2-1 ©2008 Prentice Hall, Inc.

2-2 ©2008 Prentice Hall, Inc. CORPORATE FORMATIONS & CAPITAL STRUCTURE (1 of 2)  Organization forms available  Check-the-box regulations  Legal requirements for forming a corporation  Tax considerations in forming a corporation

2-3 ©2008 Prentice Hall, Inc. CORPORATE FORMATIONS & CAPITAL STRUCTURE (2 of 2)  §351: Deferring gain or loss upon incorporations  Choice of capital structure  Worthless stock or debt obligations

2-4 ©2008 Prentice Hall, Inc. Organization Forms Available  Sole proprietorships  Partnerships  Corporations  C Corporations  S Corporations  Limited liability companies  Limited liability partnerships  Limited liability limited partnership

2-5 ©2008 Prentice Hall, Inc. Sole Proprietorship (1 of 3)  One owner  Not a separate legal entity  Income reported on Sch. C of 1040  No limited liability

2-6 ©2008 Prentice Hall, Inc. Sole Proprietorship (2 of 3)  Tax advantages  Profits taxed once  Proprietor’s marginal tax rate may be lower than if business were taxed as a corporation  No tax on contributions or withdrawals  Losses offset other income (with limitations)

2-7 ©2008 Prentice Hall, Inc. Sole Proprietorship (3 of 3)  Tax disadvantages  Profits taxed as earned, not as received  Corporate 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

2-8 ©2008 Prentice Hall, Inc. Partnerships (1 of 3)  Two or more owners  Conduit entity  Reports, but does not pay income tax  No limited liability  Except for limited partners

2-9 ©2008 Prentice Hall, Inc. Partnerships (2 of 3)  Tax advantages  No partnership-level taxes  Income 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

2-10 ©2008 Prentice Hall, Inc. Partnerships (3 of 3)  Tax disadvantages  Profits taxed as earned, not when received  Partners not employees  Profits subject to SE tax  Not eligible for some tax-exempt fringe benefits  Fiscal year deferral difficult to obtain

2-11 ©2008 Prentice Hall, Inc. C Corporations (1 of 3)  Separate taxpaying and legal entity  Limited liability  Taxation at corporate level  Rates 15% - 35%  Dividend distributions taxed to owners

2-12 ©2008 Prentice Hall, Inc. C Corporations (2 of 3)  Tax advantages  Tax rates start at 15%  Shareholders may be employees  No SE tax  Eligible for tax-exempt fringe benefits  Compensation to owners deductible  May choose fiscal year  May exclude 50% of gain on stock sale if certain requirements met

2-13 ©2008 Prentice Hall, Inc. C Corporations (3 of 3)  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

2-14 ©2008 Prentice Hall, Inc. 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

2-15 ©2008 Prentice Hall, Inc. S Corporations (2 of 3)  Tax advantages  Generally exempt from taxation  Losses flow through to shareholders  Income 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

2-16 ©2008 Prentice Hall, Inc. 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

2-17 ©2008 Prentice Hall, Inc. Limited Liability Companies  Limited liability for all owners  No ownership restrictions  May be taxed as partnership or corporation

2-18 ©2008 Prentice Hall, Inc. 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

2-19 ©2008 Prentice Hall, Inc. Check-the-Box Regulations (1 of 2)  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)

2-20 ©2008 Prentice Hall, Inc. Check-the-Box Regulations (2 of 2)  Change in status results in a deemed liquidation/reincorporation  Partner electing corp status is nontaxable  Corp electing to be disregarded is taxable

2-21 ©2008 Prentice Hall, Inc. Legal Requirements for Forming a Corporation  Dependent on state law  Minimum capital requirements  Filing articles of incorporation  Issuing stock  Paying state incorporation fees  May be assessed franchise taxes

2-22 ©2008 Prentice Hall, Inc. Tax Considerations in Forming a Corporation  Items affecting tax consequences of forming a corporation  Property to be transferred  Services to be provided  Liabilities transferred  How property should be transferred  E.g., contribution, sale

