Corporate Tax 1 Miterm Final PDF

A"iliated Group: Defined under Section 1504(a)(2), allows a group of corporations to consolidate tax returns (p. 3). Business Purpose: Essential in transactions to prevent classification as tax avoidance; links closely with sham transaction and substance-over-form doctrines (p. 4)....

A"iliated Group: Defined under Section 1504(a)(2), allows a group of corporations to consolidate tax returns (p. 3). Business Purpose: Essential in transactions to prevent classification as tax avoidance; links closely with sham transaction and substance-over-form doctrines (p. 4). Capital Gains and Losses: Corporations may deduct capital losses only to the extent of capital gains, with a three-year carryback and five-year carryforward (p. 2). Corporate Formation: Section 351 details the requirements for tax-free transfers of property for stock, emphasizing control and timing (p. 8). Corporate Tax Rate: Flat rate of 21% under current tax law, compared to varied rates internationally (p. 1). Dividends Received Deduction (DRD): Allows deductions of 50%, 65%, or 100% on qualifying dividends to prevent triple taxation; limitations apply (p. 18). Double Taxation: Corporations face double taxation on distributed earnings, incentivizing certain tax strategies like retaining earnings (p. 1). Economic Substance Doctrine: Codified test requiring transactions to have both business purposes and economic substance to prevent tax shelter abuse (p. 4). Extraordinary Dividends: Defined under IRC Section 1059; basis reduction required for large dividends if stock held less than two years (p. 18). Incorporation of a Going Business: Section 351 treatment may apply for incorporation involving accounts payable/receivable with specific income and deduction rules (p. 5). International Tax: U.S. taxes global income with certain deferral options for foreign income; recent reforms aXect planning (p. 3). Net Operating Losses (NOL): Post-2017 losses carry forward indefinitely but can oXset only 80% of taxable income; the CARES Act introduced temporary carryback options (p. 3). Organizational Expenses: Costs linked to forming a corporation, distinct from start-up costs, may be amortized with specific rules (p. 8). Passive Activity Rules: Generally not applicable to corporations, allowing broader deductions compared to individual limitations (p. 2). Problem Examples: Practical examples for application of tax rules, including Section 351 control requirements and dividend rules (pp. 5, 66). S Corporations: Flow-through entities with specific requirements; profits/losses pass directly to shareholders with no corporate tax (p. 3). Sham Transaction Doctrine: Targets transactions lacking business purpose, particularly those structured to evade tax liabilities (p. 4). Start-Up Expenses: Deductible up to $5,000, with excess amortized over 180 months; distinct from organizational costs (p. 8). Substance Over Form Doctrine: Ensures tax treatment reflects economic reality rather than formal transaction labels (p. 4). Tax Credits: Corporations may oXset tax liability through credits, subject to specific limitations and requirements (p. 2). Tax Year and Accounting Methods: Corporations may use fiscal or calendar years, with accrual methods generally required (p. 2)  Page 1 Taxaon of Business Enterprises Overview of Corporate Tax Brish Crown Recognizes Collecve Prot Earliest Acts of Taxaon – Corporaons treated Seeking enterprises as separate and apart from its shareholders Chapter 1 First US Tax of 1894 imposed 2% tax on Congress Cra3ed the “Double Tax Regime” An Overview of Corporate Tax corporate net income – Socialist Plot? – Tax imposed annually at rates established in IRC 1909 Tari. Act– Corporate level tax on income Secon 11 – FLAT RATE OF 21% UNDER TAX REFORM – Income is taxed again if and when corporaon over $5,000 distributes dividends to its shareholders Sixteenth Amendment – Allows Federal – No deducon to corporaon for dividends paid Government to impose income tax (generally speaking) Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Dividends taxed at shareholder level at rates Partnership – Flow Through Vehicle Other Consideraons depending on – Individual, Corporaon, Tax – Basis Adjustments to ensure taxability only once – IRC Secon 1202 – qualied small business stock – Newer Enes – LLC’s – generally treated as Partnerships but Exempt Enty exclusion of gain. discussed more later Transacons between Corporaon and S-Corporaon – Flow Through – New QBI Deducon available for non-corporate Shareholder are generally taxable events. – Strict Set of requirements as to number and type of taxpayers shareholders – Pass Through Losses Subchapter C- C corporaons One Class of Stock – State Tax Issues Subchapter S – S Corporaons 100 Shareholders – Employment Tax Consideraons Foreign Owners Prohibited Subchapter K - partnerships PTP’s – Treated as Corporaons for tax purposes  Page 2 Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Is the Double Tax Real or Theorecal? Is the Corporate tax worth it? Other Factors – 1950’s accounted for 25 to 30% of federal income – Historically Low Preferenal Capital Gains Rates equal to What Problems Exist with the