2-1 2008 Prentice Hall, Inc.. 2-2 2008 Prentice Hall, Inc. CORPORATE FORMATIONS CAPITAL STRUCTURE...

©2008 Prentice Hall, Inc. 2-2

CORPORATE CORPORATE FORMATIONS & CAPITAL FORMATIONS & CAPITAL

STRUCTURESTRUCTURE (1 of 2)(1 of 2)

Organization forms availableCheck-the-box regulationsLegal requirements for forming

a corporationTax considerations in forming a

corporation


CORPORATE CORPORATE FORMATIONS & CAPITAL FORMATIONS & CAPITAL

STRUCTURESTRUCTURE (2 of 2)(2 of 2)

§351: Deferring gain or loss upon incorporations

Choice of capital structureWorthless stock or debt

obligations


Organization Forms Organization Forms AvailableAvailable

Sole proprietorshipsPartnershipsCorporations

C CorporationsS Corporations

Limited liability companiesLimited liability partnershipsLimited liability limited partnership


Sole Proprietorship(1 of 3)

One ownerNot a separate legal entity

Income reported on Sch. C of 1040No limited liability



Tax advantagesProfits taxed onceProprietor’s marginal tax rate may be

lower than if business were taxed as a corporation

No tax on contributions or withdrawalsLosses offset other income (with

limitations)



Tax disadvantagesProfits taxed as earned, not as receivedCorporate tax rates may be lower than

proprietor’s marginal tax rateOwner not employee

Profits subject to SE taxNot eligible for some tax-exempt fringe

benefitsCompensation to owner not deductible

No fiscal year deferral


Partnerships(1 of 3)

Two or more ownersConduit entity

Reports, but does not pay income tax

No limited liabilityExcept for limited partners



Tax advantagesNo partnership-level taxes

Income only taxed at partner levelLosses offset other income (with

limitations)Contributions and withdrawals

generally not subject to taxationIncome retains its characterIncome/gain increases basis



Tax disadvantagesProfits taxed as earned, not when

receivedPartners not employees

Profits subject to SE taxNot eligible for some tax-exempt fringe

benefitsFiscal year deferral difficult to obtain


C Corporations(1 of 3)

Separate taxpaying and legal entity

Limited liabilityTaxation at corporate level

Rates 15% - 35%Dividend distributions taxed to

owners



Tax advantagesTax rates start at 15%Shareholders may be employees

No SE taxEligible for tax-exempt fringe benefitsCompensation to owners deductible

May choose fiscal yearMay exclude 50% of gain on stock sale

if certain requirements met



Tax disadvantagesDouble taxation of income

Corporate and shareholder levelHowever, tax rate at shareholder level is at

capital gains rates (generally 15%)Withdrawals (dividends) taxableNOLs cannot be used in current yearCapital losses cannot offset ordinary

income


S Corporations(1 of 3)

Conduit entitySimilar to a partnership, butLess 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



Tax advantagesGenerally exempt from taxationLosses flow through to shareholdersIncome retains its characterContributions and withdrawals generally

not subject to taxationIncome/gain increases basisShareholders may be employees

S Corp net income not subject to SE tax



Tax disadvantagesProfits taxed as earnedS Corp shareholders generally not

eligible for tax-exempt fringe benefits

S Corp cannot choose a fiscal year to obtain income deferral


Limited Liability CompaniesLimited liability for all ownersNo ownership restrictionsMay be taxed as partnership or

corporation


Limited Liability Partnership

Partners liable for only their own actionsNo liability for negligence or

misconduct of other partnersMay be taxed as either a

partnership or corporation


Check-the-Box Check-the-Box RegulationsRegulations

(1 of 2)(1 of 2)

Unincorporated entities choose to be taxed as partnership or corpSole proprietor or corp if one owner

Entity must choose tax status orAccept default status

Partnership (sole proprietor if one owner)


Check-the-Box Check-the-Box RegulationsRegulations

(2 of 2)(2 of 2)

Change in status results in a deemed liquidation/reincorporationPartner electing corp status is

nontaxableCorp electing to be disregarded is

taxable


Legal Requirements for Legal Requirements for Forming a CorporationForming a Corporation

Dependent on state lawMinimum capital requirementsFiling articles of incorporationIssuing stockPaying state incorporation fees

May be assessed franchise taxes


Tax Considerations in Tax Considerations in Forming a CorporationForming a Corporation

