Corporate Formations and Capital Structure

2.1 Different Forms of Organization

2.1.1 Sole Proprietorship

• Unincorporated business owned by an individual
• Selected by entrepreneurs who want to start their business with limited resources
• The sole proprietor is solely held responsible for reporting all of his business transactions and its yields within a specific span of time.
• As for tax, if the business proves to be unprofitable, the tax rate to be paid also decreases; therefore, increasing tax savings.
• Tax consequences are controlled- allowing the owner to deposit and withdraw from business funds without tax responsibilities to pay.
• If loss is incurred, it can be offset through personal funding
• Tax is directly accounted against the owner
• Social security taxes are paid in full by the sole proprietor
• Several tax exemption rules do not apply to sole proprietorship which includes premiums for group term life insurance

2.1.2 Partnerships

• Unincorporated business operated by two or more individuals in agreement to manage and operate the entity for profit
• Tax reporting but not tax paying
• Losses and profits get reported as it passes through the partners and are filed on separate tax returns
• Uses form 1065 (US Partnership Return of Income) for tax purposes
• Each partner receives a statement that details their share of the business tax
• When loss is incurred by one of the partners, the other partner may choose to provide support given than an agreement on business share adjustment is approved
• A partnership has a much lower taxable rate compared to a corporation even when reporting the same range of profit

2.1.3 Corporations

                    2.1.3.1 C Corporations

• An entity distinct and separate from its owners
• Subjected to double taxation
• Taxed 21% on taxable income
• Must report all of its expenses and compute tax liabilities through form 1120 or the US Corporation Income Tax Return
• Shareholders are taxed depending on their constant dividend share [for long-term capital gains] based on long-term capital gains
• For taxpayers with modified AGI exceeding $200,000, an incremental of 3.8% of tax rate is applied
• When earnings are not distributed to both the shareholders and the corporation, aggregate tax savings could be incurred
• Capital loses does not result to lower taxes. Tax rate remains the same even when the business starts to lose its profits

                    2.1.3.2 S Corporations

• Subjected to double taxation
• Income , deductions, profit losses, and credits are all reported by the corporation
• S Corporations go through an election of it its officers and shareholders
• For tax responsibilities, form 1120-S (US Income Tax Return for an S Corporation) should be filed.
• Shareholders have limited liability
• Tax is passed on to each shareholder and not to the corporation
• To avoid corporate losses, it passes through separate returns that may be used to help balance out the losses with the income earned from other resources connected to the business.
• Corporate taxes are calculated only against the shareholders and not against the business.

2.1.4 Limited Liability Companies

• Combines features of partnership and corporation
• Offers limited liability to shareholders- extends to all owners
• LLC with more than one owner is treated as a partnership when it comes to taxation responsibilities
• LLC is analogous to limited partnership
• LLC may be considered to have an unlimited number of individual owners which may include people, corporations, as well as different trusts and estates.
• LLC my vote to be treated either as a corporation or a partnership
  • If the business choses to be recognized as a partnership then form 1065 must be filed accordingly.

2.1.5 Limited Liability Partnerships

• Often opted by businesses offering professional services
• Partners are liable for their own acts and omissions
• Can elect to be taxed as either a partnership or a corporation [must file form 1065 if elected to be taxed as partnership]

2.2 Legal Requirements and Tax Considerations Relating to Forming a Corporation

          2.2.1 Legal Requirements

• Investment of a minimum amount of capital
• Filing the articles of incorporation
• Issuing stock
• Paying fees to the state or other jurisdictions of the state which controls general business operations

–assessment of franchise tax may be considered in order for the business to be given the pass to operate in a particular state

2.2.2 Tax Considerations

• Properties, capital and other resources for the business must be transferred from individual owners to the business in order to be taxed according to how these assets are used for business operations.
• In the instance of property transfer, taxation will only apply based on how the role of the transferor is defined to have a direct impact to the business

2.3 Section 351: Deferring Gain or Loss Upon Incorporation

Transferors recognize no gain nor loss when they transfer a property to a corporation in exchange for stock or shares

• Realized gain or loss by a transferor is not exempted from being taxed [whether it is recognized or not]
• Stock basis can be realized as follows:
  • FMV of qualified stock received
  • Deferred gains shall be deducted from FMV
  • Once shares are sold later, the recognition of either gain or loss shall be adjusted accordingly
    • Requirements for deferral of gain or loss

1. Transferor must transfer the property to the corporation
2. Stock of transferee corporation must be received in exchange for the property
3. Must be in control of corporation after exchange is completed.

2.3.1.1 Property Requirements

• According to IRS, property pertains to cash, obligations, accounts, land, and other assets that can be used to support business operations
• Exclusions include indebtedness, services rendered to corporation, and interest or accrued debt

2.3.1.2 Control Requirement

• Transferors should be in immediate control of the corporation after the transfer is made
• According to section 368 (c), control of ownership accounts for at least 80% of the overall operations and control of properties of the business
• Disproportionate exchanges of Property and Stock
  • Section 351 points out that the value of the stock receive is equal to the value of the property transferred
  • Such value of exchange is measured through agreement between the exchanging parties.

