1. Chapter 2: Corporate Formations and Capital Structure

2. 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

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

4. 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)

5. 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

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

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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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)

17. 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

18. §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

19. §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

20. §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

21. §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

22. §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

23. §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

24. §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

25. §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

26. §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

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. End of Chapter 2
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