Chapter 4A.Corporate Formation

Text – Pg. 1 to 16

Howard Godfrey, Ph.D., CPAProfessor of Accounting

UNC CharlotteCopyright © 2014. Howard Godfrey

Edited January 12, 2014

C14-Chp-04-1A-Corp-Formation-2014

The student should:1. Understand how to get a charter2. Understand general rule for computing gain

or loss under §1001, & basis where assets are contributed to a corporation in return for stock. Page 2.

3. Understand the requirements for a §351 tax-deferred exchange of property or services for stock in a corporation. Page 4.

4. Understand how to compute recognized gain or loss under §351 for contribution of assets or services to a corporation in return for corporate stock. Page 7+.

The student should:5. Understand the impact of receiving

boot or being relieved of debt. Page 9+.

6. Understand how to compute a stockholder’s basis for stock received in a §351 transaction. Page 11+.

7. Understand how to compute the corporation’s basis for assets received in a §351 transaction. Page 12+.

8. Understand built-in loss rules. Page 13.

The student should:8. Understand the rules for depreciation

recapture and credit recapture. §1245(b)(3) Page 16.

9. Know how to determine whether a §351 transaction should be chosen. Page 24.

10. Understand the tax treatment of shareholder contributions to equity, as well as contributions by non-shareholders. Page 16.

11. Understand the role of debt in capital structure. Page 18.

12. Understand the tax treatment of losses by stockholders, including §1244 losses. Page 21. Also, explain §1202 and §1044. Page 23+.

Determine legal requirements for

forming a corporation.

Legal Requirements for Forming a Corp.The legal requirements for forming a corporation depend on the laws of the state in which the corporation is incorporated. These laws provide for legal capital minimums, incorporation fee, franchise tax, and corporate tax rules. Most corporations are incorporated in the state in which they commence business. Articles of incorporation must be filed. A fee is charged for incorporation and an annual franchise tax is collected.

Legal Requirements for Forming a Corp.

When forming a corporation, may you apply for a Subchapter S corporate charter? NO!!!!

Explain the requirements for deferring gain or loss upon incorporation.

FMV Received: + Vaue of assets we receive + Our debt taken by other party + Other consideration we receive = Total value we receive- Basis of our property we give- Increase in our debt

= Gain (Loss) Realized Recognized Gain or Loss

In taxable exchange basis ofasset received is its FMV.

Gain or Loss - Sec. 61, 1001

Exchanges-Not Like-Kind

Ben paid $30,000 for land that is needed by IBM. Ben owes $5,000 on a mortgage on the land. IBM will trade IBM stock worth $100,000 for the land and will assume the mortgage of $5,000.

How much is the gain to be recognized by Ben as a result of this exchange?

Asset Exchange by Ben Amount

Value - IBM Stock received

Ben's debt assumed by buyer

Amount Realized by Ben

Basis of Property Given

Gain (Loss) Realized

Gain (Loss) Recognized

Asset Exchange by Ben Amount

Value - IBM Stock received $100,000

Ben's debt assumed by buyer $5,000

Amount Realized by Ben $105,000

Basis of Property Given $30,000

Gain (Loss) Realized $75,000

Gain (Loss) Recognized $75,000

Basis - New Asset Amount

Basis of Old Asset $30,000

Add: Boot Paid

Less: Boot Received ($5,000)

Add: Gain Recognized $75,000

Basis - New Asset $100,000

In Taxable Exchange,basis of asset received is its FMV.

Basis - New Asset- Method 2 Amount

FMV of Asset Received $100,000

Less: Gain not Recognized

Add: Loss not Recognized

Basis - New Asset $100,000

Property, money or services are transferred to the corp. in exchange for a debt or equity interest. Tax consequences may occur for the shareholder, debtholder, and the corporation.

§351: Defer Gain or Loss on Incorporation.

No gain or loss is recognized when property is transferred to a corporation solely in exchange for stock provided immediately after the exchange the transferors are in control.

Recognition of gain or loss is deferred through adjustment of the shareholder's basis in the stock.

