McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 11 Chapter 11 Dispositions of Equity Interests in Business Entities Dispositions of Equity Interests in Business Entities Slide 11-1

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Valuing Equity Interests Dependent upon fair market value of business Dependent upon fair market value of business Noncontrolling interests may result in a minority discount Noncontrolling interests may result in a minority discount Controlling interests can lead to a control premium Controlling interests can lead to a control premium Slide 11-2

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Sales of Corporate Stock Slide 11-3 Results in capital gain or loss to selling shareholder Results in capital gain or loss to selling shareholder Gain equal to amount realized less basis in stock Gain equal to amount realized less basis in stock Basis must be adjusted for capital contributions and nontaxable dividend Basis must be adjusted for capital contributions and nontaxable dividend Specific identification or FIFO used to determine basis Specific identification or FIFO used to determine basis

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Taxation of Corporate Stock Sales Individual income tax rate on long term capital gains ranges from 8% – 28% Individual income tax rate on long term capital gains ranges from 8% – 28%  Generally the rate is 20% for most transactions Corporations pay tax at the same rate on capital gains as other income Corporations pay tax at the same rate on capital gains as other income  Capital gains useful for corporation because they can be used to offset capital losses Slide 11-4

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Qualified Small Business Stock 50% of gain on qualified small business stock held more than 5 years may be excluded from income 50% of gain on qualified small business stock held more than 5 years may be excluded from income Exclusion limited to greater of $ 10,000,000 or 10 times basis of stock Exclusion limited to greater of $ 10,000,000 or 10 times basis of stock Slide 11-5

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Qualified Small Business Stock Gain not excluded subject to 28% tax rate Gain not excluded subject to 28% tax rate 42% of excluded gain considered an AMT tax preference item 42% of excluded gain considered an AMT tax preference item Stock must be issued after August 10, 1993 by a qualified small business corporation Stock must be issued after August 10, 1993 by a qualified small business corporation Stock must be issued directly to shareholder and not acquired from another shareholder Stock must be issued directly to shareholder and not acquired from another shareholder Slide 11-6

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Qualified Small Business Corporation Must be a “C” Corporation with not more than $ 50,000,000 in assets immediately after stock issued Must be a “C” Corporation with not more than $ 50,000,000 in assets immediately after stock issued Corporation must conduct an active business Corporation must conduct an active business Corporation may not be in financial, real estate, farming, mining, hospitality or professional service business Corporation may not be in financial, real estate, farming, mining, hospitality or professional service business Slide 11-7

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Section 1244 Stock Allows, within limits, any loss on disposition to be ordinary and deductible rather than capital Allows, within limits, any loss on disposition to be ordinary and deductible rather than capital Annual limit for ordinary loss is $ 50,000 or $ 100,000 if taxpayer is filing a joint return Annual limit for ordinary loss is $ 50,000 or $ 100,000 if taxpayer is filing a joint return Slide 11-8

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Section 1244 Stock Only first $ 1,000,000 of stock issued qualifies Only first $ 1,000,000 of stock issued qualifies Shareholder must be an individual who is the original holder of the stock Shareholder must be an individual who is the original holder of the stock Stock must not have been received for services Stock must not have been received for services Corporation must derive more than 50% of gross receipts from active sources Corporation must derive more than 50% of gross receipts from active sources Slide 11-9

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Stock Sale or exchange results in capital gain or loss Cannot qualify for Section 1202 exclusion but stock may qualify under Section 1244 Slide 11-10

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Stock – Basis Adjustments Basis normally adjusted at end of year to reflect shareholder’s share or income and deductions Basis normally adjusted at end of year to reflect shareholder’s share or income and deductions If stock sold before end of year adjustments must be made for share of allocable items up to date of sale If stock sold before end of year adjustments must be made for share of allocable items up to date of sale Slide 11-11

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Stock Redemptions Definition: Corporation buys its own stock Definition: Corporation buys its own stock Many possible reasons for redemptions Many possible reasons for redemptions May be treated as a sale or exchange or as a distribution May be treated as a sale or exchange or as a distribution Slide 11-12

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Redemptions: Shareholder Consequences Slide Treated as a sale or exchange if shareholder’s relative equity decreased relative to other shareholders Treated as a sale or exchange if shareholder’s relative equity decreased relative to other shareholders If shareholder’s relative equity interest is not decreased, redemption proceeds treated as a dividend to the extent of earnings and profits If shareholder’s relative equity interest is not decreased, redemption proceeds treated as a dividend to the extent of earnings and profits

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Redemptions Treated as Sales Complete termination of shareholder’s interest Complete termination of shareholder’s interest Substantially disproportionate Substantially disproportionate  After redemption, shareholder owns less than 50% of stock of corporation  Shareholder’s ownership percentage after redemption is less than 80% of percentage before redemption Slide 11-14