Corporate Tax? – 2016 forward – expected to drop to 9% dividend rates in 2003 eliminates some of the biases and – Ways to plan around? – What is the cost? incenve to plan around double tax – Who bears the burden? Corporate Tax Rates – Flat rate of 21% NOW AND IS VERY COMPETITIVE although sll high compared to the With Corporate Tax rates now Oat at 21%, consider if the bias – Creates 3 disnct Biases UK, Ireland and a growing number of other countries. d towards Corporate Form of enty has returned? – Average of 24.1% for members of the OECD – declining Against Corporate Investment to Non-Corporate – Individual Tax rates as high as 37% UNDER TAX REFORM) plus 3.8% net investment – Non-Recognion Investment income tax. Realized gains and losses vs. Recognized gains and losses. – Encourages retenon and planning at corporate level? – Tacked Holding Periods Favors Debt Financing over Equity Investment – although – Only 49% report taxable income and only 30% have any tax liability a3er available – Exchanged or carry-over basis now limited with IRC Secon 163(j) o.sets (credits). – IRC 311(b) gain is the outlier – generally will impose tax on distribuons – Planning Techniques for closely held corporaons to avoid double tax. Rents, Salaries, Favors Retenon of Earnings at the Corporate Level Loans… of appreciated property Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Internaonal Tax on US Corps Students should not expect a dy set of rules Corporate Income Tax – PRE TAX REFORM – US taxes worldwide income at combined rate of about 25% with limited – LiQle focus on determinaon of corporate tax liability credits for foreign taxes. Sense of smell should be developed Broad principles learned in basic tax class apply – Most Developed Countries tax only prots earned in the home country – Gross Income, deducons, assignment of income, ming, characterizaon all generally at rates on average of 24.1% and lower in many cases Spot Issues apply with some basic di.erences – Corporate Tax rates – Encourages Complex and sophiscated planning (although under tax reform, much of this has disappeared) Learn to apply facts and circumstances First $50,000 15% 50,001 - $75,000 US tax system can allow o.shore subsidiaries to defer the US taxaon of its Learn the basics and gain an awareness of the $75,001 - $10,000,000 25% 34% prots unl repatriated. Encourages Corporaons to park prots o.shore ($2 to $3 trillion) complex – 5% addional tax on income in excess of $100,000 up to $11,750 » Creates rst bubble of 39% on income between $100,000 and $335,000 Parking Intangibles o.shore and charging royales (Google 3% on foreign prots) Inversions – Canada (Burger King/ Tim Horton) (Pharmaceucals) Di.erence between ethical tax pracce and – 3% (or $100,000) addional tax on taxable income in excess of $15,000,000 (the double bubble) – Fast Changing Tax Law – Today’s law is tomorrow’s history unethical tax pracce. » Impact is that Corporaons with income over $18,333,333 are taxed at a Oat 35% » New rate is a Oat 21%  Page 3 Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Corporate Income Tax – connued – Charitable Contribuon limitaon is 10% for Corp not 50% or 60% as in the case of individuals – Taxable year and accounng method – At risk rules generally do sll apply – Secon 63(a) denes taxable income as gross income less allowable – Passive acvity rules generally do not apply Generally allowed any scal year or calendar year deducons – Capital losses only deducble to the extent of capital gains with a 3 year carry back and 5 year – Excepon for PSC’s Di.erences between individuals and corps carry forward » 3 month deferral or business purpose – No personal or dependency exempons – Execuve comp limited to $1,000,000 for public companies » Excepon for incenve pay – Repealed under tax reform » Required elecons on Secon 444 if deferral – No standard deducon – No itemized deducons – Secon 199 Manufacturing deducon » Secon 444 not required if valid business purpose exists – No Miscellaneous 2% rules » Deducon for 9% of the lesser of taxable income or qualied domesc producon acvity » Secon 444 requires tax payments on deferred income income – No medical expense deducon Very broad Generally must use accrual basis of accounng for tax purposes – No spousal support deducon – Secon 212 only applicable to individuals Available for regular tax and alternave minimum tax – Limited excepons for PSC’s, farmers, and small corporaon Available to corporaons and individuals – However, all expenses incurred in the pursuit of prot that are ordinary and necessary business expenses are deducble under Secon 162 – Secon 267 disallows losses between shareholder and a more than 50% owned corporaon (aQribuon applied) Corporaons Allowed Dividends received deducon from other » Corporaon presumed to be in pursuit of prot – Secon 267(a)(2) forces matching rule between accrual and cash method corporaons –PERCENTAGES CHANGED UNDER TAX REFORM – 50%, 65% No limitaon on non business losses employee/owner and 100% Non business bad debts not subject to short term capital loss generally do not apply – Corporaons Generally allowed tax credits to o.set tax liability. Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Net Operang Losses Mulple Corporaons “ASliated Group” – Pre 2018 – Secon 1561 denies mulple tax benets to “Controlled Corporaons” – Dened under Secon 1563 – Can elect to consolidate return (covered in Chapter 2 years back and 20 years forward then expire if unulized » Combined Group 3 or more corporaons each of which is a member of a group of corporaons 13) Can o.set 100% of taxable Income described below (parent/sub) one of which is a common parent and also is Allows group of corporaons to e.ecvely be treated as – Post 2017 included in a group of corporaon described below (brother/sister). one taxpayer » Controlled group if Parent/Subsidiary relaonship Unlimited carryforward – never expire At least 80% vote of all classes of stock entled to vote Dened in Secon 1504(a)(2) No Carry-Back OR at least 80% combined value of all classes of stock – Requires at least 80% of vong power and at least 80% of the » Brother/Sister relaonship Can o.set 80% of taxable income 5 or fewer persons (individuals, estates or trusts) own more than 50% of all total value of the stock (nonvong preferred stock disregarded). – Special Cares Act vong stock – Must be an includable corporaon OR 5 or fewer persons (individuals, estates or trusts) own more than 50% of the Allows 5 year carry back of 2019 and 2020 NOL’s total value of all classes of stock » Does not include tax exempts or foreign corporaons and certain other corporaons. Need to watch out for consequences – AMT, TCJA Provisions  Page 4 Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview S-Corp Alternave Corporate Classicaon – Change in number of owners – Flow through enes for shareholder tax purposes however all of subchapter C – Secon 7701 denes a corporaon to include Generally no impact, unless…. applies in cases of distribuons of appreciated property, stock redempons, – 2 member partnership becomes 1 member = DRE Associaons, joint-stock companies and insurance companies. liquidaons and acquisions – Single Member DRE gains an owner = Partnership Unincorporated associaons will be taxed as corporaons. – ASrmave S Elecon required – Specic rules for elecve changes in classicaon – Associaon regulaons pointed to 6 corporate characteriscs Maximum of 100 shareholders all of whom must be individuals (other than non-resident Partnership elects to be Corporaon » Connuity of Life aliens), estates or trusts. – Assets and liabilies contributed to newly formed Corporaon and partnership liquidates stock to » Centralized management Only permiQed one class of stock partners » Limited liability Corporaon elects to be Partnership 68% of the 6.9 Million Corporate tax returns led » Free transferability of interests – Deemed distribuon of all assets and liabilies to shareholders followed by deemed d contribuon to Compared to LLC’s and partnerships – Only one class of stock so no special allocaons » Business objecve newly formed corporaon. – Ownership limitaons » Associates Corporaon with 1 owner becomes DRE = Corporate Liquidaon – Partnerships get basis for enty level debt S-Corps shareholders do not Last 2 ignored and rst 4 reviewed and weighted equally, if 3 or more of the DRE become Corporaon = deemed contribuon to newly formed corporaon – Employment Tax consideraons of S-Corporaons rst 4 – corporaon. – All of the above governed under normal tax principles including common law » Only salary subject to FICA & FUTA » S-Corp distributable share is not self employment income as it is in the case of a partnership or LLC – Regulaons repealed and replaced with check the box regulaons with doctrines such as step transacon doctrine. As such, changes in elecon, owner/service provider the advent of LLC’s while automac are not necessarily tax free Corporate Tax Overview Corporate Tax Overview Corporate tax overview – Economic Substance Doctrine – Substance over Form Doctrine Statutory Law vs. Common Law » Documents used by the taxpayer may use one label (form) but the » IRS principal weapon in its assault on abusive tax shelters – Code & Regulaons substance of the transacon comports di.erent economic realies. AQacks transacons with purported acvity that » Individual cases tend to turn on the actual facts and circumstances – Court Cases actually occurred but lacked any economic substance Salaries = compensaon or disguised dividends Developed 5 Common Doctrines that govern overall federal outside the tax benets Rents = fair market value or disguised remuneraon taxaon Courts di.ered on approach Sales of assets or transfer of ownership in name only 2 prong test = economic substance and business – Business Purpose » A transacon movated by business reasons is compared to ine that has – Sham Transacon Doctrine purposes no substance or ulity apart from tax avoidance. » AQempt by taxpayer to ward O. tax blows with paper armor Rigid test – economic substance alone with some » Linked closely to sham transacon and substance over form doctrines. » O3en connotes near fraudulent behavior and reserved for the more disagreement on the type and amount of non – Step Transacon Doctrine egregious cases tax benet needed to sasfy economic » A series of separate transacons can be stepped together to a single » Taxpayer movated by no business