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CHAPTER # 19 REVIEW Atef Abuelaish

Chapter 19 Corporate Formation, Atef Abuelaish

Corporate Formation, Reorganization, and
Chapter 19 Corporate Formation, Reorganization, and Atef Abuelaish

Corporate Formation, Reorganization, and Liquidation
Chapter 19 Corporate Formation, Reorganization, and Liquidation Atef Abuelaish

Learning Objectives Review the taxation of property dispositions.
Compute the tax consequences to the parties to a tax-deferred corporate formation. Identify the different forms of taxable and tax-deferred acquisitions. Determine the tax consequences to the parties to a corporate acquisition. Calculate the tax consequences that apply to the parties to a complete liquidation of a corporation. Atef Abuelaish

Tax-Deferred Transfers of Property to a Corporation
Section 351 Tax Deferral Requirements Transfer of property to the corporation (not services alone) In exchange for stock of the corporation Receipt of boot triggers gain, but not loss Boot is nonqualifying property received by the shareholder Transferor(s) of property must be in control of the corporation immediately after the transfer Control is defined as ownership of 80 percent or more of the corporation’s voting stock and each class of nonvoting stock Atef Abuelaish

Receipt of boot triggers gain up to the FMV of the boot Boot is allocated based on the FMV of the properties transferred The character of gain recognized depends on the nature of the asset transferred on which gain is recognized Atef Abuelaish

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Assumption of a liability is generally not treated as boot Basis is computed as follows: Atef Abuelaish

Contributions to Capital Transfer of property but no stock or other property is received in return Corporation takes a carryover tax basis in property contributed by a shareholder, Corporation takes a zero tax basis in property contributed by a nonshareholder, Shareholder making a capital contribution increases the tax basis in existing stock by the tax basis of the property contributed Atef Abuelaish

Section 1244 Stock Small corporation (<$1 million capitalization) and Original shareholder Corporation must meet an active trade or business requirement for 5 years before the stock meets the §1244 requirements Shareholder can recognize up to $50,000 per year of ordinary loss ($100,000 if married joint) on sale of the stock (excess is capital loss) Atef Abuelaish

Taxable and Tax-deferred Corporate Acquisitions
When negotiating an acquisition, management of the acquiring corporation must decide whether to acquire assets or stock and what to use as consideration Motivations for an acquisition: Desire to diversify Acquire a source of raw materials (vertical integration) Expand into new product or geographic markets Acquire specific assets or technologies Providing improved distribution channels Atef Abuelaish

Taxable and Tax-deferred Corporate Acquisitions
Buyer can purchase either stock or assets in a transaction that is either taxable or tax-deferred to the seller Allows the acquiring corporation to step-up the tax basis of the assets acquired to fair value Stock acquisitions and tax-deferred asset acquisitions Tax basis of the target corporation’s assets remain at their carryover basis (generally, cost less any depreciation) Atef Abuelaish

Computing the Tax Consequences to the Parties from a Corporate Acquisition
1) Taxable Acquisitions Cash purchases of stock are common for public firms Cash has nontax advantages A stock acquisition for cash results in the acquired company retaining its tax and legal identity albeit as a subsidiary of the acquiring company The acquiring company can liquidate acquired company into itself or merge it into an existing subsidiary to remove the subsidiary Atef Abuelaish

2) Tax-Deferred Acquisitions Taxpayers to organize a corporation in a tax-deferred manner under §351 Taxpayers to reorganize their corporate structure in a tax deferred manner For tax purposes, reorganizations include: Acquisitions and dispositions of corporate assets (including subsidiaries stock) Corporation’s restructuring of its capital structure Atef Abuelaish

Judicial Principles Continuity of Interest (COI) - Shareholders of the acquired corporation retain a continuing ownership interest in the target Continuity of Business Enterprise (COBE) The acquiring corporation must continue the target corporation’s historic business or continue to use a significant portion of the target corporation’s historic business assets Business Purpose Test Acquiring corporation must be able to show a significant nontax avoidance purpose for engaging in the transaction for meeting business purpose test Atef Abuelaish