§351: Defer Gain or Loss on Incorporation.

Property must be transferred to the corp. in an exchange transaction. Property includes money, and almost any other kind of property including installment obligations, accounts receivable, inventory, equipment, patents and other intangibles representing "know-how," trademarks, trade names, and computer software.

§351: Defer Gain or Loss on Incorporation.Property must be transferred to the corp. in an exchange transaction. Statutorily excluded from the property definition are services received in exchange for stock in a corporation, indebtedness of the transferee corporation that is not evidenced by a security, and interest on an indebtedness of the transferee corporation that accrued on or after the beginning of the transferor's holding period for the debt.

§351: Defer Gain or Loss on Incorporation.The transferors as a group must be in control immediately after the exchange. Control is ownership of at least 80% of the total voting power of all classes of voting stock and at least 80% of the total number of shares of all other classes of stock. Only stock received for property is counted when determining if control has been received. Stock received for services does not count for purposes of determining control unless property is also contributed.

§351: Gain or Loss on Incorporation.

Transferors must be in control of the corporation immediately after the exchange.

The exchanges do not need to be simultaneous, but must be agreed to beforehand and executed in an expeditious and orderly manner.

§351: Gain or Loss on Incorporation.Stock Requirement. No gain or loss is recognized by transferors who exchange property solely for transferee corporation stock. Voting or nonvoting stock may be received by the transferors. However, nonqualified preferred stock is treated as boot. Stock rights or stock warrants are not considered stock for purposes of §351.

§351: Gain or Loss on Incorporation.

Effect of §351 on the Transferors.

If all the requirements of §351 are met, the transferors do not recognize any gain or loss on contribution of their property to the corporation. The receipt of property other than stock does not completely disqualify the transaction from coming under §351. However, receipt of property other than stock may cause the exchange to be partly taxable.

§351: Gain or Loss on Incorporation.Property other than stock that is received is considered boot. Gain is recognized to the extent of the lesser of (1) the transferor's realized gain or (2) the amount of money plus FMV of the non-money boot property received. A loss is never recognized. The character of the gain depends upon the type of the property transferred. (Where several properties are transferred a "separate properties approach" is used.)

Section 351: Gain or Loss Upon Incorporation.

The basis of the stock received in a §351 exchange is the

1. basis of the property transferred2. plus any gain recognized by the

transferor 3. minus a. any money received (including

liabilities transferred to the corporation that are treated like money received) and

b. the FMV of any non-money boot property that is received.

§351: Gain or Loss on Incorporation.

The transferee corporation computes the gain or loss (if any) it must recognize and the basis of property or services acquired. No gain or loss is recognized by a transferee corporation exchanging stock or debt instruments for property. Sec.1032

A transferee corporation must recognize gain (but not loss) if it transfers appreciated property to a transferor as part of a §351 exchange.

§351: Gain or Loss Upon Incorporation.The transferee corporation computes the gain or loss (if any) it must recognize and the basis of property or services acquired.

If the transaction is taxable to the transferor, the basis of the property acquired is its acquisition cost.

If the transaction falls under §351, the basis of the property to the transferee corporation is the transferor's basis plus gain recognized by the transferor. §358The corporation's holding period includes the transferor's period in the case of a §351 transaction.

Other Considerations in a §351 Exchange.

If a §351 exchange is nontaxable, no depreciation recapture is required. The transferor's recapture potential is transferred to the transferee corporation.

Other Considerations in a Sec. 351 Exchange.

When a shareholder transfers depreciable property in a §351 transaction, the corp. must continue to use the same depreciation method and recovery period. An allocation of the depreciation for the year that includes the transfer date must be made between the transferor and transferee. If a basis adjustment occurs because the transferor recognizes a gain, a second depreciable asset is created which is generally depreciated as a new asset under the MACRS rules.

Other Considerations in a Sec. 351 Exchange.

If a §351 exchange is nontaxable, no Assignment of Income Doctrine. This doctrine is a judicial requirement that income be taxed to the person who earns it. This doctrine does not apply to a §351 exchange if the transferor transfers substantially all the business assets and liabilities to the corporation and a business purpose exists for the transfer. Cash basis accounts receivable take a zero basis in the corporation's hands and are included in income when collected.

