Corporate Formations and Capital Structure

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Chapter2

• Corporate Formations and Capital Structure

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Corporate Formation

• Business forms
• Check-the-box regulations
• Legal requirements for forming a corporation
• 351 deferrals
• Choice of capital structure
• Worthless stock or debt obligaions

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Business Forms(slide 1 of 4)

• Sole Proprietorship
• Not a separate taxable entity
• Income reported on owners Schedule C
• One owner
• Contributions/withdrawals
• Profits taxed once
• Profits taxed even if not withdrawn from the firm

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Business Forms(slide 2 of 4)

• Partnership
• Separate entity, but does not pay tax
• Allocates partnership income to partners
• Files information return
• Partners report partnership income on personal
  tax returns
• Potential for liability
• Partners are not employees

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Business Forms(slide 3 of 4)

• S Corporation
• Separate entity, only pays special taxes
  (built-in gains)
• Allocates entity income to shareholders
• Files information return
• Shareholders report entity income on personal tax
  return

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Business Forms(slide 4 of 4)

• C Corporation
• Separate tax-paying entity
• Double Taxation Income taxed at corporate level
  and again at owner level when distributed as a
  dividend
• Shareholders my be employees
• Capital losses cannot offset ordinary income

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Nontax Issues in Selecting Entity Form (slide 1
of 3)

• Liability
• Sole proprietors and some partners have unlimited
  liability for claims against the entity
• Capital-raising
• Corporations or partnerships can raise large
  amounts of capital for entity ventures

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Nontax Issues in Selecting Entity Form (slide 2
of 3)

• Transferability
• Corporate stock is easily sold, but partners must
  approve partnership interest transfer
• Continuity of life
• Corporations exist indefinitely

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Nontax Issues in Selecting Entity Form (slide 3
of 3)

• Centralized management
• Corporate actions are governed by a board of
  directors
• Partnership operations may be conducted by each
  partner without approval by other partners

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Limited Liability Companies (LLC)

• Avoids unlimited liability
• New check the box rules effective 1/1/97
• Single member eligible entity may be classified
  for taxation purposes as either
• a corporation or
• not-separated (sole-proprietorship)
• Multiple member eligible entity may be classified
  for taxation purposes as either
• a partnership or
• a corporation

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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

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Check-the-Box-Regulations

• Unincorporated entities choose to be taxed as
  partnership or corporation
• Sole proprietor or corporation if one owner
• Entity must choose tax status or accept default
  status
• Partnership is default if more than one owner
• Sole proprietorship is default if one owner

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Requirements to Incorporate

• Dependent on state law
• Minimum capital
• Filing of articles
• Granting of charter
• Issuance of stock
• Payment of state fees

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Section 351 Deferrals

• No gain or loss is recognized when PROPERTY is
  transferred in exchange for STOCK provided
• The transferors have control of the corporation
  immediately after the exchange

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Property Requirement

• Property does not include
• Services
• Indebtedness of the transferee not evidenced by a
  security
• Interest on an indebtedness of the transferee
  that accrued on or after the beginning of the
  transferors holding period of the debt

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Control Requirement

• Those who transferred property must own
• 80 of the total combined voting power of all
  classes of stock and at least
• 80 of the total number of shares of all other
  classes of stock

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Service and Property

• The shares of a person who performs services and
  transfers property may be counted in the 80 if
• FMV of property is at least 10 of the value of
  the services rendered

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Tax Effects on Transferors in Section 351
Transfer

• General rules
• No gain or loss recognized
• Basis in stock same as basis in property
  (generally results in carryover basis)
• Holding period of property transferred carryovers
  to holding period of stock

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Tax Effects on Transferors in Section 351
Transfer

• When boot is received
• Gain recognized is lesser of realized gain or FMV
  of boot received
• Basis in stock is increased by gain recognized
• Basis in boot property is FMV
• Holding period of boot begins day after exchange

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Tax Effects on Transferee Corporationin Section
351 Transfer

• No gain or loss recognized
• Basis in property received
• Transferors adjusted basis plus gain recognized
  by transferor

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Assumption of Transferors Liabilitiesunder
Section 357(b)

• Generally, no gain recognized when liabilities
  are assumed in 351 transfer
• Not treated as receipt of cash for determining
  gain recognition
• However, liabilities assumed reduces basis in
  stock
• Two exceptions apply
• Tax avoidance or no bona fide business purpose
• Liabilities in excess of basis 357(c)

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Liabilities in Excess of Basis under 357(c)

• If total amount of liabilities transferred to
  corporation exceed total basis of all property
  transferred excess is gain taxable to transferor
• Type of gain depends on the type of property
  transferred
• The transferors basis in stock received is zero

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Choice of Capital Structures

• Debt
• Interest deductible by corporation
• 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 corporation.
• Stock redemption can be taxable dividend to sh.
• Stock received in 351 not boot to shareholder
• Worthless 1244 stock is ordinary loss to sh.
• Stock distributed b corp. not taxable to sh.

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Alternative Capital StructuresDebt vs. Equity

• When assets are exchanged for debt, the FMV of
  debt instrument is considered to be boot which
  may produce a tax for the shareholder.
• Worthless debt is generally a nonbusiness bad
  debt or a capital loss.

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Alternative Capital StructuresDebt vs Equity

• Dividends are not deductible
• Redemption of common or preferred is generally
  taxable as a dividend
• Preferred stock received as a dividend may be
  tainted and produce ordinary dividend income
  when later sold

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Worthless Stock or Debt

• An investment evidenced by a security that
  becomes worthless produces a capital loss on the
  last day of the tax year.
• Securities include
• stock of a corporation
• a right to subscribe for stock to be issued
• evidence of indebtedness (Notes/Bonds)

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Worthless Stock or Debt

• Ordinary Loss Situations
• Securities that are noncapital assets
• Securities of affiliated companies
• Section 1244 stock

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Section 1244 Stock

• Qualifying small business stock
• Must be the original purchaser
• Ordinary loss up to 50,000 or 100,000 if
  married filing jointly
• Corporation must have received property of 1
  million or less in exchange for stock