Module 6Entity Formation

and Start-up

Module Topics

Transferring assets to a business: general concepts

Creating the corporate capital structure Other transfers to corporations Organization costs and start-up expenses Accountant's role in business formation

Transferring Assets to a New Business

Key Learning Objectives Tax implications of transferring assets

Sole proprietorship

Corporation

Partnership

Sole Proprietorship

Proprietor and business are one entity Need business license Employer Identification Number

Payroll taxesPayroll taxes See Module 26 for full discussion

Corporation--Formation Tax Free if §351 Applies

GENERAL RULE: No gain or loss recognized by the transferor shareholder Transfer of propertyTransfer of property In exchange for stockIn exchange for stock 80% control after transfer80% control after transfer

Gain Recognition Exception

(No Exceptions for Losses)(No Exceptions for Losses) Stock received for services performed Always income to shareholderAlways income to shareholder If stock for property and services, count both for If stock for property and services, count both for

controlcontrol Boot received

Liabilities assumed are not boot (see next slide)Liabilities assumed are not boot (see next slide) If boot, recognized gain is lesser of

Boot received orBoot received or Realized gainRealized gain

Gain Recognition Exception

(No Exceptions for Losses)(No Exceptions for Losses) Liabilities assumed by corporation

IF>basis of properties

transferred inUse aggregate amounts

If cash basis Accounts payable not liabilitiesAccounts payable not liabilities

Shareholder's Basis inStock Received

Substituted basis

Basis of property transferred in

Plus any gain recognized

Minus any boot/money received Liabilities assumed are treated as money Liabilities assumed are treated as money

herehere

Corporation's Basis in Property Received

Basis of property transferred in Plus any shareholder gain recognized

Compliance Query:Services Transferred for Stock

Taxpayer transferred services for 10 shares of stock valued at $10,000

Calculate:

Gain realized

Gain recognized

Basis in the corporate stock

Compliance Query (con’t): Services Transferred for Stock

What is Corp’s basis in the services? How should the corporation account for the

services rendered if

(1) the services were for installing equipment?(1) the services were for installing equipment? (2) the services were for preparing the (2) the services were for preparing the

corporation’s corporation’s chart of accounts? chart of accounts?

Solution--Compliance Query:Services Transferred for Stock

Services are not "property" for §351. Realize/recognize 10,000 ordinary gain Payment is subject to either FICA or self-

employment taxes

Solution--Compliance Query: Services Transferred for Stock Shareholder’s basis in stock = 10,000

CALCULATION

Basis of property transferred in 0

Gain recognized 10,000

Boot received 0

Stock basis 10,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction

Corp’s basis in services = 10,000

CALCULATION

Basis of property transferred to corporation 0

Gain recognized 10,000

Stock basis 10,000

Solution--Compliance Query:Services Transferred for Stock

Services for installing equipment Capitalize as part of the equipment's basis and Capitalize as part of the equipment's basis and

depreciate over useful lifedepreciate over useful life Services for creating chart of accounts

Capitalize as an organization costCapitalize as an organization cost Amortize it over a period of not less than 60 Amortize it over a period of not less than 60

monthsmonths

Holding Periods in §351 Transfer

Shareholder’s in stock determined by type Shareholder’s in stock determined by type of property transferredof property transferred If §1221 or §1231 = carryoverIf §1221 or §1231 = carryover Otherwise, starts day after transferOtherwise, starts day after transfer

Corporation always gets carryoverCorporation always gets carryover

Compliance Query: Inventory Transferred in a §351

Transaction

Taxpayer transferred inventory for 50 shares of stock and $6,000 in cash

Basis to Transferor Fair Market Value $48,000 $56,000

Calculate:

Gain or loss realized/recognized

Basis/holding period in the corporate stock

Corp’s basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred in a §351 Transaction

Realized gain is 8,000 56,000 - 48,00056,000 - 48,000

Recognized gain = 6,000 Gain is recognized to the extent of boot Gain is recognized to the extent of boot

received, but never more than the received, but never more than the realized gain.realized gain.