Consequences of §351(slide 1 of 2)

• In general, no gain or loss to transferors:

–On transfer of property to corporation

–In exchange for stock–IF immediately after transfer, transferors are in control of corporation

Consequences of §351 (slide 2 of 2)

• If boot (property other than stock) received by transferors

–Gain recognized up to lesser of:•Boot received or•Realized gain

–No loss is recognized

Big Picture1. General rules for transfer by a

corporation of its stock in exchange for property. See 1.351-1(a)(2) Example 2Role of §61 and Sec. 1001(c)

2. Role of §351(a) (actually all of 351)

3. Role of §1032, §118

4. Basis issues depending on whether the transfer of assets for stock was a tax-free exchange (§358 and §362)

Ann -1

Ann transfers LAND to newly organized Big Corp. for all of its stock.

Land -- Cost $300

Land -- FMV $500

Ann-2• Presumably, Ann will receive

stock in Big Corporation that is worth about $500.

• What is her gain realized?

• [We recognize that the value of stock in a corporation is not necessarily equal to the value of the corporate assets.]

Code

1001(c) Ann's realized gain

351(a) Ann's recognized gain

368(c)

118, 1032 Big's Recog. Gain

358(a)(1) Ann's Stock Basis

362(a) Big's Land Basis

Sec. 351 ComputationsAnn-3

•Please review the Code sections identified on the next four slides.

•Are these worksheet segments accurate?

Value of consideration received:

Less: Cost of prop. given to corp.

Equals: Gain Realized (§1001)

Lesser of gain realized or boot

(include excess debt) (§357(c ))

Give Prop. to Corp. for StockGain (loss)-stockholder §351(b)

Basis of property invested§358(a)(1)

Plus: gain recognized §358(a)(1)(B)

Minus: boot received

(include all debt transferred) §358(d)

Equals basis of stock received

Give Prop. to Corp. for Stock

Stock Basis-stockholder §358

None -0-

Give Prop. to Corp. for Stock

Gain for corporation § 118, 1032

Stockholder's Basis in Prop.

Add: Stockholder gain recog.

Equals: Corp. Property Basis

Give Prop. to Corp. for Stock

Corp. asset basis §362(a)

FMV of stock given

Corp's Basis of Property

[32 B.T.A. 544] MACCALLUM GAUGE CO.

Corp. asset basis §1.1012-1

Give Prop. to Corp. for Stock

Assume a taxable exchange

Tiger – 1. Tiger incorporates his sole proprietorship by transferring his land to Big Corp. in exchange for all its stock, which is worth $1,000,000.

Before incorporating, the land had a value of $1,000,000, a basis of $800,000. There is no liability on the property.

1 Tiger’s realized gain? 2 Tiger’s recognized gain? 3 Tiger’s basis in Big Corp.

stock received? 4 Big’s recognized gain? 5 Big Corp’s basis

in the land?

Tiger – 2. What is:

FMV Received:Vaue of stock received+ Other consideration= Total value received- Cost of land given= Gain (Loss) RealizedRecog. Gain or Loss

Tiger - 3

Tiger-4 Amounts in $thousands(1) (2) (3) (4)

Tiger’s Tiger's Big BigRecog. Stock Corp’s Corp’s Gain Basis Gain Basis

a. $0 $800 $0 $800 b. 0 800 200 1,000 c. 200 800 200 1,000 d. 200 1,000 200 800

Value received by stockholder:

Value of Stock received

Liabilities assumed

Value of consideration received

Minus: Cost of land transferred

Equals: Gain Realized

Recognized Gain or Loss (lesser

of gain realized or boot received) -$

Tiger -5. Gain or loss

Basis of land transferred

Plus gain recognized

Minus boot received

(consider all debt assumed)

Equals basis of

stock received

Tiger - 6. Basis of Big stock

Cash given by owner 0

Basis of land to Tiger

Add: Gain recognized by Tiger

Equals: basis of Land to corp.