2-23 ©2008 Prentice Hall, Inc. §351 Deferring Gain or Loss upon Incorporation (1 of 2)  No gain or loss recognized if:  PROPERTY transferred in exchange for stock and  Transferors have control (80%) of corp immediately after the exchange  Transfers may be for new or existing corporations

2-24 ©2008 Prentice Hall, Inc. §351 Deferring Gain or Loss upon Incorporation (2 of 2)  Property requirement  Control requirement  Stock requirement  Effect of §351 on transferors  Effect of §351 on transferee corp  Assumption of the transferor’s liabilities  Other considerations in a §351 exchange

2-25 ©2008 Prentice Hall, Inc. 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

2-26 ©2008 Prentice Hall, Inc. 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

2-27 ©2008 Prentice Hall, Inc. Effect of §351 on Transferors (1 of 4)  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

2-28 ©2008 Prentice Hall, Inc. Effect of §351 on Transferors (2 of 4)  Receipt of boot  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

2-29 ©2008 Prentice Hall, Inc. Effect of §351 on Transferors (3 of 4)  Receipt of boot (continued)  Basis in boot property is FMV  Holding period of boot begins day after exchange

2-30 ©2008 Prentice Hall, Inc. 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

2-31 ©2008 Prentice Hall, Inc. 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

2-32 ©2008 Prentice Hall, Inc. Effect of §351 on Transferee Corp (2 of 3)  Loss property limitation  When basis > FMV of prop transferred  Corp’s basis = FMV AND  Reduction in basis allocated to other assets OR  Contributing s/h reduces her basis in corp stock  Corp recognizes gain if  appreciated property transferred to transferor in §351 exchange

2-33 ©2008 Prentice Hall, Inc. Effect of §351 on Transferee Corp (3 of 3)  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

2-34 ©2008 Prentice Hall, Inc. Assumption of the Transferor’s Liabilities (1 of 2)  General rule - §357(a)  Assumption of liabilities by transferee corp not considered receipt of money  Does 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

2-35 ©2008 Prentice Hall, Inc. 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

2-36 ©2008 Prentice Hall, Inc. Other Considerations in a §351 Exchange (1 of 2)  Depreciation recapture  Transferee corp inherits transferor’s depreciation recapture potential  Computing depreciation  Transferee corp must use same method and recovery period as transferor  Allocate depreciation expense for year of transfer based on # of months held

2-37 ©2008 Prentice Hall, Inc. Other Considerations in a §351 Exchange (2 of 2)  Assignment of income doctrine  Transferee generally recognizes income when A/R collected and deductions when pays A/P of cash-basis transferor

2-38 ©2008 Prentice Hall, Inc. Choice of Capital Structures Debt  Interest deductible by corp  Repayment of debt not taxable to shareholder  Debt 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  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

2-39 ©2008 Prentice Hall, Inc. Choice of Capital Structures: Debt  Interest deductible by corp  Debt repayment 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

2-40 ©2008 Prentice Hall, Inc. Choice of Capital Structures: 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 stk ordinary loss to s/h  Stock distributed by corp not taxable to s/h

2-41 ©2008 Prentice Hall, Inc. 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

2-42 ©2008 Prentice Hall, Inc. Worthless Stock or Debt (2 of 3)  Ordinary Loss Situations  Securities that are noncapital assets  Securities of affiliated companies  §1244 stock

2-43 ©2008 Prentice Hall, Inc. Worthless Stock or Debt (3 of 3)  §1244 stock  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

2-44 ©2008 Prentice Hall, Inc. Financial Statement Implications  SFAS 109 requires recognition of deferred tax asset/liability for difference between financial stmt asset values and tax asset values  Difference also requires corp to record goodwill on its books  Permanent difference

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 2-45 ©2008 Prentice Hall, Inc.