2015 Napa Williamsburg Special Topics Electronic

THE NATIONAL SOCIETY OF TAX PROFESSIONALS PRESENTSNUTS AND BOLTS OF A SMALLBUSINESS’S CORPORATE AND PARTNERSHIP TAX ISSUES AND KNOWING WHEN TO MAKE THE BREAK FROM A SOLE PROPRIETORSHIP DEVELOPED AND WRITTEN BY: Paul La Monaca, CPA, MST NSTP Director of Education PRESENTED BY: Paul La Monaca, CPA, MST & Nina Tross, EA, MBA

Seminar materials and seminar presentations are intended to stimulate thought anddiscussion and to provide attendees with useful ideas and guidance in the areas of federal taxationand administration. These materials as well as the comments of the instructors do not constituteand should not be treated as tax advice regarding the use of any particular tax procedure, taxplanning technique or device or suggestion or any of the tax consequences associated with them. Although the author has made every effort to ensure the accuracy of the materials and theseminar presentation, neither the author, the presenter nor the National Society of TaxProfessionals assumes any responsibility for any individual’s reliance on the written or oralinformation presented during the presentation. Each attendee should verify independently allstatements made in the materials and during the seminar presentation before applying them to aparticular fact pattern and should determine independently the tax and other consequences of usingany particular device, technique or suggestion before recommending the same to a client orimplementing the same on a client’s or on his or her own behalf. Copyright © Paul La Monaca 2015

TABLE OF CONTENTS PageI. Selecting a Business Entity for Federal Income Tax Purposes................................1A. Everything Depends.................................................................................................1B. Variations on a Theme: Types of Business Entities ................................................2C. Formation and Operation Considerations ................................................................2D. Types, Additions and Deletions of Owners .............................................................4E. Liquidation of an Ownership Interest ......................................................................5F. Changes in the Form of Entity .................................................................................5II. Introduction to Corporations as a Business Entity...................................................6 A. Formal Requirements and Formation ......................................................................6 B. §351 Transactions: The Transfer of Assets and the Issuance of Stock....................7 C. §351 Deferral of Gain or Loss: A Mandatory Provision .........................................8 D. Exceptions to the General Rule of Non-Recognition under §351 ...........................9 E. §358 Basis of Shareholder’s Stock After a §351 Transfer ....................................11 F. §362 Basis of Corporate Assets After a §351 Transfer .........................................13 G. §351 Tax Free Incorporation Transfers: Shareholder’s and Corporation’s Statements.......................................................................................14 H. Advantages of Operating as a C-Corporation........................................................23 I. Transfer of Stock Ownership by Existing Shareholders........................................24 J. Legal Disadvantages of Operating as a C-Corporation .........................................24III. Introduction to the Tax Issues Unique to a Subchapter C-Corporation ..............24 A. Double Taxation.....................................................................................................24 B. Reporting Dividends and Other Distributions .......................................................25 C. IRS Form 1099 DIV...............................................................................................25 D. IRS Form 5452.......................................................................................................25 E. §312 Earnings and Profits (E&P) ..........................................................................26 F. Calculating E&P ....................................................................................................26 G. §312 Additions to Current Year Taxable Income or Loss.....................................26 H. §312 Subtractions from the Current Year Taxable Income or Loss ......................27 I. Current Year E&P..................................................................................................28 J. Summary Schedule of E&P Adjustments ..............................................................29 K. Allocating E&P to Distributions............................................................................30 L. Dividend Defined...................................................................................................33 M. Compensation Issues..............................................................................................33 N. Constructive Dividend Issues ................................................................................35 O. Property Distributions............................................................................................35

IV. Introduction to the Liquidation of a C-Corporation ..............................................37 A. General Review......................................................................................................37 B. Converting a Subchapter C-Corporation to a Partnership .....................................38 C. C-Corporation Losses ............................................................................................39 V. Introduction to the End of the Corporate Life Cycle .............................................39 A. General Review......................................................................................................39 B. §331 Income Tax Effects of Corporate Liquidation to Shareholders ....................40 C. §334 Basis of Property Received by the Shareholder in Liquidation of their Stock..............................................................41 D. §336 Gain or Loss Recognized by the Corporation on Property Distributed in Complete Liquidation ............................................................................................41 E. Definition of a Complete Liquidation Not Defined in the Code ...........................42 F. Income Tax Effects of the General Liquidation Rules ..........................................43 G. §331 Gain or Loss Recognized by a Shareholder in a Corporate Liquidation ......44 H. Stock Acquired at Various Times ..........................................................................44 I. Partially Liquidating Distributions ........................................................................44 J. Basis of Property Received in the Liquidation ......................................................45 K. Subsequent Assessments Against the Shareholders ..............................................45 L. Open Versus Closed Transactions .........................................................................46 M. Installment Obligations Received by a Shareholder..............................................48 VI. Effects of Liquidating on the Liquidating Corporation .........................................49 A. Liquidating Issues ..................................................................................................49 B. General vs. Specific Expenses of Liquidation .......................................................50 C. Corporate Filing Requirements for the Corporate Dissolution or Liquidation......51 D. Topic Review: Tax Consequences of a Corporate Liquidation ............................52VII. Introduction to the Preparation Issues of the Corporate Income Tax Return ....52 A. Imposition of the Corporate Tax Structure ............................................................52 B. Filing Requirements of a Corporate Return...........................................................55 C. Penalty for Late Filing of Return ...........................................................................56 D. Penalty for Late Payment of the Tax .....................................................................56 E. Capital Losses ........................................................................................................56 F. Rules for Carryovers and Carrybacks ....................................................................57 G. Refunds ..................................................................................................................58 H. Form 1139..............................................................................................................58 I. Form 1120X ...........................................................................................................58 J. Charitable Contributions........................................................................................58

K. Schedule M-1 Reconciliation of Taxable Income and Financial Net Income .......59 L. Schedule M-2 Analysis of Unappropriated Retained Earnings Per Books (line 25, Schedule L)..............................................................................................60VIII. Subchapter C-Corporations “Professional Service Corporations” (PSC) ...........60 A. Definition of a PSC................................................................................................60 B. Advantages Available to PSC................................................................................61 C. Distribution of Profits via Bonus ...........................................................................61 D. Tax Issues of a PSC ...............................................................................................61 E. Distribution of Profits via Bonus Unchallenged....................................................61 F. Calendar Year Requirements .................................................................................62 G. Flat Tax and Cash Basis.........................................................................................63 Supplemental Material • Form 1120 Case Study Issues..............................................................................64 • IRS Form 1120 .....................................................................................................65 Suggested Research Areas: • Internal Revenue Code Subchapter C Corporate Distributions and Adjustments • IRS Publication 542 Corporations • IRS Website Small Business

I. Selecting a Business Entity for Federal Income Tax Purposes A. Everything Depends 1. The selection of the proper form of entity for the needs of a particular business is not always as decisive as one might first believe. No single form of entity is the proper form for every type of business. 2. In addition, once an entity choice is made the need to maintain or change the form of entity must be monitored and acted on when desired and/or necessary. The selection process depends on factors such as the particular business owner personalities and desire for exposure to creditors. 3. The federal tax consequences of each form of entity must be considered. The issue of whether the income of the business will be assessed at the entity level or the owner level is important. 4. On the other hand, it is possible that there will there be a tax consequence at both levels. This issue is very important if profits will be distributed to the owners in subsequent tax years. 5. The federal income tax issues are also very important when the business entity generates losses. The use of the losses by the owners on their personal tax returns may be desired. 6. However, the use of those losses will depend on each of the specific owner’s level of involvement in the business activity and the amount of “basis” in the entity. 7. As all tax practitioners are aware, there are several types of entity forms available to the owners to choose from when they are starting a business. We are focusing on only three choices and they are: • Sole Proprietorship (Schedule C) • Partnerships (Form 1065) • Subchapter S (Form 1120S) • Corporations (Form 1120) 8. There are advantages and disadvantages that must be analyzed in selecting each form. These advantages and disadvantages involve characteristics pertaining to both business and federal income tax consequences. 9. In some cases, the tax consequences of state and local jurisdictions must also be considered.

B. Variations on a Theme: Types of Business Entities 1. When taxpayers decide to enter into a trade or business for profit there are often questions and confusion as to the type of business entity that should be selected. 2. Both tax and business goals need to be determined in order to resolve the “type of business entity” dilemma. 3. The individual owners of the entity should be evaluated because their personal objectives may be different than the business objectives that are desired to be reached. In many cases the tax professional will have owners who are not “rule followers” and those type of owners believe that they can do anything they want at any time they want since the business “belongs to them”. 4. Many owners of small businesses will move money in and out of the entity freely without realizing or considering the legal and tax ramifications. At times owners will use or withdraw non-cash assets without realizing and understanding the tax and legal issues that could be at stake. 5. Many owners of small businesses do not recognize the importance of recording proper bookkeeping and accounting transactions. Many of these owners leave these issues until the end of the year and even worse not until the time an income tax return is required to be filed. Sometimes they wait until the presentation of financial data is needed for purposes of obtaining a loan or a lease. Tax Professional Note: In many cases these owners do nothing to determine the true financial results until they receive a notice from the IRS or some other taxing authority. 6. The mindset of a small business owner is that they are in charge of everything and are not subject to any type of compliance.C. Formation and Operation Considerations 1. The proper type of business entity needs to be considered in all stages of a business’s “life cycle.”

