Chapter 18

Chapter 18
Corporations:
Organization and Capital
Structure
Comprehensive Volume
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Big Picture (slide 1 of 3)

Emily has operated her business for 10 years as a sole
proprietorship, but has decided to incorporate the
business as Garden, Inc.
She understands that the corporate form offers several
important nontax advantages (e.g., limited liability).
Also, the incorporation would enable her husband, David,
to become a part owner in the business.
Emily expects to transfer her business assets in

exchange for her corporate interest, while David will
provide services for his equity interest.

Emilys sole proprietorship assets available for
transfer to the new corporation are:
Accounts receivable
Building
Other assets
Adjusted
Basis
$ 0
50,000
150,000
$200,000
Fair Market
Value
$ 25,000
200,000
275,000
$500,000

Aware of the double taxation problem associated with
operating as a regular corporation, Emily is
considering receiving some corporate debt at the time
of incorporation.
The interest expense on the debt will then provide a
deduction for Garden, Inc.
Emilys main concern, however, is that the

incorporation will be a taxable transaction.
Can her fears be allayed?
Read the chapter and formulate your response.
Corporation Formation Transaction
Formation Example
Ron will incorporate his donut shop:
Asset
Tax Basis
Cash
Furniture & Fixtures
Building
Total
Fair Mkt
Value .
$10,000
20,000
40,000
$70,000
$ 10,000
60,000
100,000
$170,000
Without 351: gain of $100,000.

With 351: no gain or loss. Rons economic status has not
changed.
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
Issues re: Formation

(slide 1 of 7)
Definition of property includes:

Cash
Secret processes and formulas
Unrealized accounts receivable (for cash basis
taxpayer)
Installment obligations
Code specifically excludes services from

definition of property

(slide 2 of 7)
Stock transferred
Includes common and most preferred stock
Does not include nonqualified preferred stock which
possesses many attributes of debt
Does not include stock rights or stock warrants

Does not include corporate debt or securities (e.g.,
corporate bonds)
Treated as boot
The Big Picture Example 4
Stock Transferred (slide 1 of 2)

Return to the facts of The Big Picture on p. 18-1.
Assume the proposed transaction qualifies

under 351
i.e., The transfer of property in exchange for stock
meets the control test
However, Emily decides to receive some corporate
debt along with the stock.
Stock Transferred (slide 2 of 2)

If she receives Garden stock worth $450,000 and
corporate debt of $50,000 in exchange for the
property transferred,
Emily realizes gain of $300,000 [$500,000 (value of
consideration received) $200,000(basis in the transferred
property)].
However, because the transaction qualifies under 351,
only $50,000 of gain is recognizedthe $50,000 of Garden
debt is treated as boot.
The remaining realized gain of $250,000 is deferred.

(slide 3 of 7)
Transferors must be in control immediately

after exchange to qualify for nontaxable
treatment
To have control, transferors must own:
80% of total combined voting power of all classes of
stock entitled to vote, and
80% of total number of shares of all other classes of
stock

(slide 4 of 7)
Immediately after the transfer

Does not require simultaneous transfers if more
than one transferor
Rights of parties should be outlined before first
transfer
Transfers should occur as close together as
possible

(slide 5 of 7)
After control is achieved, it is not necessarily

lost upon the sale or gift of stock received in
the transfer to others not party to the initial
exchange
But disposition might violate 351 if
prearranged

(slide 6 of 7)
Transfers for property and services

May result in service provider being treated as a
member of the 80% control group
Taxed on value of stock issued for services
Not taxed on value of stock received for property
contributions
All stock received by the person transferring both property and
services is counted in 80% test
To be considered a member of the 80% control

group
The service provider should transfer property having
more than a relatively small value
Transfers for Property and Services
(slide 1 of 2)
Assume Emily transfers her $500,000 of

property to Garden, Inc. and receives 50% of
its stock.
David receives the other 50% of the stock for
services rendered (worth $500,000).
(slide 2 of 2)
Both Emily and David have tax consequences

