Ch 2 Flashcards
A sole proprietorship is not a separate legal entity but…
A legal extension of its individual owner
5 business forms
1 sole proprietorship 2 partnership 3 corporation 4 limited liability company 5 limited liability partnership
5 Tax advantages: sole proprietorship
1 not subject to taxation as separate entity
2 marginal tax rate may be lower than that of corporation
3 contribute/withdraw cash/property from business w/out tax consequence
4 money belongs to owner
5 business losses can offset nonbusiness income (int., dividends)
Tax disadvantages: sole proprietor 6
1 profits taxed to owner whether or not withdrawn from business
2 corporate tax rates at times are lower
3 must pay full social security taxes b/c not employee of business
4 may not deduct compensation paid to owner employees
5 tax-exempt benefits (group life insurance not available)
6 can’t defer income using fiscal year
Partnership
Unincorporated business carried on by 2 or more individuals
Or entities for profit
Tax reporting but not tax paying entity
Sole proprietorship
Unincorporated business owned by one individual
Limited partnership contains
At least one general partner and one limited partner
General partners
Liable for all partnership debts
Can assume managerial rule in partnership
Limited partners
Only liable to extent of capital investment in partnership
Can’t assume managerial rule in partnership
Tax advantages: partnerships 5
1 partnership pays not tax, (no double taxation)
2 partners tax rate may be lower than corporation’ sat same level
Of taxable income
3 usually no additional taxes for withdrawing money or property
From partnership
4 can use losses to offset income from other sources
5 partner’s basis in partnership increased by his share of partnership
Tax disadvantages: partnership 5
1 partnership’s profits taxed to partners when earned, even if
Not distributed
2 partners tax rate could be higher than corporations even at
Same income level
3 partners must pay self employment taxes
4 don’t qualify for many fringe benefits
5 can’t defer income by choosing fiscal year
S Corporation
Earnings are accounted for at the corporate level, but taxed only
At the shareholder level
Special rules governing tax treatment found in sub hater as of IRC
C corporation
Separate entity taxed on its income at rates ranging from 15% to 39%
Tax advantages: C corporations 6
1 corporations marginal tax rates may be lower than owner’s
Marginal tax rates
2 shareholders employed are only liable for half their social
Security taxes
3 shareholder employees entitled to no taxable fringe benefits
4 entitled to ordinary and business deductions
5 can use fiscal year to defer income
6 special rules allow shareholder to exclude 50% of gain realized
On sale or exchange of stock held over 5 years if certain
requirements are met
Tax disadvantages: C corporations 4
1 double taxation
2 shareholders can’t withdraw money from corporation without
Recognizing income
3 no tax benefit from NOL in year incurred
4 capital losses can’t offset ordinary income
Tax Advantages: S Corporations 6
1 pay no tax, flows through to shareholders who are taxed
2 shareholders marginal tax rates may be lower than C corporations
3 losses flow through and may be used to offset other sources
Of income
4 can offset gains from capital losses against other sources and
Taxed at capital gains rate on capital gains
5 can contribute or withdraw money without recognizing gain
6 basis in S corporation stock is increased by shareholder’s
share of corporate income, basis adjustment reduces shareholder’s
Gain and avoids double taxation
Tax Disadvantages: S Corporation 5
1 shareholders taxed on all current year profits whether distributed
Or not
2 marginal tax rate may be higher than C corporation
3 non taxable fringe benefits generally not available
4 share holder employees and employers only pay half of
Social security taxes
5 can’t defer income with fiscal year
What can an LLC or LLP elect to be taxed as?
Either a corporation or as a partnership
Liability under LLP
Partners are liable for their own acts and omissions as well
As individuals under their direction
Partners aren’t liable for negligence and misconduct of other
Partners
What is an LLC analogous to?
Analogous to an LLP with no general partners
Check-the-box regulations
Incorporated business’s with 2 or more owners is treated by
Default as a partnership for tax purposes
Unless it elects to be taxed as a corporation
4 general legal requirements for forming a corporation
1 investing minimum amount of capital
2 filing articles of incorporation
3 issuing stock
4 paying state incorporation fees
If section 351 applies to formation of corporation than…
Any gain or loss realized on the exchange may be deferred
Section 351: transferors recognize no gain or loss
No gain or loss recognized by transferors when the transfer
Property to corporation solely in exchange for corp’s stock
Provided immediately after exchange transferors are in control
Basis when exchanging stock for property under section 351
2 calculations
Stock basis =
(basis of property transferred) - (liabilities assumed by corporation)
Stock basis = FMV of qualified stock received - deferred gain/loss
Section 351: 3 requirements for deferral of gain/loss
1 transferors must transfer property to corporation
2 transferors must receive stock of transferee corporation in
Exchange for their property
3 transferors must immediately control corporation after exchange
What is excluded from property in section 351, 3 things
1 services
2 indebtedness of transferee corporation not evidenced by a
Security
3 interest on transferee corporation debt accrued after beginning
Of transferor’s holding period
Section 351 control requirement
Transferors must control 80% of corporations voting stock immediately after the transfer
Is a gain realized when cash is contributed to ownership of stock?
No gain is realized when cash is contributed
Section 351 control requirement: services
Because services don’t qualify as property, stock received by
A person who exclusively provided services doesn’t count
Toward ownership
Section 351: when transferor provides both property and services in exchange for corporations stock…
What value must the property have when exchanged with services?
