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ACCY 509
Chapter 2
Corporation Formation and Capital Structure
I) Business Forms

a) Sole proprietorship -- Business owned by a single individual. Not a separate taxpaying

entity. Income or loss from the sole proprietorship is reported directly on the owner’s
individual tax return (1040) on Schedule C (or C-EZ).

b) P/S
1) General partnership
2) Limited partnership

c) Corporations
1) C corporation -- Separate taxpaying entity taxed on its taxable income at rates
ranging form 15% to 35%. All items of income and expense reported on Form 1120.
Shareholders are not taxed on the earnings of the corporation, but instead are taxed on
dividend distributions from the corporation. Thus, the earnings of the C corporation
are taxed once at the corporate level on the Form 1120 and then again as ordinary
income when distributed to the owners (shareholders) as dividends.
(i) The JGTRRAA 2003 lowered the maximum tax rate on qualified dividends to
15%.

2) S corporation -- (Subchapter S of the IRC) Closely held corporation that elects to be

treated as a conduit. Taxed virtually the same as a p/s. Items of income, expense,
gain, or loss pass through to the shareholder to be taxed at the shareholder level.
Shareholders enjoy limited liability like shareholders in a C corporation but avoid
double taxation. S corporations have less flexibility than p/s in that the number and
type of shareholders are limited and the shareholders cannot make special allocations
of income, deductions, losses, and credits in a ay that differs from their proportionate
ownership.

3) PSC -- Personal service corporation

(i) Principal activity is performance of personal services
(ii) Services are substantially performed by owner-employees
(iii) >10% of stock in value is held by owner-employees.
Generally taxed as a corporation except for special items as noted below.

d) LLC -- LLCs are taxed as a partnership while providing the limited liability of a
corporation. Limited liability extends to all of the LLC’s owners, called members.
Similar to a limited partnership with no general partners. Unlike an S corporation, LLCs
can have an unlimited number of members and there are no restrictions on the type of
entities that can be members (owners).

e) LLP -- LLP partners are liable for their own acts and the acts of individuals under their
direction. However, LLP partners are not liable for the negligence or misconduct of other
partners. LLP partner is like a limited partner with respect to other partner’s acts but like
a general partner with respect to his or her own acts.
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II) Transfers to controlled corporations --
§351(a) provides that no gain/loss shall be recognized when property is transferred to
a corporation by one or more persons solely in exchange for stock and immediately
after the exchange such person(s) are in control (as defined in §368(c)).

The specific requirements for complete deferral of gain and loss under Sec. 351(a)
are:
1. Property must be transferred to the corporation in an exchange transaction.
2. The transferors must receive stock of the transferee corporation in exchange
for their property.
3. The transferors of the property must be in control of the corporation
immediately after the exchange.

This is not an elective provision. If the three requirements are met, gain and loss must
be deferred under Sec. 351.

a) Sec. 351(a) nonrecognition treatment

1) Requirements
(i) Property – Nonrecognition treatment applies only to transfers of property to a
corporation in exchange for its stock.

(A) Property definition is comprehensive. PPE, unrealized receivables,

installment obligations, secret processes and formulas, patentable inventions

(B) Statutorily excluded from the property definition are [§351(d)]:

(i) Services rendered to the corporation in exchange for stock
(ii) Indebtedness of the transferee corporation not evidenced by a security
(iii)Interest on an indebtedness of the transferee corporation that accrued on or
after the beginning of the transferor’s holding period for the debt.

(C) The most important of the exclusions from the property definition is the
provision of services. A person receiving stock as compensation for services
must recognize the stock’s FMV as compensation (i.e., ordinary income).

An exchange of services for stock is a taxable transaction even if Sec. 351

applies to other property transfers.

(ii) Stock transferred -- Deferral of gain or loss occurs if the transferor(s)

exchange property solely for transferee corporation stock. Stock includes voting
and nonvoting stock. It includes common and most preferred stock.