from the transfers.
David has ordinary income of $500,000 because
he does not exchange property for stock.
Emily has a taxable gain of $300,000
$500,000 (fair market value of the stock in Garden) $200,000 (basis in the transferred property).
As the sole transferor of property, she receives

only 50% of the Gardens stock.
(slide 1 of 2)
Assume the same facts as in Example 9 except

that David transfers property worth $400,000
(basis of $130,000) in addition to services
rendered to Garden, Inc. (valued at $100,000).
Now David becomes a part of the control
group.
Emily and David, as property transferors, together
receive 100% of the corporations stock.
(slide 2 of 2)
Consequently, 351 is applicable to the

exchanges.
As a result, Emily has no recognized gain.
David does not recognize gain on the transfer of
the property
He does recognize ordinary income to the extent of the
value of the shares issued for services rendered.
David has current taxable income of $100,000.

(slide 7 of 7)
Subsequent transfers to existing corporation

Tax-free treatment still applies as long as
transferors in subsequent transfer own 80%
following exchange
Assumption of Liabilities
(slide 1 of 2)
Assumption of liabilities by corp does not

result in boot to the transferor shareholder for
gain recognition purposes
Liabilities are treated as boot for determining basis
in acquired stock
Basis of stock received is reduced by amount of
liabilities assumed by the corp
Assumption of Liabilities (slide 1 of 2)

Assume you learn that
Emilys husband, David, has lost interest in becoming a
stockholder in Garden, Inc., and
Emilys building is subject to a liability of $35,000 that
Garden assumes.
Consequently, Emily receives 100% of the Garden

stock and is relieved of the $35,000 liability
The building has an adjusted basis of $200,000 and fair
market value of $500,000.
Assumption of Liabilities (slide 2 of 2)

The exchange is tax-free under 351

The release of a liability is not treated as boot
under 357(a).
However, the basis to Emily of the Garden

stock is $165,000
$200,000 (basis of property transferred) $35,000
(amount of the liability assumed by Garden).
Assumption of Liabilities
(slide 2 of 2)
Liabilities are not treated as boot for gain

recognition unless:
Liabilities incurred for no business purpose or as
tax avoidance mechanism
Boot = Entire amount of liability
Liabilities > basis in assets transferred

Gain recognized = Excess amount (liabilities - basis)
Formation with Liabilities Example

(slide 1 of 3)
Property transferred has:

Fair market value =
$150,000
Basis
=
100,000
Realized Gain
=
$ 50,000
Liabilities assumed by corp. (independent facts):
Liability:
Business Business
Purpose I Purpose II
$80,000
$120,000
No Business
Purpose
$120,000

(slide 2 of 3)
Business Purpose I
FMV of stock
received
Business Purpose II
No Business Purpose
$70,000
$30,000
$30,000
80,000
120,000
120,000
Amount realized
$150,000
$150,000
$150,000
Basis of property
transferred
100,000
100,000
100,000
Gain/Loss realized
$50,000
$50,000
$50,000
Liabilities assumed

(slide 3 of 3)

Business Business
No Business
Purpose I Purpose II
Purpose
Boot
None
None
$120,000
Gain
Recognized
None
$20,000
$ 50,000*
*(Gain is lesser of $50,000 realized gain or boot)
Basis Computation for 351 Exchange

(slide 1 of 2)
Basis Computation for 351 Exchange

(slide 2 of 2)
Basis in Stock in Last Example

Adjusted Basis of transferred assets:
$100,000
Liability:
Basis in assets
Transferred
+ Gain recognized
- Liab. Transferred
Basis in stock
Business
Purpose
$ 80,000
Business
Purpose
$120,000
$100,000 $ 100,000
None
20,000
(80,000) (120,000)
$ 20,000
-0-
No Business
Purpose .
$120,000
$100,000
50,000
(120,000)
$ 30,000
Corporations Basis in Assets Received

in Last Example
Business Business
Purpose
Purpose
Liability:
$ 80,000 $120,000
Basis of transferred assets:
$100,000 $100,000
Gain recognized
by shareholder
None
20,000
Basis to Corp.
$100,000 $120,000
No Business
Purpose
$120,000
$100,000
50,000
$150,000
Basis Adjustment for Loss Property

