Chapter 2: Corporate Formations and Capital Structure

CORPORATE FORMATION Alternative business forms Check-the-box regulations Legal requirements for forming a corporation §351 deferrals Choice of capital structure Worthless stock or debt obligations

Forms of Business Sole proprietorships Partnerships Corporations C Corporations S Corporations Limited liability companies Limited liability partnerships

Sole Proprietorship (1 of 2) One owner Not a separate entity Income reported on Sch. C of 1040 No limited liability Tax advantages Profits taxed once No tax on contributions or withdrawals Losses offset other income (with limitations)

Sole Proprietorship (2 of 2) Tax disadvantages Profits taxed as earned Owner not employee Profits subject to SE tax Not eligible for some tax-exempt fringe benefits No fiscal year deferral

Partnerships (1 of 3) Two or more owners Conduit entity Reports, but does not pay income tax No limited liability Except for limited partners

Partnerships (2 of 3) Tax advantages Losses offset other income (with limitations) Income retains its character Income/gain increases basis

Partnerships (3 of 3) Tax disadvantages Profits taxed as earned Partners not employees Profits subject to SE tax Not eligible for some tax-exempt fringe benefits Fiscal year deferral difficult to obtain

C Corporations (1 of 2) Separate taxpaying entity Limited liability Tax advantages Tax rates start at 15% Shareholders may be employees No SE tax Eligible for tax-exempt fringe benefits May exclude 50% of gain on stock sale if certain requirements met

C Corporations (2 of 2) Tax disadvantages Double taxation of income Corporate and shareholder level However, tax rate at shareholder level is at capital gains rates (generally 15%) Withdrawals (dividends) taxable NOLs cannot be used in current year Capital losses cannot offset ordinary income

S Corporations (1 of 3) Conduit entity Similar to a partnership, but Less flexible than a partnership Must file an election to be an S corp. Subject to rules under Subchapter S Follows same rules as a C Corp except for specific items addressed in Subchapter S

S Corporations (2 of 3) Tax advantages Generally exempt from taxation Losses flow through to shareholders Income retains its character Income/gain increases basis Shareholders may be employees S Corp net income not subject to SE tax

S Corporations (3 of 3) Tax disadvantages Profits taxed as earned S Corp shareholders generally not eligible for tax-exempt fringe benefits S Corp cannot choose a fiscal year to obtain income deferral

Limited Liability Companies Limited liability for all owners No ownership restrictions May be taxed as partnership or corporation

Limited Liability Partnership Partners liable for only their own actions No liability for negligence or misconduct of other partners May be taxed as either a partnership or corporation

Check-the-Box Regulations Unincorporated entities choose to be taxed as partnership or corp Sole proprietor or corp if one owner Entity must choose tax status or Accept default status Partnership (sole proprietor if one owner)

Requirements to Incorporate Dependent on state law Minimum capital requirements File of articles or incorporation Granting of charter by state Issue of stock Pay state incorporation fees

§351 Deferrals (1 of 2) No gain or loss recognized if: PROPERTY transferred in exchange for stock and Transferors have control of corp immediately after the exchange Transfers may be for new or existing corporations

§351 Deferrals (2 of 2) Stock requirement Tax effects on transferors Tax effects on transferee corp Assumption of liabilities See Table C2-1 for a summary of corporate formation rules

§351 Deferrals: Property Requirement Property does not include: Services Indebtedness of transferee not evidenced by a security Interest on indebtedness of transferee that accrued on or after beginning of transferor’s holding period for the debt

§351 Deferrals: 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 stock Contribution of services & property Stock of transferor counted towards 80% if FMV of property  10% of service’s value

§351 Deferrals: Tax Effects on Transferors (1 of 3) General rules No gain or loss recognized Basis in stock same as basis in property (substituted basis) Holding period of stock includes holding period of assets

§351 Deferrals: Tax Effects on Transferors (2 of 3) When boot received Gain recognized lesser of gain realized or FMV of boot received Gain recognized when liabilities transferred exceed basis in assets transferred Basis in stock increased by gain recognized

§351 Deferrals: Tax Effects on Transferors (3 of 3) When boot received (continued) Basis in boot property is FMV Holding period of boot begins day after exchange

§351 Deferrals: Tax Effects on Transfee Corp (1 of 2) No gain or loss recognized Basis in property received Transferor’s adjusted basis plus gain recognized Basis = total FMV of property transferred when basis in property transferred > FMV If all s/h agree, s/h that contributed property can reduce her basis in stock instead of corp reducing basis in assets

§351 Deferrals: Tax Effects on Transfee Corp (2 of 2) Depreciation recapture potential transfers to transferee corporation Holding period includes transferor’s holding period Holding period begins day after transfer when basis reduced to FMV

Choice of Capital Structures Debt Interest deductible by corp Repayment of debt not taxable to s/h Debt received in §351 is boot to s/h Worthless debt is capital loss to s/h Debt distributed by corp taxable to s/h Equity Dividends not deductible by corp S/h only pays max 15% on dividends received Stock redemption can be taxable dividend to s/h Stock received in §351 not boot to s/h Worthless §1244 stock is ordinary loss to s/h Stock distributed by corp not taxable to s/h

Choice of Capital Structures: (1 of 2: Debt) Interest deductible by corp Repayment of debt not taxable to s/h Debt received in §351 is boot to s/h Worthless debt is capital loss to s/h Debt distributed by corp taxable to s/h

Choice of Capital Structures: (2 of 2: Equity) Dividends not deductible by corp S/h only pays max 15% on div. received Stock redemption can be taxable dividend to s/h Stock received in §351 not boot to s/h Worthless §1244 stock is ordinary loss to s/h Stock distributed by corp not taxable to s/h

Worthless Stock or Debt (1 of 3) Investment evidenced by a security that becomes worthless produces a capital loss on last day of tax year Securities include: Stock of a corporation Rights to subscribe for stock to be issued Evidence of indebtedness

Worthless Stock or Debt (2 of 3) Ordinary Loss Situations Securities that are noncapital assets Securities of affiliated companies §1244 stock

Worthless Stock or Debt (3 of 3) Qualifying small business stock Must be the original purchaser Ordinary loss up to $50k or $100k if MFJ Corp must have received $1M or less of property in exchange for stock

End of Chapter 2 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com