purpose other than obtaining tax substance integrated event to determine the tax treatment. benets in entering the transacon and that the transacon had no 351 drop down followed by liquidaon under 332 = 368 reorganizaon Economic Substance Codied with strict penalty economic substance because no reasonable possibility of prot exists. regime (covered in Chapter 14)  Page 5 Corporate Tax Overview Corporate Tax Overview Corporate Tax Overview Page 28 Problem Page 28 problem connued Problem Page 28 – Part A – Boots, Inc is a C-Corporaon – Income What is Boots Taxable Income? – Accrual Method with 2 equal shareholders Inventory Sale $2,600,000 What is Boots Tax Expense? Capital Gains – Part B – Shareholders are cash basis and unrelated $ 200,000 What would change in Part A if Boots distributes its a3er tax prots to – Shareholders have ordinary income tax rate of – Expenses and Losses Shareholders as qualied dividends? Operang Expenses $( 800,000) – Part C 40% and 20% for qualied dividends and long- What would change in Part A if Boots instead of paying dividends, pays each term capital gains Equipment Purchases $( 800,000) * shareholder a salary of $500,000 each? Capital Losses $( 220,000) – Part D Consider generally if there is an advantage of operang Boots as a Oow through… do shareholders qualify for QBI deducon? What addional facts would you need to evaluate? Homework Page 58 Homework Page 58 Part C Part D There is $5,000 inherent gain in the inventory transferred by B – if C contributes 2 parcels of land Chapter 2 – Parcel #1, FMV $10,000 A/B $15,000 corpora ons sells inventory later for $10,000 and B sells her stock for $10,000, how many mes will the $5,000 gain be taxed? Is there Corporate Forma on – Parcel #2. FMV $10,000 A/B $8,000 – Total built in loss of $3,000 jus 7ca on for the result? – The $5,000 gain is taxed 2x’s – once at the corporate level and once at the shareholder level… is there jus 7ca on? Well that is what Sec on 351 Must allocate the built-in loss of $3,000 to the 2 parcels of land. requires so there is jus 7ca on under the law. Since all built in loss is on Parcel #1, the $3,000 corporate basis – Is it fair? That’s another ques on…..but it is the cost of choosing to reduc on is 100% allocated to Parcel #1 incorporate and contribu ng built-in gain property. You create the 2nd level of Shareholders basis in stock is equal to the combined adjusted basis tax… a beer The Exchange Consider whether the following Transac ons Same as above – except A & B’s transfer were – Control is de7ned for purposes of Sec on 351 by Sec on 368(c) qualify under Sec on 351 part of a single integrated plan. » Ownership of the stock possessing at least 80% of the total combined vo ng power of all classes of stock en tled to vote and at least 80% of the total number of shares of all other classes of stock of the corpora on. » Dual requirement – most own both 80% of vote and 80% of all other shares – A&B unrelated. A forms Newco Inc on January 2 of Same as B above, except A transferred 25 shares » Measured at the group level Allows Dexibility – some shareholders may get vo ng while others get only non vo ng. Some may receive preferred stock while the current year by transferring a capital asset to her daughter (D) as a gi> on March 5th. What others receive preferred stock As long as the group on transferors of “property” collec vely meet the 2 tests, the transac on will qualify under Sec on 351 (FMV $50K and A/B of $10K). A receives 50 shares if A’s gi> to D was to occur on January 5th? – Immediately A>er of newco common stock. On March 2, in an Same a B above, except 2 months a>er B’s » Must be part of an integrated plan that proceeds with expedi on consistent with orderly procedure – so ming is not the key factor unrelated transac on, B transfers a capital asset Transfers separated by one hour may not qualify while transfers separated by several years may qualify under Sec on 351 – look for a predetermined plan. transfer, A sold 15 shares to E pursuant to a » Momentary control will not suGce if the 80% tests are not met as a result of disposi ons of stock by some of the transferors pursuant (FMV $10K and A/B $1K). B receives 10 shares of to a binding agreement or prearranged plan. Voluntary disposi ons, par cularly in a dona ve seHng, should not break the control requirements of sec on 351 non vo ng preferred stock that is NOT preexis ng oral agreement, without the nonquali7ed preferred stock). agreement, NewCo would not have been formed. Corporate Forma on Corporate Forma on Homework Quiz #2 One or more persons must transfer “property” Solely of Stock Requirement – Stock generally means equity investment. Complete Parts C, D & E of the problem on Includes both common and preferred stock (in most cases) regardless of vo ng or non-vo ng rights – What is property? Not de7ned but considered broadly Does not include stock rights, stock warrants or debt securi es. Certain preferred stock which resembles debt is treated as “boot” – See Sec on 351(g)(2) for non-quali7ed preferred stock. Page 69/70 – Cash, capital assets, inventory, accounts receivable, patents, certain other intangibles. – Non-quali7ed preferred stock de7ned as preferred stock with any of the following characteris cs: » Stockholder has “put” op on* – Does not, generally, include services if services were the sole or overwhelming majority » Corpora on has mandatory “call”* of value contributed by transferor. » Corpora on has “call” op on* and at the issue date it is more likely than not such call will be exercised. » If Property is equal to 10% or more of FMV of stock to be received for services. » Dividend rate on such preferred stock varies in whole or in part based on interest rates, commodity prices or other similar indices. » So… a transferor of services alone will not count in the “group” for purposes of the – Sec on 351(g) boot treatment can result in gain (but generally not loss) to the recipient on the exchange. 