(A) It does not include nonqualified preferred stock, which possesses many of the
attributes of debt [§351(g)]. Preferred stock is nonqualified if:

(i) The SH can require the corporation to redeem the stock,

(ii) The corporation is either required to redeem the stock or is likely to
exercise a right to redeem the stock, or
(iii)The dividend rate on the stock varies with interest rates, commodity
prices, or other similar indices [§351(g)(2)].
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Basically, if the preferred stock looks like debt it will be nonqualified.

Note: The redemption exceptions above (i.e., (i) and (ii)) that cause a
preferred stock to be treated as nonqualified do not apply if the redemption
cannot take place for 20 or more years.

(B) Stock rights or warrants are not considered "stock or securities" for purposes
of §351. Debt is considered "other property" - boot. [Reg §1.351-1(a)(1)(ii)]

(iii) Control -- §351 nonrecognition treatment applies if the transferors, as a

group, are in control of the transferee corporation immediately after the exchange.

(A) Control is defined by §368(c) as ownership of:

(i) at least 80% of the total combined voting power of all classes of stock
entitled to vote, and
(ii) at least 80% of the total number of shares of all other classes of stock (e.g.,
nonvoting preferred).

(B) Immediately after the exchange -- §351 requires the transferors to be in

control immediately after the exchange. This does not mean that all
transferors must exchange their property for stock simultaneously. The
exchanges must be part of a plan and the plan must be executed expeditiously.
[Reg. Sec. 1.351-1(a)(1)]

Further, §351 does not require the transferors to retain control for any
specified length of time after the exchange. Control is only required
immediately after the exchange. However, the transferors must not have a
prearranged plan to dispose of their stock outside the group. If such a plan
exists, they are not considered in control immediately after the exchange.
[Rev. Rul. 79-70, 1979-1 C.B. 144]

(C) Services -- Because services do not qualify as property, stock received by a

transferor in exchange for services does not count in determining whether the
80% control test has been met.

Unless 80% of the corporation’s stock is owned by the transferors who

exchanged property for stock, §351 does not apply, and the entire transaction
is taxable.

If the property transferors own at least 80% of the stock after the exchange,
§351 applies to them even though it does not apply to a transferor of services.

(D) Transfers of property and services -- if a person transfers both services and
property in exchange for the corporation’s stock, ALL of the stock received
by that person, including the stock received in exchange for services, is
counted in determining whether the property transferors have acquired
control.
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(i) The value of the property must be more than nominal value compared to
the services for that person’s stock to count toward the 80% control
requirement [Reg. §1.351-1(a)(1)(ii)].
(ii) Generally, the FMV of the stock received for transferred property must be
at least 10% of the value of the stock received for services provided.

(E) Transfers to existing corporations -- §351 can apply to transfers to existing

corporations as well. The same requirements apply: Property must be
transferred in exchange for stock and the property transferors must be in
control immediately after the exchange.

(i) If an existing shareholder exchanges property for additional stock to help

the transaction qualify for nonrecognition treatment under §351, the stock
received must be of more than nominal value [Reg. §1.351-1(a)(1)(ii)].

(ii) Generally, the value of the stock received for property transferred must be
at least 10% of the value of the stock already owned.

Example: Alice owns all 100 shares of Local Corporation’s stock, valued
at $100,000. Beth owns property that has a $15,000 adjusted basis and a
$100,000 FMV. Beth contributes the property to Local Corporation in
exchange for 100 shares of newly issued stock.

(F) Disproportionate exchanges of property and stock -- §351 does not require
the value of the stock received by the transferor be proportional to the value of
the property transferred. If the value of the stock received is not proportional
to the value of the property transferred, the exchange must be treated in
accordance with its true nature. That is a proportional exchange followed by a
gift, payment of compensation, or payment of a liability owed by one
shareholder to another [Reg. Sec. 1.351-1(b)(1)].

2) Effect on transferors -- If the requirements of Sec. 351 are met, the transferors
recognize no gain or loss on the exchange of their property for stock.

(i) Boot -- If a transferor receives any money or property other than stock of the
transferee corporation, the additional property is considered boot.

