University of Akron MTax Direct Melanie McCoskey, Ph.D., CPA Module 1 Corporate Formation

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1 University of Akron MTax Direct Melanie McCoskey, Ph.D., CPA Module 1 Corporate Formation May 4, 2015

2 2 Overview of Chapter Corporate Formation Effect on corp» Gain/loss recognized» Basis in property received» Holding period for property received Effect on s/h» Gain/loss recognized» Basis in stock received» Holding period for stock

3 Corporation Formation 3 Transaction

4 4 Effect on Corp - Overview Corp recognizes no gain or loss when it issues its stock (whether newly issued stock or treasury stock) for property. services boot distributed to s/h Corp s basis in property received is the s/h basis plus gain recognized by s/h Limitation for loss property Corp s holding period includes s/h holding period

5 5 Corporation s Gain or Loss IRC Sec 1032(a) - The corporation recognizes NO income, gain or loss when cash or property are received in return for its stock Increase in assets; increase in equity Applies whether Sec 351 transaction or not

6 6 Corp s basis in assets received Sec 362(a): The corporation s basis in assets received in a Section 351 transaction is generally calculated as: Adjusted basis of transferred assets + Gain recognized by transferor shareholder Basis of asset to corporation

7 7 Corp s basis in assets received S and T form New Corp. S transfers prop with a FMV of $50,000 and a basis of $30,000 in exchange for 50 shares of stock. T transfers $50,000 cash for 50 shares of stock. New Corp does not recognize a gain or loss on the transaction. Its tax balance sheet is: Cash: 50,000 Equity: Equip 30,000 C/S stock 80,000 Total assets 80,000 Total equity: 80,000

8 8 Corp s basis in assets received Sec 362(e)(2) Limitation on built-in losses If the FMV of the property transferred by a shareholder is less than the basis of that property, the corporation s basis is limited to the FMV. This determination is made on a shareholder-by-shareholder basis (not asset-by-asset basis). Sec 362(e)(2)(A)(ii) If more than one loss property is contributed, the basis reduction is allocated to each loss property in proportion to their built-in losses. Sec 362(e)(2)(B) Alternatively, an election can be made to reduce the shareholder s stock basis rather than the corporation s basis in the assets.

9 9 Corp s basis in assets received S and T form New Corp. S transfers prop with a FMV of $20,000 and a basis of $30,000 in exchange for 20 shares of stock. T transfers $50,000 cash for 50 shares of stock. New Corp does not recognize a gain or loss on the transaction. Its tax balance sheet is: Cash 50,000 Equity: Equip 20,000 C/S 80,000 Total assets 70,000 Total equity: 80,000 Doesn t balance - OK

10 10 Corp s basis in assets received Shareholders A and B form NewCo by transferring the following property: Shareholder Property Basis FMV A Land A $25,000 $50,000 Total for shareholder A $25,000 $50,000 B Equipment $15,000 $10,000 B Land B 50,000 40,000 Total for shareholder B $65,000 $50,000 Note: These are equal shareholders because they have each contributed property worth $50,000.

11 11 Corp s basis in assets received In this example, because the FMV of ALL the property contributed by Shareholder B exceeds his basis in all of the property, the corporation s basis is limited to FMV. Accordingly, the corporation s basis in the assets is: Land A $25,000 Equipment 10,000 Land B 40,000 C/S $90,000 Total $75,000 Total $90,000

12 12 Your Turn Shareholders A and B form NewCo by transferring the following property: Shareholder Property Basis FMV A Land A $25,000 $50,000 Total for shareholder A $25,000 $50,000 B Equipment $15,000 $10,000 B Inventory 30,000 10,000 B Land B 50,000 20,000 Total for shareholder B $95,000 $50,000 Note: These are equal shareholders because they have each contributed property worth $50,000.

13 13 Your Turn Answer

14 14 Your Turn Answer

15 15 Corp s basis in assets received Rather than limiting the corporation s basis in the property to FMV, the corporation and shareholder can make an election to reduce the shareholders basis in the stock. IRC Sec 362(e)(2)(C) When would you want to make this election? Why does this rule exist for loss property?

16 16 Corp s Deprn of Prop Received Carryover basis - must use same deprn method, life, etc deprn recapture carries over New basis (b/c s/h recognized gain) treated as new prop (new deprn method, life) Year of transfer: deprn split between s/h and corp based upon # of months held by each» corp is deemed holder for entire month in which transfer occurred

17 Corp s Basis in Stock Issued for 17 Services Depending on nature of services performed, corp can either expense or capitalize. Connelly Corp issued 1,000 shares of stock valued at $5 each to Todd for serving as CEO for Connelly for one year. What is the tax implication to Connelly? Connelly will receive a $5,000 salary deduction (salary expense) Connelly will record the stock on its books at $5,000 (increase in equity)

18 18 Holding Period of Prop Received Sec 1223(2): includes the holding period of the transferor if the transaction qualifies under Sec 351, regardless of property type If the transaction does not qualify under Sec 351, the holding period begins on the day after the transfer

19 19 Corporation s Gain or Loss Corp recognizes gain (but not loss) when it transfers appreciated prop to s/h as part of a Sec 351 transaction, i.e., when boot is received by s/h.

