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 as Garden, Inc. –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 equity interest.
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 Other assets 150, ,000 $200,000 $500,000
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 Garden, Inc. 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.
Corporation Formation Transaction
Formation Example Ron will incorporate his donut shop: AssetFair Mkt Tax BasisValue. Cash$10,000$ 10,000 Furniture & Fixtures 20,000 60,000 Building 40, ,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.
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
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
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
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
The Big Picture – Example 4 Stock Transferred (slide 1 of 2) Return to the facts of The Big Picture on p 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.
The Big Picture – Example 4 Stock Transferred (slide 2 of 2) If she receives Garden 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 Garden debt is treated as boot. – The remaining realized gain of $250,000 is deferred.
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
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
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
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”
The Big Picture – Example 9 Transfers for Property and Services (slide 1 of 2) Return to the facts of The Big Picture on p Assume Emily transfers her $500,000 of property to Garden, Inc. and receives 50% of its stock. David receives the other 50% of the stock for services rendered (worth $500,000).
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 Garden) - $200,000 (basis in the transferred property). –As the sole transferor of property, she receives only 50% of the Garden’s stock.
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 Garden, Inc. (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.
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.
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
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
The Big Picture – Example 14 Assumption of Liabilities (slide 1 of 2) Return to the facts of The Big Picture on p Assume you learn that –Emily’s husband, David, has lost interest in becoming a stockholder in Garden, Inc., and –Emily’s building is subject to a liability of $35,000 that Garden assumes. Consequently, Emily receives 100% of the Garden stock and is relieved of the $35,000 liability –The building has an adjusted basis of $200,000 and fair market value of $500,000.
The Big Picture – Example 14 Assumption of Liabilities (slide 2 of 2) Return to the facts of The Big Picture on p The exchange is tax-free under § 351 –The release of a liability is not treated as boot under § 357(a). However, the basis to Emily of the Garden stock is $165,000 –$200,000 (basis of property transferred) − $35,000 (amount of the liability assumed by Garden).
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)
Formation with Liabilities Example (slide 1 of 2) Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = $ 50,000
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)
Basis Computation for §351 Exchange (slide 1 of 2)
Basis Computation for §351 Exchange (slide 2 of 2)
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, $ 30,000
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
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
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
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
The Big Picture – Example 24 Stock Issued for Services Rendered (slide 1 of 2) Return to the facts of The Big Picture on p Emily transfers her $500,000 of property to Garden, Inc. and receives 50% of the stock. In addition, assume that, in exchange for 50% of the stock, David –Transfers property worth $400,000 (basis of $130,000), and –Agrees to serve as manager of the corporation for one year (services worth $100,000).
The Big Picture – Example 24 Stock Issued for Services Rendered (slide 2 of 2) Return to the facts of The Big Picture on p Emily’s and David’s transfers qualify under § 351. –Neither Emily nor David is taxed on the transfer of his or her property. David recognizes income of $100,000 –Equal to the value of the stock received for the services he will render to Garden, Inc. Garden has –Basis of $130,000 in the property it acquired from David, and –May claim a compensation expense deduction under § 162 for $100,000. David’s stock basis is $230,000 –$130,000 (basis of property transferred) + $100,000 (income recognized for services rendered).
The Big Picture – Example 25 Stock Issued for Services Rendered Assume the same facts as in Example 24 except that David provides legal services (instead of management services) in organizing the corporation. –The value of David’s legal services is $100,000. David has –No gain on the transfer of the property, but –Has income of $100,000 for the value of the stock received for the services rendered. Garden, Inc. –Has a basis of $130,000 in the property it acquired from David, and –Must capitalize the $100,000 as an organizational expenditure. David’s stock basis is $230,000 –$130,000 (basis of property transferred) + $100,000 (income recognized for services rendered).
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
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
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
Capital Contributions (slide 2 of 3) Capital contributions of property by nonshareholders –Not taxable to corporation –Basis of property received from nonshareholder is -0-
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
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
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
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
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
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
Investor Losses (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
Investor Losses (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
Investor Losses (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
Investor Losses (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
Investor Losses (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
§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
§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
§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
§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
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
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
The Big Picture – Example 35 Selecting Assets To Transfer (slide 1 of 2) Return to the facts of The Big Picture on p 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.
The Big Picture – Example 35 Selecting Assets To Transfer (slide 2 of 2) Alternatively, if the receivables are transferred to Garden 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.
Refocus On The Big Picture (slide 1 of 5) Emily, the sole property transferor, must acquire at least 80% of the stock issued by Garden Inc. 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.
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 Garden obtaining an interest deduction later.
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 Garden 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 Garden.
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 Garden. –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.
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 Garden. –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!