4 Sec. 1244., Losses on Small Business Stock (c) Section 1244 Stock Defined. (1) In general. … the term “section 1244 stock” means stock in a domestic corp. if — (A) at the time such stock is issued, the corp. was a small business corp., (B) such stock was issued by corp. for money or other property (other than stock & securities), and (C) such corp, during the period of its 5 most recent taxable years ending before the date the loss on such stock was sustained, derived more than 50 percent of its … gross receipts from sources other than royalties, rents, dividends, (etc.).
Section 1244 Stock-5 Sec. 1244., Losses on Small Business Stock (c) Section 1244 Stock Defined. (2) Rules for application of paragraph (1)(C). (A) Period … new corporations. For purposes of paragraph (1)(C), if the corp. has not been in existence for 5 taxable years ending before the date the loss on the stock was sustained, there shall be substituted for such 5-year period- (i) the period of corp.'s years ending before such date, or (ii) if the corp. has not been in existence for 1 taxable year ending before such date, the period such corporation has been in existence before such date.
Section 1244 Stock-6 Sec. 1244., Losses on Small Business Stock (c) Section 1244 Stock Defined. (2) Rules for application of paragraph (1)(C). (B) …gross receipts from the sales or exchanges of stock or securities shall be taken into account only to the extent of gains therefrom. (C) Nonapplication where deductions exceed gross income. Paragraph (1)(C) shall not apply with respect to any corp. if, for the period taken into account for purposes of paragraph (1)(C), the amount of the deductions allowed … (other than by sections 172, 243, 244, and 245) exceeds gross income.
Section 1244 Stock-7 Sec. 1244., Losses on Small Business Stock (c) Section 1244 Stock Defined. (3) Small business corporation defined. (A).. a corp. shall be treated as a small business corp. if amount of money and other property received by the corp. for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000. The determination… shall be made as of the time of the issuance of the stock in question but shall include amounts received for the stock and for all stock theretofore issued.
Section 1244 Stock-8 Sec. 1244., Losses on Small Business Stock (c) Section 1244 Stock Defined. (3) Small business corp. defined. (B) Amount taken into account with respect to property. For purposes of subparagraph (A), the amount taken into account with respect to any property other than money shall be … the adjusted basis to the corp. of such property for.. gain, reduced by any liability to which the property was subject or which was assumed …. The determination under the preceding sentence shall be made as of the time the property was received by the corp.
Section 1244 Stock-9 Sec. 1244. Losses on Small Business Stock (d) Special Rules. (1)Limits on amount of ordinary loss. (A) Contributions of property having basis in excess of value. If ---- (i) section 1244 stock was issued in exchange for property, (ii) the basis of such stock for the taxpayer is determined by reference to the basis in his hands of such property, and
Section 1244 Stock-10 Sec. 1244., Losses on Small Business Stock (d) Special Rules. (1) Limits on amount of ordinary loss. (A)Contributions of property having basis in excess of value. If ---- (iii) the adjusted basis (for determining loss) of such property immediately before the exchange exceeded its fair market value at such time, then in computing.. loss on such stock … the basis of the stock shall be reduced by.. excess described in clause (iii).
Section 1244 Stock-11 Sec. 1244., Losses on Small Business Stock (d) Special Rules. (1) Limits on amount of ordinary loss. (B) Increases in basis. In computing amount of the loss on stock for purposes of this section, any increase in the basis of such stock (through contributions to the capital of the corp., or otherwise) shall be treated as allocable to stock which is not section 1244 stock.
Section 1244 Stock-12 Sec. 1244., Losses on Small Business Stock (d) Special Rules. (2) Recapitalizations, changes in name, etc. …, stock in a corp, the basis of which (in the hands of a taxpayer) is determined.. by reference to the basis in his hands of stock in such corp. which meets the requirements of subsection (c)(1) (other than subparagraph (C) thereof), or which is received in a 368(a)(1)(F reorganization) in exchange for stock …, shall be treated as meeting such requirements. For purposes of paragraphs (1)(C) and (3)(A) of subsection (c), a successor corp. in a 368(a)(1)(F) reorganization shall be treated as the same corp. as its predecessor.
Section 1244 Stock-13 Sec. 1244., Losses on Small Business Stock (d) Special Rules. (3) Relationship to net operating loss deduction. —For purposes of section 172 (relating to NOL deduction), any amount of loss treated by reason of this section as an ordinary loss shall be treated as from a trade or business of the taxpayer. (4) For purposes of this section,“individual” does not include a trust or estate.
Section 1244 Stock-14 Sec. 1244. Losses on Small Business Stock (e) Regulations. The Secretary shall prescribe such regs as may be necessary to carry out the purposes of this section.
Section 1244 Stock-15 Mr. Jones is single. On 12-1-14, he sold stock in a small business (section 1244) corp at a loss of $200,000. He had acquired the stock when it was issued by the corp in 2001. This was his only sale in 2014. His only other income was a salary of $150,000. What is his AGI for 2014? a. $150,000 b. $100,000 c. $97,000 d. $47,000 e. none of these
Section 1244 Stock-15- Ans. Mr. Jones is single. On 12-1-14, he sold stock in a small business (section 1244) corp at a loss of $200,000. He had acquired the stock when it was issued by the corp in 2001. This was his only sale in 2014. His only other income was a salary of $150,000. What is his AGI for 2014? a. $150,000 b. $100,000 c. $97,000 d. $47,000 e. none of these
Section 1244 Stock-16 Mr. Jones is single. On 12-1-2014, he sold stock in a section 1244 corp. at a loss of $200,000. Jones bought the stock from a neighbor who had acquired the stock when it was issued by the corp. in 2000. This was his only sale in 2014. His only other income was a salary of $150,000. What is his AGI for 2014?
Section 1244 Stock-17 Mr. Jones is single. On 12-1-2014, he sold stock in a section 1244 corp. at a loss of $200,000. He had acquired the stock when it was issued by the corporation in 2000. This was his only sale in 2014. His only other income was a salary of $150,000. (He originally paid $25,000 for the stock and later made an additional capital contributions of $150,000 without receiving additional stock.) What is his AGI?
Section 1244 Stock-18 Mr. Jones is single. His only income was a salary of $150,000 in 2014. Jones invested $200,000 in stock of a section 1244 corporation stock in 2000. The company went bankrupt in 2014 and the stock is now worthless. What is his AGI for 2014? What if he had two such corporations to go bankrupt during the year?
Section 1244 Stock-19 Mr. Jones is single. His only income was a salary of $150,000 in 2014. Jones acquired stock of a section 1244 corporation in 2002 for $20,000. (He invested obsolete inventory with a cost of $20,000 and a FMV of $1,000, and received 100% of the stock of the corp.) The company went bankrupt in 2014 and the stock is now worthless. What is his AGI for 2014?
Section 1202 On October 1, 1998, Daniel bought some qualified Sec. 1202 small business stock for $2,000,000. In the current year, he sold all of that stock for $25,000,000. How much gain or loss is included in income? a. $ 0 b. $11,500,000 c. $10,000,000 d. $23,000,000 B