(A) The transferor must recognize gain to the extent of the lesser of the
transferor’s realized gain or the FMV of the boot property received.

(B) A transferor never recognizes a loss in an exchange qualifying for

nonrecognition treatment under §351, whether boot is received or not.
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(C) The character of the boot gain recognized depends on the type of property
transferred.

Note: Depreciation recapture is not required in a transaction that satisfies the

requirements of §351 unless the transferor receives boot and recognizes a gain
on the depreciated property transferred. [§§1245(b)(3) and 1250(c)(3)]

Example: Pam, Rob, and Sam for East Corporation by transferring the
following property.

Transferor’s Consideration
Transferor Asset Adjusted Basis FMV Received

Pam Machinery $10,000 $12,500 25 shs. East Stock

Rob Land 18,000 25,000 40 shs. & $5K East Note
Sam Cash 17,500 17,500 35 shs. East Stock

(D) Transfer of multiple assets -- When the transferor transfers multiple assets
then the shareholder will have to compute separate realized and recognized
gain or loss for each property transferred. The transferor is assumed to have
received a proportionate share of stock, securities, and boot for each property
transferred based on the assets’ relative FMV. [Rev. Rul. 68-55, 1968-1 C.B.
140]

Example: Joan transfers two properties to newly created North Corporation in

a transaction qualifying under Sec. 351. The total FMV of the assets
transferred is $100,000. The consideration Joan received consists of $90,000
of North stock and $10,000 of North notes. Asset #1 is a capital assets with a
FMV of $40,000 and $65,000 adjusted basis and Asset #2 is a §1231 asset
with a $60,000 FMV and $25,000 adjusted basis. Asset #2 was purchased
some years before for $100,000.
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(ii) Basis of stock to SH

(A) Boot property -- The shareholder’s basis for any boot property received is the
property’s FMV. [§358(a)(2)]

Stock -- A shareholder computes the adjusted basis for their stock as follows:

Adjusted basis of property transferred to the corporation

Plus: Any gain recognized by the transferor
Less: FMV of boot received from the corporation
Money received from the corporation
Amount of any liabilities assumed by the corporation
Adjusted basis of stock received

Note: If more than one class of stock is received, the bases for the stocks
received must be allocated among the classes of stock received in accordance
with their relative FMVs. [§358(b)(1)]

(iii) SH’s holding period -- The transferor’s holding period for any stock received
in exchange for a capital or Sec. 1231 asset includes the holding period of the
property transferred. [Sec. 1223(1)]1

The shareholder’s holding period for any boot received starts on the day after the
exchange.

3) Effect on transferee corporation

(i) Gain/loss -- Corporations recognize no gain or loss when they issue their
own stock for property or services [§1032]. This rule applies whether the
exchange is subject to §351 or not. It is irrelevant whether the corporation issues
new stock or treasury stock.

(A) Corporations also recognize no gain or loss on the issuance of their own debt
instruments for property or services.

(B) The corporation must recognize gain (but not loss) if it transfers appreciated
property to a transferor as part of a §351 exchange. Amount and character of
the gain recognized determined as though the property had been sold
immediately before the transfer.

(ii) Basis of property to corporation --

(A) A corporation that acquires property in exchange for its stock in a transaction
that is taxable to the transferor uses the property’s acquisition cost (i.e., its
FMV) as its basis for the property.

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Interestingly, Rev. Rul. 85-164, 1985-2 C.B. 117 holds that a single share of stock may have two holding periods:
a carryover holding period for the portion of the share received in exchange for a capital or §1231 asset and a
holding period that begins on the day after the exchange for the portion of the share received in exchange for
inventory or other property. The holding period is only relevant if the transferor sells the stock received within one
year of the transfer date.
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If the exchange qualifies for nonrecognition treatment under §351 and is
wholly or partially tax-free to the transferor, the corporation’s basis for the
property is computed as follows [§362]:

Transferor’s adjusted basis for the property transferred

Plus: Gain recognized by the transferor
Transferee corporation’s basis for property

(i) Any potential depreciation recapture on the transferred property carries

over to the transferee corporation (i.e., it stays with the asset).