2. When assisting in the selection of the type of entity at formation the tax professional will need to consider owner personalities and various tax ramifications including: Income taxes Local gross receipts taxes Licensing costs Personal property tax Capitalization taxes, etc.3. The tax issues could impact the entity itself as well as the individual owner(s). If the entity will be profitable in its initial year or years then the issue of entity and/or individual income taxes must be discussed with the owner(s) in order to illustrate differences in rate structures in a graduated income tax system.4. The income tax issues of “distributions” must be discussed in order for the owner(s) to understand that some, all, or none of the distribution will have tax imposed at their individual income tax level. Tax Professional Note: Many owners of a partnership don’t understand that they do not receive a salary.5. If the entity incurs a loss for the year, then the owners need to be informed that the loss could be available to them at the individual tax return level or could be “locked in” at the entity level.6. If the losses that are generated are “passed through” by the entity to the owners, then the owners need to be aware that the losses may or may not be available to them due to limitations imposed because of: Limited liability protections Basis limitations §469 Passive activity limitations §465 At-risk limitations7. During the formation stages of creating the entity, costs that are incurred could be required to be capitalized and amortized and, therefore, not deductible in the year the money is actually spent. This is an issue and a concept not readily understood by a small business owner.8. In other cases during formation some costs must be capitalized and are not amortizable. These costs are recovered only at the time the entity ceases to exist.

9. Fixed assets costs are separate issues and deductibility depends on a statutory life of an asset as determined by the Internal Revenue Code (IRC). While an election is available to perhaps “expense” a “qualifying asset” there are limitations imposed on this treatment. In addition, the owner(s) should be aware that the use of a current year deduction could have a reduced effect if entity or individual income tax rates will be greater in a subsequent year. The impact of self- employment taxes will also need to be considered. 10. Another tax issue that must be considered at the time of formation is the impact of the transfer of an individual owner’s assets to the entity. Questions as to entity and individual taxes arise as well as the bases of the assets in the hands of the entity and the holding periods involved. 11. When assets are transferred by the owner to the entity the owner needs to understand that the assets are then owned by the entity and in exchange the owner receives “rights” to certain interests. Therefore a tangible asset is exchanged for an intangible asset in the form of a stock certificate or partnership interest. 12. The transfer of the assets gives the owners “rights” to profits, losses, distributions and liquidations but only at the time and conditions stated in or set by the entity agreement whether in written form or in an oral understanding depending on the type of entity created.D. Types, Additions and Deletions of Owners 1. It is important that the tax professional discuss with the owners of the business entity that different formations allow or restrict the type of ownership permissible. 2. Some entities are permitted to allow any “person” to have an ownership interest. Therefore, the “person” could be an individual taxpayer as well as another entity type such as a corporation or a trust. 3. Other entities are more restrictive and will not permit ownership by certain “persons” such as a corporation or a foreign person or entity. 4. When ownership of the entity changes, the impact of how it is changing is important because the ownership change may be the result of the entity itself offering additional interest or the ownership could be a transaction which takes place outside of the entity by a buying and selling owner.

E. Liquidation of an Ownership Interest 1. Ownership interest could cease because the entity itself ceases to exist or because an owner disposes of some or all of the ownership interest of the entity. 2. When there is a liquidation of the entity itself the entity ceases to be an operating company for purposes of being in a trade or business and the assets will need to be either: Liquidated with the net proceeds being distributed out to the owners after the creditors’ claims have been satisfied, or The assets and liabilities will be distributed directly to the owners of the entity. In exchange for the net proceeds or transfer of assets the “persons” will transfer the “rights” of ownership back to the liquidating entity. 3. The tax implications to both the entity and the owner(s) will depend on the type of entity in existence at the time of the final transactions. 4. In some situations both parties could be required to recognize taxable events or it could be that no income is recognized by either party to the transaction. 5. The basis of individual assets at the entity level will play an important role as will the basis of the owner’s interest. 6. If the liquidation of an individual owner is the result of a transaction outside of the entity, then that owner would need to account for that transaction as outside of the entity. The owner’s basis will become an important factor in determining the individual tax impact.F. Changes in the Form of Entity 1. After a company has been formed and is in an operating mode it may be necessary for the operation to change the type of entity. 2. This may occur because of the desire to: Raise capital. Reduce exposure to creditors. Change the allocation of profits and losses. Allow for different types of ownership rights. Allow ownership by restricted types of owners. Remove an existing owner or owners.

3. If a change in the type of business entity is an issue, then the tax professional must inform the existing entity and its owners that there could be income tax ramifications to both parties. 4. A change could cause a liquidation of the entity causing: Recognition of income. Changes in basis. Changes in holding periods. Debt relief. Loss of tax carryforwards. 5. On the other hand, a change could cause a nonrecognition of income or loss thereby causing a retention of basis, holding periods, and continuation of carryforwards. This may not be a goal of the conversion. 6. Careful analysis should be performed before a change in the type of entity takes place for an ongoing operation.II. Introduction to Corporations as a Business Entity A. Formal Requirements and Formation 1. Corporations are created as a result of state law and as a result they are subject to formal requirements which are not imposed on sole proprietorships and general partnerships. Also they are structured more formally than an Limited Liability Company (LLC). 2. Ownership is witnessed through the issuance of stock to investors. 3. Stockholders have the legal right to distribution and liquidation of assets but technically do not own the underlying assets of the business. 4. In order for a corporation to come into existence it must comply with a number of state-imposed formalities and requirements. 5. Generally, the corporation and/or shareholders must file, adopt, issue, conduct and/or prepare: • Articles of Incorporation • Written Corporate Charter • Written By-Laws • Election of a Board of Directors • Organizational Meetings • Minutes of Meeting • Stock Certificates (Shares) • Franchise Fees • Registered Agent

6. Observing the required corporate formalities is an important step in ensuring that the corporation is treated as a separate entity from its owners.TAX PROFESSIONAL ALERT: Failure to observe these formalities can resultin shareholders being held personally liable for corporate debts and liabilities.B. §351 Transaction: The Transfer of Assets and Issuance of Stock 1. §351 provides a general rule that the act of incorporating is not a taxable event to the corporation or the shareholders as long as specific conditions are met: The shareholders transfer “property” to the corporation, The transfer is “solely” in exchange for the stock of the corporation, and Immediately after the transfer the transferors are in “control” of the corporation. Tax Professional Note: For purposes of this provision control means at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.2. As a result, it is possible for a taxpayer to transfer appreciated property to the corporation, and as long as the requirements of §351 are met, the taxpayer can put the assets to use in the corporation and defer recognition of gain at the individual taxpayer level.EXAMPLE: Don is incorporating his donut shop. Don realizes that if heincorporates his shop, he will be liable only for the debts of the business that hehas personally guaranteed. Don transfers the following assets to thecorporation:Cash Fair Market Value Tax BasisFurniture and fixtures $10,000 $10,000Buildings 20,000 60,000Totals 40,000 100,000 $70,000 $170,000Don will receive stock worth $170,000 in exchange for the assets. Without thenonrecognition provisions of §351 he would recognize a taxable gain of $100,000on the transfer. However, under §351, Don does not recognize any gain becausehis economic status has not really changed.

Don's investment in the assets of his unincorporated donut shop carry over to hisstock investment in the incorporated donut shop. Therefore, §351 provides fornonrecognition on the incorporation of Don's business.Tax Professional’s Note: The §351 transfer provision applies both to individualsand groups who transfer property to a corporation. §351 also applies whether thecorporation is being formed or is already in operation.TAX PROFESSIONAL ALERT: Both the corporation and any taxpayerinvolved in a §351 nontaxable exchange of property for stock must attach totheir tax returns a complete statement of all facts pertinent to the exchange.C. §351 Deferral of Gain or Loss: A Mandatory Provision 1. It is important to note that §351 is a mandatory provision, therefore, §351 applies to losses as well as gains. EXAMPLE: Don and Nanette form X Corporation. Don transfers property with an adjusted basis of $30,000 and a fair market value of $60,000 for 50% of the stock.Nanette transfers property with an adjusted basis of $70,000 and a fair marketvalue of $60,000, for the remaining 50% of the stock.The transfer qualifies under §351. Don has an unrecognized gain of $30,000 andNanette has an unrecognized loss of $10,000. Both have a carryover basis in thestock in X Corporation. Don has a basis of $30,000 in his stock in X Corporation,and Nanette has a basis of $70,000 in her stock in X Corporation.Amount Realized Nanette DonLess: Adjusted Basis $60,000 $60,000Gain Loss Realized (30,000) (70,000)Gain Loss Recognized $30,000 $(10,000)Basis of Assets Given Up $ -0- $ -0-Add: Gain Recognized $30,000 $70,000Less: Loss RecognizedLess: Boot Received -0- -0-Basis of Stock Received -0- -0- (-0-) (-0-) $30,000 $70,000TAX PROFESSIONAL ALERT: Taxpayers should not transfer depreciatedassets to the corporation in a §351 transaction because they would be preventedfrom recognizing a loss on the transfer.

