Essentials of taxation 2016 cengage chapter 12

Partnership slide 1 of 2• Separate entity, but does not pay tax – Files information return Form 1065 • Most income and expense items are aggregated in computing the ordinary business inc

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The Big Picture (slide 1 of 3)

• Amber 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, Jimmy,

to become a part owner in the business

• Amber expects to transfer her business assets in

exchange for her Garden stock, while Jimmy will

provide accounting and legal services for his interest

The Big Picture (slide 2 of 3)

• Amber’s sole proprietorship assets available for transfer to the new corporation are:

The Big Picture (slide 3 of 3)

• Aware of the double taxation problem associated with

operating as a regular corporation, Amber 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

• Amber’s main concern, however, is that the

incorporation will be a taxable transaction

– Can the transaction be structured to avoid tax?

• Read the chapter and formulate your response.

Various Business Forms

• Business operations can be conducted in a number of different forms including

Sole Proprietorship

• Not a separate taxable entity

• Income reported on owner’s Sch C

Partnership (slide 1 of 2)

• Separate entity, but does not pay tax

– Files information return (Form 1065)

• Most income and expense items are aggregated in computing the ordinary business income (loss) of the partnership

– Certain income and expense items are reported

separately to the partners

– e.g., Interest and dividend income, long term

capital gain, charitable contributions and

investment expenses

Partnership (slide 2 of 2)

• Partnership ordinary business income (loss) and separately reported items are allocated to partners according to their profit and loss sharing ratios

– Each partner receives a Schedule K–1

• Reports partner’s share of partnership ordinary business income (loss) and separately stated items

– Each partner reports these items on his or her own

tax return

S Corporation

• Separate entity, only pays special taxes (e.g., built-in

gains)

– Files information return Form 1120S

• Similar to partnership taxation

– Ordinary business income (loss) flows through to the

shareholders to be reported on their separate returns

– Certain items flow through to the shareholders and retain their separate character when reported on the shareholders’ returns

• The S corporation ordinary business income (loss)

and the separately reported items are allocated to the shareholders according to their stock ownership

interests

C Corporation

• C corporations are subject to an entity-level Federal

income tax which results in what is known as a

double taxation effect

– C corporation reports its income and expenses and

computes tax on the taxable income reported on its Form 1120

• Uses tax rate schedule applicable to corporations

– When corporation distributes its income, the corporation’s shareholders report dividend income on their own tax

returns

• Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level

• Double taxation stems, in part, from the fact that

dividend distributions are not deductible by the

corporation

• To alleviate some of the double taxation effect,

Congress reduced the tax rate applicable to dividend income of individuals for years after 2002

– Generally, dividends are taxed at same marginal rate

applicable to a net capital gain

• Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received

• Individuals subject to the 25, 28, 33, or 35 percent marginal tax rates pay a 15% tax on qualified dividends

Corporate Income Tax Rates

Nontax Issues in Selecting

Entity Form (slide 1 of 3)

• Liability

– Sole proprietors and some partners have unlimited

liability for claims against the entity

• Capital-raising

– Corporations and partnerships to a lesser extent

can raise large amounts of capital for entity

ventures

Nontax Issues in Selecting

Entity Form (slide 2 of 3)

• Transferability

– Corporate stock is easily sold, but partners must

approve partnership interest transfer

• Continuity of life

– Corporations exist indefinitely

Nontax Issues in Selecting

Entity Form (slide 3 of 3)

• Centralized management

– Corporate actions are governed by a board of

directors

– Partnership operations may be conducted by each

partner without approval by other partners

Limited Liability Companies (LLC)

• LLCs have proliferated since 1988 when IRS ruled it would treat

qualifying LLCs as partnerships

– Major nontax advantage

• Allows owners to avoid unlimited liability

– Major tax advantage

• Allows qualifying business to be treated as a partnership for tax purposes, thereby avoiding double taxation associated with C corporations

Entity Classification After 1996 (slide 1 of 2)

• Check-the-box Regulations

– Allows taxpayer to choose tax status of entity

without regard to corporate or noncorporate

characteristics

– Entities with > 1 owner can elect to be classified as

partnership or corporation

– Entities with only 1 owner can elect to be

classified as sole proprietorship or as corporation

Entity Classification After 1996 (slide 2 of 2)

• Check-the-box Regulations (cont’d)

– If no election is made, multi-owner entities treated

as partnerships, single person businesses treated as sole proprietorships

– Election is not available to:

• Entities incorporated under state law, or

• Entities required to be corporations under federal law (e.g., certain publicly traded partnerships)

Corporation Formation Transaction

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

Issues re: Formation

(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 9

Stock Transferred (slide 1 of 2)

• Return to the facts of The Big Picture on p 12-1.