6,000 of boot was received6,000 of boot was received

Solution--Compliance Query: Inventory Transferred in a §351 Transaction

Shareholder’s basis in stock = 48,000

CALCULATION

Basis of property transferred to corporation 48,000

Gain recognized 6,000

Boot received <6,000>

Stock basis 48,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction

Corp’s basis in inventory = 56,000

CALCULATION

Basis of property transferred to corporation 48,000

Gain recognized 6,000

Stock basis 56,000

Solution--Compliance Query: Inventory Transferred in a §351 Transaction

Shareholder’s holding periodShareholder’s holding period Starts day after transferStarts day after transfer Inventory in not §1221 or §1231Inventory in not §1221 or §1231

Corp’s holding period is carryover, but Corp’s holding period is carryover, but since inventory is ordinary income asset, since inventory is ordinary income asset, gain will be ordinary regardless of holding gain will be ordinary regardless of holding periodperiod

General Rule: Partnership Formation

No gain or loss is recognized when property is contributed in exchange for a partnership interest By a partner By a partner Or the partnership Or the partnership

No 80% control test No limits on type of property

Partnership Formation: Gain Recognition Exceptions

Services performed Capital vs. Profits interest received Liabilities assumed by the other partners in

excess of partner's (adjusted) basis Investment companies Disguised sales No loss exceptions

Partner's Original Partnership Interest Basis

Cash contributed + basis of non-cash assets contributed

No adjustment for any liabilities > basis No adjustment for any liabilities > basis

+ other partners' liabilities assumed - liabilities assumed by other partners + any service gain recognized + any investment company gain

Partnership's Basis in Contributed Assets

Carryover basis for assets transferred Add any investment company gain

recognized by partner No adjustment for liabilities > basis gain

recognized Depreciation recapture potential and

holding periods also carryover

Holding Periods in Partnership Transfer

Partner’s in partnership interest is Partner’s in partnership interest is determined by type of property transferreddetermined by type of property transferred If §1221 or §1231 = carryoverIf §1221 or §1231 = carryover Otherwise, starts day after transferOtherwise, starts day after transfer

Partnership gets carryover Partnership gets carryover

Tax Avoidance Rules

5-year character rule for Inventory Inventory Capital loss propertyCapital loss property

Prevents partnership from converting use of property to avoid Inventory--ordinary income treatmentInventory--ordinary income treatment Capital loss--limitations on loss deductionsCapital loss--limitations on loss deductions

Compliance Query: Inventory Transferred To A Partnership

Taxpayer transferred inventory for 50% interest in a partnership and $6,000 in cash

Basis to Transferor Fair Market Value $48,000 $56,000

Calculate:

Gain or loss realized/recognized by partner

Basis/holding period in partnership interest

P’ship’s basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred To A Partnership

Realized/recognized gain is 0 Partner does not recognized gain on transfer

to a partnership unless money/debt relief is more than adjusted basis of property transferred to partnership

Solution--Compliance Query: Inventory Transferred To A Partnership

Shareholder’s basis in partnership = 42,000

CALCULATION

Basis of property transferred to partnership 48,000

Money/debt relief <6,000>

Partnership basis 42,000

Solution--Compliance Query: Inventory Transferred To A Partnership

Partnership’s basis in inventory = 48,000

CALCULATION

Basis of property transferred to partnership 48,000

Investment gain recognized N/A

Partnership’s basis 48,000

Solution--Compliance Query: Inventory Transferred To A Partnership

Partner’s holding periodPartner’s holding period Starts day after transferStarts day after transfer Inventory is not §1221 or §1231Inventory is not §1221 or §1231

Partnership’s holding period is carryover, Partnership’s holding period is carryover, but inventory must retain its character as an but inventory must retain its character as an ordinary income asset for 5 yearsordinary income asset for 5 years