However, as a practical matter those assets might be very important for the operation of the business venture's success.D. Exceptions to the General Rule of Non-Recognition Under §351 1. There are three exceptions to nonrecognition provision of §351. Boot Exception §351(b) provides that: • A transferor who receives non-qualified property or “boot” (anything other than stock in the corporation) in the exchange must recognize gain equal to the sum of: the amount of money received and the fair market value of such other property received. EXAMPLE: Don and Peter form a C-Corporation. Don transfers an asset with a basis of $30,000 and an FMV of $70,000 and Peter borrows $60,000 from his VISA card and invests it in the C-Corporation. Don and Peter each receive 6,000 shares of stock worth $10 per share and Don also receives $10,000 in cash. The following are the results of the transaction to Don, Peter and the C-Corporation: Shareholders Basis in Stock Don Peter $60,000Fair Market Value of Stock Received $60,000 (60,000)Less: -0- -0-Basis of Property Transferred (30,000) $ -0-Gain Realized 30,000 $ -0-Add: Other Property Received 10,000 $60,000Realized Gain $40,000 -0- -0-Recognized Gain: Lesser of Boot or $10,000Realized Gain $60,000Adjusted Basis of Stock:Basis of Asset Given Up $30,000Add: Gain Recognized 10,000Less: Boot Received (10,000)Basis of Stock Received $30,000 Corporation’s Basis of Assets ReceivedCarryover Basis of Assets Receivedfrom Shareholders $30,000Add: Don’s Recognized Gain 10,000Basis of Asset to the Corporation $40,000

Service Exception§351(d) provides that: A transferor who receives stock in exchange for services must recognize gain because services are not considered “property” for this purpose. EXAMPLE: Don and Nanette each transfer property to X Corporation in exchange for one-third of the stock. Mary receives the other one-third of the stock for services rendered. The transaction will not qualify under §351 because Mary is not a member of the group transferring property and Don and Nanette together received only 66 2/3% of the stock. The post-transfer control requirement is not met. In order to satisfy the 80% control requirement assume that Mary also transfers property. Then she is a member of the group, and the transaction qualifies under §351. Mary is taxed on the value of the stock issued for services, but the remainder of the transaction is tax-free. Note, however, that if the property transferred by Mary is of a relatively small value in comparison to the stock she receives for services, and the primary purpose for including the property is to cause the transaction to be tax-free for Don and Nanette, then the exchange does not qualify under §351. Gain or loss is recognized by all parties. The Service generally requires that before a transferor who receives stock for both property and services can be included in the control group, the value of the property transferred must be at least 10 percent of the value of the services provided. Rev. Proc. 77-37, 1977-2 C.B. 568, §3.07. If the value of the property transferred is less than this amount then the IRS will not issue an advance ruling that the exchange meets the requirements of §351.Debt Greater than Basis Exception §357 provides that a transferor must recognize gain to the extent that aggregate liabilities that the transferor transfers to the corporation exceeds the aggregate basis of assets the transferor transfers to the corporation.

EXAMPLE: Don transfers assets with an adjusted basis of $40,000 to anewly formed corporation in exchange for 100% of the stock. Thecorporation assumes liabilities on the transferred properties in theamount of $50,000. §357(c) requires that Don recognize a gain of$10,000.Liability Assumed $50,000Less: Basis of Property (40,000)Gain $10,000As a result, the stock will have a zero basis in Don's hands, determinedas follows:Basis in the property transferred $40,000Add: Gain recognized 10,000Less: Boot received ( -0- )Less: Liabilities assumed (50,000)Basis in the stock received Thus, no negative basis results. NOTE: Accounts payable of a cash basis taxpayer that give rise to a deduction are not considered to be liabilities for purposes of §357(c).E. §358 Basis of Shareholder's Stock After a §351 Transfer 1. §358 provides that if §351 nonrecognition transaction applies, then a shareholder takes a basis in the stock received equal to the basis in the property transferred. (Carryover basis.) 2. If boot is received in the transfer, then the shareholder's basis in the stock is reduced by the amount of boot received and increased by the amount of gain recognized on the transfer.3. The shareholder's basis in the stock is also reduced by the amount of liability assumed by the corporation from the shareholder.• The formula for shareholder's stock basis is computed under §358 as follows:Basis of Assets Given UP $Add: Gain Recognized on Transfer ()Less: Boot Received ()Debt Assumed by Corporation ()Equals: Basis of Stock Received $

NOTE: The purpose of the basis adjustment is to prevent double taxationlater when the taxpayer disposes of the stock.EXAMPLE: Don, a cash basis taxpayer, incorporates his soleproprietorship. In return for all of the stock of the new corporation, hetransfers the following assets and liabilities:Cash Fair Market Adjusted BasisUnrealized accounts receivable ValueTrade accounts payable $10,000 $10,000Note Payable -0- 40,000 -0- 30,000 5,000 5,000 Unrealized accounts receivable and trade accounts payable have a zero basis. Under the cash method of accounting, no income is recognized until the receivables are collected, and no deduction is allowed until the payables are paid. The note payable has a basis because it was issued for consideration received. The accounts receivable and the trade accounts payable are disregarded. Therefore, Don has only transferred cash of $10,000 and a note payable of $5,000 and does not have a problem of liabilities in excess of basis.4. The definition of liabilities under §357(c) excludes obligations that would have been deductible to the transferor had he or she paid those obligations before the transfer. Therefore, Don has no gain.5. Liabilities: If the corporation assumes shareholder liabilities, then the exchange generally is not treated as money or other property received. There are two exceptions to this treatment:• If the liabilities assumed by the corporation are greater than the adjusted basis in the property transferred, then gain is recognized up to the difference. However, if the liabilities assumed give rise to a deduction when paid, such as a trade account payable or interest, no gain is recognized.• If there is no good business reason for the corporation to assume liabilities, or if the main purpose in the exchange is to avoid federal income tax, the assumption is treated as if the shareholder received money in the amount of the liabilities.

EXAMPLE: Don transfers property to a corporation for stock. Immediately after the transfer, he controls the corporation. He also received $10,000 in the exchange. His adjusted basis in the transferred property is $20,000. The stock Don received has an FMV of $16,000. The corporation also assumed a $5,000 debt on the property for which he was personally liable. Gain is realized as follows: FMV of stock received.........................................................................$16,000 Cash received .........................................................................................10,000 Liability assumed by corporation.............................................................5,000 Total amount realized ..........................................................................$31,000 Less: Adjusted basis of Property transferred ....................................... (20,000) Realized gain.......................................................................................$11,000 Recognized Gain..................................................................................$10,000 The liability assumed is not treated as money or other property because debt was not greater than basis. The recognized gain is limited, to the lesser of realized gain of $11,000 or $10,000 cash received (boot).F. §362 Basis of Corporate Assets After a §351 Transfer 1. §362 provides that the corporation's basis in the assets received from the shareholder is a carryover basis in the property received increased by any gain recognized by the shareholder. • The formula for calculating the basis of assets under §362 is as follows: Basis of Assets Received from Shareholders Add: Gain Recognized by Shareholders Equals: Basis of Corporate Assets Corporate Holding Period Issues: 1. When depreciable assets are transferred to a corporation under a §351 transaction the corporation steps into the shoes of the transferor shareholder and has the same cost basis, accumulated depreciation, depreciation method and recovery period. 2. The transferring shareholder calculates the current depreciation up to the date of transfer and the acquiring corporation continues with the same recovery life beginning as of date after acquisition. Corporate Recapture Issues: 1. In a pure §351 nontaxable transfer any depreciation recapture remains with the transferred property now owned by the corporation.

EXAMPLE: Don transfers depreciable fixed assets with an original cost of $50,000 and an adjusted basis of $-0- because he took §179 deductions on the assets. The assets have a FMV of $30,000. If Don would have sold these assets then he would have had a §1245 gain of $30,000. If the Corporation sells these assets then the Corporation recognizes the §1245 recapture upon disposition. If, however, Don had received $15,000 on the transfer then he would have recognized $15,000 of the recapture as §1245 ordinary income and the remaining $15,000 of recapture would carryover to the corporation. • Remember: Don’s recognized gain is the lower of the realized gain of $30,000 or the $15,000 boot received and the Corporation’s basis is increased by the same amount as Don’s recognized gain.G. §351 Tax-Free Incorporation Transfers: Shareholder’s and Corporation’s Statements. Shareholder’s Statement: 1. Each person who received stock of a controlled corporation in a tax free exchange of property under §351, or who received stock and other property in a partially taxable exchange of property under §351 is required to file with their income tax return a complete statement of all facts pertinent to the exchange for the tax year in which the exchange is made. 2. Contents of the Statement. The statement must contain the following information: A description of the property transferred, or of the transferor’s interest in such property, together with a statement of its cost or other basis, adjusted to the date of transfer. With respect to stock of the controlled corporation received in the exchange, a statement of: The kind of stock and preferences, if any; The number of shares of each class received; and The fair market value per share of each class at the date of the exchange. The amount of money received, if any.

