Solution Manual for Prentice Halls Federal Taxation 2016

Corporations Partnerships Estates and Trusts 29th Edition Pope

Rupert Anderson 0134105850 9780134105857
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Chapter C:2

Corporate Formations and Capital Structure

Discussion Questions

C:2-1 Various. A new business can be conducted as a sole proprietorship, partnership, C

corporation, S corporation, LLC, or LLP. Each form has tax and nontax advantages and
disadvantages. See pages C:2-2 through C:2-8 for a listing of the tax advantages and disadvantages
of each form. A comparison of the C corporation, S corporation, and partnership alternative
business forms appears in Appendix F. pp. C:2-2 through C:2-8.

C:2-2 Alice and Bill should consider forming a corporation and making an S corporation
election. An S corporation election will permit the losses incurred during the first few years to be
passed through to Alice and Bill and be used to offset income from other sources. The corporate
form affords them limited liability. As an alternative to incorporating, Alice and Bill might
consider setting up a limited liability company that is taxed as a partnership and also has limited
liability. pp. C:2-6 through C:2-8.

C:2-3 Yes, several alternative classifications. The only default tax classification for the LLC is a
partnership. Because the LLC has two owners, it cannot be taxed as a sole proprietorship. The
entity can elect to be taxed as a C corporation or an S corporation. If the entity makes such an
election, Sec. 351 applies to the deemed corporate formation. The entity would have to make a
separate election to be treated as an S corporation. pp. C:2-8 and C:2-9.

C:2-4 The default tax classification for White Corporation is a C corporation. However, White can
be treated as an S corporation if it makes the necessary election. Following an S corporation
election, the entity’s income will be taxed to its owners, thereby avoiding double taxation. The S
corporation election is made by filing Form 2553 within the first 2½ months of the corporation’s
existence (see Chapter C:11). pp. C:2-6 and C:2-7.
C:2-5 The only default tax classification for the LLC is a sole proprietorship. Because the LLC
has only a single owner, it cannot be treated as a partnership. Thus, the default classification is a
“disregarded entity” taxed as a sole proprietorship. The entity can elect to be taxed as a C
corporation or an S corporation. If the entity makes such an election, Sec. 351 applies to the
deemed corporate formation. pp. C:2-8 and C:2-9.
C:2-6 Possible arguments include:

PRO (Corporate formations should be taxable events):

1. A corporate formation is an exchange transaction; therefore, parties to the exchange
should recognize gains and losses.
2. Making a corporate formation a taxable event increases tax revenues.
3. Simplification is achieved by eliminating one of the two options - whether a transaction is
taxable or not. This change will make administration of the tax laws easier.

Copyright © 2016 Pearson Education, Inc.

C:2-1
4. This change eliminates the need for taxpayers to structure transactions to avoid Sec. 351
to recognize gains and/or losses.
CON (No change should occur to current law):
1. A change in current law would hurt start-up corporations by reducing their capital
through the income tax paid by transferors on an asset transfer.
2. No economic gains or losses are realized. Just a change in the form of ownership (direct
vs. indirect) has occurred. Therefore, it is not appropriate to recognize gains and losses at
this time.
3. With taxation, corporations will have to raise more capital because transferors of noncash
property will have less capital to invest and because money must be diverted to pay taxes.
4. Taxpayers are prevented from recognizing losses under the current system, thereby
increasing revenues to the government.
5. With taxation, businesses would be deterred from incorporating because of the tax
consequences, and therefore economic growth in the U.S. would be adversely affected.
pp. C:2-9 and C:2-10.
C:2-7 The following tax consequences, if Sec. 351 applies: Neither the transferor nor the transferee
corporation recognizes gain or loss when property is exchanged for stock. Unless boot property (i.e.,
property other than qualified stock) is received, the transferor’s realized gain or loss is deferred until
he or she sells or exchanges the stock received. If boot property is received, the recognized gain is
the lesser of (1) the amount of money plus the FMV of the nonmoney boot property received or
(2) the realized gain. The transferor recognizes no losses even if boot property is received. The
transferor’s basis in the stock received references his or her basis in the property transferred and
is increased by any gain recognized and is reduced by the amount of money plus the FMV of the
nonmoney boot property received and the amount of any liabilities assumed by the transferee
corporation. The basis of the boot property is its FMV. The transferee corporation recognizes no
gain on the transfer. The transferee corporation’s basis in the property received is the same basis
that the transferor had in the property transferred increased by any gain recognized by the
transferor. pp. C:2-12, C:2-16, and C:2-17.

