Pen your notes in the margin!

M1.CH8.Corporate Formation & Distribution

Purpose
These notes will help you understand the major
topics/themes for taxable and non-taxable property
dispositions. To understand exceptions to the general tax
rules will require further reading and study in the text, as well
as problem solving.

Task
To use these notes effectively, you might print them and
then
 Review the outline in “chunks”—do not read in its
entirety
 Watch for the notation to “Stop Now is a good
time to practice what you’ve learned. You should
complete end-of-chapter Problem #.” This allows
you to apply the concepts you reviewed in the most
recent “chunk” of the outline.
 Read along in the text and make notes in the margin
 Highlight/underline/circle important concepts;
exceptions to the general tax rule; etc.

Corporate Formation & Distribution

Chapter Outline
1) Review of the Taxation of Property Dispositions
a) Gain or loss is realized when a person engages in a
transaction (an exchange of property rights with
another person).
b) Gain or loss realized is computed by subtracting the
transferor’s tax-adjusted basis in the property
exchanged from the amount realized in the exchange.
c) Gain or loss realized is recognized (included in the
computation of taxable income) unless exempted
or deferred by a provision of the tax laws.
d) See Exh 8-1 for Computing Gain or Loss Realized in
a Property Transaction.
e) See Exh 8-2 for Computing the Amount Realized in a
Property Transaction.
f) See Exh 8-3 for Computing a Property’s Adjusted Tax
Basis in a Property Transaction.
2) Tax-Deferred Transfers Of Property To A Corporation
a) Tax deferral only applies to transfers of property to a
corporation.
1-AFT Ch 8 Outline
 b) Gain deferred decreases the shareholder’s tax basis
in the stock to an amount equal to the stock’s fair
market value less the gain deferred.
c) Loss deferred increases the shareholder’s tax basis in
the stock to an amount equal to the stock’s fair
market value plus the loss deferred.
d) The shareholder’s tax basis in the stock received
reflects the tax basis of the property transferred.
e) The persons transferring property to a corporation
must receive solely stock in the corporation in return.
f) The persons transferring property to a corporation
must collectively control the corporation after the
transaction.
g) Transactions Subject to Tax Deferral
i) For shareholders to receive tax deferral in a
transfer of property to a corporation, either at
formation or later, the transferors must meet the
requirements of IRC §351.
h) Meeting the Section 351 Tax Deferral Requirements
i) Section 351 Applies Only to the Transfer of
Property to the Corporation
(1) Property includes money, tangible assets, and
intangible assets (for example, company name,
patents, customer lists, trademarks, and
logos).
(2) Services are excluded from the definition of
property (that is, a person who receives stock
in return for services generally has
compensation equal to the fair market value of
the stock received).
(a) IF the s/h contributes property at least 10%
of FMV of services, then the s/h’s shares
count toward the “control test.” The s/h’s
property contribution would be eligible for
tax deferral, but the services are taxed.
(3) See EX 8-1.
ii) The Property Transferred to the Corporation Must
Be Exchanged Solely for Stock of the
Corporation
(1) To receive tax deferral on the transfer, the
transferor cannot receive something other than
qualifying stock from the corporation in return
for the property transferred which is often
referred to as boot.

2-AFT Ch 8 Outline
 (2) The receipt of boot will cause the transferor
to recognize gain, but not loss, realized on
the exchange.
(3) The type of stock a shareholder can receive in
a §351 exchange is quite flexible and includes
voting or nonvoting, common or preferred
stock.
(4) Stock for purposes of §351 does not include
stock warrants, rights, or options.
(5) Property transferred in exchange for debt of
the corporation is not eligible for deferral under
§351.
(6) See EX 8-2.
iii) The Transferor(s) of Property to the Corporation
Must Be in Control, in the Aggregate, of the
Corporation Immediately after the Transfer
(1) Control is defined as ownership of 80 percent
or more of the corporation’s voting stock and
80 percent or more of each class of
nonvoting stock.
(a) NOTE: Remember 10% de minimus for
property contributed with services.
(i) Similarly, the 10% de minimus applies
for subsequent contributions when
determining whether Sec. 351 applies
(See EX 8-8).
(2) Whether the control test is met is based on the
collective ownership of the shareholders
transferring property to the corporation
immediately after the transfer.
(3) Voting power generally is defined as the ability
of the shareholders to elect members of the
corporation’s board of directors.
(4) See EX 8-3. (fail control test)
(5) See EX 8-4. (fail control test at second “what
if”)
(6) See EX 8-5. (transfer of services with property
>=10%)
i) Tax Consequences when a Shareholder Receives
no Boot (in a Section 351 Transaction)
i) The tax basis of stock received in a tax-deferred
§351 exchange equals the tax basis of the
property transferred.
ii) Most practitioners refer to the stock as having a
substituted basis (that is, the basis of the property

