Tax-free formation of a corporation

A corporation’s initial shareholders often wish to transfer property to the corporation upon its formation.

General Rule-No Gain

This transfer may qualify for an exception to the general rule that a taxpayer must recognize gain or loss on the disposition of property.

A taxpayer recognizes no gain or loss on the transfer of property to a corporation solely in exchange for common stock of the corporation (and certain types of preferred stock) if the taxpayer (and other transferors of property, if any) is in control of the corporation immediately after the exchange.

Exceptions to Gain Recognition

The taxpayer-transferor may, however, be required to recognize gain if, in addition to receiving qualifying stock, he also receives other property (called “boot”), such as cash, a promissory note, or nonqualified preferred stock.

The transferor may also recognize gain if the transferee corporation assumes liabilities of the transferor. In that case, the transferor recognizes gain if the total amount of liabilities assumed exceeds the transferor’s total adjusted basis in transferred assets. This situation may arise if, for example, property was depreciated (for tax purposes) at a rate faster than the rate of repayment of the debt that the property secured.

Tax Free Incorporation Requirements

To qualify for nonrecognition treatment, a transferor must transfer “property.” Thus, if a transferor provides services for the stock received, he must recognize compensation income. If both property and services are transferred, a reasonable allocation must be made between the stock received in exchange for property and the stock received for services.

The stock received in the exchange may generally be either common or preferred, and either voting or nonvoting. However, “nonqualified preferred stock” is treated as boot and triggers gain recognition. In certain cases, the stock received may be either contingent stock or escrowed stock.

To qualify for nonrecognition treatment, the transferors must also have “control” of the transferee corporation “immediately after the exchange.” “Control” generally means ownership of stock having 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 each other class of stock outstanding.

Furthermore, the transferors must have a valid business purpose for the exchange of property for stock — otherwise, the transaction may be treated as a taxable exchange.

Deferred Gain Recognition even in ‘Non Taxable’ Corporate Formations

Nonrecognition treatment does not mean that the transferor’s gain escapes taxation.

Rather, it means only that the taxation of the gain is deferred until the stock received in the exchange is disposed of in a recognition transaction (e.g., sold). The transferor takes a substituted basis in the qualifying stock received (decreased by the amount of boot received and increased by any gain recognized).

Corporate Tax Effect

The transferee-corporation does not recognize gain or loss on its issuance of stock. The corporation takes a “carryover basis” in the property received in the exchange, meaning that its tax basis in the property is the same as that of the property’s transferor (increased by the gain, if any, that the transferor recognized on the exchange).

Investment Company Exception

Nonrecognition treatment is not applicable to the transfer of property to an “investment company,” which include, for example, a corporation more than 80% of the value of whose assets are held for investment. Nonrecognition may be similarly unavailable in other exceptional cases (e.g., if the corporation is bankrupt).

The following is a brief explanation of the most important nontax and tax aspects of this kind of business organization.

General.

A C corporation is a corporate entity (either U.S. or non-U.S.).

A U.S. corporation is organized in a single state, although the corporation may do business in many states. Ownership of a corporation is in the form of stock. There is no limit to the number of shareholders that can own a single C corporation. In addition, there is no limit on the number of classes of stock that can be issued. A corporation comes into being when its organizers file articles of incorporation with a state (or country, in the case of a foreign corporation).

Assets and liabilities.

A corporation owns its assets and is liable for its debts. Shareholders are not liable for corporate debt. The fact that the shareholders are not liable for corporation debt is one of the primary advantages of the corporation as a form of business.

Management and employees.

The C corporation is managed by its employees, who are hired by the corporation’s board of directors. The members of the board of directors are elected by shareholders. The shareholders do not have a right to directly manage the affairs of the C corporation. Instead, they exercise indirect control over the corporation by electing the board, which then appoints corporate managers.

Shareholders who provide services to a C corporation are treated either as employees or independent contractors, depending on the specific circumstances, and are taxable on compensation received. When shareholders are employees of a C corporation they are eligible to receive tax-free fringe benefits, such as health care benefits. They can also participate in company-sponsored retirement plans.

Taxation of a C corporation.

A C corporation is taxable on the income it earns. Shareholders of a C corporation are not directly taxable on this income. A C corporation is the only business form where this is the case. All other forms of business are pass-through entities, where owners are taxed directly on entity-level income.

Although shareholders are not taxed directly on corporation income, they can be indirectly taxable on the income. If a C corporation distributes the income in the form of dividends, then the shareholders pay tax.

Transfers of assets and liabilities to a C corporation.

When a C corporation is formed shareholders contribute cash, property, or services to the corporation in exchange for stock; and sometimes the corporation assumes shareholder liabilities (such as debt to which property is subject). Contributions of property and debt in exchange for stock are usually tax-free; however, there are exceptions. When the corporation assumes debt, and the debt exceeds the basis of property transferred in exchange for stock, then the excess debt triggers gain recognition. In addition, transfers of appreciated property to a corporation in exchange for its stock are tax-free only if the transferors of property own at least 80% of the corporation after the transfer.

When stock is received in exchange for services provided to a C corporation, the receipt of stock is usually taxable.

Distributions of property to shareholders.

Although the transfer of property to a C corporation is tax-free, the distribution of appreciated property by a corporation to a shareholder is usually taxed. When appreciated property is distributed by a C corporation to a shareholder, either as a dividend or as consideration for the repurchase of stock, the corporation ordinarily recognizes gain as if it sold the property to the shareholder; and, the shareholder recognizes gain equal to the excess of the value of the property received over the shareholder’s stock basis.

Estate planning.

The C corporation is a useful device for minimizing estate and gift tax. In general, stock in a C corporation is often valued (for estate and gift tax purposes) at a discount to the value of assets owned by the corporation.