(slide 1 of 2)
When built-in loss property is contributed to a

corporation
Aggregate basis in property may have to be
stepped down so basis does not exceed the F.M.V.
of property transferred
Necessary to prevent parties from obtaining double
benefit from losses involved
Basis Adjustment for Loss Property

(slide 2 of 2)
Step-down in basis is allocated among assets

with built-in loss
Alternatively, if shareholder and corporation both
elect, the basis reduction can be made to the
shareholders stock
Built-in loss adjustment places loss with either

the shareholder or the corporation but not both
Stock Issued for

Services Rendered
Corporation may be able to deduct the fair market
value of stock issued in exchange for services as a
business expense
e.g., Performance of management services
May claim a compensation expense deduction under 162
If the services are such that the payment is

characterized as a capital expenditure (e.g., legal
services in organizing the corporation)
Must capitalize the amount as an organizational
expenditure

Stock Issued for Services Rendered
(slide 1 of 2)
Emily transfers her $500,000 of property to

Garden, Inc. and receives 50% of the stock.
In addition, assume that, in exchange for 50%
of the stock, David
Transfers property worth $400,000 (basis of
$130,000), and
Agrees to serve as manager of the corporation for
one year (services worth $100,000).

(slide 2 of 2)

Emilys and Davids transfers qualify under 351.
Neither Emily nor David is taxed on the transfer of his or her property.
David recognizes income of $100,000

Equal to the value of the stock received for the services he will render
to Garden, Inc.
Garden has
Basis of $130,000 in the property it acquired from David, and
May claim a compensation expense deduction under 162 for
$100,000.
Davids stock basis is $230,000

$130,000 (basis of property transferred) + $100,000 (income
recognized for services rendered).

Assume the same facts as in Example 24 except that David
provides legal services (instead of management services) in
organizing the corporation.
The value of Davids legal services is $100,000.
David has
No gain on the transfer of the property, but
Has income of $100,000 for the value of the stock received for the
services rendered.
Garden, Inc.
Has a basis of $130,000 in the property it acquired from David, and
Must capitalize the $100,000 as an organizational expenditure.
Davids stock basis is $230,000

$130,000 (basis of property transferred) + $100,000 (income
recognized for services rendered).
Holding Period
Holding period of stock received
For capital assets or 1231 property, includes
holding period of property transferred to
corporation
For other property, begins on day after exchange
Corps holding period for property acquired in

the transfer is holding period of transferor
Recapture Considerations
In a 351 transfer where no gain is
recognized, the depreciation recapture rules do
not apply
Recapture potential associated with the property
carries over to the corporation
Capital Contributions
(slide 1 of 3)
No gain or loss is recognized by corp on

receipt of money or property in exchange for
its stock
Also applies to additional voluntary pro rata
contributions of money or property to a corp even
though no additional shares are issued
(slide 2 of 3)
Capital contributions of property by

nonshareholders
Not taxable to corporation
Basis of property received from nonshareholder is
-0-
(slide 3 of 3)
Capital contributions of cash by

nonshareholder
Must reduce basis of assets acquired during 12
month period following contribution
Any remaining amount reduces basis of other
property owned by the corp
Applied in the following order to depreciable property,
amortizable property, assets subject to depletion, and
other remaining properties
Debt vs. Equity

(slide 1 of 2)
Debt
Corporation pays interest to debt holder which is
deductible by corporation
Interest paid is taxable as ordinary income to
individual or corporate recipient
Loan repayments are not taxable to investors
unless repayments exceed basis
Debt vs. Equity