3-AFT Ch 8 Outline
 transferred is substituted for the basis of the
property received).
iii) See Exh 8-4 for Computing the Tax Basis of Stock
Received in a Tax-Deferred Section 351
Transaction.
iv) See EX 8-6. (property transferred subject to debt;
realized gain; stock basis)
j) Tax Consequences When a Shareholder Receives
Boot
i) A shareholder who receives property other than
stock (boot) in the transferee corporation
recognizes gain (but not loss) in an amount not to
exceed the lesser of gain realized or the fair
market value of the boot received. (NOTE:
Intuition is that you cannot recognize more gain
than is realized.)
ii) The amount of gain recognized when boot is
received in a §351 transaction must be allocated
to the property exchanged on a pro rata basis
using the relative fair market values of the
properties.
iii) The character of gain recognized (capital gain,
§1231 gain, ordinary income) is determined by the
type of property to which the boot is allocated.
(1) See EX 8-7. (see fn#16—remember the Sec.
1239 related party rule)
(2) See Exh 8-5 for Computing the Tax Basis of
Stock in a Section 351 Transaction When Boot
Is Received
(3) See EX 8-8.
k) Assumption of Shareholder Liabilities by the
Corporation
i) When an unincorporated business is incorporated
or an existing corporation creates a subsidiary, the
newly created corporation frequently assumes the
outstanding liabilities of the business. (NOTE:
See narrative related to fn #20. Liabilities that give
rise to a business deduction are not considered
“debt.” NOTE2: This is applicable only for a
CASH-METHOD taxpayer [i.e., the amount hasn’t
been paid yet and therefore not deducted for tax
yet] {OR for payment liabilities (pp. 1-24 to1-26)
which are the equivalent of a cash-method
taxpayer}.)
ii) An important tax issue is whether the assumption
of these liabilities by the newly created corporation
4-AFT Ch 8 Outline
 constitutes boot received by the shareholder
transferring the liabilities to the corporation.
iii) Under the general rule, the corporation’s
assumption of a shareholder’s liability attached to
property transferred is not treated as boot received
by the shareholder.
iv) Tax-Avoidance Transactions
(1) The “avoidance” motive may be present
where shareholders leverage their appreciated
assets prior to the transfer and have the
corporation assume the liabilities.
(a) The “no business purpose” motive can
be present where shareholders have the
corporation assume the shareholder’s
personal liabilities.
(2) See EX 8-9.
v) Liabilities in Excess of Basis
(1) If the liabilities assumed by the corporation
exceed the aggregate tax basis of the
properties transferred by the shareholder, the
shareholder recognizes gain to the extent of
the excess liabilities.
(2) These liability concepts are Sec. 357
(a) Sec. 357(a) general rule; per (2) above
not treated as boot
(b) Sec. 357(b) tax avoidance; per (3) above
“taints” the transaction and the shareholder
may be subject to additional gain
recognition; specifically, Sec. 357(b) trumps
Sec. 357(c) (i.e., ALL debt treated as boot,
not just that in excess of the aggregate
adjusted basis) [See EX 8-13]
(c) Sec. 357(c) excess liabilities; per (4)
shareholder recognizes gain equal to the
excess; prevents negative tax basis
(d) See EX 8-10. (Sec. 357(c) example; note
the “aggregate tax basis of the properties”
application)
(e) See EX 8-11. (See (i) above re: fn #20; A/P
is not considered a “liability”)
l) Tax Consequences to the Transferee Corporation
(in a Section 351 Transaction)
i) The corporation receiving property in exchange for
its stock in a §351 transaction does not recognize
(excludes) gain or loss realized on the transfer.