The stock received in exchange for services is counted towards
80% ownership
The property must be at least 10% the value of the stock
Section 351: existing corporations
Same rules that apply to newly created corporations
Property must be transferred in exchange for stock, property
Transferors must be in control of corporation immediately after
Exchange
Section 351: how can existing majority owning shareholders help smaller transferor shareholders meet the requirement for section 351
Existing majority shareholders can transfer property for additional
Stock
Must be at least 10% value of stock already owned
Section 351: immediate control after exchange 3 things
1 Exchanges must be agreed upon before hand
2 But can be executed on different days and still qualify
3 Won’t count as control if it was prearranged to immediately sell
Stock after the transfer
Section 351: preferred shares received in exchange, stock rights, stock warrants
Treated as boot
Boot
Cash, notes, securities in another corporation, non voting stock
Gain recognition of boot of transferor
Loss recognition of transferor?
Transferor recognizes gain to extent of lesser of transferor’s
Realized gain or FMV of boot property received
transferor never recognizes loss in an exchange qualifying under
Section 351 whether or not boot is received
Section 351: character of recognized gain
Depends on type of property transferred:
1 if shareholder transfers capital asset (ex. Stock of another co.)
It’s recognized as a capital gain
2 if shareholder transfers sec. 1231 property (ex. Equipment,
inventory, Building) it’s recognized as ordinary income to extent of
Depreciation recapture
Section 351: when does depreciation recapture occur?
Depreciation recapture occurs when transferor receives boot
And recognizes gain on depreciated property transferred
Section 351: Computing gains on several assets transferred
The gain and loss realized and recognized is computed separately
For each property transferred
Transferors basis in boot property
Equals FMV of boot property received
Share holders basis AKA adjusted basis of stock received equation
Shareholder’s basis =
(Adjusted basis of property transferred to corporation) + (gain recognized by transferor) - (FMV boot received from corporation and liabilities assumed by corporation)
Section 351: Basis among more than one class of qualified stock received
Basis must be allocated
Section 351: Transferor’s holding period for any stock received in exchange for a capital asset or Sec. 1231 property
Includes Holding period before transfer
Section 351: holding period for boot and inventory
Begins day after transfer
Section 351: gain or loss recognized by transferee corporation
Corporations recognize no gain or loss when they issue their
Own stock or debt in exchange for property or services
Recognize a gain but not a loss when they transfer appreciated
Property to transferor as part of Section 351 exchange
Section 351: if the corporation reduces a property’s basis to its FMV under the loss property limitation rule, what happens to the property’s holding period .
The holding period will begin the day after the exchange date
Because no part of the new basis references the transferor’s
Basis
Gene rule section 357: the transferee corporation’s assumption of liabilities in section 351 exchange, how is it treated
2 exceptions
Not treated as boot for a gain recognition
Exception 1) treated as boot when used for tax avoidance
Exception 2) treated as boot when total amount of liabilities
Assumed by transferee corporation exceeds total basis of
Property transferred
Assignment of income doctrine
Holds that income is taxable to person who earned it and it may
Not be assigned to another person for tax purposes
Expenses deductible only by party that incurred those liabilities
What does the deductibility of interest payments create an incentive for the corporation to do?
Deductibility of interest payments creates an incentive for
Corporations to incur as much debt as possible
Tax implications for dividends paid with an equity instrument of the payor corporation
Not tax deductible by the payor corporation
Section 351: transferor transfers appreciated property in exchange for the issuance of corporate debt
The debt received will be treated as boot possibly leading to
Gain recognition
Extinguishment of debt: tax treatment
Generally the retirement of debt is not a taxable event
Tax advantages: debt in corporation’s capital structure 2
1 corporation can deduct interest paid on debt obligation
2 shareholders don’t recognize income in debt retirement as
They would in stock redemption
Tax disadvantages: using debt in corporation’s capital structure 2
1 when shareholder makes capital contribution and receives
Debt instrument it is treated as boot (taxable if a gain)
2 if debt becomes worthless, it’s treated as a capital loss,
not as an ordinary loss
Tax advantages: using equity in corporation’s capital structure 6
1 70%, 80%, or 100% dividends received deduction available
To corporate shareholder who receives dividends
2 can receive common/preferred stock in tax-free corporate
Formation
3 can be distributed to shareholders as dividends tax free
4 common/preferred stock that shareholder sells or exchanges
That becomes worthless is eligible for ordinary loss treatment
5 section 1202 excludes 50%-100% capital gains realized on sale
Or exchange of qualified C corporation small business stock
6 qualified dividends are taxed at capital gains rate
3 tax disadvantages: using equity in corporation’s capital structure
1 dividends aren’t deductible in corporation’s taxable income
2 redemption of common or preferred shares is generally
Taxable to shareholder’s as dividend
3 possible for dividend of preferred stock to be treated as
Ordinary income
Capital contributions by non shareholders
1 excluded from corporation’s gross income
2 given basis of $0 by IRC
3 financial accounting rules report donated capital at FMV
4 can’t take depreciation expense for tax purposes because
Basis is 0
3 instances when securities can be sold for ordinary losses
1 securities that are noncapital assets
2 affiliated corporations (own over 80% of voting stock)
3 section 1244 stock (qualifying small business)
What qualifies a stock as section 1244, 2 requirements
1 receives $1million or less for aggregate stock
2 derived more than 50% of gross receipts from a active sources of income (other than dividends, royalties, rents, interest, capital gains)
Nonbusiness bad debt
Unpaid loan not evidenced by a security
Treated less favorable than business bad debts (evidenced by
Security), deductible as short term capital losses up to $3k/yr.
Business bad debts
Deductible as ordinary losses without limitation when partially
Or totally worthless
Loans from shareholder to corporation in connection with stock investment, how are they treated?
Generally Treated as nonbusiness loan
Business loan if protects employment, so depends on nature
of loan
Recognizing losses on corporate transfers, when basis exceeds fair value
1 have transferors own less than 80% of company
2 no shareholder can own over 50% of company
