Corporation Formation

by Annette Nellen

Introduction

This chapter covers the tax rules applicable to shareholders and corporations when the shareholders (or soon to be shareholders) contribute cash or other property to the corporation in exchange for stock in the corporation. For example, if individual I contributes equipment with a basis to I of $500 and a fair market value of $800, to corporation C in exchange for $800 worth of C stock, must I recognize a taxable gain of $300? The answer to this question is discussed in this chapter. Also, what is C's basis in the equipment it receives from I. In addition to the tax effects of contributions to corporations in exchange for corporate stock, other corporate formation concerns are addressed including the effects of shareholders loaning money to the corporation, whether the corporation qualifies as a small business corporation and the benefits of so qualifying, and state law concerns.

Formation of a Corporation

A business operated in the corporate form may have started in the corporate form when the business first began, or the business may have operated as a sole proprietorship or partnership prior to incorporating. The rules and issues discussed below apply to any manner in which a business begins in the corporate form. The approach taken below is to identify issues an existing or new business must deal with when forming a corporation. The major tax rules are discussed by using an example where a sole proprietor has decided to incorporate his or her business.

Question #1 - Is the fact that the maximum tax rate for a corporation is 35%, while the maximum tax rate for an individual is 39.6%, a sufficient reason why a sole proprietor might want to incorporate his or her business?

 

Tax Issues and Concerns That Arise in the Formation of a Corporation

Many tax questions and concerns arise in forming a corporation. It is important for the shareholders and corporate officers to look carefully at the options available and their associated tax consequences in order to obtain the optimal tax consequence for all parties. Also, decisions made at formation can easily have important tax consequences later, when for example, the corporation liquidates or reorganizes. For example, suppose a new shareholder transfers a building to a corporation in exchange for corporate stock. The building has a basis to the shareholder of $30,000 and a fair market value of $300,000. If properly structured, the shareholder will not have to recognize (report) any of the $270,000 realized gain when he gives up a $30,000 basis asset and receives $300,000 of stock in return. However, the shareholder and the corporation must consider what the tax effect would be if the corporation sold the building later. In that situation, the corporation would recognize a taxable gain and at some point in the future when the corporation pays a dividend to the shareholder, the shareholder would pay tax, resulting in double taxation. If the shareholder had instead continued to own the building directly, there would only be a single layer of tax when the shareholder later sold the building.

Question #2 - What could the shareholder and the corporation do to enable the corporation to have use of the building with the shareholder remaining as the owner?

 

 

Example

Sole proprietor S has decided to incorporate her office supplies store on January 1, 1999. At that date, the assets of the store consist of the following:

   

Adjusted Basis

FMV

  Bank checking account

$10,000

$10,000

  Inventory

$40,000

$60,000

  Equipment, furniture

$5,000

$2,000

  Building

$35,000

$100,000

  Land

$10,000

$100,000

  Total

$100,000

$272,000

Issue/concern #1 - What assets and liabilities should S transfer into the new corporation?

S could transfer all of the assets into the new corporation in exchange for corporate stock, or S might want to hold some of the assets out and continue to own them individually, as discussed earlier. S and the corporation might realize some tax benefits by having S lease these assets to the corporation instead. S and her tax advisor need to consider this before any assets are contributed. S's estate planning concerns will likely be a factor in this decision as well.

Issue/concern #2 - What is the tax effect to the shareholder(s) and the corporation when shareholders exchange property for corporate stock? Is there any gain or loss to either party? What is each party's basis in the property they receive in the exchange?

IRC provisions relevant in determining the tax consequences to the shareholders and the corporation (excerpts from these Code sections are included in this chapter to be used in better understanding the rule and to gain practice in reading and applying the Code rules):

Chapter 1 - Normal Taxes and Surtaxes

Subchapter C - Corporate Distributions and Adjustments

Part III - Corporate Organizations and Reorganizations

  • Subpart A - Corporate Organizations
  • 351 - Transfer to corporation controlled by transferor
  • Subpart B - Effects on Shareholders and Security Holders

  • 357 - Assumption of liability

    358 - Basis to distributees (shareholders)

  • Subpart C - Effects on Corporations

  • 361 - Nonrecognition of gain or loss to corporation; treatment of distributions

    362 - Basis to corporations

  • Subpart D - Special Rule; Definitions

  • 368(c) - Control defined
  • Subchapter O - Gain or Loss on Disposition of Property

  • Part III - Common Nontaxable Exchanges
  • 1032 - Exchange of stock for property
  • Question #3 - Read IRC 351(a) and 368(c) which follow this question. What is the tax effect to S of transferring all the business assets into the new corporation in exchange for 100% of the corporate stock?