With respect to other property received: A complete description of each separate item; The fair market value of each separate item at the date of exchange; and In the case of a corporate shareholder, the adjusted basis of the other property in the hands of the controlled corporation immediately before the distribution of such other property to the corporate shareholder in connection with the exchange. With respect to liabilities of the transferors assumed by the controlled corporation, a statement of: The nature of the liabilities, When and under what circumstances created, The corporate business reason for assumption by the controlled corporation, and Whether such assumption eliminates the transferor’s primary liability.Tax Professional Recommendation: If more than one item of property istransferred by the same person to a controlled corporation in the same transactionand the transferor and the corporation want to specify the consideration given bythe corporation for each item (e.g., shares of stock for one item, stock and boot fora second item, and cash for a third item), then the statement should state exactlyhow the consideration is being allocated for each transferred item.Tax Professional Alert: If the transferor(s) and the corporation agree to a specificallocation, the IRS may not actually allow it and may require that theconsideration given by the corporation in exchange be apportioned among theitems of transferred property according to their fair market value.The IRS takes the position that gain or loss is computed separately for each assetand cash and other property are allocated in proportion to the relative fair marketvalue of each asset. Nevertheless, the transferors and the corporation will be noworse off it they try to make a specific allocation which is disallowed than theywould have been if no allocation had been made in the first place.Transferor’s Sample filled-in statement. Enclosed is a sample filled-instatement for an individual transferor in which a specific allocation ofconsideration to each item of transferred property is made. This is a samplestatement only. Note: There is no official form.

Tax Professional Recommendation: Reg. §1.351-3(a) requires that thestatement be filed with the transferor’s return for the year when the transfer ismade. The regulation does not state where the statement should be attached to thereturn. If a partially taxable transfer resulting in the recognition of taxable incomeis made, then it would probably be best to attach the statement to the schedule onwhich the income is reported, e.g., Schedule D, Form 4797 if the income is capitalgain or business property. Otherwise, attach the statement to the last page of thereturn. Transferor’s Statement Reg. §1.351-3(a) Ken Jennings SSN 000-00-9988 FORM 1040, Tax Year Ending 12/31/2014.1. Description of property transferred.On June 23, 2014, taxpayer transferred the following property to Jeopardy, Inc.(“transferee”), a California corporation (EIN 13-9999999):Property Tax Basis (Adjusted to June 23, 2014)Patents Fair Market Value $20,000Software 50,000Machinery & Equipment $100,000 40,000Accounts Receivable 100,000 50,000 50,000 50,000The items of property set out above are listed, and described, in detail in thetransferee’s permanent books of account.2. Stock received: Taxpayer received the following shares of stock of transferee as consideration:1,000 shares of no par value voting common stock with a fair market valueof $100 a share (“common”) as full consideration for the transfer of thepatent.500 shares of common stock as part consideration for the transfer of thesoftware.800 shares of $50 par value cumulative non-participating non-votingpreferred stock paying an annual dividend of $7 a share with a fair marketvalue of $50 a share (“preferred”) as part consideration for the transfer ofthe machinery and equipment.1,000 shares of preferred stock as full consideration for the transfer of theaccounts receivable.

3. Money received. The following amounts of money were received as part of the consideration: $20,000 as part of the consideration for the transfer of the patent. $10,000 as part of the consideration for the transfer of the machinery and equipment.4. Other property received As part of the consideration for the transfer of the software taxpayer received a note of the transferee described below. Description of note-Unsecured note in principal amount of $30,000, dated June 23, 2014, with interest payable quarterly at a yearly rate of 6% and with the principal payable June 23, 2015. Fair market value of note-The fair market value of the note on June 23, 2014, the date of the exchange was $30,000. Basis of note to transferee-The adjusted basis of the note to the transferee immediately before the exchange was $-0-.5. Liabilities assumed: None.Corporation’s Statement:1. Every controlled corporation that received property in exchange for stock in a tax free exchange under §351, or that received property in exchange for stock and other property in a partially taxable exchange under §351 is required to file with its income tax return (a complete statement of all facts pertinent to the exchange for the year in which the exchange is made).2. Contents of the statement. The statement must contain the following information: A complete description of all the property received from the transferors. A statement of the cost or other basis of the property in the hands of the transferors adjusted to the date of transfer. The following information with respect to the capital stock of the controlled corporation: The total issued and outstanding capital stock immediately prior to and immediately after the exchange, with a complete description of each class of stock;

The classes of stock and number of shares issued to each transferor in the exchange and the number of shares of each class of stock owned by each transferor immediately prior to and immediately after the exchange, and The fair market value of the capital stock as of the date of exchange which was issued to each transferor. The amount of money, if any, which passed to each of the transferors in connection with the transaction. With respect to other property which passed to each transferor: A complete description of each separate item; The fair market value of each separate item at the date of exchange, and In the case of a corporate transferor, the adjusted basis of each separate item in the hands of the controlled corporation immediately before the distribution of such other property to the corporate transferor in connection with the exchange. The following information as to the transferor’s liabilities assumed by the controlled corporation in the exchange: The amount and a description of the liabilities, When and under what circumstances created, and The corporate business reason or reasons for assumption by the controlled corporation.Tax Professional Recommendation: If more than one item of property istransferred by the same person to a controlled corporation in the same transactionand the transferor and the corporation want to specify the consideration given bythe corporation for each item (e.g., shares of stock for one item, stock and boot fora second item, and cash for a third item), then have the statement state exactlyhow the consideration is being allocated to each transferred item.NOTE: The corporation and/or the transferors may be able to realize substantialtax savings if they are allowed to allocate the consideration given by thecorporation among the items of transferred property in the manner they desire.For example, if taxable gain is recognized as a result of the transfer then it mightbe possible to allocate more of that gain to depreciable property so as to increasethe basis of that property in the corporation’s hands.Tax Professional Alert: If the corporation and the transferors agree to a specificallocation the IRS may not allow it and may require that the consideration givenby the corporation in exchange be apportioned among the items of transferredproperty according to their fair market value.

IRS takes the position that gain or loss is computed separately for each asset andcash and other property is allocated in proportion to the relative fair market valueof each asset. Nevertheless, the corporation and the transferors will be no worseoff if they try to make a specific allocation which is disallowed than they wouldhave been if no allocation had been made in the first place.Corporation’s Sample filled-in statement: Enclosed is a sample filled-instatement for a transfer of property to a controlled corporation by two individualtransferors in which a specific allocation of consideration to each item oftransferred property is made. This is a sample statement only; there is no officialform.Tax Professional Recommendation: Reg. §1.351-3(b) requires that thestatement be filed with the controlled corporation’s return for the year when thetransfer was made. It doesn’t state where the statement should be attached to thereturn. It would probably be best to attach it to the end of the return. Transferee Corporation’s Statement Reg. §1.351-3(b) Jeopardy EIN 13-1999999 Form 1120, Tax Year Ending 3/31/20151 & 2 Description of Property Transferred: On June 23, 2014, transferee, in exchange for the consideration set out in paragraph (3) of this statement, received the property listed below. The adjusted basis of each item of property to the transferors as of the date of the transfer is set out in the column entitled, “Tax Basis, etc.” From Ken Jennings (SSN 000-99-9988):Property Tax Basis to Transferor (Adjusted to June 23, 2014)Patents Fair Market Value $20,000Software 50,000Machinery & Equipment $100,000 40,000Accounts Receivable 100,000 50,000 50,000 50,000From David Kelly (SSN 001-98-8899):Property Tax Basis to Transferor (Adjusted to June 23, 2014)Machinery & Equipment Fair Market Value $100,000Accounts Receivable 50,000 $150,000 50,000The items of property set out above are listed in detail in the transferee’spermanent books of account.

3. Information about transferee’s capital stock:Total issued and outstanding capital stock of transferee immediately beforeand immediately after the exchange.Class of Stock No. of Shares Outstanding No. of Shares OutstandingNo par value voting common Before Exchange Immediately After Exchange Immediatelystock (“common”)$50 par value cumulative 1,500 4,000Non-participating preferredstock paying yearly dividend 0 1,800of $7 a share (“preferred”) None NoneOther classesTotal number of shares of each class issued to each transferor in the exchange,the number of shares of each class owned by each transferor immediatelybefore the exchange, and the number of shares of each class owned by eachtransferor immediately after the exchange.Issued to Ken Jennings-Ken Jennings was issued the following shares oftransferee’s capital stock in the exchange: 1,000 shares of common stock as full consideration for the transfer of the patents. 500 shares of common stock as part consideration for the transfer of the software. 800 shares of preferred stock as part consideration for the transfer of the machinery and equipment. 1,000 shares of preferred stock as full consideration for the transfer of the accounts receivable.Issued to David Kelly-David Kelly as issued the following shares oftransferee’s capital stock in the exchange:500 shares of common stock as part consideration for the transfer of themachinery and equipment.500 shares of common stock as full consideration for the transfer of theaccounts receivable.