80% tests , however a transferor who provides both property (10% or more) & services quali7es to be part of the “group” for purposes of the 80% test. » Loss is allowed if only non quali7ed preferred stock is received in the exchange. Treated as stock for all Note that although all of the stock counts towards the 80% control group – that other purposes of the code. individual would s ll have ordinary income to the extent of the FMV of the stock he/she received for the services. Basis in stock that por on of stock *Only if the right or obliga on may be exercised within 20 years from the date of issuance and such would be FMV and not carryover. No corporate deduc on right or obliga on is not subject to a con ngency which makes such exercise remote.  Page 7 Corporate Forma on Corporate Forma on Corporate Forma on Sec on 351(b) Timing of Sec on 351(b) Gain “BOOT” – Gain is deferred by shareholder un l receipt of money (payment). – The receipt by the transferor of “other property” in addi on to – If a transac on would have otherwise quali7ed under Sec on 351(a) but for the fact the transferor receives other property or – Basis in shareholders stock is increased immediately by the total poten al gain to be realized. money in addi on to stock, then the transferor’s realized gain (if any) must be recognized to the extent of cash received and quali7ed stock – i.e. a viola on of the solely in exchange for stock the FMV of the other property. – Corpora on takes transferred basis and increases basis in asset as gain is recognized by requirement. Gain is characterized by the nature of the property transferred (include recapture provisions). shareholder Other property includes corporate debt, cash, non-quali7ed preferred stock, – Example: Building basis of $100 and FMV $500 transferred to C for stock plus $50 cash – See Proposed Regula ons 1.453-1(f)(1)(i) and virtually any other type of property (eg tangible personal property). » A has gain of $50 equal to cash received. – Example: » Gain is likely capital in nature subject to recapture as ordinary income (Sec on 1250) A’s Building has basis of $10 and FMV of $100 Absent Sec on 351(b), transferor, despite being in control and having had » A’s basis in stock is $100 ($100 less $50 cash received plus $50 gain realized). Basic formula: Basis of asset transferred, less FMV of property received, plus gain recognized). See Sec on 358(a)(1)(B)(ii) A Receives stock worth $80 and C’s 5 year note of $20 transferred “property”, would be required to recognize gain. » A’s basis in boot is $50 – in this case it is cash so that is easy, but if it was say tangible personal property, the other property has a FMV in the hands of the shareholder. See Sec on 358(a)(1)(B)(ii) A has realized gain of $90 (100 – 10) but recognizes gain to the extent of boot = $20 for the note – Example: assume A transfers to C Corp a building with a basis of $100 and a FMV of $500 » C’s basis in Building is equal to $150 (transferred basis plus the amount of gain recognized by shareholder). See Sec on 362(a) and receives common stock with a FMV of $450 and Cash of $50. Clearly A has a realized – Day 1 recognized gain is $0 – no cash received. gain of $400… Loss is never allowed under Sec on 351(b) – see also Sec on 267(a)(1) – Basis in stock is $10 plus poten al gain recogni on ($20) so basis in stock on day 1 is $30 » Absent Sec on 351(b) – – Basis in note is zero since all basis allocated to stock up to its FMV (excess basis is allocated to the note) If transferor exchanges mul ple assets in exchange for stock and boot, then the gain recognized and character of such gain is determined by A would have recognized gain on the full amount of the realized gain ($400). A’s alloca ng the boot pro-rata based on the rela ve FMV of the assets transferred. – A receives $4 per year in years 2 through 6 (20/5) basis in C stock would be $500. – A’s gain ra o is 100% so every payment results in gain of $4 – Revenue Ruling 68-55 is a must understand – No loss recognized and can not oset gains, basis is equal to transferred basis less FMV of property C would have a basis in building equal to $500 (equal to A’s basis in the property received plus gain recognized (FMV of property may exceed gain recognized). Holding period for stock is split based rela*ve FMV of property – C’s basis in building on day 1 is $10 (transferred basis plus gain recognized) plus the amount of gain realized - $100 plus $400) transferred. – C increases basis in building by $4 in years 2 through 6 as A recognizes gain on installment por on. Corporate Forma on Corporate Forma on Corporate Forma on Assump ons of Liabili es Assump on of Liabili es & Sec on 357/358 Assump on of liabili es – Sec on 357 con nued – Early court cases ruled that assump on of liabili es by the corpora on was akin to – Most o>en Involves the transfer of encumbered property boot – Character of 357 gain is allocated to the transferred assets in – for instance a building subject to a mortgage. Created problems and frustrated the purpose of Sec on 351 – no cash to pay taxes and no real propor on to their respec ve FMV’s/ change in substance of underlying property. – Example: – Under general federal income tax principles, an Congress enacted what is now Sec on 357 – Sec on 357(a) provides that for purposes of 351 (and others) an assump on of a liability by a transferee A’s transfers building with a $30 basis and a FMV of $100 subject to a assump on of a liability is treated as addi onal proceeds. corpora on in connec on with a 351 exchange will neither cons tute boot or prevent the exchange from liability of $55 qualifying under Sec on 351 Assume you sell a house with a basis of $100 that has a – Sec on 358(d) provides that liabili es assumed are treated as monies received by the shareholder for A’s receives stock FMV of $45 purposes of determining basis – in other words, decrease stock basis by the amount of liability assumed but mortgage of $65. You received $135 in cash plus the buyer not below zero – Without Sec on 357(c) A’s basis under 358 would be nega ve ($25) - $30 less assumes the mortgage. » Excess liabili es assumed are treated as gain from the sale or exchange of property – see Sec on 357(c) $55 debt = ($25) » Sec on 357(b) is an abuse provision that is applied in cases where there is bad intent. Where bad intent – Sec on 357(c) requires gain of $25 to be recognized so A’s basis in the stock – Your amount realized is $200 –(cash of 135 + 65 liability assumed) is involved, the liabili es assumed are treated as boot. received is $0 ($30 - $55 + $25). – Your Gain is $100 – ($200 amount realized less $100 basis) Bad intent taints all liabili es assumed Bad intent can be asserted where no business purpose exists for the assump on of liabili es – » Note the realized gain of $70 ($100 - $30) is either recognized or preserved. – Buyers basis in property is $200 ($135 cash + 65 liability assumed) personal debt Basis in stock of $0 and FMV of $45 would give rise to a $45 gain, plus the Bad intent can be asserted in cases of bail outs – borrowing immediately prior to transfer $25 gain recognized under Sec on 357(c).  Page 8 Corporate Forma on Corporate Forma on Corporate Forma on Assump on of Liabili es – Sec on 357(c) excep on. Incorpora on of a Going Business Collateral Issues – Sec on 357(c)(3) Liabili es assumed that would otherwise give rise to a deduc on in the normal course of – In the context of Sec on 351 related to accounts – Contribu ons to Capital payment, do not give rise to a gain under 357(c) because the income and deduc on would receivable and accounts payable Shareholder contributes cash or property to a corpora on but be oYset. does not take back stock – technically Sec on 351 does not apply. – Sec on 358(d)(2) Where a valid business reasons exists for the transfer the Otherwise deduc ble liabili es assumed under 357(c) do not result in basis decreases. Sec on 118 however provides that capital contribu ons are not service has ruled that the transferee corpora on is to – Sec on 357(c)(3) taxable exchanges to the transferor ( no gain or loss on recognize the income and take the deduc ons when they are Does not impact the treatment of these liabili es for corporate deduc bility purposes or contribu on of property to corpora on) other areas of the code, including Sec ons 357(a) and 357(b) paid. This is consistent with case law such Hempt Brothers. – Rather shareholder increases basis in exis ng stock by the FMV of – So these liabili es do not cons tute boot unless there is clear tax avoidance purposes to the assump on Note the assignment of income doctrine will not override property contributed. under Sec on 358. Furthermore, if the liability is otherwise deduc ble – the corpora on can claim a deduc on when paid. Sec on 351 treatment. – Contribu ons to capital are also not gross income to the transferee Recourse liabili es and non recourse liabili es may be treated diYerently. If the corpora on The tax bene7t rule may override 351 in cases where the shareholder is s ll on the hook, perhaps the liability was never assumed? Consider Sec on 362(a)(2) provides carryover basis in property to planning with tax exempts or foreign investors? deduc on was previously taken. transferee corpora on. Corporate Forma on Corporate Forma on Collateral Issues Con nued Collateral Issues – Con nued – Organiza onal & Start up expenses – Sec on 351 is NOT elec ve – it applies whenever the Organiza onal expenses requirements are met. – Expenses incurred during the forma on of the corpora on that are: » Incidental to the crea on of the corpora on » Chargeable to the Capital Account