  • Sec. 351 Transfer to corporation controlled by transferor

    (a) General rule - No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.

    (b) Receipt of property - If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock permitted to be received under subsection (a), other property or money, then

    (1) gain (if any) to such recipient shall be recognized, but not in excess of

  • (A) the amount of money received, plus
  • (B) the fair market value of such other property received; and
  • (2) no loss to such recipient shall be recognized.

    (d) Service, certain indebtedness, and accrued interest not treated as property - For purposes of this section, stock issued for (1) services, (2) indebtedness of the transferee corporation which is not evidenced by a security, or (3) interest on indebtedness of the transferor corporation which accrued on or after the beginning of the transferor's holding period for the debt, shall not be considered as issued in return for property.

    Section 368(c) Control defined - ... the term "control" means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.

    Section 7701(a)(1) - Person - The term "person" shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation.

    Property - The word "property" as used in section 351 ... includes money. (Rev. Rul. 69-357, 1969-1 CB 101).

  • IRC 351 provides that if the 80% control requirement is met, the shareholder will not recognize gain or loss on the exchange of property for corporate stock. This is a mandatory rule, not an elective one. In our example, S would have had a recognized loss if she had sold the equipment instead of contributing it to the corporation. If the corporation does not need the equipment, S should consider selling it to a third party and recognizing the loss. If S were to instead sell it to the new corporation, S would most likely be treated as receiving cash in the exchange which would be taxable to the extent of her recognized gain. Since her realized gain would exceed the $2,000 cash received, she would have a $2,000 gain (IRC 356).

    Question #4 - On June 1, 19X5, 5 individuals form X Corporation. Each shareholder contributes $20,000 of inventory or other non-cash property for a 20% interest in the corporation. Will there be any tax effect to the five individuals? Explain.

    Question #5 - Read 1032(a) below. What is the tax effect to the corporation of receiving money or other property in exchange for its stock?

  • Sec. 1032(a) - Nonrecognition of gain or loss - No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. ...
  • Question #6 - Read 358(a) below - Assuming S transfers all of the assets into the new corporation in exchange for stock, compute S's basis in the stock.

  • Sec. 358 Basis to Distributees

    (a) General rule - In the case of an exchange to which section 351, 354, 355, 356, or 361 applies

  • (1) Nonrecognition property - The basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged

    (A) decreased by

  • (i) the fair market value of any other property (except money) received by the taxpayer,

    (ii) the amount of any money received by the taxpayer, and

    (iii) the amount of loss to the taxpayer which was recognized on such exchange, and

  • (B) increased by

  • (i) the amount which was treated as a dividend, and

    (ii) the amount of gain to the taxpayer which was recognized on such exchange (not including any portion of such gain which was treated as a dividend).

  • (2) Other property - The basis of any other property (except money) received by the taxpayer shall be its fair market value.

  • Question #7 - Read 362(a) below. Compute the corporation's basis in the assets received in the 351 exchange.

  • Sec. 362 Basis to corporations

    (a) Property acquired by issuance of stock or as paid-in surplus - If property was acquired on or after June 22, 1954, by a corporation - (1) in connection with a transaction to which section 351 (related to transfer of property to corporation controlled by transferor) applies, or (2) as paid-in surplus or as a contribution to capital, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.

  •  

    There is no depreciation recapture in a 351 exchange. However, the potential for depreciation recapture will carryover to the corporation (IRC 1245(b)(3) and 1250(d)(3)). Thus, when the corporation later disposes of the depreciable property, it must also consider the depreciation previously taken by the contributing shareholder in determining the depreciation recapture, if any, for the corporation.

    If S also received $3,000 of cash in addition to the stock, the results would change as follows:

  • • The no recognized gain or loss provision of 351 only applies if the property is transferred solely in exchange for stock. In this revised example, S did not receive solely stock because she also received cash. Per 351(b) (see above), because S received property or money in addition to the stock, she will have to recognize gain to the extent of the other property or cash received. Thus, S will have to recognize $3,000 of her realized gain. In this type of situation, the shareholder's recognized gain cannot exceed the cash received plus the fair market value of any other property received. If the shareholder instead had a realized loss and received property in addition to the stock, the loss may not be recognized under these rules.