5-AFT Ch 8 Outline
 ii) The tax basis of property received by the
corporation equals the property’s tax basis in the
transferor’s hands.
iii) Most practitioners refer to the transferred property
as having a carryover basis.
(1) Carryover basis is INCREASED by any gain
recognized by the transferee (i.e.,
shareholder). (See Exh 8-6 and EX 8-12)
(2) Carryover basis is DECREASED when the
aggregate adjusted basis exceeds the
aggregate FMV of the assets; the decrease is
allocated to the bases of the “built-in-loss” (BIL)
assets (See EX 8-13 at second and third “what
if”)
iv) To the extent the shareholder’s tax basis carries
over to the corporation and the property is §1231
property or a capital asset, the shareholder’s
holding period also carries over.
v) This could be important in determining if
subsequent gain or loss recognized on the
disposition of the property qualifies as a §1231
gain or loss or a long-term capital gain or loss.
vi) See Exh 8-6 for Computing the Tax Basis of
Property Received by the Corporation in a Section
351 Transaction.
vii) See EX 8-12. (shows corporation’s increase to
A.B. for shareholder’s recognized gain)
viii) See EX 8-13; first “what if.” (BIL property;
aggregate basis < aggregate FMV; no basis
reduction; “good news” because BIL (building) is
preserved at the corporate level)
ix) See EX 8-13; second “what if.” (BIL property;
aggregate basis > aggregate FMV; basis reduction
required; “bad news” because some/all BIL
(building) is lost) NOTE: Al receives only stock
at the second “what if.”
x) See Ex 8-13; third “what if.” (BIL property;
aggregate basis > aggregate FMV; basis reduction
required; “bad news” because some/all BIL
(building) is lost) NOTE: Al receives stock and
cash (i.e., boot) so Al recognizes gain. Notice
how the corporate result changes because Al
recognized gain—the corporation loses more of
the BIL on the building.
xi) Stop Now is a good time to practice
what you’ve learned. You
6-AFT Ch 8 Outline
 should complete end-of-chapter Problem
39 (see Sec. 1244 below to answer last
part of problem), P43
m) Other Issues Related to Incorporating an Ongoing
Business
i) Depreciable Assets Transferred to a Corporation
(1) To the extent a property’s tax-adjusted basis
carries over from the shareholder, the
corporation steps into the shoes of the
shareholder and continues to depreciate the
carryover basis portion of the property’s tax
basis using the shareholder’s depreciation
schedule.
(a) The corporation will also be subject to Sec.
1245 and Sec. 291 recapture.
(2) See EX 8-14.
(3) Practitioners often advise against transferring
appreciated property (especially real estate)
into a closely held corporation.
(4) By transferring the property into the
corporation, the shareholder creates two
assets with the same built-in gain as the
original.
n) Contributions to Capital
i) It is not a taxable event to the shareholder
because the shareholder does not receive any
additional consideration in return for the transfer.
ii) A shareholder making a capital contribution gets to
increase the tax basis in her existing stock in an
amount equal to the tax basis of the property
contributed.
o) Section 1244 Stock
i) For individuals, long-term capital gains are taxed
at a maximum tax rate of 20 percent. Losses can
only offset capital gains plus $3,000 of ordinary
income per year.
ii) It allows a shareholder to treat a loss on the sale
or exchange of stock that qualifies as §1244 stock
as an ordinary loss.
iii) It applies only to individual shareholders who
are the original recipients of the stock.
iv) The maximum amount of loss that can be treated
as an ordinary loss under §1244 is $50,000 per
year ($100,000 in the case of married, filing jointly
shareholders).

7-AFT Ch 8 Outline
 v) To qualify for this tax benefit, the corporation from
which the stock was received must be a “small
business corporation” when the stock was issued.
(1) The IRC defines a small business corporation
as one in which the aggregate amount of
money and other property received in return for
the stock or as a contribution to capital did not
exceed $1 million.
(2) There is an additional requirement that for
the five taxable years preceding the year in
which the stock was sold, the corporation must
have derived more than 50 percent of its
aggregate gross receipts from an active trade
or business.
(3) It provides a tax benefit to entrepreneurs who
create a risky start-up company that ultimately
fails rather than succeeds.
vi) See EX 8-15.
3) Taxable And Tax-Deferred Corporate Acquisitions
(OMISSION pp. 8-19 to 8-32)

4) Complete Liquidation of A Corporation (RESUME p 8-32)

a) Tax Consequences to the Shareholders in a
Complete Liquidation
i) The tax consequences to the shareholders in a
complete liquidation depend on the shareholder’s
identity and ownership percentage in the
corporation.
ii) The corporation files Form 996 within 30 days
from owners’/board’s decision to liquidate.
iii) All noncorporate shareholders receiving
liquidating distributions have a fully taxable
transaction.
iv) The shareholders treat the property received as in
“full payment in exchange for the stock”
transferred.
v) The shareholder computes capital gain or loss by
subtracting the stock’s tax basis from the money
and fair market value of property received in
return.
vi) If a shareholder assumes the corporation’s
liabilities on property received as a liquidating
distribution, the amount realized in the
computation of gain or loss is reduced by the
amount of the liabilities assumed.