Shares owned by transferors immediately before the exchange:Name of Transferor No. of Shares of No. of Shares ofKen Jennings Common PreferredDavid Kelly 500 0 500 0 Totals 0 1,000Shares owned by transferors immediately after exchange:Name of Transferor No. of Shares of No. of Shares ofKen Jennings Common PreferredDavid Kelly 1,800 2,000 0 Totals 1,500 1,800 3,500Percentage of outstanding shares of each class of stock owned by transferorsimmediately after the exchange:Immediately after the exchange, the transferors owned 3,500 of the 4,000shares of transferee’s common stock then outstanding, i.e., 87.5% and 1,800of the 1,800 shares of transferee’s preferred stock then outstanding, i.e.,100%.Fair market value of shares issued in exchange-Each share of common stockissued in the exchange had a fair market value of $100 per share and eachshare of preferred stock issued in the exchange had a fair market value of $50.Accordingly:The 1,000 shares of common stock issued to Ken Jennings as fullconsideration for the transfer of the patent had a fair market value of$100,000.The 500 shares of common stock issued to Ken Jennings as partconsideration for the transfer of the software had a fair market value of$50,000.The 800 shares of preferred stock issued to Ken Jennings as partconsideration for the transfer of the machinery and equipment had a fairmarket value of $40,000.The 1,000 shares of preferred stock issued to Ken Jennings as fullconsideration for the transfer of the accounts receivable had a fair marketvalue of $50,000.The 500 shares of common stock issued to David Kelly as partconsideration for the transfer of the machinery and equipment had a fairmarket value of $50,000.

The 500 shares of common stock issued to David Kelly as full consideration for the transfer of the accounts receivable had a fair market value of $50,000.Money Paid to Transferors in Connection with the ExchangeThe following amounts of money were paid to the transferors in connectionwith the exchange:1. To Ken Jennings (a) $20,000 as part of the consideration for the transfer of the software. (b) $10,000 as part of the consideration for the transfer of the machinery and equipment.2. To David Kelly (a) $25,000 as part of the consideration for the transfer of the machinery and equipment.Other property given to transferors in connection with the exchange:1. To Ken Jennings: As part of the consideration for the transfer of the building, Ken Jennings was given the following note of the transferee: (a) Description of note-Unsecured note in principal amount of $30,000, dated June 23, 2014, with interest payable quarterly at a yearly rate of 13% and with the principal payable June 23, 2014. (b) Fair market value of note-The fair market value of the note on June 23, 2014 the date of the exchange was $30,000. (c) Basis of note to transferee-The adjusted basis of the note to the transferee immediately before the exchange was $-0-.2. To David Kelly: Nothing. (a) Liabilities of transferors assumed by transferee in connection with exchange: (1) Liabilities of Ken Jennings: None.

(2) Liabilities of David Kelly: Transferee has assumed David Kelly’s liability of $25,000 on a promissory note payable to Fourth Street National Bank. The liability arose in connection with the purchases of machinery and equipment used in David Kelly’s business as a sole proprietor. The corporate business purpose for assuming the liability is that the machinery and equipment was transferred to the transferee as part of the exchange.H. Advantages of Operating as a C-Corporation 1. Limited Liability The most important non-tax advantage of incorporating is the limited liability protection afforded to the shareholders. Generally, shareholders are not held personally liable for the corporate entity's debts and liabilities and therefore the amount of personal loss is limited to their investment in their stock and capital. It is important to note that in many cases creditors will require loan guarantees from one or more shareholders and, therefore, the protection is greatly diminished and the shareholder will not be able to use the corporate shield to escape personal obligations. However, unsecured creditors cannot reach to the shareholders personal assets and as a result the desired corporate protection is available. In addition, a shareholder who commits a tort (a civil wrong for which damages are recoverable) while acting on behalf of the entity can be sued by the victim and held personally liable. Also, if a shareholder commits a tort while acting on behalf of the corporation, then the corporation itself may also be liable under the legal doctrine of respondeat superior. Shareholders of closely held corporations need to be aware that courts may “pierce the corporate veil” and hold them personally liable for corporate debts and liabilities. Although this is not a common event, it is important that shareholders, particularly sole or majority shareholders, be aware of this possibility and not take any action that would increase this risk.

I. Transfer of Stock Ownership by Existing Shareholders 1. C-corporations give owners freedom with regard to the transfer of equity interests. 2. Absent contractual restrictions on share transfers, a C-Corporation shareholder can transfer ownership by merely selling or transferring the stock. This transaction generally has no effect on the corporate entity or other shareholders. 3. Since the transfer does not directly involve the corporation, it is not a taxable event with regard to the corporation. 4. It is important to remember that in most cases the closely held corporation is going to restrict the transfer of ownership by including in the shareholder agreement that a right of first refusal be used to give the existing shareholders and/or the corporation itself the right or option to acquire the stock of a departing shareholder before sale to a new shareholder is permitted. J. Legal Disadvantages of Operating as a C-Corporation 1. While the use of a C-Corporation allows the freedom of unrestricted ownership and generally provides for limited liability as well as providing a general rule that the transfer of assets for stock is a tax-free event there are several disadvantages to forming a business as a C-Corporation. 2. Because of the formalities required by state law C-Corporations are subject to a number of filings at state and local levels. There is generally an annual filing of corporate registration which requires a fee at both the state and local levels. 3. There are administrative requirements such as: Annual organization meetings Preparation of minutes of those meetings Formal documentation of all transactions between the corporation and shareholders, officers and related parties is generally requiredIII. Introduction to the Tax Issues Unique to a Subchapter C-Corporation A. Double Taxation 1. Double taxation and earnings and profits (E&P) are an important issue for Subchapter C Corporations. 2. Profits are taxed at the corporate level at the graduated rates imposed under federal income tax law. When the profits are later distributed to shareholders they are taxed as dividends to the extent that the corporation has earnings and profits (E&P).

3. The current year's earnings and profits is not the same amount as the current year's taxable income or taxable loss. 4. The current year's E&P begins with the corporation's net income or net loss before the Net Operating Loss (NOL) carryforward from prior tax years and has adjustments under §312 which can increase and decrease current year's taxable income or taxable loss.B. Reporting Dividends and Other Distributions 1. A corporate distribution to a shareholder is generally treated as a distribution of earnings and profits (E&P). 2. Any part of a distribution from either current or accumulated earnings and profits is reported to the shareholder as a dividend. 3. Any part of a distribution that is not from earnings and profits is applied against and reduces the adjusted basis of the stock in the hands of the shareholder. 4. If the distribution is not from earning and profits and the balance is more than the adjusted basis of the stock, then this results in the shareholder having a gain from the sale or exchange of property.C. Form 1099-DIV 1. The corporation must file Form 1099-DIV with the IRS for each shareholder to whom it paid dividends and other distributions on stock of $10 or more during a calendar year. 2. A corporation must generally send Forms 1099-DIV to the IRS with Form 1096 by February 28 (March 31 if filing electronically) of the year following the year of the distribution. 3. Generally, the corporation must furnish Forms 1099-DIV to shareholders by January 31 of the year following the close of the calendar year during which the corporation made the distributions.D. IRS Form 5452 1. A corporation should file IRS Form 5452 if nondividend distributions were made to shareholders. 2. A calendar tax year corporation must file Form 5452 with its income tax return for the tax year in which the nondividend distributions were made.

3. A fiscal tax year corporation must file Form 5452 with its income tax return due for the first fiscal year ending after the calendar year in which the nondividend distributions were made.E. §312 Earnings and Profits (E&P) 1. The tax concept of “earnings and profits” (E&P) is similar in many respects to financial accounting concept of “retained earnings” (RE). Both are methods of measuring a corporation’s capital balance accumulation. 2. The distinction of E&P is that it is determined using specific provisions under §312 of the Code. 3. E&P calculates the upper limit on the amount of the distribution by a corporation that a shareholder receives that must be recognized as a “dividend.” 4. E&P represents a corporation’s ability to pay dividends without infringing on its contributed capital.F. Calculating E&P 1. §312 does not provide a definition of E&P but §312 does provide for a series of adjustments to taxable income that will determine a corporation’s “economic income.” 2. Accumulated E&P is fixed as of the beginning of the tax year. It is the accumulation of undistributed earnings of a corporation since February 28, 1913. 3. Current E&P is the undistributed earnings of a corporation since the first day of the current taxable year attributable to the current tax year’s operations.G. §312 Additions to Current Year Taxable Income or Loss 1. In order to calculate current year E&P. Certain items which were excluded from taxable income must be added back to current year taxable income. 2. Examples of some positive adjustment items are: Municipal bond interest Life insurance proceeds Federal income tax refunds paid in prior year Dividends received deduction Deferred gain on an installment sale Any depreciation greater than the straight line under the ADS rules (§168(g)(2)) 80% of any current year §179 deduction. Etc.

