Corporate Formation and Capitalization


Tax Consequences  Alternative #3

1. No gain or loss is recognized by the partners on the transfer of their partnership interests to the corporation for its stock (§351).

2. On the transfer of the partnership interests to the corporation, the partnership terminates under §708(b)(1)(A).

3. Under §358(a), the partners’ basis in the stock received from the corporation equals the basis of their partnership interests reduced by the corporation’s assumption of liabilities of the partnership (for each partner, $1,000,000 minus $500,000 = $500,000).

4. The assumption of the liabilities is treated as a payment of money to the partners under §752(d) and §358(d).

5. The corporation’s basis in the assets received equals the basis of the partners (allocated under §732(c)) in their partnership interests ($1,000,000 +$1,000,000 = $2,000,000).

a requirement of § 351 of the Internal Revenue Code

Accounts Receivable

Accounts receivable should be transferred to the corporation. However, accounts payable may be retained by the contributor or assigned to the corporation, depending on the particular tax situation. If a taxpayer elects to transfer the accounts payable to the corporation, be certain that such accounts payable represent, an ordinary and necessary business expense to the corporation. Otherwise,

the corporation may lose the deduction and the payables may be treated as a part of the acquisition cost (i.e. a capital item which must be amortized). The other edge of this sword is that the shareholders’ cannot individually deduct an expense paid by the corporation. Therefore, taxpayers lose out all the way around.

The Advantages of General Partnerships

Continuing Partnership

Finally, if a taxpayer wants to create a new corporation, but continue to exist as a partnership as well, be sure to look at R.R. 80-198 before playing games with the accounts receivable and accounts payable. If you’re not careful, accounts receivable that have been transferred to the new corporation may be taxed to the partnership when they are paid under the assignment of income principles.

Section 1244 Stock

Perhaps the most frequently overlooked benefit of incorporation is §1244 stock. Shareholders should be advised that if their investment becomes worthless, their loss will generally be treated as a capital loss (§165(g)). Section 1244 allows an original shareholder’s loss to be treated as an ordinary loss.

An individual (not including a trust or estate) can deduct, as an ordinary loss, a loss on the sale, exchange, or worthlessness of small business stock. This ordinary loss is reported on Form 4797. The gain on this stock, however, is a capital gain if the stock is a capital asset and is reported on Schedule D, Form 1040 (Reg.§1.1244(a)-1; Reg. §1.1244(b)-1).

Maximum Ordinary Loss

The deductible ordinary loss on this stock is limited to $50,000. On a joint return, the limit is $100,000 even if only one spouse has this type of loss. Thus, if the loss is $110,000 and the taxpayer’s spouse has this type of loss, the taxpayer may deduct $100,000 on a joint return. The excess of $10,000 is a capital loss (Reg.§1.1244(b)-1).

Note: Do not offset the gains against the losses that are within the ordinary loss limits, even if the transactions are in stock of the same corporation.

How to Capitalize an LLC

Original Issuance

The stock must be issued to the individual taking the loss. The ordinary loss deduction is available only to the original owner of this stock. To claim a deductible loss on stock issued to a partnership, a taxpayer must have been a partner when the stock was issued and remain so until the time of the loss. Partners add their distributive share of the partnership loss to any individual loss they may have on the stock before applying the deduction limitation (Reg. §1.1244(a)-1(b)).

Distributed Stock

If the partnership distributes the stock to the partners, the partners will not be able to treat a stock loss as an ordinary loss (Reg. §1.1244(a)-1(b))  Distribution Stock

General Requirements

The following requirements must be met to qualify as §1244 stock:

(1) The stock four must have been issued for money or other property and not for stock or securities (§1244(c)(1)(B));

(2) The stock must be in a domestic corporation (§1244(c)(1));

(3) For five years before the date of the loss, the corporation must have been primarily an active 5 trade or business (§1244(c)(1)(C)); and

(4) At the time of the stock issuance, the total amount paid in for stock can exceed $1,000,000 (§1244(c)(1)(A)).

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