20 20 Corporation s Gain or Loss Fred (sole s/h) transfers a piece of equipment with a FMV of $100,000 and an adjusted basis of $60,000 to Old Corp in exchange for 50 shares of Old stock (FMV $100 per share) and land (a capital asset) with a FMV of $50,000 and an adjusted basis of $30,000 to Old. Old must recognize $20,000 capital gain on the distribution of the land (50,000 FMV - 30,000 basis) Effect of boot on shareholder is covered later.

21 21 Recap - Effect on Corp Generally, no gain/loss services received appreciated prop distributed Steps into shoes of transferor basis carries over» Limitation of built-in losses deprn carries over holding period carries over

22 22 Section 351 Effect on Shareholder No gain or loss is recognized if property is transferred to a corp by one or more persons solely in exchange for stock of the corp and the transferors are in control of the corp immediately after the transfer Governs transfers to controlled corps applies to both new and existing corps If Sec 351 requirements are not met, the transfer is taxable under Sec 1001.

23 23 Shareholder Gain or Loss Shareholder s realized (and recognized, if required) gain or loss is calculated on a asset-by-asset basis. Rev Rul , CB 140.

24 24 Control To have control, transferors of property must own: 80% of total combined voting power of all classes of stock entitled to vote, plus 80% of total number of all non-voting classes of stock All property transferors are counted in determining whether 80% control is attained.

25 25 Property What qualifies as property transferred? Code specifically excludes services. Sec 351(d) Almost all other assets are property:»cash» Secret processes and formulas» Accounts receivable» PPE» Land

26 26 Shareholder s Stock Basis Section 358(a)(1): Basis of transferred assets + Gain recognized on exchange - FMV boot received - Liabilities transferred to corporation Sec 358(d)* = Basis of stock received by shareholder Note> Don t double-deduct boot and liabilities transferred * See also Reg for example of liability treatment.

27 27 Basis of Boot Received Sec 358(a)(2): Basis of boot received = FMV

28 28 S/h s Holding Period Sec 1223(1)For stock: includes the holding period of the s/h if the transferred property was a capital asset or a Section 1231 asset in the hands of the transferor. does not include the holding period of the s/h if the transferred property was inventory (or other prop) in the hands of the transferor (begins on day after transfer). If both types of property are transferred by a shareholder, each share has a split holding period. Rev Rul , 1985-c CB 117 For boot: begins on day after transfer

29 29 Formation Example Tim and Sam will incorporate their donut shop: Asset Fair Mkt Tax Basis Value Cash (Tim) $200,000 $200,000 Furniture & Fixtures (Sam) 20,000 50,000 Building (Sam) 50, ,000 Total $270,000 $400,000

30 30 Formation Example Realized Gain/Loss calculation: Tim Sam Sam FMV Prop Transferred 200,000 50, ,000 Basis Prop Transferred 200,000 20,000 50,000 Realized gain 0 30, ,000 Recognized gain Each shareholder s stock basis: Tim Sam Basis of prop transferred 200,000 70,000 Plus: gain recognized 0 0 Less: liabilities transferred 0 0 Less: boot received 0 0 Stock basis 200,000 70,000

31 31 Formation Example Corporation s tax balance sheet: Cash (Tim) $200,000 O/E 270,000 Furniture & Fixtures (Sam) 20, ,000 Building (Sam) 50,000 Total $270,000 Corporation s FMV balance sheet: Cash (Tim) $200,000 O/E 400,000 Furniture & Fixtures (Sam) 50, ,000 Building (Sam) 150,000 Total $400,000

32 32 Formation Example If shareholders sell their stock tomorrow, the gain they will recognize is: Tim Sam SP 200, ,000 Less stock basis 200,000 70,000 Recognized gain 0 130,000 Which is exactly equal to their realized gains that they didn t recognize on formation.

33 33 Formation Example Alternatively, if the corporation sells the assets: F&F Bldg SP 50, ,000 Less basis 20,000 50,000 Recognized gain 30, ,000 = 130,000 for corp The corp s FMV Balance Sheet is now: Cash 400,000 S/h Equity 400,000 If each s/h sells his stock tomorrow: Tim Sam SP 200, ,000 Less stock basis 200,000 70,000 Recognized gain 0 130,000 = 130,000 for s/h. Ouch!