Type A Asset Acquisitions One corporation acquires the assets and liabilities of another corporation in return for stock or a combination of stock and cash Acquisition is tax-deferred if the transaction satisfies the continuity of interest, continuity of business, and business purpose requirements Must meet state law requirements to be a merger or consolidation Atef Abuelaish

Forward Triangular Type A Merger Acquiring corporation uses stock of its parent corporation to acquire the target corporation’s stock, after which the target corporation merges into the acquiring corporation For tax-deferred purpose, the transaction must meet the requirements to be a Type A merger Acquiring corporation must use solely the stock of its parent corporation and acquire “substantially all” of the target corporation’s property in the transaction Target corporation merges into an 80 percent or more owned acquisition subsidiary of the acquiring corporation Acquisition subsidiary must acquire “substantially all” of the target corporation’s properties in the exchange Atef Abuelaish

Tax deferred forward triangular asset (“A”) acquisition T Shareholders Acquiring A stock & cash A stock + $ T stock Acquisition Subsidiary Target Assets & Liabilities Atef Abuelaish

Reverse Triangular Type A Merger Acquiring corporation uses stock of its parent corporation to acquire the target corporation’s stock, after which the acquiring corporation merges into the target corporation For tax-deferred purpose, the transaction must satisfy three requirements Surviving corporation must hold “substantially all” of the properties of both the surviving and the merged corporations Target shareholders must transfer in exchange an amount of stock in the target that constitutes control of the target (80 percent or more of the target’s stock) Target shareholders must receive parent corporation voting stock in return Atef Abuelaish

Tax deferred reverse triangular asset (“A”) acquisition T Shareholders Acquiring A stock & cash A stock + $ T stock Acquisition Subsidiary Target Assets & Liabilities Atef Abuelaish

Type B Stock-for-Stock Reorganizations Acquiring corporation must exchange solely voting stock for stock of the target corporation Acquiring corporation must control the target corporation after the transaction Acquiring corporation takes a carryover tax basis in the target corporation stock received in the exchange For tax-deferred purpose, the target shareholders must receive solely voting stock of the acquiring corporation Atef Abuelaish

Tax deferred stock acquisition (“B” reorganization) “solely” A voting stock S A A T stock “controls” T T Atef Abuelaish

Type C Acquiring corporation uses its voting stock to acquire “substantially all” of the target corporation’s assets End result of a Type C reorganization resembles a Type A reorganization Major difference between Type C and Type A is that state law governs the form of the Type A merger, while the IRC governs the form of the Type C reorganization Type D Corporation transfers all or part of its assets to another corporation, and immediately after the transfer the shareholders of the transferor corporation own at least 50 percent of the voting power or value of the transferee corporation and own at least 80 percent of the transferee corporation Atef Abuelaish

Cash mergers generally are carried out through an acquisition (merger) subsidiary An acquisition subsidiary isolates the liabilities of T in a separate corporation apart from the parent company The transfer of cash to the Target shareholders is taxable to the shareholders Atef Abuelaish

Structure of the transaction Acquiring Corporation T Shareholders 2 cash 1 cash AS stock T stock Acquisition Subsidiary Target Corporation Reverse merger 3 Atef Abuelaish

End result Acquiring Corporation Isolates liabilities Target Corporation Atef Abuelaish

Tax fiction – purchase of shares for cash Taxable event to T shareholders Acquiring Corporation T Shareholders 2 T stock Cash 1 Acquisition Subsidiary Assets + Liabilities Target Corporation Atef Abuelaish

Complete Liquidation of a Corporation
Occurs when a corporation acquires all of its stock from all of its shareholders in exchange for “all” of its net assets, after which time the corporation ceases to do business For tax purposes, Form 966 needs to be filed by corporation in order to inform IRS of its intention to liquidate its tax existence Form should be filed within 30 days after the owners resolve to liquidate the corporation Atef Abuelaish

Complete Liquidation of a Corporation
Tax Consequences to the Shareholders in a Complete Liquidation Depends on Shareholder’s identity Ownership percentage in the corporation All noncorporate shareholders receiving liquidating distributions have a fully taxable transaction Shareholders treat the property received as in “full payment in exchange for the stock” transferred Atef Abuelaish