Tiger - 7Basis of Land to Big

Bill & Bart formed a corp. in 2007. Bill gave land (FMV of $200,000 and basis to Bill of $120,000). Bart gave cash of $200,000. Bill & Bart each received 2,000 shares of common stock. Bill should report:a. Ordinary gain of $80,000 b. Section 1231 gain of $80,000.c. Capital gain of $80,000. d. Neither gain nor a loss.e. None of the above. CPAM-72

(CPAN95#21) Clark & Hunt start Jet Corp. (authorized stock of $400,000.)Clark gave $60,000 cash. Clark & Hunt gave other property for Jet stock:

PercentAdjusted of Jet

Basis FMV StockClark $50,000 $100,000 40%Hunt 120,000 240,000 60%What was Clark's basis in Jet stock?

Other Prop. Given:

a. $0 b. $100,000c. $110,000 d. $160,000

Lind & Post started Ace Inc., which issuedcommon stock with a FMV of $120,000. They each gave property for stock:

Adj. Percent ofProp. Basis FMV Ace Stock

Lind Bldg $40,000 $82,000 60%Post Land $5,000 $48,000 40%Building subject to $10,000 mortgage.Ace assumed the mortgage.How much gain did Lind recognize?a. $0 b. $10,000 c. $42,000 d. $52,000

Preceding question ….Ace's basis in building?a. $30,000 b. $40,000 c. $72,000 d. $82,000

Lind's basis in Ace stock?a. $82,000 b. $40,000c. $30,000 d. $0

(CPAN94#52) Adams, Beck, & Carr started Flexo Corp. with authorized stockof $100,000. Adams received 10% of the stock for organizational services he rendered. Adams did not give prop. toFlexo. Beck & Carr gave prop. for stock:

Adj. Percent ofBasis FMV Flexo Stock

Beck 5,000 20,000 20%Carr 60,000 70,000 70%What is Carr's gain recognized?a.$40,000 b.$15,000 c.$10,000 d.$0 c

Stone (cash basis) incorporated her CPA practice. No debts were transferred. These assets were transferred to corp: Cash (checking account) $ 500 Computer equipment Adjusted basis 30,000 Fair market value 34,000 Cost 40,000Stone owns 100% of the corp. Corp's total basis for these assets is:a. $30,000 b. $30,500c. $34,500 d. $40,500

Stone (cash basis) incorporated her CPA practice. Prev. Slide Answer: $30,500

FMV:$80,000, adj. basis: $10,000)

Y's land basis? D's stock basis?a. $30,000 $0b. $30,000 $5,000c. $50,000 $30,000d. $50,000 $50,000e. $75,000 $75,000

D gave land to Y Corp. (Land:

D received 90% of Y's stock.Land was subject to $30,000 debt. FMV of Y's stock is $50,000.

FMV:$80,000, adj. basis: $10,000)

Y's land basis? D's stock basis?a. $30,000 $0b. $30,000 $5,000c. $50,000 $30,000d. $50,000 $50,000e. $75,000 $75,000

D gave land to Y Corp. (Land:

D received 90% of Y's stock.Land was subject to $30,000 debt. FMV of Y's stock is $50,000.

A had land with adjusted basisof $30,000 & FMV of $90,000. A started B Corp. by giving the land. and receiving 1,000 shares of stock. A became the sole shareholder. B Corp. assumed debt of $40,000. Stock: Par value: $20, FMV: $50 Sh.What is A's gain on the exchange? a. $10,000 b. $20,000 c. $30,000 d. $40,000 A’s stock basis? B’s Land Basis?

Answer: A

This assumes the debt was incurred for a business purpose.