    • In applying the shareholder stock basis rule of 358 to S, she ends up with stock basis of $100,000 computed as follows:

    Adjusted basis of property exchanged $100,000

    less: FMV of other property received -0-

    less: cash received ( 3,000)

    less: loss recognized by shareholder -0-

    plus: amount treated as a dividend -0-

    plus: gain recognized by shareholder 3,000

    Basis of stock received $100,000

    This stock basis ensures that S's realized gain that is deferred $169,000 ($172,000 total realized gain less $3,000 that is recognized per 351(b)) is not eliminated. For example, if S were to sell the stock the next day, she would likely receive $269,000 (value of the corporate assets after $3,000 was given to S) and would have a gain of $169,000, which added to the recognized gain of $3,000 adds up to her $172,000 realized gain.

    • The formula at 362(a) results in the following basis of the assets to the corporation:

    Basis of assets to the transferor (S) $100,000

    plus: gain recognized by transferor (S) 3,000

    Basis of assets $103,000

  • Question #8 - Would 351 apply if S contributed her property to the corporation in exchange for 70% of the stock and Mr. R received 30% of the stock in exchange for contributing his services to the corporation?

     

    Question #9 - Does 351 only apply at the formation of a corporation?

     

    Treatment of liabilities transferred in a 351 exchange: What would have been the effect if S had also transferred a liability into the new corporation? For example, assume that the land and building had a $20,000 mortgage on it that the new corporation will assume. IRC 357(a) provides that even though the corporation assumes a liability of a shareholder in an exchange of property for stock, 351(a) can still apply and the shareholder's debt relief will not be treated as the receipt of money or other property. Thus, in applying 351, the shareholder will not have any recognized gain from the corporation's assumption of the shareholder debt. However, there will be an effect on the shareholder's basis in the stock received in the 351 exchange. IRC 358(d) provides that for purposes of determining a shareholder's basis in the stock received, any assumption by the corporation of a shareholder's liability will be treated as cash received in the exchange.

    Question #10 - What is S's recognized gain or loss if the corporation also assumes the $20,000 mortgage on the building and land?

     

    Question #11 - What is S's basis in the stock she receives in the 351 exchange where the corporation assumes the $20,000 mortgage?

     

     

    Question #12 - Section 358(d) required the shareholder to treat the debt assumed by the corporation as a reduction in computing the shareholder's basis in the stock received. What if the debt assumed by the corporation exceeded the basis of the assets that the shareholder transferred into the corporation - could a taxpayer have negative basis in an asset (here, the corporate stock)? For example, what if the individual had a mortgage of $120,000 on the assets contributed to the building, which would be possible as $120,000 is less than the fair market value of the contributed assets. [IRC 357(c)]

     

     

    Question #13 - Do you think the general rules would be applied differently to S if she obtained a $100,000 mortgage on her building and land a few days before transferring them in a 351 exchange with the corporation assuming the liability? Why or why not?

     

     

     

     

    Transfer of accounts receivable and accounts payable: Suppose that S also had $5,000 of accounts receivable that she transferred to the corporation. This brings up an interesting issue in that 351 provides that as long as the control requirement is met, no gain or loss is to be recognized from the exchange. However, assuming that S is a cash basis taxpayer, she would have had ordinary income if she had kept the accounts receivable and collected the amounts owed from the customers. The IRS has held that as long as there was no tax avoidance purpose in S transferring the accounts receivable to the corporation, S will not recognize any gain from the transfer, assuming the control requirement is met (Revenue Ruling 80-198). S's basis in the stock will not reflect the accounts receivable because they had a $0 basis to S. The corporation will also have a $0 basis in the accounts receivable under 362 (carryover basis) assuming S had no recognized gain on the exchange. The corporation will have income when the receivables are collected.

    Suppose S had also transferred accounts payable to the corporation in the exchange, which the corporation assumed. Assuming the control requirement was met and there was no tax avoidance purpose, S would not have any recognized gain or loss under 351. However, S's stock basis would not be decreased by the amount of the payables assumed due to special rules at 357(c) and 358(d) which exclude liabilities that would result in a deduction (Revenue Ruling 80-198). As S is a cash basis taxpayer, the accounts payable would have led to a deduction when she paid them.

    Additional Issues: The following list summarizes the formation issues discussed above as well as some additional ones.

    1) What assets and liabilities should be transferred into the corporation?

    owner could lease them to the corporation, but must consider the potential effects of the 469 passive activity loss limitation rules

    would the asset produce a usable loss to the shareholder if sold to a third party?

    should accounts payable be left out to allow the shareholder a deduction for them?

    2) What is the tax effect to the shareholder(s) and the corporation?

    3) Do the parties want to obtain an advance ruling from the IRS that the exchange meets the no gain or loss rule of 351?

    4) Should the shareholder(s) loan money to the corporation instead of just contributing to its capital?