Chapter 20 Forming and Atef Abuelaish

Chapter 20 Forming and Operating Atef Abuelaish

Forming and Operating Partnerships
Chapter 20 Forming and Operating Partnerships Atef Abuelaish

Learning Objectives Determine whether a flow-through entity is taxed as a partnership or S corporation, and distinguish the entity approach from the aggregate approach for taxing partnerships. Resolve tax issues applicable to partnership formations and other acquisitions of partnership interests, including gain recognition to partners and tax basis for partners and partnerships. Determine the appropriate accounting periods and methods for partnerships. Atef Abuelaish 20-36

Learning Objectives Calculate and characterize a partnership’s ordinary business income or loss and its separately stated items, and demonstrate how to report these items to partners. Explain the implications of a partner’s tax basis and the adjustments that affect it. Apply the basis, at-risk, and passive activity loss limits to losses from partnerships. Atef Abuelaish 20-37

Break for Minutes Atef Abuelaish

Flow-Through Entities
Income earned by flow-through entities is not taxed at the entity level Owners of flow-through entities are taxed on the entity-level share of income allocated to them Income from flow-through entities is taxed only once when it “flows through” to owners of these entities Aggregate and Entity Concepts Entity approach Atef Abuelaish 20-39

Flow-Through Entities
Treats tax partnerships as entities separate from their partners Aggregate approach Treats tax partnerships as an aggregation of partners separate interests in the assets and liabilities of the partnership One of the most basic tenets of partnerships tax law - “Partnerships don’t pay taxes” - reflects the “aggregate approach” Partnerships, rather than partners, making most tax elections represents the entity concept Atef Abuelaish 20-40

Partnership Formations and Acquisitions of Partnership Interests
Acquiring partnership interests when partnerships are formed Partnership interest When a partnership is formed, partners may transfer cash, other tangible or intangible property, and services to it in exchange for an equity interest Partnership rights Right to receive a share in the partnership assets if the partnership were to liquidate, called a capital interest Right or obligation to receive a share of future profits or future losses, called a profits interest Partners who contribute services instead of property, frequently receive only profits interests Atef Abuelaish 20-41

Contributions of Property Depending on the transaction, realized gains and losses from the exchange of contributed property for partnership interests are either fully or partially deferred for tax purposes Similar to rationale for permitting tax deferral when corporations are formed Follows aggregate theory of partnership taxation Atef Abuelaish 20-42

Gain and loss recognition Generally, neither partnerships nor partners recognize gain or loss when they contribute property to partnerships Definition of property includes a wide variety of both tangible and intangible assets but not services General rule facilitates Contributions of property with built-in gains (FMV > tax basis) General rule discourages Contributions of property with built-in losses (FMV < tax basis) Atef Abuelaish 20-43

Partner’s initial tax basis Required to compute partners taxable gains and losses when they sell their partnership interests Partner’s initial tax basis when partnership doesn't have any debt = sum of tax basis of property and cash contributed by partners Atef Abuelaish 20-44

Partner’s initial tax basis Computation of partner’s initial tax basis when partnership's have debt Each partner must include his/her share of the partnership’s debt in calculating the tax basis in her partnership interest Outside basis of partner contributing property must also reflect partner’s debt relief and any gain recognized from debt relief Atef Abuelaish 20-45

Partnership may have recourse debt Debts for which partners have economic risk of loss Usually allocated to the partners who will ultimately be responsible for paying it Partnership may have nonrecourse debt If secured by real property gives lenders the right to obtain the secured property in the event the partnership defaults on the debt Usually allocated according to partners’ profit-sharing ratios Atef Abuelaish 20-46

Partner contributing property secured by debt recognizes gain when debt relief exceeds the partner’s basis in her partnership interest before debt relief Contributing partner’s holding period in a partnership interest depends on the type of property contributed Contributing partner’s tax basis and holding period in contributed property carries over to the partnership Atef Abuelaish 20-47

