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Chapter 2:Corporate

Formationsand CapitalStructure

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CORPORATE CORPORATE FORMATIONFORMATION

Alternative business formsCheck-the-box regulationsLegal requirements for forming a

corporation§351 deferralsChoice of capital structureWorthless stock or debt obligations

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Forms of BusinessForms of Business

Sole proprietorshipsPartnershipsCorporations

C CorporationsS Corporations

Limited liability companiesLimited liability partnerships

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Sole Proprietorship(1 of 2)

One ownerNot a separate entity

Income reported on Sch. C of 1040No limited liabilityTax advantages

Profits taxed onceNo tax on contributions or withdrawalsLosses offset other income (with limitations)

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Sole Proprietorship(2 of 2)

Tax disadvantagesProfits taxed as earnedOwner not employee

Profits subject to SE taxNot eligible for some tax-exempt

fringe benefitsNo fiscal year deferral

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Partnerships(1 of 3)

Two or more ownersConduit entity

Reports, but does not pay income tax

No limited liabilityExcept for limited partners

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Partnerships(2 of 3)

Tax advantagesLosses offset other income (with

limitations)Income retains its characterIncome/gain increases basis

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Partnerships(3 of 3)

Tax disadvantagesProfits taxed as earnedPartners not employees

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

benefitsFiscal year deferral difficult to obtain

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C Corporations(1 of 2)

Separate taxpaying entityLimited liabilityTax advantages

Tax rates start at 15%Shareholders may be employees

No SE taxEligible for tax-exempt fringe benefits

May exclude 50% of gain on stock sale if certain requirements met

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C Corporations(2 of 2)

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

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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

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S Corporations(2 of 3)

Tax advantagesGenerally exempt from taxationLosses flow through to shareholdersIncome retains its characterIncome/gain increases basisShareholders may be employees

S Corp net income not subject to SE tax

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S Corporations(3 of 3)

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

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Limited Liability Companies

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

corporation

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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

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Check-the-Box Check-the-Box RegulationsRegulations

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)

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Requirements to Requirements to IncorporateIncorporate

Dependent on state lawMinimum capital requirementsFile of articles or incorporationGranting of charter by stateIssue of stockPay state incorporation fees

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§351 Deferrals§351 Deferrals(1 of 2)(1 of 2)

No gain or loss recognized if:PROPERTY transferred in exchange

for stock andTransferors have control of corp

immediately after the exchangeTransfers may be for new or

existing corporations

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§351 Deferrals§351 Deferrals(2 of 2)(2 of 2)

Stock requirementTax effects on transferorsTax effects on transferee corpAssumption of liabilitiesSee Table C2-1 for a summary of

corporate formation rules

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§351 Deferrals:Property Requirement

Property 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

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§351 Deferrals:Control Requirement

Transferors 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 stockContribution of services & property

Stock of transferor counted towards 80% if FMV of property 10% of service’s value

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§351 Deferrals:Tax Effects on Transferors (1

of 3)

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

property (substituted basis)Holding period of stock includes

holding period of assets

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§351 Deferrals:Tax Effects on Transferors (2

of 3)

When boot receivedGain recognized lesser of gain realized

or FMV of boot receivedGain recognized when liabilities transferred

exceed basis in assets transferredBasis in stock increased by gain

recognized

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§351 Deferrals:Tax Effects on Transferors (3

of 3)

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

after exchange

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§351 Deferrals: Tax Effects on Transfee Corp (1 of 2)

No gain or loss recognizedBasis in property received

Transferor’s adjusted basis plusgain recognizedBasis = total FMV of property transferred when

basis in property transferred > FMVIf all s/h agree, s/h that contributed property can

reduce her basis in stock instead of corp reducing basis in assets

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§351 Deferrals: Tax Effects on Transfee Corp (2 of 2)

Depreciation recapture potential transfers to transferee corporation

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

transfer when basis reduced to FMV

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Choice of Capital Choice of Capital StructuresStructures

Debt Interest deductible by

corp Repayment of debt not

taxable to s/h Debt received in §351

is boot to s/h Worthless debt is

capital loss to s/h Debt distributed by

corp taxable to s/h

Equity Dividends not deductible by corp

S/h only pays max 15% on dividends received

Stock redemption can be taxable dividend to s/h

Stock received in §351 not boot to s/h

Worthless §1244 stock is ordinary loss to s/h

Stock distributed by corp not taxable to s/h

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Choice of Capital Choice of Capital Structures:Structures:

(1 of 2: Debt)(1 of 2: Debt)

Interest deductible by corpRepayment of debt 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

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Choice of Capital Choice of Capital Structures:Structures:

(2 of 2: Equity)(2 of 2: 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 stock is ordinary loss to

s/hStock distributed by corp not taxable to s/h

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Worthless Stock or Worthless Stock or DebtDebt(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

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Worthless Stock or Worthless Stock or DebtDebt(2 of 3)(2 of 3)

Ordinary Loss SituationsSecurities that are noncapital

assetsSecurities of affiliated companies§1244 stock

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Worthless Stock or Worthless Stock or DebtDebt(3 of 3)(3 of 3)

§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

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Kenneth W. Monfort College of Businessrichard.newmark@PhDuh.com