(slide 2 of 2)
Equity:
Corporation pays dividends which are not
deductible
Taxable to individuals at low capital gain rates to extent
corp has E & P
Corporate shareholder may receive dividends received
deduction
Reclassification of
Debt as Equity
If corp is thinly capitalized, i.e., has too
much debt and too little equity
IRS may argue that debt is really equity and deny
tax advantages of debt financing
If debt has too many features of stock, principal
and interest payments may be treated as dividends
Thin Capitalization Factors

(slide 1 of 2)
Debt instrument documentation

Debt terms (e.g., reasonable rate of interest
and definite maturity date)
Timeliness of repayment of debt
Whether payments are contingent on earnings
Thin Capitalization Factors

(slide 2 of 2)
Subordination of debt to other liabilities

Whether debt and stock holdings are
proportionate
Use of funds (if used to finance initial
operations or to acquire capital assets, looks
like equity)
Debt to equity ratio
Investor Losses (slide 1 of 5)

Stock and security losses
If stocks and bonds are capital assets, losses from
worthlessness are capital losses
Loss is treated as occurring on last day of tax year in
which they become worthless
No loss for mere decline in value

Stock and security losses
If stocks and bonds are not capital assets, losses
from worthlessness are ordinary losses (e.g.,
broker owned)
Sometimes an ordinary loss is allowed for
worthlessness of stock of affiliated company

Business versus nonbusiness bad debts
General rule: Losses on debt of corporation
treated as business or nonbusiness bad debt
If noncorporate person lends as investment, loss is
nonbusiness bad debt
Short-term capital loss
Only deductible when fully worthless

Business versus nonbusiness bad debts (cont)
If corporation is lender, loss is business bad debt
Ordinary loss deduction
Deduction allowed for partial worthlessness
All bad debts of corporate lender qualify as business
bad debts

Business versus nonbusiness bad debts (cont)
Noncorporate lender may qualify for business bad
debt treatment if:
Loan is made in some capacity that qualifies as a trade
or business, or
Shareholder is in the business of lending money or of
buying, promoting, and selling corporations
1244 stock
(slide 1 of 4)
Treatment of 1244 stock:

Ordinary loss treatment for loss on stock of small
business corporation (as defined)
Gain still capital gain
1244 stock
(slide 2 of 4)
1244 stock:
Applies to the first $1 million of corp.'s stock
If > $1 million of stock issued, entity designates which
shares qualify for 1244 treatment
Property received in exchange for stock is valued at its
adjusted basis, reduced by any liabilities assumed by
the corporation
The fair market value of the property is not considered
1244 stock
(slide 3 of 4)
Annual loss limitation:

$50,000 or
$100,000 if married filing joint return
Any remaining loss is a capital loss
Only original holder of 1244 stock (whether

an individual or a partnership) qualifies for
ordinary loss treatment
Sale or contribution of stock results in loss of
1244 status
1244 stock
(slide 4 of 4)
If 1244 stock is issued for property with basis

> fair market value
For determining ordinary loss, stock basis is
reduced to fair market value on date of exchange
Gain from Qualified

Small Business Stock (slide 1 of 2)
Noncorporate shareholders may exclude 50%
of gain from sale or exchange of such stock
Must have held stock for > 5 years and acquired
stock as part of original issue
50% exclusion can be applied to the greater of:
$10 million, or
10 times shareholders aggregate adjusted basis of
qualified stock disposed of during year
Gain from Qualified

Small Business Stock (slide 2 of 2)
Qualified Small Business Corp
C corp with gross assets not greater than $50 million on
date stock issued
Actively involved in a trade or business
At least 80% of corporate assets are used in the active conduct of
one or more trade or businesses
Under ARRTA of 2009, the exclusion increases to

75% for qualified stock acquired after February 17,
2009, and
From subsequent legislation, the exclusion increased
to 100% for qualified stock acquired after September
27, 2010, and before 2014
Selecting Assets To Transfer (slide 1 of 2)

If Emily decides to retain the $25,000 of cash

basis accounts receivable rather than
transferring them to the newly formed
corporation
She will recognize $25,000 of ordinary income
upon their collection.
Selecting Assets To Transfer (slide 2 of 2)