Chapter 2 – Planning opportuni es s ll exist to convert ordinary income » Of a character which, if expended to create a corpora on having a limited life would be amor zable over that life. into capital or receive step up in basis of assets inside the Legal Fees dra>ing ar cles of incorpora on Fees paid to state of incorpora on Bylaws Does not include expenses related to selling the corpora ons stock or expenses incurred with transferring assets to the corpora on Corporate Forma on Start-Up Expenses corpora on – Costs incurred that would otherwise be deduc ble when incurred in an ongoing business » Salaries prior to date trade or business begins – Structuring as a sale versus a 351 contribu on » Rent expense prior to date trade or business begins » U li es prior to date trade or business begins » All other 162 ordinary and necessary expenses incurred prior to the date the ac ve trade or business began. – Disposing of stock and bus ng the immediately a>er – Elec on to deduct $5,000 currently, remainder must be amor zed over 180 month period beginning with the date the provisions. ac ve trade or business starts – $5,000 is reduced to extent organiza onal expenses exceed $50,000 in the aggregate – Group issues – if one shareholders busts may cause en re – Shareholder expenses such as appraisals must be capitalized into shareholders stock basis – Corporate expenses for items that are not organiza onal or start-up in nature o>en referred to as syndica on costs. group to bust and 351 to fail across the board. Syndica on costs are permanently capitalized.  Page 9 Corporate Forma on Corporate Forma on Corporate Forma on General Principle Stock issued in exchange for property Sec on 351 – Generally provides for transfers of property for stock to be “tax-free”. The – Need for Ini al Opera ng Capital generally received – Without special interven on there would be a taxable non-recogni on provisions. by issuance of its stock or from borrowing. exchange Policy reasons = mere change in form of ownership or investment. Property contributed to Corpora on would be deemed to be – 3 Basic Requirements – Cash received for shares of stock = rou ne One or more persons (all en es or individuals) must transfer property to the sold or exchanged for the stock received. Treated as cash purchase for all intent and purpose corpora on Taxpayer would have gain or loss on the exchange measured The transfer must be solely in exchange for stock of the corpora on – Basis of stock to shareholder is the amount of cash contributed. by the di0erence between the adjusted basis of the property The transferor or transferors, as a group, must be in control immediately a:er the – Holding period begins on date of contribu on exchange. in the hands of the shareholder and the fair market value of – Corpora ons basis in Cash is the face value = cash is cash – Control is de;ned for purposes of Sec on 351 by Sec on 368(c) the stock received. – Corpora on recognizes no gain or loss on the issuance of its own » Ownership of the stock possessing at least 80% of the total combined shares – See Code Sec on 1032(a) Corpora on could have gain as well vo ng power of all classes of stock en tled to vote and at least 80% of – Value of property received over the basis in newly issued shares the total number of shares of all other classes of stock of the (probably zero) corpora on. Corporate Forma on Corporate Forma on Corporate Forma on Limita ons to 351 – Results when 351 applies – Contribu ons of Loss Property Because of the carryover features of Sec on 351 under Sec ons 358, 362, – Transferred Property has a net built-in loss when the Shareholder recognizes no gain or loss and instead receives a “carryover or exchanged basis”. See Code sec on 358(a)(1) 1032 and 1223. Inherent Gain in the property is preserved at both the aggregate adjusted basis of the property transferred exceeds corporate level and the shareholder level. Duplicated Gain = Double its fair market value. Shareholders holding period of stock is determined by including the period Taxa on. during which the property transferred was held if the property transferred is – Any gain recognized on the transfer is taken into considera on to Without a special provision – a loss could also be duplicated. a capital asset or a 1231 asset; otherwise holding period begins on the day determine net built-in loss – Congress learned of the abuses some taxpayers were engaging in and of the transfer. See Code Sec on 1223(1) – Mul ple proper es contributed by the same transferor are enacted addi onal provisions. Corpora on does not recognize gain or loss on the issuance of its own stock aggregated to determine if there is a NET built-in loss. » If property with a built-in loss is transferred to a corpora on in a – Sec on 1032 – Requires alloca on of basis reduc on if mul ple loss proper es Sec on 351 transac on or as a contribu on to capital, the Corpora on steps into the shoes of the shareholder for basis purposes – so corpora ons aggregated adjusted basis in such is limited to the that property received from the shareholder has the same basis inside the Alterna ve to basis limita on fair market value of the transferred property immediately