34 34 Your Turn A and B formed a new corporation by contributing the following assets: Shareholder Property Basis FMV Shares A Cash $100,000 $100, B Land 25,000 60, B Equipment 35,000 40,000

35 35 Your Turn Answer Does Section 351 apply to this transaction? What is each shareholder s realized and recognized gain or loss? What is each shareholder s basis in his stock?

36 36 Your Turn Answer Prepare the corporation s tax balance sheet. Prepare the corporation s FMV balance sheet.

37 37 Your Turn Answer If each shareholder sells his stock tomorrow, how much gain or loss will each report? How does this tie in to the realized and recognized gain or loss on formation?

38 38 Your Turn Answer When the corporation sells each asset, how much gain or loss will it report? How does this tie in to the realized and recognized gain or loss on formation?

39 39 Formation Example Shareholders A and B form NewCo by transferring the following property: Shareholder Property Basis FMV A Land A $25,000 $50,000 Total for shareholder A $25,000 $50,000 B Equipment $15,000 $10,000 B Land B 50,000 40,000 Total for shareholder B $65,000 $50,000

40 40 Formation Example Realized Gain/Loss calculation: A B - equip B - Land FMV Prop Transferred 50,000 10,000 40,000 Basis Prop Transferred 25,000 15,000 50,000 Realized gain 25,000 (5,000) (10,000) Recognized gain 0 0 Each shareholder s stock basis: A B Basis of prop transferred 25,000 65,000 Plus: gain recognized 0 0 Less: liabilities transferred 0 0 Less: boot received 0 0 Stock basis 25,000 65,000

41 41 Formation Example Corporation s tax balance sheet: Land A $25,000 Equipment 10,000 Land B 40,000 C/S $90,000 Total $75,000 Total $90,000 Corporation s FMV balance sheet: Land A $ 50,000 Equipment 10,000 Land B 40,000 C/S $100,000 Total $100,000 Total $100,000

42 42 Formation Example If shareholders sell their stock tomorrow, the gain they will recognize is: A B SP 50,000 50,000 Less stock basis 25,000 65,000 Recognized gain 25,000 (15,000) Which is exactly equal to their realized gains that they didn t recognize on formation.

43 43 Formation Example Alternatively, if the corporation sells the assets: Land A Equip Land B SP 50,000 10,000 40,000 Less basis 25,000 10,000 40,000 Recognized gain 25, The gain on Land A is recognized twice once by the shareholder when he sells his stock and again when the corporation sells the asset. The losses on the Equipment and Land B are only recognized once when the shareholder sells his stock. Alternatively, the corporation and shareholder could make an election to reduce the shareholder s stock basis rather than the corporation s basis in the assets. However, bottom line, the losses will only be recognized once.

44 44 Transfer of Services Transferor recognizes ordinary income = FMV of stock received Transferor s basis in stock =FMV Transfer both services and property recognize gain on services only. Reg (a)(2)(Ex 3).

45 45 Transfer of Services Example Sam, Fred, and Mark decide to form a travel agency named Travel, Inc.: Sam purchases 45 shares of the stock for $4,500. Fred contributes equipment with a basis of $1,000 and a FMV of $4,500 for 45 shares of stock. Mark provides accounting services for Travel, Inc. in exchange for 10 shares of stock. What are the tax implications to each of the individuals?

46 46 Transfer of Services Ex, cont. Sam and Fred are the property contributors. They own 90% of the stock after the transfer, so the exchange of property (cash or equip for stock) qualifies under Section 351. Therefore, they recognize no gain or loss on the transaction. Sam has a $4,500 basis in his stock. Fred has a carryover basis of $1,000 in his stock (his gain is deferred until he sells his stock)

47 47 Transfer of Services Ex, cont. Mark will recognize $1,000 of ordinary income since the transaction is like a cash payment for services, followed by a purchase of stock. Even though Sec 351 applies to the entire transaction, transferor of services must pay tax on FMV of services rendered. Mark will have a basis of $1,000 in his stock. If the services Mark performed relate to the formation of the corporation, the corporation will capitalize the $1,000 of salary expense. If an ordinary expense, the corp will expense them this year.