Items affecting tax consequences of forming a corporationProperty to be transferredServices to be providedLiabilities transferredHow property should be transferred

E.g., contribution, sale


§351 Deferring Gain or §351 Deferring Gain or Loss upon IncorporationLoss upon Incorporation

(1 of 2)(1 of 2)

No gain or loss recognized if:PROPERTY transferred in exchange

for stock andTransferors have control (80%) of

corp immediately after the exchangeTransfers may be for new or

existing corporations


§351 Deferring Gain or §351 Deferring Gain or Loss upon IncorporationLoss upon Incorporation

(2 of 2)(2 of 2)Property requirementControl requirementStock requirementEffect of §351 on transferorsEffect of §351 on transferee corpAssumption of the transferor’s liabilitiesOther considerations in a §351 exchange


Property RequirementProperty does not include:

ServicesIndebtedness of transferee not

evidenced by a securityInterest on indebtedness of

transferee that accrued on or after beginning of transferor’s holding period for the debt


Control RequirementTransferors 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 & propertyStock of transferor counted towards

80% if FMV of property 10% of service’s value


Effect of §351 on Transferors

(1 of 4)

General rulesNo gain or loss recognizedBasis in stock same as basis in

property (substituted basis)Holding period of stock includes

holding period of assets



(2 of 4)

Receipt of bootGain recognized lesser of gain

realized or FMV of boot receivedGain recognized when liabilities

transferred exceed basis in assets transferred

Basis in stock increased by gain recognized



(3 of 4)

Receipt of boot (continued)Basis in boot property is FMVHolding period of boot begins day

after exchange



(4 of 4)

Computing shareholder’s basisAdjusted basis of property transferred

+ Gain recognized by transferor- Money received- Liabilities assumed by transferee corp= Shareholder’s basis in corp stock


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



Loss property limitationWhen basis > FMV of prop transferred

Corp’s basis = FMV ANDReduction in basis allocated to other assets ORContributing s/h reduces her basis in corp stock

Corp recognizes gain if appreciated property transferred to

transferor in §351 exchange



Depreciation recapture potential transfers to transferee corporation

Holding period includes transferor’s holding periodHolding period begins day after

transfer when basis reduced to FMV


Assumption of the Transferor’s Liabilities (1 of 2)

General rule - §357(a)Assumption of liabilities by transferee

corp not considered receipt of moneyDoes not trigger gainIncreases amount realized by transfereeDecreases transferee’s basis in stock

If no bona fide business purposeAssumption of liabilities considered

receipt of money


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

transferredGain recognized


Other Considerations in a §351 Exchange (1 of 2)

Depreciation recaptureTransferee corp inherits transferor’s

depreciation recapture potentialComputing depreciation

Transferee corp must use same method and recovery period as transferor

Allocate depreciation expense for year of transfer based on # of months held


Other Considerations in a §351 Exchange (2 of 2)

Assignment of income doctrineTransferee generally recognizes

income when A/R collected and deductions when pays A/P of cash-basis transferor


Choice of Capital Choice of Capital StructuresStructures

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

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


Choice of Capital Structures:

Debt

Interest deductible by corpDebt repayment not taxable to s/hDebt received in §351 is boot to s/hWorthless debt is capital loss to s/hDebt distributed by corp taxable to

s/h


Choice of Capital Structures:

Equity

Dividends not deductible by corpS/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/hWorthless §1244 stk ordinary loss to s/hStock distributed by corp not taxable to

s/h


Worthless Stock or DebtWorthless Stock or Debt(1 of 3)(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 corporationRights to subscribe for stock to be

issuedEvidence of indebtedness



Ordinary Loss SituationsSecurities that are noncapital

assetsSecurities of affiliated companies§1244 stock



§1244 stockQualifying small business stockMust be the original purchaserOrdinary loss up to $50k or $100k if

MFJCorp must have received $1M or less

of property in exchange for stock


Financial Statement Financial Statement ImplicationsImplications

SFAS 109 requires recognition of deferred tax asset/liability for difference between financial stmt asset values and tax asset valuesDifference also requires corp to

record goodwill on its booksPermanent difference

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of [email protected]

2-45©2008 Prentice Hall, Inc.

2-1 2008 Prentice Hall, Inc.. 2-2 2008 Prentice Hall, Inc. CORPORATE FORMATIONS CAPITAL STRUCTURE...

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