Choice of Corporate Capital Choice of Corporate Capital StructureStructure

Key Learning Objectives Debt vs. equity

Choice of Capital Structure

StockStock

CommonCommon

PreferredPreferred DebtDebt

Debt to equity ratio importantDebt to equity ratio important

Debt issued at transfer treated as bootDebt issued at transfer treated as boot

StockGeneral Rules

§351 may apply Dividend payments are not deductible by

corporation Corporation does not have to repay equity

capital invested Stockholder has capital loss if stock becomes

worthless or is sold at a loss Unless it is §1244 stockUnless it is §1244 stock

Debt General Rules

Interest payments are deductible by corporation

Corporation must also repay principal Holder of debt has a capital loss if debt

becomes worthless or is sold at a loss Outside creditors may not like high debt to

equity ratio

Special Topics

Key Learning Objectives

Other transfers to corporations Related party transactions—§267 Losses on §1244 stock

Other Transfers to Corporations

Contributions without consideration Surrendering shares Contributions by nonshareholders Generally treated as nontaxable events

Related Party Transactions--§267

Related parties include Spouse, sibling, ancestor, descendant More than 50% owned corporations Other complex relationships

Related Party Transactions--§267

Disallowed property transaction losses Gain offset provision Unpaid expenses

Accrual basis payor deducts when cash basis Accrual basis payor deducts when cash basis payee includes in incomepayee includes in income

Related Party Transactions--§707

Applies many of §267 rules to partners and partnerships

More than 50% owned partnerships

Losses on §1244 Stock

Only first million $ of stock qualifies Only original stockholders eligible Owned by individuals, but not trusts/estates Ordinary loss treatment Limited to $50,000

$100,000 married joint$100,000 married joint

Capital Costs Incurred in Organizing a Business Entity

Key Learning Objectives

Organizational and start-up costs Deducting organizational and start-up costs Syndication costs

Organizational and Start-up Expenditures

Qualifying expenses Election Amortization Distinguish from syndication

costs

Qualifying Expenses Organizational Costs

§248 & §709 All expenses paid in creating a

business entity Expenses for drafting documents

Organizational minutes, articles, partnership Organizational minutes, articles, partnership agreements bylaws, and stock certificatesagreements bylaws, and stock certificates

Qualifying Expenses Start-up Costs--§195

All expenses incurred before beginning operations Includes investigating creation or acquisitionIncludes investigating creation or acquisition

Does not include Does not include InterestInterest TaxesTaxes Research and experimental expendituresResearch and experimental expenditures

Election and AmortizationOrganization and Start-Up Costs

Separate elections are required Election to amortize over 60 months Starting with month

Business begins--§248Business begins--§248 Active trade or business begins--§195Active trade or business begins--§195

Untimely election will be denied

Research Query:When Does Business Begin?

§248 & §709 allow amortization to start in §248 & §709 allow amortization to start in month business beginsmonth business begins

§195 allows amortization to start in month §195 allows amortization to start in month active trade or business beginsactive trade or business begins

Are these the same month?Are these the same month? Hint: Hint:

IRS Letter Rulings 9027002 & 9047032IRS Letter Rulings 9027002 & 9047032

Solution-- Research Query:When Does Business Begin?

The amortization deduction begins when The amortization deduction begins when activities have advanced to the extent activities have advanced to the extent necessary to establish the nature of the necessary to establish the nature of the business operation business operation

For start-up expenditures, the IRS follows For start-up expenditures, the IRS follows the standard of carrying on a trade or the standard of carrying on a trade or business found at §162(a) in determining business found at §162(a) in determining when a trade or business beginswhen a trade or business begins

Syndication Costs--Corporations

The costs paid to issue stock Underwriter's commissionsUnderwriter's commissions Attorney's feesAttorney's fees Printing of stock certificatesPrinting of stock certificates

Must be deducted from cost of stock.

Syndication Costs--Partnerships

Partnership interest sold as investment Includes

Printing feesPrinting fees Brokerage commissionsBrokerage commissions Mailing expensesMailing expenses

Must reduce basis in partnership interest by these amounts

Services Accounting Professionals Provide

Key Learning Objectives

Identifying the important filings Other tax and accounting

assistance