Allocating Partnership Debt
Example 1 When CCS was organized early in 2010, Nicole contributed $10,000 of cash and land with a fair market value of $150,000 and adjusted basis of $20,000 to CCS. The land was encumbered by a $40,000 nonrecourse mortgage executed three years before. Recalling that CCS already had $60,000 in bank debt before Nicole’s contribution, what tax bases to Nicole, Sarah, and Chanzz Inc. initially have in their CCS interests? Atef Abuelaish 20-48

Allocating Partnership Debt
Example 1 Solution Atef Abuelaish 20-49

Gain on Contributed Property
Example 2 Assume Sarah and Chanzz Inc., but not Nicole, personally guarantee all $100,000 of CCS’s debt ($60,000 bank loan + $40,000 mortgage on land). How much gain, if any, would Nicole recognize on her contribution to CCS and what would be the basis in her CCS interest? Atef Abuelaish 20-50

Gain on Contributed Property

Contribution of Services Capital interest represents a current economic entitlement amenable to measurement Service partners receiving capital interests report ordinary income Service partner’s tax basis in the capital interest = amount of ordinary income she/he recognizes Profits interests No liquidation value when received Service partner will not recognize income and non-service partners will not receive deductions Atef Abuelaish 20-52

Services for Capital Interest
Example 3 On December 31, 2010, all members of CCS agreed Sarah would receive an additional capital interest in CCS with a liquidation value of $20,000 and an increase in her profit-and-loss-sharing ratio from percent to 40 percent (leaving the other members with a 30 percent share of profits and losses),to compensate her for the time she would spend on an additional project. At this point, CCS’s debt was $100,000. What are the tax consequences to Sarah and CCS of giving her an additional capital interest? Atef Abuelaish 20-53

Services for Capital Interest

Services for Profits Interest
Example 4 Assuming Sarah received only a profits interest for her services instead of the capital interest she received in the previous example, what are the tax consequences to Sarah, Nicole, Chanzz Inc., and CCS? Atef Abuelaish 20-55

Services for Profits Interest

Tax basis of a purchased partnership interest = purchase price + partnership debt allocated to partner, and the holding period begins on purchase date Organization, Start-up, and Syndication Costs For benefit of the partnership and for tax purposes some costs must be capitalized rather than expensed Atef Abuelaish 20-57

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Partnership Accounting Periods, Methods, and Tax Elections
Includes Election of overall accounting method Election to expense a portion of organization and start-up costs Election to expense tangible personal property Partnership makes most tax elections Accounting Methods Partnerships are generally eligible to use the cash method unless they have average gross receipts greater than $5 million and have corporate partners Atef Abuelaish 20-59

Reporting the Results of Partnership operations
Ordinary Business Income (Loss) and Separately Stated Items Separately stated items change partners’ tax liabilities when they are separately stated Partnership ordinary business income (loss) is all partnership income (loss) exclusive of any separately stated items of income (loss) Separately stated items share one common characteristic Are treated differently from a partner’s share of ordinary business income (loss) for tax purposes Atef Abuelaish 20-62

Guaranteed Payments Fixed amounts paid to partners regardless of profit or loss earned by partnership Treated as ordinary income by partners receiving them Generally deducted in computing a partnership’s ordinary income or loss for the year Separately stated to the partners receiving them Self-Employment Tax Shares of ordinary business income (loss) may or may not be treated by LLC members as self-employment income (loss), depending on the extent of their involvement with the LLC Atef Abuelaish 20-64

Shares of ordinary business income (loss) are always Treated as self-employment income (loss) by general partners Not treated as self-employment income (loss) by limited partners LLC members that should be classified as general partners when applying the self-employment tax rules are the members who have Personal liability for the debts of the LLC by reason of being an LLC member, Authority to contract on behalf of the LLC, or Participated in more than 500 hours in the LLC’s trade or business Atef Abuelaish 20-65

Partnership Items Included in Computation of Net Investment Income Tax Individual partner’s share of interest, dividends, annuities, royalties, rent Individual partner’s share of income from a trade or business that is a passive activity Individual partner’s share of gains from the disposition of property not used in an active trade or business Separately stated to the partners receiving them Atef Abuelaish 20-66