48 48 Transfer of Services Ex, cont. Lee, Jeff, and Ted formed the LJT Corp. by transferring the following assets in exchange for stock: Transferor Transferred Basis FMV Shares Recd Lee Services 0 100, Jeff Equipment 10, , Ted Building 120, , Since the transferors of property do not own at least 80% of the corp, the transaction does not qualify for nonrecognition under Section 351. S/h Gain/Ord inc Basis in Stock Lee 100,000 ord inc 100,000 Jeff 90,000 gain 100,000 Ted 20,000 loss 100,000

49 Nominal Property Transferred 49 Example The transferor of services can be counted as a transferor of property if the FMV of property transferred is equal to or greater than 10% of the FMV of services provided. Rev Proc

50 Nominal Property Transferred 50 Example Corp BigDawg is formed by Shareholders A, B, C and S. S transfers services worth $30,000 in exchange for 30% of the BigDawg s stock. S also contributes $5,000 worth of equipment for an additional 5% of the stock. All 35% of S s stock (not just the 5% relating to the property contribution) is counted in determining control because the property transferred is not nominally small in value relative to the services provided (i.e., 5,000/30,000 > 10%)

51 51 Your Turn X, Y, and Z form NewCo by transferring the following: shares Shareholder Asset Basis FMV received X Equipment $33,000* $50, Y Cash 20,000 20, Z Services 30, *X originally paid $60,000 for the equipment. Does Section 351 apply to this transaction?

52 52 Your Turn Answer What is each shareholder s realized and recognized gain or loss? What is each shareholder s basis in his stock? What is the corporation s basis in each asset? What is required in order for Section 351 to apply?

53 53 Immediately After Transfers not required to be simultaneous if more than one transferor, but Rights of parties must be outlined before first transfer Transfers should occur as close together as possible

54 54 Immediately After Example A, B, C, and D agree to form a corporation. A, B, and C contribute land, machinery, and a building, respectively on April 15 for 25 shares ownership each. D contributes machinery on May 30 for the remaining 25% of stock. What is the tax treatment? If a plan existed, all four transactions will qualify for nonrecognition under Section 351 If no plan existed, then Section 351 applies to the transaction on April 15 because A, B, and C own 100% of the stock. D, however, would recognize a gain or loss because he does not obtain 80% control in that transaction.

55 55 Immediately After Can stock received be sold immediately? Yes, because the transferor has the freedom to either sell or retain the stock. However, sale might violate Section 351 if prearranged» Intermountain Lumber Co v Commissioner

56 56 Stock Sec 351(g): Common and plain vanilla preferred stock stock that does not participate in corporate growth to any significant extent and is limited in the amount, but preferred as to the receipt, of dividends.

57 57 Stock Anything else received by s/h is boot Other types of preferred stock (Nonqualified preferred stock)» The holder or the issuer has the right to redeem the stock,» The issuer has the right to redeem the stock and on the issue date, it is more likely than not that the redemption will occur» The dividend rate varies with interest rates, commodity prices, or other similar indices Stock rights or stock warrants Debt of the corp (bonds) Contingent shares are counted as stock. Carlberg v US, 281 F 2d 507 Even though the NQPS is considered boot, it is still considered stock in determining the 80% control requirement.

58 58 Stock Example: If C contributes appreciated property to new corporation X for all of the X common stock (representing 90% of the value and all of the voting power) and B contributes cash for NQPS representing 10% of the value of X, B has received boot, but the NQPS is still treated as stock for purposes of 351(a) and 368(c) until regulations are issued requiring a different result. Thus, C's transfer qualifies for nonrecognition treatment under 351, because B and C, the two transferors in the transaction, control X immediately following the transfers (C alone does not control X, because C owns none of the nonvoting class held by B). If B had received other stock in addition to NQPS, B would be required to recognize gain only to the extent of the fair market value of the NQPS received.

59 59 Stock Obama s budgets for 2012, 2013, and 2014 have called for the discontinuing the treatment of NQPS as boot.

60 60 Stock/Boot Boot can be received without voiding Section 351 Sec 351(b): However, receipt of boot may result in gain to transferor Gain is equal to the lesser of :» gain realized» boot received Boot never triggers recognition of losses

61 61 Boot Shareholder s basis = FMV. Sec 358(a)(2) Shareholder s holding period begins on the day after receipt

62 62 Boot Example Lee and Barbara formed the Bad Weather Corp. Lee transferred a snow plow with a FMV of $100,000 and a basis of $60,000 and received 95 shares of stock and $5,000. Barbara contributed $5,000 and received 5 shares of stock. Barbara and Lee are property contributors and own 100% of the corp after the exchange; thus, Sec 351 applies. Lee has received boot (cash from the corp) and so must recognize gain to the lesser of realized gain or boot received

63 63 Boot Example Lee Barb FMV property transferred 100,000 5,000 Basis of property transferred (60,000) (5,000) Realized gain 40,000 0 Boot received 5,000 0 Recognized gain 5,000 0 Basis of property transferred 60,000 5,000 Plus recognized gain 5,000 0 Less Boot received (5,000) 0 Less Liabilities transferred 0 0 S/h stock basis 60,000 5,000

64 64 Boot Example The tax balance sheet is: Equipment 65,000 O/E 65,000 Total 65,000 Total 65,000 The FMV balance sheet is: Equipment 100,000 O/E 100,000 Total 100,000 Total 100,000 If each s/h sold her stock tomorrow: Lee Barb SP 95,000 5,000 - stock basis 60,000 5,000 Recog gain 35,000 0

65 65 Your Turn A, B, C, and D form NewCo by transferring the following assets: C/S cash S/h Asset Basis FMV received received A Land $68,000 $70, $10,000 B Patent 15,000 70, ,000 C Equip 80,000 60, ,000 D Cash 30,000 30, Does Section 351 apply to this transaction?

