2. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

3. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 3 Introduction

4. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-3 Business Organization Forms Corporations C Corporation S Corporation Pass-through Entities Unincorporated Businesses S Corporations

5. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-4 Unincorporated Entities Sole Proprietorships Partnerships General Partnerships Limited Partnerships Limited Liability Partnerships Limited Liability Companies Disregarded Entities

6. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-5 State Taxation S Corporations Some states recognize election Some require separate state election Some tax as C Corporation Franchise Tax May be imposed on unincorporated entities

7. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-6 C Corporations Income subject to tax at corporate rates Double Taxation Dividends taxable to shareholders 15% maximum rate on dividends received by individuals Dividends received deduction Constructive Dividends

8. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-7 Passthrough Entities Income taxed once to owner of entity Income taxed at owner’s rate

9. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-8 Losses - C Corporations Deductible only against income earned by corporation NOL carryovers Carryback – 2 years Carryforward – 20 years

10. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-9 Losses - Passthrough Entities Losses passed through to owner to offset other income Limitations Basis At Risk Passive Loss

11. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-10 Debt - C Corporations Shareholders must sometimes lend money to adequately capitalize corporation Debt vs. Equity Interest deductible; Dividends nondeductible Beware of debt recharacterized as equity

12. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-11 Section 351 Overview S1 and S2 control C S1 S2 C Stock Property

13. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-12 Section 351 Requirements Property transferred for stock Does not apply to transfers for services Transferors control corporation after transfer Control-80% of voting and nonvoting stock

14. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-13 Section 351 Consequences Result: No gain or loss to shareholders Shareholder takes a substituted basis in his or her stock

15. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-14 Section 351-Boot Property received by shareholders other than stock Consequences: Shareholder recognizes gain equal to lesser of fair market value of boot received or gain realized Basis of stock reduced by amount of boot received

16. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-15 Section 351-Liability Assumption Generally no effect on income recognition Exceptions: No Business Purpose Debt exceeds basis of assets transferred Exception: Liabilities that would be deductible when paid are ignored

17. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-16 Sec 351-Effect on Corporation No gain or loss to corporation on issuance of stock due to Section 1032 This would be true even if Section 351 did not apply Corporation takes carryover basis in assets

18. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-17 Contributions to Corporation Capital No gain to corporation Shareholder increases basis in stock May be done by nonshareholders Often done by governments or civic groups to encourage business

19. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-18 Partnership Formation Overview I1 I2 P Property Partnership Interest

20. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-19 Partnership Formation No gain or loss to partners on receipt of partnership interest for property No control requirement Partner takes substituted basis in partnership (“outside basis”) Partnership’s basis in assets (“inside basis”) is carried over

21. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-20 Disguised Sales Anti abuse rule Applies when partner makes contribution of appreciated property to partnership at the same time receiving a cash distribution A portion of the property contributed is deemed sold

22. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-21 Partnership Liability Assumption Treated as a nontaxable cash distribution that reduces partner’s outside basis but does not cause recognition of gain Exception: Debt relief exceeds partner’s outside basis Allocation of liability depends on whether liability is recourse or nonrecourse

23. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-22 Sales to Controlled Entities Section 267 prevents recognition on losses incurred on sales to controlled entities Gains on sales of capital assets to controlled entities result in ordinary income to seller if asset is depreciable by buyer Gains on sales of capital assets between a partner and a controlled partnership result in ordinary income unless asset is capital asset to buyer

24. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 3-23 Leases to Controlled Entities Will avoid negative tax consequences of sales If lease payments from corporation unreasonable high may be deemed constructive dividend Self-rental rule will prevent lease payments to partnerships from being considered passive income