Corporate Formation Study Unit 13 PDF

1 STUDY UNIT THIRTEEN CORPORATE FORMATION 13.1 Recognized Gain or Loss................................................ 1 13.2 Basis of Assets Transferred in an Exchange...............

1 STUDY UNIT THIRTEEN CORPORATE FORMATION 13.1 Recognized Gain or Loss................................................ 1 13.2 Basis of Assets Transferred in an Exchange................................. 4 Once a decision has been reached to use the corporate form, the investors generally must transfer money, property, or services to the corporation in exchange for a debt or equity interest in the corporation. These transfers may have tax consequences to both the transferor and the corporation. Section 351 was enacted to allow taxpayers to incorporate without incurring adverse tax consequences and to prevent taxpayers from recognizing losses while maintaining ownership of the loss assets indirectly through stock ownership. 13.1 RECOGNIZED GAIN OR LOSS Section 351 requires that no gain or loss be recognized if property is transferred to a corporation by one or more persons (i.e., individuals, trusts, estates, partnerships, associations, companies, or corporations) solely in exchange for stock (including treasury stock) in the corporation and, immediately after the exchange, such person(s) control the corporation. Examples of property include cash, tangible property, and nontangible property. This nonrecognition treatment is mandatory, not elective. Control 1. Control is ownership of 80% or more of the voting power of stock and 80% or more of the shares of each class of nonvoting stock of the corporation. a. Stock exchanged for services is not counted toward the 80%-ownership test, unless property is also transferred by the service provider. 1) The FMV of the stock is gross income to the shareholder when stock is transferred for services. 2) The shareholder’s basis in the stock exchanged for services is its FMV. b. Nonqualified preferred stock is treated as boot received and is not counted as stock toward the 80%-ownership test. Generally, nonqualified preferred stock has any of the following characteristics: 1) The holder has the right to require the issuer or a related person to redeem or buy the stock. 2) The issuer or a related person is required to redeem or buy the stock. 3) The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised. 4) The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 13: Corporate Formation Solely for Stock 2. To the extent the shareholder receives the corporation’s stock solely in exchange for property, nonrecognition is required. EXAMPLE 13-1 Transfer of Asset in a Sec. 351 Exchange -- Solely for Stock Taxpayer transfers an asset to the corporation solely for stock in a Sec. 351 exchange. The asset has a basis of $10,000. Taxpayer receives stock worth $15,000. Taxpayer has a realized gain of $5,000 but will recognize no gain. a. Inequality of FMV of the stock and property exchanged (i.e., disparate value) is not relevant in itself. 1) The shareholder may have gross income if the disparity represents an (unstated) additional transaction, e.g., payment of compensation, a constructive dividend. b. Section 351 may apply to an exchange after formation of the corporation. c. Section 351 can apply to contributions of property even if the corporation issues no stock in the exchange, e.g., a capital contribution by a sole shareholder who receives no stock in exchange for the contribution. d. Section 351 may apply when the corporation exchanges treasury stock as well as newly issued stock. e. Whenever a shareholder (or group of shareholders) makes a Sec. 351 property exchange for stock in a corporation, a statement of all facts relevant to the exchange must be attached to the individual tax returns, as well as to the corporate return, in the year of the exchange. Boot 3. The shareholder recognizes gain realized to the extent of money and the FMV of other property (except the stock of the corporation) received in the exchange. a. FMV of property given up is used if FMV of property received cannot be ascertained. b. Character of the gain depends on the property contributed. c. No loss is recognized on the receipt of boot. EXAMPLE 13-2 Transfer of Asset in a Sec. 351 Exchange -- Stock and Boot Taxpayer transfers an asset to the corporation in a Sec. 351 exchange. The asset has a basis of $10,000. Taxpayer receives $3,000 in cash and stock worth $15,000. Taxpayer has a realized gain of $8,000 and a recognized gain of $3,000. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 13: Corporate Formation 3 Liabilities 4. Section 351 applies even if the corporation assumes the shareholder’s liability or takes property subject to a liability in the exchange. Liabilities generally are not treated as boot. a. The amount of the liabilities is treated as recognized gain from the sale or exchange of an asset only to the extent it exceeds the adjusted basis (AB) of all property contributed by the shareholder. 