Partnership Compliance Issues Although partnerships don’t pay taxes, they are required to file Form 1065, U.S. Return of Partnership Income, with the IRS by March 15 for a calendar year partnership Page 1 of Form 1065 shows details of calculation of the partnership’s ordinary business income (loss) for the year Page 3, Schedule K, lists the partnership’s ordinary business income (loss) and separately stated items Schedule K-1s are included with Form 1065 when it is filed, and Schedule K-1s are also separately provided to all partners Atef Abuelaish 20-67

Partner's Adjusted Tax Basis in Partnership Interest
Partners make the following adjustments to the basis in their partnership interests annually: Increase for actual and deemed cash contributions to the partnership during the year Increase for partner’s share of ordinary business income and separately stated income/gain items and tax-exempt income Decrease for actual and deemed cash distributions during the year Decrease for partner’s share of nondeductible expenses (fines, penalties, etc.), ordinary business loss and separately stated expense/loss items Atef Abuelaish 20-68

Partner's Adjusted Tax Basis in Partnership Interest
Cash Distributions in Operating Partnerships Partners are taxed on income when partnership earns it but not when distributed If cash is distributed when partners have a positive tax basis in their partnership interests, the distribution effectively represents Distribution of profits that have been previously taxed Return of capital previously contributed by the partner to the partnership Distribution of cash the partnership has borrowed, or some combination of the three Cash distributions (deemed or actual) in excess of a partner’s basis are taxable and are generally treated as capital gains Atef Abuelaish 20-69

Loss Limitations Operating losses, can generate current tax benefits when partners can deduct them against other sources of taxable income Ordinary losses from partnerships are deductible against any type of taxable income Losses are deductible on the partner’s tax return only when they clear three separate hurdles Tax basis At-risk amount Passive activity loss hurdles Atef Abuelaish 20-70

Loss Limitations 1) Tax Basis Limitation
In a sense, partner’s basis represents the amount a partner has invested in a partnership or may have to invest to satisfy her debt obligations Partners may not utilize partnership losses in excess of their outside basis in their partnership interests Losses allocated in excess of their basis must be suspended and carried forward indefinitely until partners have sufficient basis to utilize the losses Partners may create additional tax basis by making capital contributions Atef Abuelaish 20-71

Loss Limitations 2) At-Risk Limitation
More restrictive when compared to tax basis limitation Adopted to limit the ability of partners to use nonrecourse debt as a means of creating tax basis Limits partners’ losses to their at-risk amount Only nonrecourse debt considered to be at-risk is nonrecourse real estate mortgages from commercial lenders called “qualified nonrecourse financing” Partners are considered to be at-risk for Amount equal to cash and the tax basis of property contributed to the partnership and Recourse debt and qualified nonrecourse financing allocated to them Atef Abuelaish 20-72

Loss Limitations 3) Passive Activity Loss Limitation
Enacted as a backstop to the at-risk rules and are applied after the tax basis and at-risk limitation Applies primarily to individuals and also to estates, trusts, closely held C corporations, and personal service corporations Limits the ability of partners in rental real estate partnerships and other partnerships they don’t actively manage from using their ordinary losses from these activities to reduce other sources of taxable income Passive activity Activity which involves the conduct of a trade or business, and in which the taxpayer does not “materially participate” Atef Abuelaish 20-73

Loss Limitations Atef Abuelaish 20-74

Loss Limitations Atef Abuelaish 20-75

Happiness is having all homework up to date
Homework assignment Using Connect – 6 Questions for 60 Points for Chapter 20. Tax Return; Course Project: Corporation Tax Return Problem # 2 “Blue Catering Service Inc.'s (BCS) 2016 Form 1120” on Pages C-16 till C-18. Complete the “Connect Orientation” at Connect web site for 5 points, before 03/26/2017. Prepare case # 1 on pages C-13 to C-16 and form 1120 for next meeting on 3/20. Prepare chapters 15, 16, 17, 18, and 19 for Mid-Term Exam on 3/27, after Spring break. Happiness is having all homework up to date Atef Abuelaish

Thank you and See You The Week After at the Same Time, Take Care
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