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Chapter 2: Corporate Formations and Capital Structure. Chapter 2: Corporate Formations and Capital Structure. CORPORATE FORMATION. Alternative business forms Check-the-box regulations Legal requirements for forming a corporation §351 deferrals Choice of capital structure

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Chapter 2: Corporate Formations and Capital Structure

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Chapter 2:Corporate Formationsand CapitalStructure

Chapter 2:

Corporate

Formations

and Capital

Structure


CORPORATE FORMATION

  • Alternative business forms

  • Check-the-box regulations

  • Legal requirements for forming a corporation

  • §351 deferrals

  • Choice of capital structure

  • Worthless stock or debt obligations


Forms of Business

  • Sole proprietorships

  • Partnerships

  • Corporations

    • C Corporations

    • S Corporations

  • Limited liability companies

  • Limited liability partnerships


Sole Proprietorship(1 of 2)

  • One owner

  • Not a separate entity

    • Income reported on Sch. C of 1040

  • No limited liability

  • Tax advantages

    • Profits taxed once

    • No tax on contributions or withdrawals

    • Losses offset other income (with limitations)


Sole Proprietorship(2 of 2)

  • Tax disadvantages

    • Profits taxed as earned

    • Owner not employee

      • Profits subject to SE tax

      • Not eligible for some tax-exempt fringe benefits

    • No fiscal year deferral


Partnerships(1 of 3)

  • Two or more owners

  • Conduit entity

    • Reports, but does not pay income tax

  • No limited liability

    • Except for limited partners


Partnerships(2 of 3)

  • Tax advantages

    • Losses offset other income (with limitations)

    • Income retains its character

    • Income/gain increases basis


Partnerships(3 of 3)

  • Tax disadvantages

    • Profits taxed as earned

    • Partners not employees

      • Profits subject to SE tax

      • Not eligible for some tax-exempt fringe benefits

    • Fiscal year deferral difficult to obtain


C Corporations(1 of 2)

  • Separate taxpaying entity

  • Limited liability

  • Tax advantages

    • Tax rates start at 15%

    • Shareholders may be employees

      • No SE tax

      • Eligible for tax-exempt fringe benefits

    • May exclude 50% of gain on stock sale if certain requirements met


C Corporations(2 of 2)

  • Tax disadvantages

    • Double taxation of income

      • Corporate and shareholder level

        • However, tax rate at shareholder level is at capital gains rates (generally 15%)

    • Withdrawals (dividends) taxable

    • NOLs cannot be used in current year

    • Capital losses cannot offset ordinary income


S Corporations(1 of 3)

  • Conduit entity

    • Similar to a partnership, but

    • Less flexible than a partnership

  • Must file an election to be an S corp.

  • Subject to rules under Subchapter S

    • Follows same rules as a C Corp except for specific items addressed in Subchapter S


S Corporations(2 of 3)

  • Tax advantages

    • Generally exempt from taxation

    • Losses flow through to shareholders

    • Income retains its character

    • Income/gain increases basis

    • Shareholders may be employees

      • S Corp net income not subject to SE tax


S Corporations(3 of 3)

  • Tax disadvantages

    • Profits taxed as earned

    • S Corp shareholders generally not eligible for tax-exempt fringe benefits

    • S Corp cannot choose a fiscal year to obtain income deferral


Limited Liability Companies

  • Limited liability for all owners

  • No ownership restrictions

  • May be taxed as partnership or corporation


Limited Liability Partnership

  • Partners liable for only their own actions

    • No liability for negligence or misconduct of other partners

  • May be taxed as either a partnership or corporation


Check-the-Box Regulations

  • Unincorporated entities choose to be taxed as partnership or corp

    • Sole proprietor or corp if one owner

  • Entity must choose tax status or

  • Accept default status

    • Partnership (sole proprietor if one owner)


Requirements to Incorporate

  • Dependent on state law

  • Minimum capital requirements

  • File of articles or incorporation

  • Granting of charter by state

  • Issue of stock

  • Pay state incorporation fees


§351 Deferrals(1 of 2)