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Stock Attribution Rules Terminations and substantially disproportionate distributions tested using stock attributed to shareholder as well as stock actually owned Terminations and substantially disproportionate distributions tested using stock attributed to shareholder as well as stock actually owned Stock owned by partnership attributed to proportionately to partners Stock owned by partnership attributed to proportionately to partners Stock owned by family considered to be owned by redeeming shareholder Stock owned by family considered to be owned by redeeming shareholder Slide 11-15

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Effect of Redemption on Corporation Redemptions with appreciated property cause redeeming corporation to recognize gain Redemptions with appreciated property cause redeeming corporation to recognize gain Earnings and profits of redeeming corporation reduced Earnings and profits of redeeming corporation reduced  Reduction limited to proportionate amount of stock redeemed if treated as a sale Slide 11-16

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Redemptions by S Corporations Rules applicable to “C” corporations applicable Rules applicable to “C” corporations applicable S corporations with earnings and profits must reduce earnings and profits in the same manner as “C” corporations S corporations with earnings and profits must reduce earnings and profits in the same manner as “C” corporations Accumulated adjustments accounts reduced in same manner as earnings and profits Accumulated adjustments accounts reduced in same manner as earnings and profits Slide 11-17

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Sales and Exchanges of Partnership Interests Gain equal to difference between amount realized and “outside” basis of partner’s interest Gain equal to difference between amount realized and “outside” basis of partner’s interest Debt relief considered additional amount realized Debt relief considered additional amount realized Slide 11-18

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Character of Gain or Loss on Partnership Dispositions Slide General rule: Gain or loss on sale of a partnership interest is capital General rule: Gain or loss on sale of a partnership interest is capital Exception: Section 751 Exception: Section 751

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Hot Assets Assets which can cause ordinary income under section 751 Assets which can cause ordinary income under section 751  Inventory  Unrealized receivables  Trade account receivables not previously included in income  Any ordinary gain that would be generated through depreciation recapture if a partnership asset were sold Slide 11-20

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Purchase of a Partnership Interest Purchasing partner takes a cost basis in partnership interest Purchasing partner takes a cost basis in partnership interest Inside bases of partnership assets remains the same after the purchase of a partnership interest Inside bases of partnership assets remains the same after the purchase of a partnership interest Slide 11-21

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Special Basis Adjustment Partnership can adjust inside bases of assets after a sale if it has made an election under section 754 Partnership can adjust inside bases of assets after a sale if it has made an election under section 754 Difference between purchase price and underlying asset bases allocated to specific partnership assets Difference between purchase price and underlying asset bases allocated to specific partnership assets Adjustment belongs only to the purchasing partner Adjustment belongs only to the purchasing partner Slide 11-22

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Tax Consequences of Special Basis Adjustment Any gain on sale of appreciated asset allocated to purchasing partner will be reduced Any gain on sale of appreciated asset allocated to purchasing partner will be reduced Depreciation expense on appreciated asset allocated to purchasing partner will be increased Depreciation expense on appreciated asset allocated to purchasing partner will be increased Amortizable goodwill may be created Amortizable goodwill may be created Slide 11-23

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Liquidations of Partnership Interests Maybe based upon book value or fair market value of partner’s interest Maybe based upon book value or fair market value of partner’s interest Slide 11-24

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Tax Consequences of Liquidation Partners do recognize gain or loss to the extent that the amount of distribution exceeds or is less than their “outside” basis Partners do recognize gain or loss to the extent that the amount of distribution exceeds or is less than their “outside” basis Gain or loss is capital Gain or loss is capital Slide 11-25

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Effect of Liquidation on Partnership Generally no adjustment to bases of partnership assets Generally no adjustment to bases of partnership assets If Section 754 election made, partnership adjusts asset bases If Section 754 election made, partnership adjusts asset bases Slide 11-26

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Special Rule for Cash Basis Partnerships Only applies to service partnerships Only applies to service partnerships Portion of liquidation paid for liquidating partner’s interest in accounts receivable is treated as a guaranteed payment Portion of liquidation paid for liquidating partner’s interest in accounts receivable is treated as a guaranteed payment  Ordinary income to recipient  Deductible by partnership Slide 11-27

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Suspended Losses Losses may be suspended due to lack of basis. If partner sells partnership suspended losses permanently lost Losses may be suspended due to lack of basis. If partner sells partnership suspended losses permanently lost Losses may be suspended due to at-risk limitation. Suspended losses may offset any gain recognized on sale Losses may be suspended due to at-risk limitation. Suspended losses may offset any gain recognized on sale Losses may be suspended due to passive activity rules. Disallowed loss allowed on taxable disposition Losses may be suspended due to passive activity rules. Disallowed loss allowed on taxable disposition Slide 11-28