66 66 Your Turn Answer What is each shareholder s realized and recognized gain or loss? What is each shareholder s basis in his stock? What is each shareholder s basis in the cash received?

67 67 Your Turn Answer Prepare the corporation s tax balance sheet. Prepare the corporation s FMV balance sheet.

68 68 Your Turn Answer If each shareholder sells his stock tomorrow, how much gain or loss will each report? How does this tie in to the realized and recognized gain or loss on formation?

69 69 Boot If a shareholder transfers multiple assets and boot is received, the boot is allocated to each asset based upon its relative FMV. Rev Rul 68-55, CB 140.

70 70 Boot - Multiple Assets Transferred Example: Johnny Bravo contributed the following assets to form the JB Corp: Asset Basis FMV Cash 2,500 2,500 comb shirt 1,000 2,400 camera 1,500 5,000 5,200 10,000 In return, Johnny receives stock w/ a FMV of $8,000 and $2,000 cash.

71 71 Boot - Multiple Assets Transferred Allocate the note to each asset based on that asset s relative FMV: Asset: Relative FMV * FMV boot = boot allocation Cash 2,500/10,000 2, Comb 100/10,000 2, Shirt 2,400/10,000 2, Camera 5,000/10,000 2,000 1,000 2,000 Cash Comb Shirt Camera Total FMV less: basis (5200) realized g/l 0 (100) boot received recognized gain

72 72 Boot - Multiple Assets Transferred Basis in stock Basis of prop transferred 5,200 Plus: Recognized gain 1,420 Less: Boot received (2,000) Less: Liability transferred 0 Stock basis 4,620 Basis in cash 2,000

73 73 Boot - Multiple Assets Transferred Corp basis in assets is: Cash Comb Shirt Camera S/H basis 2, ,000 1,500 S/H recog gain ,000 Corp s basis 2, * 1,420 2,500 The corporation s basis in the comb is not limited to FMV because the basis of ALL the assets transferred by the shareholder is less than the FMV of ALL the assets transferred by the shareholder. Note>> The cash reported on the balance sheet is only $500 because $2,000 was distributed to Johnny as boot.

74 Boot - Multiple Assets Transferred Tax balance sheet: Cash 500 Comb 200 Shirt 1,420 O/E 4,620 Camera 2,500 Total 4,620 Total 4,620 FMV balance sheet: Cash 500 Comb 100 Shirt 2,400 O/E 8,000 Camera 5,000 Total 10,000 Total 8,000

75 75 Boot - Multiple Assets Transferred If Johnny sells his stock tomorrow: SP 8,000 Less stock basis 4,620 Recognized gain 3,380 Check: Gain on stock sale 3,380 Gain on formation 1,420 Realized gain 4,800

76 76 Boot - Multiple Assets Transferred If the corporation sells each asset tomorrow for its FMV: Cash Comb Shirt Camera SP ,400 5,000 Basis ,420 2,500 Recognized gain/loss 0 (100) 980 2,500 = 3,380 Gain recogn by s/h ,000 = 1,420 Realized gain 0 (100) 1,400 3,500 = 4,800 It is only the gain that is NOT recognized by the shareholder that is taxed twice (once when corp sells property and again when shareholder sells stock). Gain recognized by corp 3,380 Gain recognized by shareholder on formation 1,420 Gain recognized by shareholder on stock sale 3,380

77 Boot -Timing of the gain recognition 77 when boot is in the form of a note The s/h will recognize gain when the note is paid, not when the corporate formation takes place. If the note is paid in installments, the s/h follows the installment sale rules under Prop Reg (f)(3) and reports gain as cash is received, but gets to increase his basis in his stock immediately The corporation increases it basis in the assets received as the s/h recognizes the gain. If the corporation sells the property before the note is completely repaid (and therefore before its basis in the asset is increased by the full gain that the s/h will recognize), the corporation will recognize a loss when it repays the note. Prop Reg (f)(3)(iii) Example 1.

78 78 Example Shareholder A forms his wholly-owned corporation by transferring Land with a basis of $10 and a FMV of $100. In exchange, A receives 100% of the stock and a $20 note payable over 5 years. FMV property transferred 100 Basis of property transferred 10 Realized gain/loss 90 Boot received 20 This must be bifurcated into two transactions transfer of property for stock and transfer of property for boot.