  • No gain or loss recognized if:

    • PROPERTY transferred in exchange for stock and

    • Transferors have control of corp immediately after the exchange

  • Transfers may be for new or existing corporations


§351 Deferrals(2 of 2)

  • Stock requirement

  • Tax effects on transferors

  • Tax effects on transferee corp

  • Assumption of liabilities

  • See Table C2-1 for a summary of corporate formation rules


§351 Deferrals:Property Requirement

  • Property does not include:

    • Services

    • Indebtedness of transferee not evidenced by a security

    • Interest on indebtedness of transferee that accrued on or after beginning of transferor’s holding period for the debt


§351 Deferrals:Control Requirement

  • Transferors must own at least:

    • 80% of total combined voting power of all classes of stock and

    • 80% of total number of shares of all other classes of stock

  • Contribution of services & property

    • Stock of transferor counted towards 80% if FMV of property  10% of service’s value


§351 Deferrals:Tax Effects on Transferors (1 of 3)

  • General rules

    • No gain or loss recognized

    • Basis in stock same as basis in property (substituted basis)

    • Holding period of stock includes holding period of assets


§351 Deferrals:Tax Effects on Transferors (2 of 3)

  • When boot received

    • Gain recognized lesser of gain realized or FMV of boot received

      • Gain recognized when liabilities transferred exceed basis in assets transferred

    • Basis in stock increased by gain recognized


§351 Deferrals:Tax Effects on Transferors (3 of 3)

  • When boot received (continued)

    • Basis in boot property is FMV

    • Holding period of boot begins day after exchange


§351 Deferrals: Tax Effects on Transfee Corp (1 of 2)

  • No gain or loss recognized

  • Basis in property received

    • Transferor’s adjusted basis plus

    • gain recognized

    • Basis = total FMV of property transferred when basis in property transferred > FMV

      • If all s/h agree, s/h that contributed property can reduce her basis in stock instead of corp reducing basis in assets


§351 Deferrals: Tax Effects on Transfee Corp (2 of 2)

  • Depreciation recapture potential transfers to transferee corporation

  • Holding period includes transferor’s holding period

    • Holding period begins day after transfer when basis reduced to FMV


Choice of Capital Structures

Debt

Interest deductible by corp

Repayment of debt not taxable to s/h

Debt received in §351 is boot to s/h

Worthless debt is capital loss to s/h

Debt distributed by corp taxable to s/h

Equity

Dividends not deductible by corp

S/h only pays max 15% on dividends received

Stock redemption can be taxable dividend to s/h

Stock received in §351 not boot to s/h

Worthless §1244 stock is ordinary loss to s/h

Stock distributed by corp not taxable to s/h


Choice of Capital Structures:(1 of 2: Debt)

  • Interest deductible by corp

  • Repayment of debt not taxable to s/h

  • Debt received in §351 is boot to s/h

  • Worthless debt is capital loss to s/h

  • Debt distributed by corp taxable to s/h


Choice of Capital Structures:(2 of 2: Equity)

  • Dividends not deductible by corp

    • S/h only pays max 15% on div. received

  • Stock redemption can be taxable dividend to s/h

  • Stock received in §351 not boot to s/h

  • Worthless §1244 stock is ordinary loss to s/h

  • Stock distributed by corp not taxable to s/h


Worthless Stock or Debt(1 of 3)

  • Investment evidenced by a security that becomes worthless produces a capital loss on last day of tax year

  • Securities include:

    • Stock of a corporation

    • Rights to subscribe for stock to be issued

    • Evidence of indebtedness


Worthless Stock or Debt(2 of 3)

  • Ordinary Loss Situations

    • Securities that are noncapital assets

    • Securities of affiliated companies

    • §1244 stock


Worthless Stock or Debt(3 of 3)

  • §1244 stock

    • Qualifying small business stock

    • Must be the original purchaser

    • Ordinary loss up to $50k or $100k if MFJ

    • Corp must have received $1M or less of property in exchange for stock


End of Chapter 2

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’sKenneth W. Monfort College of [email protected]


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