Tinker incorporates his sole proprietorship by transferring land to Tinker Corp. in exchange for all its stock.The property has a value of $1,200,000, subject to a $40,000 liability that the corporation assumes. Tinker’s basis in land was $800,000.Tinker receives stock worth $1,160,000.What is the amount of gain to be recognized by Tinker?a. $760,000 b. $800,000 c. $840,000 d. $1,200,000

Tinker incorporates his proprietorship by transferring his land to the Tinker Corp. in exchange for all its stock, which is worth $1,160,000. The property has a value of $1,200,000, a basis of $800,000 and a $40,000 liability that the corporation assumes. What is his basis in the stock received by Tinker?a. $760,000 b. $800,000 c. $840,000 d. $1,200,000Also, gain to corp? Basis to Tinker & Corp.

Value received by stockholder:

Value of Stock received $1,160,000

Liabilities assumed 40,000

Value of consideration received 1,200,000

Minus: Cost of assets transferred (800,000)

Equals: Gain Realized $400,000

Recognized Gain or Loss: (lesser

of gain realized or boot received) $0

Tinker. Gain or loss to stockholder

Basis of land transferred $800,000

Plus gain recognized -

Minus boot received

(Consider all debt Assumed) (40,000)

Equals basis of stock received $760,000

Basis of stock to stockholder

Tinker

Cash given by owner

Basis of land from owner $800,000

Add: Gain recog. by owner $0

Equals: basis of land to corp. $800,000

Corporation's Basis in Land

Tinker

Tax Planning Considerations.Sec. 351 treatment is mandatory, not elective, if the provisions are met. In some cases shareholders may wish to recognize gains or losses. In order to accomplish this, one of the provisions necessary for the application of §351 must be violated.

Compliance and Procedural Requirements.

Every person who receives stock, securities, or other property in an exchange qualifying under §351 must attach a statement to his tax return for the period that includes the date of the exchange.

The transferee corporation must attach a statement to its tax return for the year in which the exchange takes place.

Court Case BriefsAmerican Bantam Car Company v. CIR, 11 T.C. 397 (1948), aff'd. per curiam 177 F.2d 513 (3rd Cir., 1949).This is a leading case in the determination of whether a transfer to a corporation is a tax-free transfer to a controlled corporation under the Code Sec. 351. This case is based on Section 112(b)(5) of the Revenue Act of 1936, the precursor of Code Sec. 351.In this case, property was transferred to the newly formed American Bantam Car Company in exchange for stock of the corporation by three individuals, who immediately after the transfer owned greater than an 80% interest in the corporation. Subsequent to this transfer, the corporation entered into agreements with underwriters for the public offering of stock of the corporation, which if such offering had resulted in sufficient sales, would have reduced the interests of these three initial shareholders, based on the voting rights endowed upon the stock in the articles of incorporation.

Court Case BriefsAmerican Bantam Car Company v. CIR, Cont’dThe issue before the court was whether these transactions were all part of an integrated plan, thereby eliminating tax-free exchange treatment under Section 112(b)(5) or whether they were actually separate transactions. The court looked at four factors in making their decision: 1) intent of the parties, 2) mutual interdependence of steps, 3) time element, and 4) ultimate result. There is a detailed analysis of each factor and a summary of prior court cases in this case. The court held that the transactions were indeed separate and that the transfer of assets to the corporation should be treated as a tax-free exchange. Therefore, the basis of the assets for the corporation was their basis in the hands of the transferors on the date of the exchange.

Now lets compare the corporate rules with corresponding partnership rules for contributions of assets to a new business.See Reg. §1.722-1.

Sec. Transfer Assets to Ptshp721 Contribution of property

to partnership 752(b), 731 Decrease in liabilities

of New Partner722, 733 Basis of partnership interest

Also 1.722-1723 Basis of property

contributed to partnership.

731 Gain or loss on distribution.

Existing Partnership debt. -$ Bob's Percent ownership 50% Bob's land: Had a FMV of: Had a basis of: 5,000$ Was subject to debt of: 9,000$

What is gain? Basis? (Twice)

Bob invests land in partnership - 1

Partnership assumed Bob's debt.

Bob invested land into partnership.Bob received general ptshp interest.