a:er corpora on as it had in the hands of the taxpayer – See Code Sec on 362(e) the transfer. – Shareholder and Corpora on may jointly elect to reduce the Sec on 1223(2) provides for “tacked” holding period to the corpora on Applied on a transferor by transferor basis rather than on shareholders basis in the stock that it receives to its fair market value (carryover basis and carryover holding period) – Basis reduc on is only to extent of the amount necessary to reduce an aggregated group of transferor’s the built-in loss  Page 10 Corporate Forma on Corporate Forma on Corporate Forma on Problem Page 59 Problem Page 59 Homework/Quiz #2 – A,B,C, D, E form X corpora on with the following: – A) What are the tax consequences (gain/loss – Send me an email no later than 6PM on A $25,00 Cash for 25 shares recognized; basis and holding period in the stock Wednesday September 8th with the answers to B Inventory value of $10,000, adjusted basis of $5,000 for received to A,B,C,D & E? Parts C & D of the problem on Page 59 10 shares – B) What are the tax consequences to X C Land value of $20,000, adjusted basis of $25,000 for 20 shares corpora on (gain recognized, basis and holding D Equipment value of $25,000, adjusted basis of $5,000 period in each of the assets received?) (a:er deprecia on previously taken of $20,000) for 25 shares E Installment Note value of $20,000 Capital Structure Capital Structure Corporaons need capital to run a business – Capital can be many things but is The relaonship to the corporaon of both debt holders generally referring to cash and other assets – Simplest Method of raising capital is Equity and equity holders is di+erent - while both contribute – Issue Stock for Cash, property or services. capital to help run and grow the business. Chapter 3 – Corporate Tax Stock may be common or preferred with various rights, preferences, priories as to vote, dividends, liquidaon and converbility. – Equity holders are “adventurer’s” in that they take on the risk of the business’s success in terms of pro/t and stock – Corporaons may also raise capital by borrowing or issuing debt. appreciaon. Most shareholders will only bene/t if the Capital corporaon does well. Debt can come from the same group of founders or from banks, or other outside lenders such as private equity companies, instuonal’s, etc. – Debt holders or creditors, get compensated based on the me Structure value of money and are essenally compensated for not Debt can take the form of sharing the pro/ts. Creditors are paid regardless of the success Debt & Equity Consideraons – – Notes Bonds of the corporaon and have rights to take capital back when – Converble debentures – Hybrid instruments payment dates arise.  Page 11 Capital Structure Capital Structure Capital Structure Corporaons must decide the ulmate mix of debt to equity Whether an investment is treated as debt or The Tax Code Bias example – While some of the decision is made without regard to the tax consideraons, – See return of equity example on page 118 – REVISED for current tax rates and there is an undeniable bias in the tax law in favor of debt /nancing. equity have far reaching implicaons assuming 20% dividend tax rate to shareholder and 40% combined federal and – Negave side e+ects of too much debt can be high interest rates, lower state tax rate on interest income. 11.85% vs. 15.8% ROE credit scores, potenal insolvency. Add tax at individual level – Debt issuance however are a principal means of avoiding the double tax – Interest is deducble or is it a dividend – 100% equity regime – especially in closely held corporaons. » Shareholder gets dividend of $118.50 Dividends are includable in shareholder income (albeit at a preferenal rate) they are – Worthless stock vs. bad debt deducons Total tax expense is approximately $55.20 on $150 of pre-tax income. Net return to shareholder $94.80 on $150 of corporate pre tax income. not deducble to the corporaon. Interest income does not necessarily receive preferenal rate at the individual level, – Boot in the form of an installment note or debt – 50% equity & 50% debt » Shareholder gets dividend of $79 but is deducble to the corporaon Total tax expense is approximately $36.80 on $100 of pre-tax income Debt repayment is tax free to the shareholder and excess repayments above the investment Net return to shareholder is $63.20 on $100 of corporate pre tax income lenders basis is generally a capital gain Under Secon 1271 Shareholder could also be debt holder – picking up another $50 of income which is net $30 aDer tax expense. So total return to shareholder increases to $93.20 and total tax is $56.80 – Redempons, covered later in this course, while very similar to a debt repayment, can be enrely Without preferenal rate on dividends – $71.10 return to shareholder and total tax expense of taxable as a dividend unless subject to an excepon. $78.90 vs. $77.40 in net return and $72.60 total tax expense Capital Structure Capital Structure Capital Structure What is Debt & What is Equity Debt vs. Equity Factors Hybrid Instruments lend themselves to – Labels or name – Common Law Standard Not everything that is called debt is debt and not everything that is presented as