Corporate Formations and Capital Structure (Day 4) 2 Chapter Corporate Formations and Capital Structure (Day 4)

Capital Structure

Equity Capital Dividends paid are not deductible to the corporation [IRC §311(a)] Dividends received are taxable to the shareholder [IRC §61(a)(7)] Qualifying dividends are taxed at favorable capital gains tax rates [IRC §1(h)]

Equity Capital Gains (losses) from sales of stock are generally capital gains (losses) to the shareholders [IRC §1221] Gains (losses) from sales of stocks by securities dealers are ordinary

Equity Capital Partial exclusion of gain from certain small business stock: Qualified small business stock [IRC §1202(c)] For individual taxpayers, 50% of the gain is excluded from taxable income if the stock was held for more than 5 years [IRC §1202(a)(1)] Remaining gain is taxed at maximum 28% capital gains tax rate [IRC §1(h)(3)] 7% of excluded gain is a tax preference for AMT purposes [IRC §57(a)(7)]

IRC §1202 - Example Six years ago, Violet transferred property with a basis of $100,000 and a FMV of $300,000 to VCorp (a new corporation) in exchange for 100% of VCorp stock. This year, she sold the stock for $600,000. Violet’s realized gain is $500,000 Violet’s recognized gain is $250,000 (subject to a maximum 28% rate) Violet has a $17,500 AMT tax preference

Equity Capital Losses on small business stock IRC §1244 stock defined [IRC §1244(c)] Up to $50,000 ($100,000 MFJ) of losses from the sale or exchange of §1244 stock are ordinary losses [IRC §1244(a)&(b)] Reduced limit if IRC §1244 stock was issued for property having basis > FMV [IRC §1244(d)] Problems C2-51 and C2-52

Worthless Securities If a security is a capital asset to the taxpayer and it becomes worthless during the year, it is treated as a capital loss on the last day of the tax year [IRC §165(g)]

Worthless Securities Exception [IRC §165(g)(3)] : Problem C2-49 If a corporation owns worthless securities in an affiliated corporation, the loss is ordinary Affiliated corporation must be at least 80% owned and More than 90% of gross receipts were from active sources for all tax years Problem C2-49

Capital Structure Choice Debt Interest paid is deductible Interest income is ordinary income to debtholders Principal repayments not taxable Debt is boot in IRC §351 Debt distributed is taxable Worthless debt is capital loss Equity Dividend paid is not deductible Dividend income taxed at lower rate (15%) to shs Stock redemptions are taxable Stock is not boot in IRC §351 Stock dividends are not taxable Worthless stock may qualify for IRC §1244 Gains from stock sales may qualify for IRC §1202 exclusion

Capital Contributions A corporation is not taxed on contributions to its capital [IRC §118(a)] If a shareholder contributes property to a corporation: The corporation’s basis in the property equals the shareholder’s basis [IRC §362(a)] Limitation for built-in losses [IRC §362(e)] The shareholders’ basis in existing stock increases [Reg. §1.118-1] Election to reduce stock basis instead of corporation’s basis for built-in losses [IRC §362(e)]

Capital Contributions Example Chad has owned 100% of Chad Corp. for three years. His basis in the stock was $100,000 at the beginning of the current year. During the current year, he contributed property to the corporation that had a FMV of $50,000 and a basis of $35,000. Chad Corp.’s basis in the property is $35,000 Chad’s basis in his stock is $135,000 after the contribution to capital

Capital Contributions A corporation is not taxed on contributions to its capital [IRC §118(a)] If a nonshareholder contributes property to the corporation, its basis is zero [IRC §362(c)(1)] If a nonshareholder contributes cash to the corporation [IRC §362(c)(1)] the basis of property acquired within 12 months is reduced by the amount of the cash contribution any excess cash contribution reduces the basis of existing property Problem C2-47