79 79 Example A s basis in the land is first allocated to the stock, up to the FMV of the stock. A s basis in the land is $10 and the FMV of the stock is $80, so the entire $10 basis in the land is allocated to A s stock. His basis in the note is $0. Now the installment sales rules apply. The FMV of the note is $20, and A s basis in the note is $0, so 100% of each payment on the note must be included in income. As A receives $4 over the next 5 years, he will report the entire $4 as income. As A recognizes the income, the corporation increases its basis in the land.

80 80 Example Corp s basis in the land at formation: $10 Corp s basis in the land after first installment paid: $14 Corp s basis in the land after second installment paid: $18 Corp s basis in the land after third installment paid: $22 Corp s basis in the land after fourth installment paid: $26 Corp s basis in the land after fifth installment paid: $30 However, when calculating the shareholder s basis in his stock, Prop Reg (f)(3)(ii) treats the shareholder as opting out of the installment method. Accordingly, A s basis in his stock at formation is: Basis of property transferred 10 Plus Recognized gain 20 Less Boot received 0 Less: Liabilities transferred 0 A s basis in his stock 30

81 81 Example If the corporation sells the land after the third installment is paid, the corporation s basis in the land is $22. Then, as the shareholder recognizes the income on the last two installment payments, the corporation has no asset to which it can apply the increase in basis. In that case, the corporation recognizes a loss as it makes the last two installment payments. Prop Reg (f)(3)(iii) Example 1.

82 Boot Basis allocation when boot is 82 in the form of a note If the s/h basis in the property transferred exceeds the fmv of the stock received, the s/h allocates any such excess to the note received. Prop Reg (f)(1)(iii) 1(f)(3)(ii) This basis in the note will decrease the s/h recognized gain when the note is repaid.

83 83 Example Shareholder A forms his wholly-owned corporation by transferring Land with a basis of $85 and a FMV of $100. In exchange, A receives 100% of the stock and a $20 note payable over 5 years. FMV property transferred 100 Basis of property transferred 85 Realized gain/loss 15 Boot received 20 This must be bifurcated into two transactions transfer of property for stock and transfer of property for boot.

84 84 Example A s basis in the land is first allocated to the stock, up to the FMV of the stock. A s basis in the land is $85 and the FMV of the stock is $80, so $80 of his basis in the land is allocated to A s stock. The remaining $5 basis is allocated to the note. Now the installment sales rules apply. The FMV of the note is $20, and A s basis in the note is $5, so 75% of each payment on the note must be included in income. As A receives $4 over the next 5 years, he will report the entire $3 as income (for a total of $15, his realized gain). As A recognizes the income, the corporation increases its basis in the land.

85 85 Example Corp s basis in the land at formation: $80 Corp s basis in the land after first installment paid: $83 Corp s basis in the land after second installment paid: $86 Corp s basis in the land after third installment paid: $89 Corp s basis in the land after fourth installment paid: $92 Corp s basis in the land after fifth installment paid: $95 However, when calculating the shareholder s basis in his stock, Prop Reg (f)(3)(ii) treats the shareholder as opting out of the installment method. Accordingly, A s basis in his stock at formation is: Basis of property transferred 80 (limited to fmv of stock) Plus Recognized gain 15 Less Boot received 0 Less: Liabilities transferred 0 A s basis in his stock 95 A s basis in the note was $5, so we have allocated all $100 of basis to the two assets he received, stock and note.

86 Can Liability Assumption Ever 86 Cause Gain Recognition? General Rule: Liabilities transferred to corp are not considered cash received when determining the s/h gain or loss and therefore are not considered boot, which could trigger gain. IRC Sec 357(a)

87 87 Transfer of Liabilities to Corp Tony forms a Maid Company by contributing cleaning equipment with a basis of $10,000 and a FMV of $15,000. The equipment is subject to a $3,000 liability, which he also transfers to the new corp. Tony received all 100 shares of the Maid Company stock in the exchange. What is the tax implication of the transaction?

88 88 Transfer of Liabilities to Corp FMV of prop transferred 15,000 Basis of prop transferred 10,000 Realized gain 5,000 Basis of prop transferred 10,000 Plus: recognized gain 0 Less: liability transferred (3,000) * Less: boot received 0 S/h stock basis 7,000 * Liabilities are not considered boot, but they do decrease the shareholder s stock basis. Sec 357(a), Sec 358(d), and Reg

89 89 Transfer of Liabilities to Corp Tax balance sheet: Equipment 10,000 Liability 3,000 O/E 7,000 Total 10,000 Total 10,000 FMV balance sheet: Equipment 15,000 Liability 3,000 O/E 12,000 Total 15,000 Total 15,000 If Tony sells his stock tomorrow: SP 12,000 Less stock basis 7,000 Recognized gain 5,000 Which equals his realized gain

90 90 Your Turn During the year, Y and Z form NewCo by transferring the following: Shareholder Asset Basis FMV shares Y Equipment $18,000 $20, Z Warehouse 10,000 25, There is a $5,000 liability on the warehouse, which was used to purchase the warehouse. These are equal shareholders because they contribute the same net amount. Y Z FMV prop transferred $20,000 $25,000 Liability on prop transferred 0 5,000 Net FMV of prop transferred $20,000 $20,000

91 91 Your Turn What is each shareholder s realized and recognized gain or loss? Compute each shareholder s stock basis.

