Module 6Entity Formation and Start-up

Module TopicsTransferring assets to a business: general conceptsCreating the corporate capital structureOther transfers to corporations Organization costs and start-up expensesAccountant's role in business formation

Transferring Assets to a New Business Key Learning ObjectivesTax implications of transferring assets Sole proprietorshipCorporationPartnership

Sole ProprietorshipProprietor and business are one entityNeed business licenseEmployer Identification Number Payroll taxesSee Module 26 for full discussion

Corporation--Formation Tax Free if 351 AppliesGENERAL RULE:No gain or loss recognized by the transferor shareholderTransfer of propertyIn exchange for stock80% control after transfer

Gain Recognition Exception(No Exceptions for Losses)Stock received for services performedAlways income to shareholderIf stock for property and services, count both for controlBoot received Liabilities assumed are not boot (see next slide)If boot, recognized gain is lesser of Boot received orRealized gain

Gain Recognition Exception(No Exceptions for Losses)Liabilities assumed by corporation IF>basis of properties transferred inUse aggregate amountsIf cash basis Accounts payable not liabilities

Shareholder's Basis inStock ReceivedSubstituted basisBasis of property transferred inPlus any gain recognized Minus any boot/money received Liabilities assumed are treated as money here

Corporation's Basis in Property ReceivedBasis of property transferred inPlus any shareholder gain recognized

Compliance Query:Services Transferred for StockTaxpayer transferred services for 10 shares of stock valued at $10,000Calculate:Gain realizedGain recognizedBasis in the corporate stock

Compliance Query (cont): Services Transferred for StockWhat is Corps basis in the services?How should the corporation account for the services rendered if(1) the services were for installing equipment?(2) the services were for preparing the corporations chart of accounts?

Solution--Compliance Query:Services Transferred for StockServices are not "property" for 351. Realize/recognize 10,000 ordinary gainPayment is subject to either FICA or self-employment taxes

Solution--Compliance Query: Services Transferred for StockShareholders basis in stock = 10,000CALCULATION 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 TransactionCorps basis in services = 10,000CALCULATION Basis of property transferred to corporation 0 Gain recognized 10,000 Stock basis 10,000

Solution--Compliance Query:Services Transferred for StockServices for installing equipment Capitalize as part of the equipment's basis and depreciate over useful lifeServices for creating chart of accountsCapitalize as an organization costAmortize it over a period of not less than 60 months

Holding Periods in 351 TransferShareholders in stock determined by type of property transferredIf 1221 or 1231 = carryoverOtherwise, starts day after transferCorporation always gets carryover

Compliance Query: Inventory Transferred in a 351 TransactionTaxpayer 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/recognizedBasis/holding period in the corporate stockCorps basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred in a 351 TransactionRealized gain is 8,000 56,000 - 48,000Recognized gain = 6,000Gain is recognized to the extent of boot received, but never more than the realized gain.6,000 of boot was received

Solution--Compliance Query: Inventory Transferred in a 351 TransactionShareholders basis in stock = 48,000CALCULATION Basis of property transferred to corporation 48,000 Gain recognized 6,000 Boot received Stock basis 48,000

Solution--Compliance Query: Inventory Transferred in a 351 TransactionCorps basis in inventory = 56,000CALCULATION Basis of property transferred to corporation 48,000 Gain recognized 6,000 Stock basis 56,000

Solution--Compliance Query: Inventory Transferred in a 351 TransactionShareholders holding periodStarts day after transferInventory in not 1221 or 1231Corps holding period is carryover, but since inventory is ordinary income asset, gain will be ordinary regardless of holding period

General Rule: Partnership FormationNo gain or loss is recognized when property is contributed in exchange for a partnership interest By a partner Or the partnership No 80% control testNo limits on type of property

Partnership Formation: Gain Recognition ExceptionsServices performedCapital vs. Profits interest receivedLiabilities assumed by the other partners in excess of partner's (adjusted) basisInvestment companiesDisguised salesNo loss exceptions

Partner's Original Partnership Interest BasisCash contributed+ basis of non-cash assets contributedNo 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 AssetsCarryover basis for assets transferred Add any investment company gain recognized by partnerNo adjustment for liabilities > basis gain recognizedDepreciation recapture potential and holding periods also carryover