H. §312 Subtractions from the Current Year Taxable Income or Loss1. §312 provides that it is necessary to subtract certain items from the current year’s taxable income in order to calculate the current year E&P.2. Examples of some negative adjustments are: Expenses incurred to produce tax-exempt income Life insurance premiums paid on key employees Fines and penalties Excess capital losses Portions of disallowed accelerated depreciation from prior year Disallowed losses under §267 related party rules Excess charitable contributions Etc.EXAMPLE #1: In 2012 C-Corp sells a piece of unimproved land for $100,000whose adjusted basis is $20,000. In 2013-2016 C-Corp will receive $25,000 ayear plus the interest on the installment note. For 2012 C-Corp has no taxableincome but will have an $80,000 positive adjustment for E&P in 2012. In each ofthe subsequent tax years 2013-2016 when the $25,000 is received $20,000 will bea negative adjustment for calculating E&P.EXAMPLE #2: On January 15, 2014 C-Corp purchased $30,000 worth of 7 yearequipment with an ADR midpoint life of 10 years. In 2014 the depreciation underMACRS was $4,287 ($30000 - 14.29%). The depreciation under the ADRrecovery period is 10 years on a mid-year convention resulting in depreciation of$1,500 ($30,000 ÷ 10 yrs. ÷ ½ yr.). The result for purposes of E&P is a positiveadjustment in 2004 of $2,787 ($4,287 MACRS less $1,500 ADR).EXAMPLE #3: Expanding Example #2 above further the following will illustratethe adjustments in years 2013-2015 which will include a sale of the asset in 2015for a selling price of $27,000 on December 21, 2015Year Adjustment MACRS ADS Amount2013 Cost Recovery Computations $4,287 $1,500 $2,787 $30,000 x 14.29%2014 $30,000 ÷ 10-year ADR recovery 7,347 3,000 4,347 period x ½ (half-year for first year of service) $30,000 x 24.49% $30,000 ÷ 10-year ADR recovery period2015 $30,000 x 17.49% x ½ (half-year for year of 2,624 1,500 1,124 disposal) $14,258 $6,000 $8,258 $30,000 ÷ 10-year ADR recovery period x ½ (half-year for year of disposal)Total Cost Recovery

Each year C-Corp increases its taxable income by the adjustment amountindicated above to determine E&P. Under the provisions of §312(f)(1) whencomputing E&P for 2015 the C-Corp reduces taxable income by $8,258 toaccount for the excess gain recognized for income tax purposes. Income Tax E&P $27,000Amount realized on sale $27,000 (24,000)Adjusted basis for income tax (15,742) $3,000($30,000 cost - $14,258 MACRS)Adjusted basis for E & P($30,000 cost - $6,000 ADS)Gain on sale $11,258Adjustment amount ($8,258)($30,000 - $11,258) NOTE: The ADR midpoint life for most assets is set out in Rev. Proc. 87-56, 1987-2 C.B. 674. The recovery period is 5 years for automobiles and light-duty trucks and 40 years for real property. For assets with no class life, the recovery period is 12 years.I. Current Year E&P 1. If a corporation’s earnings and profits for the year (calculated as of the close of the year without reduction for any distributions made during the year) are more than the total amount of distributions made during the year, then all distributions made during the year are treated as distributions of current year earnings and profits. 2. If the total amount of distributions is more than the earnings and profits for the year, then the corporation has distribution issues dealing with accumulated earnings and profits.EXAMPLE. Don is the only shareholder of a corporation that uses the calendaryear as its tax year. In January, the corporation uses the worksheet in the Form5452 instructions to calculate the corporation’s current year earnings and profitsfor the previous year. During the year, the corporation made four $1,000distributions to Don. At the end of the year (before subtracting distributions madeduring the year), the corporation had $10,000 of current year earnings andprofits.

Since the corporation’s current year earnings and profits of $10,000 was more than the amount of the $4,000 distribution it made during the year, all of the distributions are treated as distributions of current year earnings and profits. The corporation must issue a Form 1099-DIV to Don by January 31 to report that $4,000 distributed to Don during the previous year as dividends. The corporation must use Form 1096 to report this information to the IRS by February 28 (March 31 if filing electronically). The corporation does not deduct these dividends on its income tax return because “distributions” are not an expense they are a reduction of earnings and profits for income tax purposes and a reduction of retained earnings for financial reporting purposes. Accumulated earnings and profits: If a corporation’s current year earnings and profits (calculated as of the close of the year without reduction for any distributions made during the year) are less than the total distributions made during the year, then part or all of each distribution is treated as a distribution of accumulated earnings and profits. Accumulated earnings and profits are earnings and profits that the corporation accumulated before the current year and did not distribute them to shareholders in prior tax years.J. Summary Schedule of E&P Adjustments: 1. E&P serves as a measure of the earnings of the corporation that are available for distribution as taxable dividends to the shareholders. Current E&P is determined by making a series of adjustments to the corporation’s taxable income. These adjustments are reviewed below.Computing E & P Adjustment to Taxable Transaction Income to Determine Current E & P Addition SubtractionTax-Exempt income X XDividends received deductions X XCollection of proceeds from insurance policy on life ofcorporate officer (in excess of cash surrender value) X XDeferred gain on installment sale (all gain is added to E & P inyear of sale)Future recognition of installment sale gross profitExcess capital loss and excess charitable contribution (Over10% limitation) in year incurred

Computing E & P Adjustment to Taxable Transaction Income to Determine Current E & P Addition SubtractionDeduction of charitable contribution, NOL, or capital loss Xcarryovers in succeeding taxable year (increase E&P becausededuction reduces taxable income while E&P was reduced in aprior year)Federal incomes taxes paid XFederal income taxes refund XLoss on sale between related parties XNondeductible fines and penalties XPayment of premiums on insurance policy on life of corporate Xofficer (in excess of increase in cash surrender value of policy)Realized gain (not recognized) on an involuntary conversion No EffectRealized gain or loss (not recognized) on a like-kind exchange No EffectPercentage depletion (only cost depletion can reduce E&P) XAccelerated depreciation (E&P is reduced only by straight-line, Xunits-of-production, or machine hours depreciation)30% and 50% additional first-year depreciation X§179 expense in year elected (80%) X§179 expense in four years following election (20% each year) XIntangible drilling costs deducted currently (reduce E&P in Xfuture years by amortizing costs over 60 months)Mine exploration and development costs (reduce E&P in future Xyears by amortizing costs over 120 months)K. Allocating E & P to Distributions1. Current E&P is allocated first to distributions on a pro rata basis; then accumulated E&P is applied (to the extent necessary) in chronological order beginning with the earliest distribution.

2. Unless, and until the parties can show otherwise, it is presumed that current E&P covers all distributions.3. When a deficit exists in accumulated E&P and a positive balance exists in current E&P, distributions are regarded as dividends to the extent of current E&P.4. When a deficit exists in current E&P and a positive balance exists in accumulated E&P, the two accounts are netted at the date of distribution. If the resulting balance is zero or a deficit, then the distribution is treated as a return of capital, first reducing the basis of the stock to zero, then generating capital gain. If a positive balance results, then the distribution is a dividend to the extent of the balance. Any loss in current E&P is allocated ratably during the year unless the parties can show otherwise.5. When a positive balance exists in both the current and the accumulated E&P accounts, corporate distributions are deemed to be made first from current E&P and then from accumulated E&P.6. When distributions exceed the amount of current E&P, it becomes necessary to allocate current and accumulated E&P to each distribution made during the year. Current E&P is allocated on a pro rata basis to each distribution. Accumulated E&P is applied in chronological order, beginning with the earliest distribution. This allocation is important if any shareholder sells stock during the year. EXAMPLE: As of January 1 of the current year, Don’s Corporation has accumulated E&P of $10,000. Current E&P for the year is $30,000. Don and Peter are sole equal shareholders from January 1 to July 31. On August 1, Don sells all of his stock to Terry. The corporation makes two distributions to shareholders during the year: $40,000 to Don and Peter ($20,000 to each) on July 1, and $40,000 to Peter and Terry ($20,000 to each) on December 1. Current and accumulated E&P are allocated to the two distributions as follows: Source of DistributionCurrent E & P Accumulated Return of E&P Total Capital DistributionJuly 1 $15,000 $10,000 $15,000 $40,000distributionDecember 1 $15,000 -0- $25,000 $40,000distribution

Since 50% of the total distributions are made on July 1 and December 1,respectively one-half of current E&P is allocated to each of the two distributions.Accumulated E&P is applied in chronological order, so the entire amount isattributed to the July 1 distribution. The tax consequences to the shareholders arepresented below. ShareholdersJuly Distribution Don Peter Terry Totals1. Dividend income:a. From current E&P $7,500 $7,500 $-0- $15,000b. From accumulated E&P 5,000 5,000 -0- 10,000Total Dividend 12,500 12,500 -0- 25,0002. Return of Capital 7,500 7,500 -0- 15,000Total Distribution $20,000 $20,000 $-0- $40,000December Distribution1. Dividend Income:a. From current E&P $-0- $7,500 $7,500 $15,000 b. From accumulated E&P -0- -0- -0- -0-Total Dividend -0- $7,500 $7,500 $15,0002. Return of capital -0- 12,500 12,500 25,000Total for December Distribution -0- $20,000 $20,000 $40,000Summary:Total Dividends for the Year $12,000 $20,000 $7,500 $40,000Total Distribution for the Year $20,000 $40,000 $20,000 $80,000Since the balance in the accumulated E&P account is exhausted when it is applied to theJuly 1 distribution, Don has more dividend income than Terry even though both receiveequal distributions during the year. In addition, each shareholder’s basis is reduced by thenontaxable return of capital any excess over basis results in capital gain.