92 92 Your Turn Prepare the corporation s tax balance sheet. Prepare the corporation s FMV balance sheet.

93 93 Your Turn If D sells his stock tomorrow, what is his recognized gain or loss?

94 Can Liability Assumption Ever 94 Cause Gain Recognition? General Rule: Sec 357(a) Exceptions: Liabilities treated as boot: Liabilities transferred where primary purpose is tax avoidance or that have no bona fide business purpose. Sec 357(b) Liabilities triggering gain: Liabilities transferred in excess of basis of property transferred. Sec 357(c)

95 95 Liabilities Treated As Boot Liabilities incurred for no business purpose or as tax avoidance mechanism Boot = Entire amount of all liabilities transferred by that s/h

96 96 Liabilities Treated As Boot, Ex Brad wants to transfer his personal yacht to his travel corp. The boat has a basis of $50,000 and a FMV of $300,000. He takes out a $200,000 loan on the boat, then transfers the boat and the loan to the corp, keeping the $200,000 loan proceeds for himself. There is no business purpose for the loan, so the entire $200,000 mortgage assumed by the corp will be treated as boot to Brad.

97 97 Liabilities treated as boot FMV of prop transferred 300,000 Basis of prop transferred 50,000 Realized gain 250,000 Boot received 200,000 Recognized gain 200,000 Basis of prop transferred 50,000 Plus: recognized gain 200,000 Less: liability transferred (200,000) Less: boot received 0 S/h stock basis 50,000 Treat the liability as either a liability or boot, but not both, when calculating the stock basis.

98 98 Liabilities treated as boot Tax balance sheet: Yacht 250,000 Liability 200,000 O/E 50,000 Total 250,000 Total 250,000 FMV balance sheet: Yacht 300,000 Liability 200,000 O/E 100,000 Total 300,000 Total 300,000 If Brad sells his stock tomorrow: SP 100,000 Less stock basis 50,000 Recognized gain 50,000 Which equals his realized gain that wasn t recognized on formation.

99 99 Liabilities Triggering Gain Liabilities > basis in ALL assets transferred Gain = Excess amount (liabilities - basis) The excess liability is a gain, not boot; thus, s/h recognizes gain whether he has a realized gain or not. Exception: liabilities that would be deductible when paid are not included. IRC Sec 357(c)(3)» Example: A/P of cash-basis taxpayers

100 100 Liabilities Triggering Gain Sandy transferred the following assets to her newly-formed, 100%- owned corporation: Asset Basis FMV Liability Computer 1,000 2,000 0 Building 200, , ,000 Furniture 4,000 6,000 0 Totals 205, , ,000 Sandy s gain is: FMV property transferred 228,000 Basis in property transferred 205,000 Realized gain 23,000 Recognized gain 0

101 Liabilities Triggering Gain Basis of prop transferred 205,000 Plus: recognized gain 0 Less: liability transferred (225,000) Less: boot received 0 S/h stock basis (20,000) Since her basis in her stock cannot be negative, she recognizes a $20,000 gain (character based upon type of property transferred) and her basis in her stock is $0. The corporation will increase its basis in the assets based on each asset s relative FMV: Adjustment basis new basis Computer: 2,000/228,000 * 20,000 = $ 175 1,000 1,175 Building: 220,000/228,000 * 20,000 = $19, , ,298 Furniture: 6,000/228,000 * 20,000 = $527 4,000 4,527 Total $20, , ,000

102 102 Liabilities Triggering Gain Tax balance sheet: Computer 1,175 Liability 225,000 Building 219,298 Furniture 4,527 O/E 0 Total 225,000 Total 225,000 FMV balance sheet: Computer 2,000 Liability 225,000 Building 220,000 Furniture 6,000 O/E 3,000 Total 228,000 Total 228,000 If Sandy sells her stock tomorrow: SP 3,000 Basis 0 Gain recognized 3,000 Gain on formation 20,000 Gain realized 23,000

103 103 Your Turn During the year, D formed his wholly-owned corporation by contributing Land with a basis of $70,000 and a FMV of $150,000. The land was subject to a $100,000 liability. A bona fide business purpose exists for the liability What is D s realized and recognized gain or loss? What is D s stock basis?