Holding Periods in Partnership TransferPartners in partnership interest is determined by type of property transferredIf 1221 or 1231 = carryoverOtherwise, starts day after transferPartnership gets carryover

Tax Avoidance Rules5-year character rule forInventory Capital loss propertyPrevents partnership from converting use of property to avoidInventory--ordinary income treatmentCapital loss--limitations on loss deductions

Compliance Query: Inventory Transferred To A PartnershipTaxpayer 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 partnerBasis/holding period in partnership interestPships basis/holding period in the inventory

Solution--Compliance Query: Inventory Transferred To A PartnershipRealized/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 PartnershipShareholders basis in partnership = 42,000CALCULATION Basis of property transferred to partnership 48,000 Money/debt relief Partnership basis 42,000

Solution--Compliance Query: Inventory Transferred To A PartnershipPartnerships basis in inventory = 48,000CALCULATION Basis of property transferred to partnership 48,000 Investment gain recognized N/A Partnerships basis 48,000

Solution--Compliance Query: Inventory Transferred To A PartnershipPartners holding periodStarts day after transferInventory is not 1221 or 1231Partnerships holding period is carryover, but inventory must retain its character as an ordinary income asset for 5 years

Choice of Corporate Capital Structure Key Learning ObjectivesDebt vs. equity

Choice of Capital StructureStockCommonPreferredDebtDebt to equity ratio importantDebt issued at transfer treated as boot

StockGeneral Rules351 may apply Dividend payments are not deductible by corporationCorporation does not have to repay equity capital investedStockholder has capital loss if stock becomes worthless or is sold at a lossUnless it is 1244 stock

Debt General RulesInterest payments are deductible by corporationCorporation must also repay principalHolder of debt has a capital loss if debt becomes worthless or is sold at a lossOutside creditors may not like high debt to equity ratio

Special Topics Key Learning ObjectivesOther transfers to corporationsRelated party transactions267 Losses on 1244 stock

Other Transfers to CorporationsContributions without considerationSurrendering sharesContributions by nonshareholdersGenerally treated as nontaxable events

Related Party Transactions--267Related parties includeSpouse, sibling, ancestor, descendantMore than 50% owned corporationsOther complex relationships

Related Party Transactions--267Disallowed property transaction lossesGain offset provisionUnpaid expensesAccrual basis payor deducts when cash basis payee includes in income

Related Party Transactions--707Applies many of 267 rules to partners and partnershipsMore than 50% owned partnerships

Losses on 1244 StockOnly first million $ of stock qualifiesOnly original stockholders eligibleOwned by individuals, but not trusts/estatesOrdinary loss treatmentLimited to $50,000 $100,000 married joint

Capital Costs Incurred in Organizing a Business Entity Key Learning Objectives

Organizational and start-up costsDeducting organizational and start-up costsSyndication costs

Organizational and Start-up ExpendituresQualifying expensesElectionAmortizationDistinguish from syndication costs

Qualifying Expenses Organizational Costs248 & 709All expenses paid in creating a business entity Expenses for drafting documentsOrganizational minutes, articles, partnership agreements bylaws, and stock certificates

Qualifying Expenses Start-up Costs--195All expenses incurred before beginning operations Includes investigating creation or acquisitionDoes not include InterestTaxesResearch and experimental expenditures

Election and AmortizationOrganization and Start-Up CostsSeparate elections are requiredElection to amortize over 60 monthsStarting with month Business begins--248Active trade or business begins--195Untimely election will be denied

Research Query:When Does Business Begin?248 & 709 allow amortization to start in month business begins195 allows amortization to start in month active trade or business beginsAre these the same month?Hint: IRS Letter Rulings 9027002 & 9047032

Solution-- Research Query:When Does Business Begin?The amortization deduction begins when activities have advanced to the extent necessary to establish the nature of the business operation For start-up expenditures, the IRS follows the standard of carrying on a trade or business found at 162(a) in determining when a trade or business begins

Syndication Costs--CorporationsThe costs paid to issue stockUnderwriter's commissionsAttorney's feesPrinting of stock certificatesMust be deducted from cost of stock.

Syndication Costs--PartnershipsPartnership interest sold as investmentIncludesPrinting feesBrokerage commissionsMailing expensesMust reduce basis in partnership interest by these amounts

Services Accounting Professionals Provide

Key Learning ObjectivesIdentifying the important filingsOther tax and accounting assistance

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