Bob is admitted to Local Partnership

1 Bob's land had a value of

2 Bob's land had a basis of 5,000$

3 Ptshp capital % received by Bob 50%

4 Ptshp capital % - other partners 50%

5 Partnership debt before investment

6 Partnership debt assumed by Bob

7 Bob's debt assumed by PTSHP

8 Bob's debt assumed by other Ptnrs

9 Excess of line 8 over (lines 2 + 6)

10 Bob's Gain-Positive Amt. on Line 9

Bob contributes land to partnership - 2

1 Bob's land had a value of

2 Bob's land had a basis of 5,000$

3 Ptshp capital % received by Bob 50%

4 Ptshp capital % - other partners 50%

5 Partnership debt before investment -

6 Partnership debt assumed by Bob -

7 Bob's debt assumed by PTSHP 9,000

8 Bob's debt assumed by other Ptnrs 4,500

9 Excess of line 8 over (lines 2 + 6) -

10 Bob's Gain-Positive Amt. on Line 9 -$

Bob contributes land to partnership - 2A

Land basis before contribution

Add:Partnership debt assumed by Bob

Less: Bob's Debt assumed by other Ptnrs

Bob's Basis - Cannot be negative

Bob's Basis in partnership

Bob contributes land to partnership - 3

Land basis before contribution 5,000

Add:Partnership debt assumed by Bob

Less: Bob's Debt assumed by other Ptnrs (4,500)

Bob's Basis - Cannot be negative $500

Bob's Basis in partnership

Bob contributes land to partnership - 3A

Bob's land basis (before cont.) 5,000

Add: gain - investment co.(rare)

Do not add gain for excess debt XXX

Ptshp's basis in asset invested 5,000

Partnership basis in land received.

Bob contributes land to partnership - 3

(CPAM94#26) On January 2, Black acquired a 50% interest in New Partnership by contributing property with an adjusted basis of $7,000 and a FMV of $9,000. The other partner gave cash of $9,000. What was Black's recognized gain?a. $3,500 b. $4,000 c. $5,500 d. $7,000 e. $0

(CPAM94#26) On Jan. 2, Black acquired a 50% interest in New Partnership by giving property with an adj. basis of $7,000 and a FMV of $9,000. The other partner gave cash of $9,000. What is Black's basis in New Partnership on January 2?a. $3,500 b. $4,000 c. $5,500 d. $7,000

(CPAM95#27) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $16,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's recognized gain?

a. $0 b. $16,000 c. $26,000 d. $2,000

(CPAM94#26) On Jan. 2, Black acquired a 50% interest in New Partnership by giving property with a basis of $7,000 and a FMV of $9,000, subject to a mortgage of $3,000. What was Black's basis in New Partnership on January 2?a. $3,500 b. $4,000 c. $5,500 d. $7,500

(CPAM95#27) Strom acquired a 25 percent interest in Ace Partnership by contributing land with a basis of $16,000 and FMV of $50,000. The land was subject to a $24,000 debt, which was assumed by Ace. No other debt existed at the time of the contribution. What was Strom's basis in Ace?

a. $0 b. $16,000 c. $26,000 d. $32.000

Step Transactions-Plan A • IBM wants to acquire your

appreciated land by giving you an appropriate amount of IBM stock.

• Is this a tax-free exchange?

Step Transactions-Plan B• You organize “New Corp.” You invest

land (basis of $100,000 & FMV of $800,000).

• You receive 100% of “New Corp.” stock worth $800,000.

• Then you trade your “New Corp.” stock to IBM for IBM Stock worth $800,000.

• Is this a tax-free Sec. 351 transaction followed by tax-free reorganization?

Revenue Ruling 70-140

How many ways can you incorporate an existing partnership?

Tax Planning Considerations.Sec. 351 treatment is mandatory, not elective, if the provisions are met. In some cases shareholders may wish to recognize gains or losses.

In order to accomplish this, one of the provisions necessary for the application of §351 must be violated.

Compliance and Procedural Requirements.

Every person who receives stock, securities, or other property in an exchange qualifying under §351 must attach a statement to his tax return for the period that includes the date of the exchange.

The transferee corporation must attach a statement to its tax return for the year in which the exchange takes place.

The

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