L. Dividend Defined 1. §316(a) provides that a dividend is a distribution of a corporation’s current and accumulated “earnings and profits” (E&P). EXAMPLE #1: Don received a distribution of $500 from IBM on January 31, 2015. Don’s marginal tax bracket is 35% but because the distribution is from IBMs E&P it is “qualified dividend income” to Don and is taxed at 15%. 2. If an existing Subchapter S-Corporation converted from a C-Corporation which has undistributed accumulated E&P, then a distribution of those profits would now be “qualified dividend income” to the shareholders. EXAMPLE #2: Don and Molly own Peter, Inc. a Subchapter S-Corporation with undistributed E&P from prior C-Corp years. Peter, Inc. distributes $5,000 of E&P to each shareholder. Don is in a 15% bracket and, therefore is subjected to a maximum dividend rate of 0%. Molly is in a 35% bracket and is subjected to a maximum rate of 15%. Since 2013, if a taxpayer is in the 39.6% marginal bracket the maximum long- term capital gain rate is 20%.M. Compensation Issues 1. Now that there is a 15% and 20% tax rate for “qualifying dividend income,” tax professionals and taxpayers will need to review the issues over excessive compensation paid to shareholder-employees of a Subchapter C-Corporation. 2. If excessive compensation is recharacterized as “disguised dividends” then the amount is nondeductible by the corporation. However, a maximum tax of 15% or 20% would be assessed against the individual. EXAMPLE #1: C-Corporation paid its only shareholders $250,000 in salary. The corporation pays tax at 34% and taxpayer was in the 39.6% bracket. Based on all the facts and circumstances, a reasonable salary for the work was $100,000. The IRS audits the corporation’s return and reclassifies $150,000 of the salary as a dividend. The corporation’s tax increases by $51,000 for each shareholder (34% of $150,000). Shareholders reported the salary as ordinary income so the shareholders paid tax of $57,900 (39.6% x $150,000). Shareholders tax is decreased by $29,400 because the tax on $150,000 of dividends would also be taxed at only 20%. 3. It is also interesting to note that the new lower dividend rate may tempt the corporation shareholders to have the corporation pay those wages that are less than reasonable.

EXAMPLE #3: A C-Corporation has taxable income of $64,000, beforeconsidering wages to its sole shareholder. The corporation pays a fair salary of$50,000, based on all facts and circumstances. The shareholder has income fromother sources, and is in the 35% individual income tax bracket. The corporation’staxable income is $14,000 ($64,000 - $50,000). Corporate income is taxed at 15%for income up to $50,000.The overall tax on corporate income and salary is $19,600 calculated as follows:Corporation’s tax ($14,000 x 15%) $2,100Shareholder’s tax on salary ($50,000 x 35%) 17,500 Total overall tax on corporate income and salary $19,600EXAMPLE #4: Assume the same facts as in Example #3 except that now areasonable salary for shareholder is $14,000 (rather than $50,000). The taxpayerneeds at least $50,000 from the corporation so the corporation also issuesdividends of $36,000 during the year. The corporation’s taxable income is now$50,000 ($64,000 - $14,000). The overall tax on the corporation’s income and thesalary and dividend it paid would be $17,800, calculated as follows:Corporation’s tax ($50,000 x 15%) $7,500Taxpayer’s tax on salary ($14,000 x 35%) 4,900Taxpayer’s tax on dividend ($36,000 x 15%) 5,400Total overall tax on corporate income, dividend & salary $17,800• The taxpayer has received $50,000 from the corporation in both scenarios, butthe overall reduction in tax is $1,800 ($19,600 - $17,800), plus payroll taxsavings on the $36,000 difference between $50,000 and $14,000 of salarywhich could be as much as $5,508 ($36,000 x 15.3%). Salary @ Salary @ Difference $50,000 $14,000 (decrease)Corporation’s Tax $2,100 $7,500 $5,400Shareholder’s Tax on Salary 17,500 $4,900 (12,600)Shareholder’s Tax on Dividend -0- 5,400 5,400FICA & Medicare 7,650 2,142 (5,508)Total Tax $27,250 $19,942 $(7,308)• The tax professional must remember that other issues should be considered such as reduced contributions to pension plans as the result of a reduced salary.

TAX PROFESSIONAL ALERT: Given IRS scrutiny, the manipulation of shareholder compensation to accomplish tax-savings objectives can be risk. The better the documentation (e.g., in the corporate minutes) and the greater the business purpose for such transactions, the more likely the transactions will withstand IRS attack. In any case, the compensation to the shareholder- employee must be reasonable for the services rendered.*Refer to IRS Publications: 542, 550 N. Constructive Distribution Issues 1. Below-market loans: If a corporation gives a shareholder a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate, then the interest not charged may be treated as a distribution to the shareholder. 2. Corporation cancels shareholder’s debt: If a corporation cancels a shareholder’s debt without repayment by the shareholder, then the amount canceled is treated as a distribution to the shareholder. 3. Transfers of property to shareholders for less than FMV: A sale or exchange of property by a corporation to a shareholder may be treated as a distribution to the shareholder. For a shareholder who is not a corporation, if the FMV of the property on the date of the sale or exchange exceeds the price paid by the shareholder, then the excess may be treated as a distribution to the shareholder. 4. Unreasonable rents: If a corporation rents property from a shareholder and the rent is unreasonably more than the shareholder would charge to an independent third party for use of the same property, then the excessive part of the rent may be treated as a distribution to the shareholder. (For more information, see Chapter 4 in IRS Publication 535.) 5. Unreasonable salaries: If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed by the shareholder-employee, then the excessive part of the salary may be treated as a distribution to the shareholder-employee. (For more information, see Chapter 2 in IRS Publication 535.) O. Property Distributions 1. Double taxation is also an issue when a C-Corporation distributes property to shareholders. The distribution of property by the corporation to the shareholder is a “deemed sale” of an asset at the asset's fair market value on the date of distribution.

2. The Corporation measures the difference between the: FMV of Assets On Distribution Date Less: Adjusted Basis of Asset Equals: Gain at Corporate Level • Losses on the distribution of property are not recognized.3. The individual shareholder will have a dividend equal to the FMV of the asset distributed to the extent of E&P of the corporation.4. The value of a distribution is equal to: FMV of Assets Distributed Less: Debt Assumed By Shareholder Equals: Value of Distribution5. The distribution is comprised of three possible tax effects to the shareholder: (a) Dividend to extent of E&P: ordinary income (b) Return of capital: tax free distribution (c) Any excess over the return of capital is equal to sale of a capital asset: capital gainEXAMPLE: A C-Corporation with E&P of $20,000 distributes property with abasis of $8,000 and a FMV of $14,000 to Don, a 50% shareholder.Don's stock basis is $10,000. On the distribution of the property, thecorporation recognizes a $6,000 gain.On the receipt of the property, Don has a taxable dividend of $14,000 which isthe FMV of the property.Corporate Level:FMV of Property Distributed $14,000Less: Adjusted Basis of Property (8,000)Equals: Gain at Corporate Level $ 6,000

Shareholder Level:FMV of Property Received $14,000Less: Debt Assumed by Shareholder $ (-0-)Distribution Value $14,000Earnings & Profits $20,000Dividend $14,000IV. Introduction to the Liquidation of a C-CorporationA. General Review1. When a C-Corporation liquidates it ceases to exist and the shareholders transfer their stock back to the corporation in exchange for the corporate assets. The corporation can liquidate the assets by either: Selling the assets and distributing the proceeds to the shareholders Or Distributing the assets directly to the shareholders (“deemed sale”)2. In either situation the corporation has a recognized gain or (loss) under §336 by measuring the difference between:FMV of Assets on the Date of the TransferLess: Adjusted Basis of AssetsEqual: Corporate Gain or (Loss)3. The shareholders have an individual recognized gain or (loss) under §331 on the disposition of their stock by measuring the difference between: FMV of ASSETS received from Corporation Less: Adjusted Basis of STOCK Given Up Equals: Individual Gain or (Loss) This gain or loss is reported on the individual shareholder's Form 1040 Schedule D.