104 104 Your Turn Prepare the corporation s tax balance sheet. Prepare the corporation s FMV balance sheet. If D sells his stock tomorrow, what is his recognized gain or loss?

105 105 Liabilities Triggering Gain IRC Sec 362(d)(1) the basis of any property contributed cannot be increased in excess of its FMV due to gain recognition based upon assumption of liability. So, shareholder still recognizes gain, but that recognized gain cannot increase the corp s basis in the asset above FMV.

106 106 Example A transfers land with a basis of $60,000, FMV of $75,000 to his newlyformed, wholly-owned corporation. The land is subject to an $80,000 liability. FMV of prop transferred 75,000 Basis of prop transferred 60,000 Realized gain 15,000 Basis of prop transferred 60,000 Plus recognized gain 0 Less boot received 0 Less liabilities transferred (80,000) S/h stock basis can t be negative; therefore shareholder recognizes a $20,000 gain and his stock basis is $0

107 107 Example Normally, the corporation s basis in the asset would be computed as: S/h basis in property 60,000 S/h recognized gain 20,000 Corp s basis in property 80,000 However, the corporation s basis is limited to the FMV of $75,000.

108 108 Proposed Net Value Regulations Stock is not considered to be issued for property if the liability transferred exceeds the FMV of the property transferred. Prop Reg (a)(2) Ex 4: B transfers property with a FMV of $175,000 and a liability o $190,000 to his newlyformed corporation in exchange for 10 shares of stock. Because the liability exceeds the FMV, the 10 shares of stock are not considered to be issued for property.

109 109 Incorporation of a Going Business A cash-basis TP has a zero basis in the accounts receivable. Income is recognized when it is received A cash-basis TP has a zero basis in accounts payable Deducts them when paid Under Section 351, if cash-basis A/R are transferred to a corporation, the corporation, not the transferor, recognizes the gain. Hempt Brothers, Inc. v US, 490 F2d 1172 (cert denied) S/h has a zero basis in the A/R to allocate to his stock basis Under Section 351, the cash-basis liabilities transferred to a corporation are not considered when determining gain recognition to the s/h under Section 357(c)(1). The corporation deducts them as they are paid. They do not decrease the s/h stock basis under Section 358. IRC Sec 358(d)(2)

110 110 Example Z owns a cash-basis sole proprietorship. Z forms a wholly-owned corporation by transferring the following assets and liabilities from the sole proprietorship to the corporation: Basis FMV Cash 5,000 5,000 A/R 0 10,000 Inventory 15,000 15,000 A/P 0 12,000 N/P to bank 10,000 10,000

111 111 Example The corporation will recognize the A/R as income when they are collected and will deduct the A/P when they are paid. FMV of property transferred 30,000 Basis in property transferred 20,000 Realized gain or loss 10,000 Recognized gain or loss 0 Basis property transferred 20,000 Recognized gain 0 Boot received 0 Liabilities transferred 10,000 S/H stock basis 10,000 Holding period for the stock is bifurcated: part ST and part LT

112 112 Example Corporation s tax balance sheet: Cash 5,000 Liabilities 10,000 A/R 0 O/E 10,000 Inventory 15,000 Total 20,000 Total 20,000 Corporation s FMV balance sheet: Cash 5,000 Liabilities 22,000 A/R 10,000 O/E 8,000 Inventory 15,000 Total 30,000 Total 30,000

113 113 Example If the shareholder sells his stock tomorrow: SP 8,000 Basis 10,000 Recognized loss (2,000) His realized gain was $10,000 and his recognized loss was $2,000. This results from an interaction between IRC Sec 357(c)(3) and IRC Sec 358(d)(2) to give him a deduction for the accounts payable before they are paid.

114 114 Organizational and Start-Up Exp Organizational: IRC Section 248 Expense first $5,000; remainder is amortized over 180 months The $5,000 immediate expensing is reduced dollar-for-dollar to the extent the qualifying expenses exceed $50,000. Start-up: IRC Section 195 Expense first $5,000; remainder is amortized over 180 months The $5,000 immediate expensing is reduced dollar-for-dollar to the extent the qualifying expenses exceed $50,000.

115 115 Recap - Effect on S/h No g/l recognized when transferors of property receive stock and are in control of the corp immediately after the exchange. Exception: services boot received some liabilities transferred Basis in stock received Basis in property transferred plus any gain recognized less boot received less liabilities transferred Holding period for stock received Next day: cash and ordinary-income property Day after asset purchased: capital and Sec 1231 property

116 116 Chapter Recap Corporate Formation Effect on corp» Gain/loss recognized» Basis in property received» Holding period for property received Effect on s/h» Gain/loss recognized» Basis in stock received» Holding period for stock