(ii) NOTE: Sec. 363(e)(2) prevents shareholders from creating double losses
by transferring loss property to a corporation.

1. If a corporation’s total AB for all properties transferred by a SH

exceeds their total FMV, the basis to the corporation of the properties
is limited to their total FMV.

2. The reduction in basis must be allocated among the properties in

proportion to their respective built-in losses.

3. Limitation applies on a shareholder-by-shareholder basis.

4. The reduction in the AB of the properties can be avoided if the

corporation and all of its SHs so elect. Under the election, the SH
(who transferred property AB>FMV) would reduce his/her basis in the
stock received for the property by the excess AB.

(iii) Holding period -- The transferee corporation’s holding period for property
acquired in a transaction satisfying the requirements of §351 includes the period
of time the property was held by the transferor [§1223(2)].

This general rule applies to all properties without regard to their character in the
transferor’s hands or the amount of gain recognized by the transferor.

(iv) Other -- Stock issued for services rendered. A transfer of shares in

consideration for services rendered may be deductible by the transferee
corporation. If the services are deductible in nature the corporation gets a
deduction equal to the FMV of the stock issued for those services. If the services
are characterized as capital expenditures, then the FMV must be capitalized but
the corporation may make an election to amortize the expenditure under §248
(organizational expenditures) or §195 (start-up expenditures).

4) Assumption of transferor’s liabilities

(i) General rule -- A transferee corporation’s assumption of liabilities in a §351
exchange does not result in the receipt of money/boot by the shareholder for gain
recognition purposes. The liabilities are treated as money for purposes of
determining the basis of the stock received [§357(a)].
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(A) Exception 1 -- All liabilities assumed by a transferee corporation are
considered money/boot by received by the transferor if the principal purpose
of the transfer of any of the liabilities is tax avoidance or if no bona fide
business purpose exists for the transfer [§357(b)].
(i) Liabilities that were incurred shortly before the transfer
(ii) Look at length of time between incurrence of the liability and the transfer
of the liability to the corporation.
(iii)The assumption of liabilities is considered to have a business purpose if
the transferor incurred them in the normal course of business or in the
course of acquiring business property.
1. Examples of liabilities that have no business purpose include personal
obligations of the transferor, including home mortgage loans or other
personal loans.

Note: If any of the liabilities are considered are tainted they all are.

2. Exception 2 -- If the total amount of liabilities assumed by the

transferee corporation exceed the total basis of all property transferred,
the transferor recognizes the excess liability amount as gain [§357(c)].

This exception applies whether the transferor realizes any gain or loss.

The transferor’s basis in the stock received is zero.

Example: Judy transfers land, a capital asset, having a $70,000

adjusted basis and a $125,000 FMV and $10,000 cash to Duke
Corporation in exchange for all its stock. Duke Corporation assumes
the $100,000 mortgage on the land. The mortgage assumption has no
tax-avoidance purpose and has the requisite business purpose.

3. If both §357(b) and §357(c) apply to the same transfer, §357(b)

predominates [§357(c)(2)(A)].

5) Other considerations

(i) Depreciation recapture --

(A) If a Sec. 351 exchange is completely nontaxable (i.e., the transferor receives
no boot), no depreciation recapture is required [§§1245(b)(3) and 1250(c)(3)].
Instead, the entire amount of the transferor’s recapture potential transfers to
the transferee corporation.

(B) Where the transferor recognizes part of the depreciation recapture as ordinary
income [§351(b)], the remaining recapture potential transfers to the transferee
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corporation. If the transferee corporation subsequently disposes of the
property, it is subject to the depreciation recapture rules on all depreciation it
has claimed plus the recapture potential transferred by the transferor.

(ii) Computing depreciation --

(A) When a shareholder transfers depreciable property to a corporation in a

nontaxable §351 exchange, and the shareholder has been depreciating the
property, the corporation must continue to use the same depreciation method
and recovery period [§168(i)(7)].