• Assume the proposed transaction qualifies under § 351

– i.e., The transfer of property in exchange for stock

meets the control test

– However, Amber decides to receive some

corporate debt along with the stock

The Big Picture – Example 9

Stock Transferred (slide 2 of 2)

• If she receives Garden stock worth $900,000 and

corporate debt of $100,000 in exchange for the

property transferred,

– Amber realizes gain of $600,000

• $1,000,000 (value of consideration received) – $400,000 (basis in the transferred property)

– However, because the transaction qualifies under § 351, only $100,000 of gain is recognized.

• The $100,000 of corporate debt is treated as boot.

– The remaining realized gain of $500,000 is deferred.

Issues re: Formation

(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

Issues re: Formation

(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

Issues re: Formation

Issues re: Formation

(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”

Issues re: Formation

(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

The Big Picture – Example 16

Transfers for Property and Services (slide 1 of 2)

• Return to the facts of The Big Picture on p 12-1.

• Assume Amber transfers her $1,000,000 of property to Garden, Inc and receives 50% of its stock

• Jimmy receives the other 50% of the stock for services rendered (worth

$1,000,000)

The Big Picture – Example 16

Transfers for Property and Services (slide 2 of 2)

• Both Amber and Jimmy have tax consequences from the transfers

– Jimmy has ordinary income of $1,000,000 because

he does not exchange property for stock

– Amber has a taxable gain of $600,000

• $1,000,000 (fair market value of the stock in Garden) -

$400,000 (basis in the transferred property)

• As the sole transferor of property, she receives only 50% of the corporation’s stock.

The Big Picture – Example 17

Transfers for Property and Services (slide 1 of 2)

• Assume the same facts as in Example 16 except that Jimmy transfers property worth $800,000 (basis of $260,000) in addition to services

rendered to Garden, Inc (valued at $200,000)

• Now Jimmy becomes a part of the control group

– Amber and Jimmy, as property transferors,

together receive 100% of the corporation’s stock

The Big Picture – Example 17

Transfers for Property and Services (slide 2 of 2)

• Consequently, § 351 is applicable to the exchanges

– As a result, Amber has no recognized gain

– Jimmy does not recognize gain on the transfer of

The Big Picture – Example 21

Assumption of Liabilities (slide 1 of 2)

• Return to the facts of The Big Picture on p 12-1

• Assume you learn that

– Amber’s husband, Jimmy, has lost interest in becoming a stockholder in Garden, Inc., and

– Amber’s building is subject to a liability of $70,000 that Garden assumes.

• Consequently, Amber receives 100% of the Garden

stock and is relieved of the $70,000 liability

– The building has an adjusted basis of $400,000 and fair market value of $1,000,000

The Big Picture – Example 21

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 Amber of the Garden stock is $330,000

– $400,000 (basis of property transferred) − $70,000

(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)

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):

Business Business No Business Purpose I Purpose II Purpose

Liability: $80,000 $120,000 $120,000

Formation with Liabilities Example

(slide 2 of 3)

Business Purpose I Business Purpose II No Business Purpose

FMV of stock

received $70,000 $30,000 $30,000Liabilities assumed 80,000 120,000 120,000 Amount realized $150,000 $150,000 $150,000 Basis of property

transferred 100,000 100,000 100,000Gain/Loss realized $50,000 $50,000 $50,000

Formation with Liabilities Example

(slide 3 of 3)

Liabilities assumed by corp (independent facts):

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

Liabilities assumed by corp (independent facts):

Business Business No Business Purpose Purpose Purpose .

Liability: $ 80,000 $120,000 $120,000 Basis in assets

Transferred $100,000 $ 100,000 $100,000 + Gain recognized None 20,000 50,000

- Liab Transferred (80,000) (120,000) (120,000) Basis in stock $ 20,000 -0- $ 30,000

Corporation’s Basis in Assets Received

in Last Example

Liabilities assumed by corp (independent facts):

Business Business No Business Purpose Purpose Purpose

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

shareholder’s 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

The Big Picture – Example 32 Stock Issued for Services Rendered (slide 1 of 2)

• Return to the facts of The Big Picture on p 12-1

• Amber transfers her $1,000,000 of property to Garden, Inc and receives 50% of the stock

• In addition, assume that, in exchange for 50% of the stock, Jimmy

– Transfers property worth $800,000 (basis of

$260,000), and

– Agrees to serve as manager of the corporation for

one year (services worth $200,000)