2.3.1.3 Stock Requirement

• Transferors who gain immediate control of the property after the exchange do not recognize gain or loss through the transaction
• Nonqualified preferred stock as considered as boot

2.3.2 Transferors and Section 351

• Transfer of property does not render the transferor to recognize any gain or loss in the transaction
• Receiving property instead of stock does not render the transaction taxable
• Property could be considered as gain on the part of the transferor

2.3.3 Computing Gain from Transferred Assets

• Revenue Ruling 68-55: The separate properties approach
  • Realized gain or loss from a transfer transaction is calculated separately for each property
  • Transferor should receive a proportionate share of the stock or securities based on the asset FMVs agreed through the transaction

2.3.4 The Transferor’s holding Period

• Section 1231 includes holding period for the transferred property which begins on the day after the exchange

2.3.5 Consequences to Transferee Corporation

• IRC rules apply to any corporation that issues stocks in exchange for property or services
  • The corporation does not incur any gain or loss once they issue their stock in exchange for the property or service rendered to them
  • The same is true when debt instruments are used as objects of exchange
  • Gain is incurred when appreciated property is transferred
  • The gain is realized as a value exchanged for sale during the transfer
• Reduction of Loss Property
  • Section 362 (e) (2) prevents the incurrence of double loses upon transferring property
  • Limitations are determined by shareholder-by-shareholder basis
  • Shareholder losses and property values are not aggregated

2.3.6 Assumptions of the Transferor’s Liabilities

• When a property is transferred to a controlled corporation, liability on the part of the transferor is often assumed
• Often, the assumption of liability is paid out in cash to the transferor
• If there is an existing liability on the part of the transferor then the property transferred shall be treated as cash payment [presumably having the same value in terms of the liability in record]
• Section 357 (a) –the transferee’s assumption of liabilities is assumed to be only a part of the realized amount of the transferor’s gain
• Section 357 (b)- Tax avoidance (no bona fide business purpose)
  • Liabilities assumed by a controlled corporation are considered as money received by transferor after exchange of property occurs.
  • Liabilities are incurred shortly before the transfer to avoid property taxation
• Section 357 (c) (3) Liabilities of Cash Method Taxpayer
  • Hybrid method of transfer that includes cash, property, and liabilities all added into the property during the exchange
  • Transferor gains from the exchange as the liabilities exceed the value of the property parted with

2.3.7 Other Considerations in Section 351

• Recapture of Depreciation
  • Nontaxable exchange incurs no depreciation rate in properties being transferred
  • Corporation inherits the value of recapture from the transferor
  • Depreciation recapture is considered ordinary income on the part of the transferor

2.4 Choice of Capital Structure

          2.4.1 Characterization of Obligations as Debt or Equity

• Deductibility of interest payments
  • This is incurred as the sufficient debt maximizes the internet deduction during transfer in a form of debt financing
  • Section 385 determines a standard of determining a value as debt or equity

2.4.2 Debt Capital

                    2.4.2.1 Issuance of Debt

• Transfer of appreciated property for stock is nontaxable

                    2.4.2.2 Payment of Interest

• Section 163 (j) C Corporations with gross exceeding $26 million have limited interest deduction based on their interest income and 30% of their adjusted taxable revenue.
• Section 171, for debtor corporations, the premium reduces the deductible interest of the liability incurred

                    2.4.2.3 Extinguishment of Debt

• Debt extinguishment is not taxable
• Amount received by the holder are noted as values in exchange for the liability
• The holder recognizes capital gain or loss in instances when the adjusted value basis is different from the amount received

2.4.2.4 Equity Capital

• Issuing various types of stock to permit non-family employees to gain equity of the corporation
• To finance another corporation closely related to the base business through issuing stock to an outside party which may include investors to the entity outside the corporation.

2.4.3 Capital Distributions by Shareholders

• No income is recognized when a corporation receives cash as capital contribution
• If shareholders agree to pay volunteer amount to add into the corporation’s assets, it is recognized as additional amount to stocks already owned
• UNDERSTOOD AS: amount of cash contributed + non cash property contributed + any other form of gain = increased stock value

2.4.4 Capital Contribution by Non Shareholders

• May be in form of cash or property
• Value of such contribution may change based on depreciation, amortization value, depletable property value, and other properties considered to incur adjusted value through time

2.4.5 Worthlessness of Stock or Debt Obligations

          2.4.5.1 Securities

• A security investment that loses value at the end of the tax year
  • Stock share in a corporation
  • Right to receive share from a corporation
  • Bond or other evidence of indebtedness

2.4.5.2 Unsecured Debt Obligations

• Funds that have been lent to corporations
• Non-repayment from corporations results to loss of investment
• Losses incurred by a shareholder who guarantees loan to a third party is considered a non-business bad debt

2.4.6 Tax Planning Considerations

          2.4.6.1 Avoiding non recognition of losses under section 351

An exchange of property could be considered a non-loss on the part of the transferor if it is used to offset the income through using other resources

                    2.4.6.2 Avoiding non recognition of gain under section 351

• A transferor wants to recognize gain based on appreciated property so the corporation will have a stepped-up basis on the transfer
• This can be achieved of the transfer is made through exchanging the property for cash than for stocks

2.4.7 Compliance and Procedural Considerations

• Reporting Requirements as Noted in Section 351
  • Description of the property transferred
  • Description f the stock received
  • Description of securities
  • Amount of money exchanged
  • Statement of liabilities being transferred