C:2-8 For purposes of Sec. 351, the following items are considered to be property: Money and
almost any other kind of tangible or intangible property, including installment obligations,
accounts receivable, inventory, equipment, patents, trademarks, trade names, and computer
software. Property does not include services, an indebtedness of the transferee corporation that is
not evidenced by a security, or interest on an indebtedness that accrued on or after the beginning
of the transferor’s holding period for the debt. pp. C:2-12 and C:2-13.
C:2-9 “Control” is defined as follows: Transferrers as a group must own at least 80% of the total
combined voting power of all classes of stock entitled to vote and at least 80% of the total
number of shares of all other classes of stock. The nonvoting stock ownership is tested on a
class-by-class basis. pp. C:2-13 through C:2-16.
C:2-10 The IRS has interpreted the phrase as follows: Sec. 351 requires the transferors to control the
transferee corporation immediately after the exchange but does not specify how long this control
must be maintained. The transferors, however, must not have a prearranged plan to dispose of their

Copyright © 2016 Pearson Education, Inc.

C:2-2
stock outside the control group. If they have such a plan, the IRS may not treat the transferors as
in control immediately after the exchange. p. C:2-16.

C:2-11 No. The Sec. 351 requirements are not met because Peter is not considered a transferor of
property. Even though he transferred $1,000 of money, this property is of nominal value--less
than 10% of the value of the stock he received for services ($49,000). Therefore, only John and
Mary are deemed to have transferred property and, since they own only 66 -2/3% of the stock of
New Corporation, they are not in control. The 10% minimum is specified in Rev. Proc. 77-37
and applies only for advance ruling purposes. The shareholders may choose to engage in the
transaction without an advance ruling, report it as nontaxable, and run the risk of being audited,
with the result that the IRS treats the transaction as taxable. Alternatively, they might restructure
the transaction by having Peter provide a larger amount of cash to the corporation and take more
shares of stock. Another option would be for Peter to provide fewer services with the increased
amount of cash and still receive 100 shares of stock. pp. C:2-14 and C:2-15.

C:2-12 No. Section 351 does not require that the shareholders receive stock equal in value to the
property transferred. Section 351 would apply to the transfer by Susan and Fred if all other
requirements are met. However, Fred probably will be deemed to have made a gift of 25 shares
of stock, paid compensation of $25,000, or repaid a $25,000 debt to Susan by transferring the
Spade stock. pp. C:2-15 and C:2-16.

C:2-13 Yes. Section 351 applies to property transfers to an existing corporation. For the exchange to
be tax-free, the transferors must be in control of the corporation immediately after the exchange. In this
example, Carl is not in control since he owns only 75 out of 125 shares, or 60% of the North stock.
Therefore, the Sec. 351 requirements are not met. To qualify under Sec. 351, Carl can transfer enough
property to acquire a total of 200 shares out of 250 (200 shares held by Carl and
50 shares held by Lynn) outstanding shares. In this situation, Carl would own exactly 80% of
North stock (250 shares x 0.80 = 200 shares). A less expensive alternative would be for Lynn to
transfer property equal to or exceeding $10,000 (50 shares owned x $2,000 per share x 10%
minimum) to be considered a transferor. pp. C:2-14 and C:2-15.

C:2-14 The transferor’s basis in stock received in a Sec. 351 exchange is determined as follows
(Sec. 358(a)):

Adjusted basis of property transferred to the corporation

Plus: Any gain recognized by the transferor
Minus: FMV of boot received from the corporation
Money received from the corporation
The amount of any liabilities assumed by the
transferee corporation
Adjusted basis of stock received

For purposes of calculating stock basis, liabilities assumed by the transferee corporation are
considered money and reduce the shareholder’s basis in any stock received (Sec. 358(d)).

Copyright © 2016 Pearson Education, Inc.

C:2-3
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 Transcriber’s Notes
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