8-AFT Ch 8 Outline
 vii) The shareholder’s tax basis in the property
received equals the property’s fair market
value.
viii) See EX 8-20 (notice the “what if” scenario for
Jim; his stock basis is less and the corporation
distributes the land and cash (i.e., boot) to Jim,
the tax effect changes).
ix) Corporations that own 80 percent or more of the
liquidating corporation’s stock do not recognize
gain and usually loss in a complete liquidation of
the corporation. (See tax deferred liquidating
distribution portion of outline.)
x) See EX 8-21.
b) Tax Consequences to the Liquidating Corporation in a
Complete Liquidation SEE SEPARATE
TABLE/SUMMARY on liquidation concepts
i) Taxable Liquidating Distributions
(1) The liquidating corporation recognizes all
gains and certain losses on taxable
distributions of property to shareholders.
(2) Sec. 336(d)(1) R.P. losses The liquidating
corporation does not recognize loss IF the
property is distributed to a related party and
either the distribution is non-pro rata, or the
asset distributed is disqualified property.
(a) A related person generally is defined as a
shareholder who owns more than 50
percent of the stock of the liquidating
corporation (Sec. 267).
(b) Disqualified property is property acquired
within five years of the date of distribution in
a tax deferred §351 transaction or as a
nontaxable contribution to capital (i.e., if
acquired in a non-taxable transaction).
(3) See EX 8-22. (pro rata)
(4) See EX 8-22. (non-pro rata at the first “what if”;
loss disallowed)
(a) Here are some additional comments about
EX 8-22:
(i) The first “what if”
1. This is application of Sec. 336(d)(1)
2. IF this were a pro-rata distribution of
EACH property, then the corp. would
be able to recognize the loss
(ii) The second “what if”

9-AFT Ch 8 Outline
 1. The loss property is distributed to a
NON-related shareholder, therefore
Sec. 336(d)(1) is NOT applicable
2. IF the inventory had been
contributed within two years, then
the “tax avoidance” Sec. 336(d)(2)
would apply and the ($2k) built-in-
loss (BIL) would be disallowed
a. REMEMBER, when Sec. 336(d)
(2) applies, the BIL is disallowed
but any further decline in value IS
RECOGNIZED LOSS
(5) Sec. 336(d)(2) “tax avoidance” A second
loss disallowance rule applies to built-in
loss that arises with respect to property
acquired in a §351 transaction or as a
contribution to capital (i.e., if acquired in a non-
taxable transaction).
(a) A loss on the complete liquidation of such
property is not recognized if the property
distributed was acquired in a §351
transaction or as a contribution to capital,
and a principal purpose of the contribution
was to recognize a loss by the liquidating
corporation (i.e., “tax avoidance”).
(b) The rule prevents a built-in loss existing
at the time of the distribution from being
recognized by treating the basis of the
property distributed as being its fair market
value at the time it was contributed to the
corporation. (NOTE: This is really a loss
limitation, since losses CAN be recognized
if there is further decline in FMV since the
corporation’s receipt of the property.)
(c) This prohibited tax avoidance purpose is
presumed if the property transfer occurs
within two years of the liquidation.
(i) EXCEPTIONS
1. If property acquired within first two
years of existence (i.e., forced to
liquidate when corp only two years
old)
2. This presumption can be overcome if
the corporation can show that there
was a corporate business purpose

10-AFT Ch 8 Outline
 for contributing the property to the
corporation.
(d) This provision is designed as an anti-
stuffing provision to prevent shareholders
from contributing property with built-in
losses to a corporation shortly before
liquidation to offset gain property distributed
in the liquidation.
(6) See EX 8-23.

Stop Now is a good time to practice what

you’ve learned. You should complete end-of-
chapter Problem 52 & 62.

i) Tax Deferred Liquidating Distributions

(1) The liquidating corporation does not recognize
gain or loss on tax-free distributions of property
to an 80 percent corporate shareholder.
(2) If any one of the shareholders receives tax
deferral in the liquidation, the liquidating
corporation cannot recognize any loss, even on
distributions to shareholders who receive
taxable distributions.
(3) See EX 8-24.
(4) Liquidation-related expenses, including the
cost of preparing and effectuating a plan of
complete liquidation, are deductible by the
liquidating corporation on its final Form 1120.
(5) Deferred or capitalized expenditures such as
organizational expenditures also are deductible
on the final tax return.

11-AFT Ch 8 Outline