Alternatively, if the receivables are transferred
to Garden as the facts suggest, the corporation
will recognize the ordinary income.
However, a subsequent corporate distribution to
Emily of the cash collected could be subject to
double taxation as a dividend
Given the alternatives available, Emily needs

to evaluate which approach is better for the
parties involved.
Refocus On The Big Picture (slide 1 of 5)

Emily, the sole property transferor, must
acquire at least 80% of the stock issued by
Garden Inc. to receive tax-deferred treatment
under 351.
Otherwise, a tremendous amount of gain (up to
$300,000) will be recognized.
As a corollary, David must not receive more

than 20% of the corporations stock in
exchange for his services.

However, even if 351 is available, any
corporate debt issued by the corporation will
be treated as boot and will trigger gain
recognition to Emily.
Therefore, she must evaluate the cost of
recognizing gain now versus the benefit of Garden
obtaining an interest deduction later.

What If?
Can the 351 transaction be modified to further
reduce personal and business tax costs, both at the
time of formation and in future years?
Several strategies may be worth considering.
Instead of having Garden issue debt on formation,

Emily might withhold certain assets.
If the building is not transferred, for example, it can be
leased to the corporation.
The resulting rent payment would mitigate the double tax problem
by producing a tax deduction for Garden.

What If?
An additional benefit results if Emily does not
transfer the cash basis receivables to Garden.
This approach avoids a tax at the corporate level
and a further tax when the receipts are distributed
to Emily in the form of a dividend.
If the receivables are withheld, their collection is
taxed only to Emily.

What If?
No mention is made as to the existence of any
accounts payable outstanding at the time of corporate
formation.
If they do exist, which is likely, it could be wise for Emily
to transfer them to Garden.
The subsequent corporate payment of the liability produces
a corporate deduction that will reduce any corporate tax.
Double taxation can be mitigated in certain situations

with a modest amount of foresight!
If you have any comments or suggestions concerning this

PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Chapter 18

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Chapter 18

The Big Picture (slide 1 of 3)

Emily expects to transfer her business assets in

The Big Picture (slide 2 of 3)

The Big Picture (slide 3 of 3)

Emilys main concern, however, is that the

Read the chapter and formulate your response.

Corporation Formation Transaction

Without 351: gain of $100,000.

In general, no gain or loss to transferors:

If boot (property other than stock) received by

Issues re: Formation

Definition of property includes:

Code specifically excludes services from

Issues re: Formation

Does not include stock rights or stock warrants

The Big Picture Example 4

Stock Transferred (slide 1 of 2)

Assume the proposed transaction qualifies

The Big Picture Example 4

Stock Transferred (slide 2 of 2)

Issues re: Formation

Transferors must be in control immediately

Issues re: Formation

Immediately after the transfer

Issues re: Formation

After control is achieved, it is not necessarily

Issues re: Formation

Transfers for property and services

To be considered a member of the 80% control

The Big Picture Example 9

Transfers for Property and Services

Return to the facts of The Big Picture on p. 18-1.

Assume Emily transfers her $500,000 of

The Big Picture Example 9

Transfers for Property and Services

Both Emily and David have tax consequences

As the sole transferor of property, she receives

The Big Picture Example 10

Transfers for Property and Services

Assume the same facts as in Example 9 except

The Big Picture Example 10

Transfers for Property and Services

Consequently, 351 is applicable to the

Issues re: Formation

Subsequent transfers to existing corporation

Assumption of liabilities by corp does not

The Big Picture Example 14

Assumption of Liabilities (slide 1 of 2)

Consequently, Emily receives 100% of the Garden

The Big Picture Example 14

Assumption of Liabilities (slide 2 of 2)

The exchange is tax-free under 351

However, the basis to Emily of the Garden

Liabilities are not treated as boot for gain

Liabilities > basis in assets transferred

Formation with Liabilities Example

Property transferred has:

Formation with Liabilities Example

Formation with Liabilities Example

Liabilities assumed by corp. (independent facts):

*(Gain is lesser of $50,000 realized gain or boot)