    5) Will the corporation be set up as a small business corporation entitling the individual shareholders to special rules if they have a loss on their stock?

  • This special loss rule applies if the stock is 1244 stock. This is defined at IRC 1244 as stock in a domestic corporation that meets the definition of a small business corporation. The stock must have been issued by the corporation in exchange for cash or other property; the shareholder may not have obtained it from another shareholder. Also, in the five years prior to the shareholder recognizing a loss on the stock, the corporation must have derived over 50% of its gross receipts from non-passive type sources (sources other than interest, dividends, royalties, etc.). A small business corporation is one with capitalization of $1,000,000 or less.

    The benefit of stock meeting the definition of 1244 stock only applies to shareholders that realize a loss from sale, exchange or worthlessness of the stock. The benefit only applies to individuals. The benefit is that $50,000 of the loss will be treated as an ordinary loss. If the individual is married and files a joint return, the ordinary loss amount is $100,000. Thus, instead of the stock loss being treated as a capital loss, up to $50,000 (or $100,000) of it may be treated as ordinary. As there is no limitation on the deductibility of ordinary losses, this is a great benefit to the individual shareholder. For example, suppose Mr. K, a single individual sells 1244 stock and realizes an $80,000 loss. Under the typical rules, K would have a $80,000 capital loss that is only usable against capital gain income plus $3,000 of ordinary income, with any excess to be carried forward subject to the same limitation each year. However, since the stock was 1244 stock, $50,000 of the loss is ordinary and not subject to limitation and the remaining $30,000 is a capital loss.

  • Question #14 - What might Mr. K have been able to do to improve the tax consequences of selling the stock?

     

     

  • If an investor loans money to the corporation and the corporation is unable to pay the investor back, assuming it was a bona fide loan, the investor will have a bad debt loss. Treatment of the loss on the investor's tax return depends on whether the debt was a business debt or a non-business debt. This determination depends on what business the lender is in. Assuming the investor is not in the business of loaning money, the debt would be a nonbusiness debt. Per 166(d), a bad debt loss on a nonbusiness debt is treated as a short-term capital loss. Application of this rule is not dependent on the corporation being a small business corporation.

    6) Will the corporation be set up as a qualified small business corporation entitling the individual shareholders to special rules if they have a gain upon disposition of their stock after holding it for over five years?

  • The Revenue Reconciliation Act of 1993 added IRC 1202 which provides a special capital gain rule for individuals who dispose of qualified small business stock at a gain after owning such stock for over five years. The benefit to the individual shareholder is that he or she may exclude 50% of the gain from income. That is, 50 percent of the gain is not subject to regular tax. However, the individual may owe alternative minimum tax (AMT) on part of the excluded gain, depending on their particular tax picture. There are many restrictions on what constitutes qualified small business stock and the definition is different from the small business stock rule of 1244 discussed above.

    The major requirements and restrictions on the definition of qualified small business stock are listed below:

    • the benefit only applies to non-corporate shareholders, such as individuals

    • the stock must have been held for over 5 years

    • the shareholder must have acquired the stock directly from the qualified small business in exchange for money or other property, or as compensation for services

    • the stock must be originally issued after August 10, 1993

    • the corporation must be an "active business" meaning that generally, 80 percent of the corporations assets (measured by value) must be used in the active conduct of a qualified trade or business. A qualified trade or business is generally one involved in manufacturing or sales of goods. Several businesses are specifically excluded from the definition. Excluded businesses include corporations that provide services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other business where the main asset is the reputation or skill of one or more employees; banking; insurance; investing; farming; hotels and motels; and restaurants. Thus, if an individual bought stock from a corporation in the hotel business, such stock would not be qualified small business stock and the 50% gain exclusion rule would not apply to that individual. However, if the corporation instead manufactured semiconductor chips, and the stock was acquired from the corporation after August 10, 1993, the stock would be qualified small business stock, assuming all other requirements of 1202 were satisfied.

    • the corporation's aggregate gross assets must not exceed $50 million at any time after August 10, 1993 and before the issuance of the stock

  • Question #15 - Although corporations are not eligible for the 50% gain exclusion rule of 1202, could 1202 still be viewed as a rule favorable to certain corporations? Explain.

     

     

    7) Procedural Matters

    8) First year tax concerns - some of the items the corporation must consider in its first year of operation are listed below. The rules necessary to be able to analyze some of these questions are beyond the scope of an introductory tax text. They are provided here to illustrate the number and importance of these first year concerns.

