1. 2-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

2. 2-2 CORPORATE FORMATIONS & CAPITAL STRUCTURE (1 of 2)  Organization forms available  Legal requirements for forming a corporation  Check-the-box regulations  Tax considerations in forming a corporation ©2011 Pearson Education, Inc. Publishing as Prentice Hall

3. 2-3 CORPORATE FORMATIONS & CAPITAL STRUCTURE (2 of 2)  §351: Deferring gain or loss upon incorporations  Choice of capital structure  Worthless stock or debt obligations  Tax planning considerations  Compliance & procedural considerations  Financial statement implications ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4. 2-4 Organization Forms Available  Sole proprietorships  Partnerships  Corporations  C Corporations  S Corporations  Limited liability companies  Limited liability partnerships ©2011 Pearson Education, Inc. Publishing as Prentice Hall

5. 2-5 Sole Proprietorship (1 of 3)  One owner  Not a separate legal entity  Income reported on Sch. C of 1040  No limited liability ©2011 Pearson Education, Inc. Publishing as Prentice Hall

6. 2-6 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) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

7. 2-7 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

8. 2-8 Partnerships (1 of 3)  Two or more owners  Conduit entity  Reports, but does not pay income tax  No limited liability  Except for limited partners ©2011 Pearson Education, Inc. Publishing as Prentice Hall

9. 2-9 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

10. 2-10 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  Cannot use fiscal year-end to defer income ©2011 Pearson Education, Inc. Publishing as Prentice Hall

11. 2-11 C Corporations (1 of 3)  Separate taxpaying and legal entity  Limited liability  Taxation at corporate level  Rates 15% - 35%  Dividend distributions taxed to owners at lower capital gains tax rates ©2011 Pearson Education, Inc. Publishing as Prentice Hall

12. 2-12 C Corporations (2 of 3)  Tax advantages  Corp’s marginal tax rate may be lower than owners’ tax rates  Shareholders may be employees  No SE tax  Eligible for tax-exempt fringe benefits  Compensation to owners deductible  May choose fiscal year ©2011 Pearson Education, Inc. Publishing as Prentice Hall

13. 2-13 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% through 2010)  Withdrawals (dividends) taxable  NOLs cannot be used in current year  Capital losses cannot offset ordinary income ©2011 Pearson Education, Inc. Publishing as Prentice Hall

14. 2-14 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

15. 2-15 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16. 2-16 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

17. 2-17 Limited Liability Companies  Limited liability for all owners  No ownership restrictions  May be taxed as partnership or corporation ©2011 Pearson Education, Inc. Publishing as Prentice Hall

18. 2-18 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

19. 2-19 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) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

20. 2-20 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

21. 2-21 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

22. 2-22 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  See Table 1 for overview of corp formation rules ©2011 Pearson Education, Inc. Publishing as Prentice Hall

23. 2-23 §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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

24. 2-24 §351 Deferring Gain or Loss upon Incorporation (2 of 2)  Property requirement  Control requirement  Stock requirement  Exchange solely for stock  Effect of §351 on transferors  Effect of §351 on transferee corp  Assumption of the transferor’s liabilities  Other considerations in a §351 exchange ©2011 Pearson Education, Inc. Publishing as Prentice Hall

25. 2-25 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

26. 2-26 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

27. 2-27 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

28. 2-28 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

29. 2-29 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

30. 2-30 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

31. 2-31 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

32. 2-32 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

33. 2-33 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

34. 2-34 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

35. 2-35 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

36. 2-36 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

37. 2-37 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

38. 2-38 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 (through 2010)  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

39. 2-39 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

40. 2-40 Choice of Capital Structures: Equity  Dividends not deductible by corp  S/h only pays max 15% on div. received  Through 2010  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 dist. by corp not taxable to s/h ©2011 Pearson Education, Inc. Publishing as Prentice Hall

41. 2-41 Choice of Capital Structures: Contributions by Nonshareholders (1 of 2)  Eg., state, local, and city governments  Contributions of money and/or property to encourage a corporation to move to a particular location  Basis of property acquired by is zero ©2011 Pearson Education, Inc. Publishing as Prentice Hall

42. 2-42 Choice of Capital Structures: Contributions by Nonshareholders (2 of 2)  Property purchased w/in 12 months of cash contribution reduced by cash received  Basis of other non-cash assets reduced by remaining cash at end of 12-month period ©2011 Pearson Education, Inc. Publishing as Prentice Hall

43. 2-43 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

44. 2-44 Worthless Stock or Debt (2 of 3)  Ordinary Loss Situations  Securities that are noncapital assets  Securities of affiliated companies  §1244 stock ©2011 Pearson Education, Inc. Publishing as Prentice Hall

45. 2-45 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

46. 2-46 Tax Planning considerations Avoiding §351  Mandatory provision, not elective  Avoid if transferring loss property to corp  Need to also avoid §267 related party loss limitation as well  Avoid if transferring gain property and want corp to have stepped-up basis ©2011 Pearson Education, Inc. Publishing as Prentice Hall

47. 2-47 Compliance and Procedural Considerations  Attachment to s/hs’ individual tax returns for §351 transactions  Must include all facts pertinent to the exchange ©2011 Pearson Education, Inc. Publishing as Prentice Hall

48. 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 2-48 ©2011 Pearson Education, Inc. Publishing as Prentice Hall