1) This rule differs from like-kind exchanges, in which liabilities are treated as boot. EXAMPLE 13-3 Liability Transfer under Sec. 351 A taxpayer transfers an asset with a basis of $60,000 and a FMV of $100,000 to a corporation for all of its stock. The asset has a liability attached of $70,000. The taxpayer must recognize $10,000 of income, the excess of the liability ($70,000) over the basis of the asset ($60,000). b. If tax avoidance was a purpose or if no business purpose was present for the assumption or transfer, a gain may be recognized to the extent of the liability (the full amount) plus the FMV of any property received (not including stock). 5. The corporation recognizes no gain on exchange of its stock for property (including money). No gain or loss is recognized on treasury stock. a. The corporation recognizes gain on exchanging other property (neither money nor its stock), even when the exchange is with a shareholder, unless an exception applies. 6. Stock is not considered issued in exchange for property if it is issued for services or unsecured debts of the transferee or for the interest accrued to the transferor on debts owed by the transferee. EXAMPLE 13-4 Stock Issued for Services John and Mary form a corporation. John transfers a building worth $90,000 to the corporation for stock. Mary receives 10% of the stock in the corporation for services she provided in organizing and setting up the corporation. Mary must recognize $10,000 as ordinary income when she receives the stock. 7. Even though a transaction may not qualify as a tax-free transfer under Sec. 351, shareholders may not be able to deduct a loss if they exchange property with an adjusted basis that is higher than the FMV of the property they received. a. If the shareholder owns more than 50% of the corporation’s stock, directly or indirectly, (s)he cannot recognize any losses on an exchange of the property for the corporation’s stock or other property. 8. When a transaction does not qualify as a tax-free transfer under Sec. 351, the corporation’s initial basis in the property is the FMV of the stock at the time of the exchange. a. If the FMV of the stock at the time of the exchange cannot be determined, the basis is the FMV of the property received. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 13: Corporate Formation 13.2 BASIS OF ASSETS TRANSFERRED IN AN EXCHANGE In a tax-free transaction under Sec. 351, the bases of assets transferred equal the bases of the assets in the hands of the prior owner, with certain adjustments. Basis of Shareholder in Stock 1. Basis of a controlled group shareholder in the stock of the corporation is the adjusted basis in contributed property adjusted for the boot received and the gain recognized. Cash and AB in contributed property – Boot received Money FMV of property received (other than above and the corporation’s stock) – Liability relief (corporation assumes or takes subject to) + Any amount treated as a dividend + Gain recognized (by shareholder) = Basis in stock of issuing corporation a. All liabilities assumed by the corporation are treated as boot when computing stock basis (but not treated as boot for gain purposes). b. The holding period is generally tacked; i.e., the holding period of the property exchanged for stock is added to the holding period of the stock. c. If capital assets and other assets (e.g., Sec. 1231 property) are contributed by a sole proprietor when incorporating a business, each share received in the exchange has a split holding period. Basis of Shareholder in Boot 2. Boot generally has a basis equal to fair market value. Basis of Shareholder in Stock Received for Services 3. The shareholder’s basis in the stock exchanged for services is its fair market value. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 13: Corporate Formation 5 Basis of Corporation in Property 4. The corporation’s initial carryover basis in property exchanged by a control group shareholder for its stock is an adjusted carryover basis. AB in property to shareholder + Gain recognized by shareholder = Basis in property to corporation a. This basis also applies when the shareholder receives nothing in return. b. This basis is also the corporation’s initial depreciable basis in the property. 1) Allowable depreciation is apportioned based on the number of months the corporation owned the asset. 2) The step-up in basis is treated as a second property whose depreciation commences on the day of the exchange. c. When the shareholder’s AB in the property exceeds the FMV (i.e., when a built-in loss exists), the basis is limited to the FMV. d. The holding period is tacked. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].