    Summary

    Obviously, a corporation and its shareholders have a lot of rules to consider in the formation of a corporation. In addition to the tax rules that apply to the shareholder contributions to the corporation in exchange for corporate stock, the parties must also consider longer term effects such as the shareholder's estate planning, the potential application of 1244 and/or 1202 to the shareholders, and typical concerns of any new business as to selection of accounting methods and the accounting period. Future chapters will cover the tax treatment of corporate distributions to shareholders, including liquidation of a corporation; and reorganization of a corporation such as through a merger with another corporation.

     


    Exercises

    1. Upon formation of M Corporation, Ms. I contributes the following assets to become the sole shareholder:

     
  • Asset

  • Adjusted basis to Ms. I

  • FMV

  •  
  • Cash
  • $20,000

  • $20,000

  •  
  • Computer equipment
  • $10,000

  • $8,000

  •  
  • Building
  • $80,000

  • $100,000

  •  
  • Land
  • $50,000

  • $140,000

  • a. What is the tax effect to shareholder I in the above exchange?

    b. What is the tax effect to new Corporation M in the above exchange?

    c. What is I's basis in the Corporation M stock she receives?

    d. What is M's basis in the assets it receives?

    e. What would be the change in the tax effect and stock basis to I if there were a $10,000 mortgage on the building which M Corporation assumed?

    2. Why is the IRS concerned with thin capitalization of a corporation and what can a corporation and its shareholders do to prevent the IRS from successfully challenging a corporation's debt/equity mix as being too thin on equity, assuming the shareholders do want to loan some amount of money to the corporation?

    3. What must a business do in your state in order to form a corporation? Where would you obtain this information? Be specific.

    4. What must a business do in your city and county to be able to form a business? Where would you obtain this information?

     


    Answers to Chapter Questions

    Question #2:

    Question #3:

  • • S has a realized gain of $172,000, assuming the corporate stock she received is worth $272,000

    • S has a recognized gain of $0 because she meets the control requirement of 351(a) - that is, after the exchange, those shareholders that transferred property into the corporation own 80% or more of the corporation (they are in control of it)

  • Question #6:

  • 358(a) provides the following formula:
  • Adjusted basis of property contributed
  • $100,000

  • less: FMV of other property rec'd by the s/h
  • -0-

  • less: cash rec'd by the s/h
  • -0-

  • less: loss recognized by the s/h
  • -0-

  • plus: amount treated as a dividend
  • -0-

  • plus: gain recognized by s/h
  • -0-

  • basis of stock received
  • $100,000

  • Question #8:

  • • 351 would not apply because R did not contribute property (services are not considered property) and S who did contribute property is not in control of the corporation after the exchange as she only owns 70%

    • S's realized gain would be recognized, it could not be deferred

    • R would have ordinary income equal to the value of his services (value of the stock received)

    • the remedy would be to have R also transfer in some property of value. Then when viewing the group that did transfer in property to see if they are in control afterwards, R would be included in that group and the 80% control requirement would be satisfied and S would be able to defer her realized gain

  • Question #10: per 357(a), there is still no recognized gain or loss to S

    Question #11: in computing stock basis under the 358 formula, S is treated as having no recognized gain, but per 358(d), the debt assumption is treated as if she received $20,000 of cash

    Adjusted basis of property exchanged
  • $100,000

  • less: FMV of other property rec'd by the s/h
  • -0-

  • less: cash rec'd by the s/h
  • ($20,000)

  • less: loss recognized by the s/h
  • -0-

  • plus: amount treated as a dividend
  • -0-

  • plus: gain recognized by s/h
  • -0-

  • basis of stock received
  • $80,000

  • • the $80,000 stock basis will postpone the $20,000 debt relief income

    Question #12:

    NO - 357(c) generally provides that the excess of the liabilities assumed in the 351 exchange over the basis of the assets transferred by the shareholder is treated as a gain to the shareholder, as if they had sold the property. That gain recognized would then go into the 358 basis determination leaving the shareholder with a $0 basis in the stock they received.

    For example, assume S had a $150,000 mortgage on the building and land (FMV $200,000) which the corporation assumed. Under 357(c), S would have a $50,000 gain (excess of liability assumed $150,000 over basis of assets transferred $100,000). Under 358, stock basis would be $100,000 basis of assets transferred, less $150,000 money received, plus $50,000 gain recognized, for a basis of $0

    Question #13:

    Question #15: Yes - 1202 should provide new corporations with a new incentive in the selling of their stock in that non-corporate shareholders will obtain a tax benefit if the stock is held over 5 years, sold at a gain and the corporation meets the qualified trade or business and active business requirements.