(B) The depreciation is allocated between the transferor and the transferee
corporation in the year of transfer based on the number of months the property
was held by each. The transferee corporation gets the entire month in which
the property is transferred.

(C) If the transferee corporation’s basis for the depreciable property exceeds the
transferor’s basis, the corporation treats the excess as a newly purchased
MACRS property and uses the recovery period and method applicable to the
type of property transferred [Prop. Reg. Sec. 1-168-5(b)(7)].

(iii) Other

(A) Accounts receivable of a cash basis taxpayer transferred in a nontaxable §351

exchange take a zero basis and are included in the corporation’s income when
collected [Rev. Rul. 80-198, 1980-2 C.B. 113].

Note: Substantially all the business assets and liabilities must be transferred
and a business purpose for the transfer must exist.

(B) Accounts payable transferred to a transferee corporation in a nontaxable §351

exchange may be deducted by the transferee corporation when paid [Rev. Rul.
80-198, 1980-2 C.B. 113].

II) Choice of capital structure --

a) A corporation recognizes no income when it receives money or property as a capital

contribution [§118(a)].

b) If additional contributions are made but no additional stock is issued, the additional
payments are regarded as an additional price paid for the stock already owned. The
shareholders’ bases are increased by the additional money paid.

c) From time to time a corporation will receive a contribution to capital from a non-
shareholder.
1) These contributions are excluded from income if they are not a payment for goods or
services nor a subsidy to induce the corporation to limit production [Reg. Sec. 1.118-
1.
2) If a non-shareholder contributes property other than money to a corporation, the basis
of the property is zero [Sec. 362(c)(1)].
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3) If a non-shareholder contributes money, the basis of any property acquired with the
money during a 12-month period beginning on the day of the contribution was
received is reduced by the amount of the contribution.
4) The amount of any money received from non-shareholders not spent to purchase
property during the 12-month period reduces the basis of any other property held by
the corporation on the last day of the 12-month period.

The basis reduction is applied to property in the following order

(i) Depreciable property
(ii) Amortizable property
(iii) Depletable property
(iv) All other property

III) Worthlessness of stock or debt obligations

a) §1244 stock -- loss on §1244 stock issued to an individual or partnership that would have
been capital will be ordinary loss.
1) Maximum amount treated as ordinary is $50,000 ($100,000 for MFJ) [§1244(b)]
2) Definition of §1244 stock is stock in a domestic corporation if:
(i) the corporation was a small business corporation when the stock was issued,
(ii) the stock was issued for money and other property (not stock and securities)
AND
(iii) for the 5 most recent tax years (or life if < 5 years) > 50% of the aggregate
gross receipts are from sources other than royalties, rents, dividends, interest,
annuities, and sales or exchanges of stocks or securities (i.e., >50% of income
must be from active trade or business). This gross receipts test does not apply if
the corporation has a loss for the overall period in (c) above.
(iv) A small business corporation is defined in §1244(c)(3) as one whose amount
received for the stock issue does not exceed $1 million.

3) Other limitations include: If property is received for stock and the basis of the
property > FMV, and the basis of the stock is based on the basis of the property, on
the FMV amount is treated as ordinary loss.

4) Reg. §1.1244-1(b) says that only the original holder of the stock can take an ordinary
loss.

IV) Gain from qualified small business stock -- exclude 50% of the gain from the sale or
exchange of small business stock if the stock is held for > 5 years for a taxpayer other than
the corporation.
a) limitation on the amount of the exclusion to the greater of (A) $10 million, or (B) 10 *
adjusted bases of stock

b) §1202(c) defines qualified small business stock as stock in a c corporation originally

issued after enactment of the Revenue Reconciliation Act of 1993 if:
1) the corporation is a qualified small business at the time of issuance
2) such stock is acquired by the taxpayer at original issue for money or property or as
compensation for services.

c) §1202(d) defines a qualified small business as a domestic c corporation if aggregate gross

assets <= $50 million on the date the stock was issued.