EXAMPLEA Subchapter C-Corporation liquidates and distributes all of its assets andliabilities to Don the sole shareholder. The assets have a net FMV of $65,000 andadjusted basis of $40,000.Don's stock basis is $16,000 at liquidation.Corporate:Net FMV of Assets $65,000Less: Adjusted Basis of Assets (40,000)Corporate Gain $25,000Shareholder:Net FMV of Asset Received $65,000Less: Adjusted Basis of Stock (16,000)Capital GainB. Converting a Subchapter C-Corporation Into a Partnership 1. Converting a C-Corporation to a partnership would cause a liquidation to take effect thereby having possible tax at both the corporation and shareholder levels. 2. The tax consequences of liquidating a Subchapter C-Corporation as was discussed above can cause a trap for those entities that change their form of business entity (LLC). 3. Goodwill: Since the conversion taking place is a “deemed sale” of corporate assets with a distribution to the shareholders. A very crucial issue could be the asset concerning Goodwill. TAX PROFESSIONAL ALERT: Goodwill has a tax basis of zero and, therefore a taxable event takes place. Also other intangible assets created will have a smaller basis than the FMV. 4. The assets receive a stepped up basis since gain has been recognized, but this could be a very expensive change.

C. C-Corporation Losses 1. If the corporation generates a taxable loss then that loss is “locked” into the corporation since it is treated as a separate taxable entity. 2. The losses cannot pass through to the individual shareholders. Therefore, there is no use of these current year losses outside of the entity. If the entity liquidates, the losses are lost forever. It is recommended that if the corporation can continue to exist and another business activity can be generated the losses could be used in the future activity. Remember NOL's can be carried forward for 20 years.V. Introduction to the End of the Corporate Life Cycle A. General Review 1. The course objective is to give a general background of the income tax consequences of liquidation to both the shareholders and the corporate entity. 2. As part of the corporate life cycle, taxpayers may decide to discontinue the operations of a profitable corporation by liquidating it. As a result of this decision, the shareholders may receive liquidating distributions of the corporation's assets. 3. Preceding the formal liquidation, the corporation may sell part or all of the corporation's assets. The sale may take place in order to: Dispose of assets which the shareholder(s) may not want to receive in a liquidating distribution or To obtain cash which can be used to pay off the corporation's liabilities. 4. Generally for the small business client the liquidation is motivated by tax reasons such as: If the assets are producing operating and/or capital losses, then it may be to the shareholders advantage to hold the assets in an unincorporated form and deduct the losses on their personal tax returns. Since corporate earnings are taxed twice liquidation permits the assets to be held in an unincorporated form, thereby avoiding double taxation of the corporate earnings.

The bases of the corporate assets are stepped-up or down to their fair market value (FMV) when distributed in a liquidating distribution. This permits a smaller gain to be recognized by the shareholder when appreciated properties are subsequently sold or exchanged. The tax effect of this basis adjustment is that the liquidating corporation must recognize gain when making the distribution. 5. Sometimes the corporation is terminated because a buyer cannot be found or there are no family members who want to continue the daily operation. 6. Sometimes the corporation is terminated due to the fact that it is debt ridden and cannot continue to operate.B. §331 Income Tax Effects of Corporate Liquidations to Shareholders 1. The tax consultant assists their individual tax client in solving the three following issues: What is the amount and character of the shareholders' recognized gain or loss? What is the adjusted basis of the property that is received by the shareholder? When does the holding period commence for the property that is received by the shareholders? 2. When a corporation is liquidated the liquidating distribution is treated as an amount received in exchange for the shareholder's stock. 3. The shareholder recognizes the excess of the money received plus the FMV of other property received over the adjusted basis of their stock as a capital gain or loss. 4. §331(a) of the Internal Revenue Code provides that when a corporation ceases to exist and it distributes assets to a shareholder the amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as full payment in exchange for the stock. 5. The corporation can liquidate the assets by either: Selling the assets and distributing the proceeds to the shareholders Or Distributing the assets directly to the shareholders (“deemed sale”).

C. §334 Basis of Property Received by the Shareholder in Liquidation of their Stock 1. The bases of the properties that are received are stepped-up or stepped-down to the property's FMV on the liquidation date. The holding period of the assets commences on the day after the liquidation date. 2. §334(a) provides a general rule that if property is received in a distribution in complete liquidation, and if gain or loss is recognized on receipt of such property, then the basis of the property in the hands of the shareholder shall be the fair market value of such property at the time of the distribution.D. §336 Gain or Loss Recognized by the Corporation on Property Distributed in Complete Liquidation 1. The tax consultant also assists the corporate client in solving the two following income tax issues: What is the amount and character of the corporation's recognized gain or loss? 2. §336(a) provides a general rule that gain or loss shall be recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the shareholder at its fair market value. 3. §336(b) addresses the issue of any liabilities that may be attached to the property distributed. The law provides that if any property distributed in liquidation is subject to a liability or the shareholder assumes a liability of the liquidating corporation in connection with the distribution then the fair market value of such property cannot be less than the amount of such liability assumed or acquired. 4. §336(b) was enacted because the corporation has an economic gain or benefit equal to the amount of the liability assumed or acquired by the shareholder (and not just the lower FMV of the property distributed) as part of the liquidation. 5. The shareholders of the liquidated corporation will presumably be permitted to take a basis for the distributed property in the amount of the liability assumed or acquired.

EXAMPLE: Don Corporation owns assets costing $300,000 which have beendepreciated and the adjusted basis is $240,000. The property is secured by a$270,000 note. A plan of liquidation is adopted, and the property and the note aredistributed to Joe, the sole shareholder. At the time the property's FMV is$220,000. Don Corporation must recognize a $30,000 gain ($270,000 - $240,000)on distributing the property since its FMV cannot be less than the $270,000 noteon the property. Therefore, the property's basis to Joe is also $270,000.Corporation§336(b) Deemed Selling Price $270,000*Less: Adjusted Basis (240,000)Recognized Gain $ 30,000*FMV cannot be less than the amount of liability assumed by the shareholder.Also the shareholder’s basis will be the FMV attributed to the corporation’sdeemed selling priceIf Joe were to sell the property later at the actual FMV of $220,000 then he wouldhave a capital loss on the disposition of the asset of $50,000 calculated as follows:Selling Price $220,000Less: Adjusted Basis (270,000)Recognized Loss $(50,000)E. Definition of a Complete Liquidation Not Defined in the Code 1. The term complete liquidation is not defined in the Code. However, Reg. §1.332-2(c) indicates that distributions made by a liquidating corporation must: Completely cancel or redeem all of its stock in accordance with a plan of liquidation, or Be one of a series of distributions that completely cancels or redeems all of its stock in accordance with a plan of liquidation. 2. When there is more than one distribution, the corporation must be in a liquidation status at the time that the first liquidating distribution is made under the plan. This liquidation status must continue until the liquidation is completed.3. A distribution that is made before a plan of liquidation is adopted will generally be taxed under the dividend distribution or stock redemption rules.

4. A liquidation status exists when the corporation: Ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, Paying its debts, and Distributing any remaining properties to its shareholders. 5. A liquidation is completed when the liquidating corporation has divested itself of all properties. The retention of a nominal amount of assets (e.g., to retain the corporation's name) does not prevent a liquidation from occurring for tax purposes. 6. The liquidation of a corporation does not mean that a corporation has undergone dissolution. Dissolution is a legal term that implies that the corporation has surrendered the charter that it originally received from the state. A corporation may complete its liquidation prior to surrendering its charter to the state and undergoing dissolution. Dissolution may never occur if the corporation retains its charter in order to protect the corporate name from being acquired by another party. EXAMPLE: Don Corporation adopts a plan of liquidation in December 2014. All but a nominal amount of Don's assets are distributed to its shareholders in January 2015. The nominal assets are retained to preserve the corporation's existence under state law and to prevent others from acquiring the corporation's name. The retention of the nominal amount of assets does not prevent Don from having been liquidated for tax purposes in January 2015.F. Income Tax Effects of the General Liquidation Rules The coverage of the general liquidation rules is divided into four parts: 1. Amount and timing of gain or loss recognition, 2. Character of the recognized gain or loss, 3. Basis of property received in the liquidation, and 4. The open versus closed transaction concept.

G. §331 Gain or Loss Recognized by a Shareholder in a Corporate Liquidation 1. §331(a) requires that amounts received by a shareholder as a distribution in complete liquidation of a corporation be treated as full payment in exchange for the stock. 2. The amount of the shareholder's recognized gain or loss equals the difference between the amount realized and the basis for the stock. 3. If a shareholder assumes or acquires liabilities of the liquidating corporation, then the amount of these liabilities reduces the amount realized by the shareholder. EXAMPLE #1: Don Corporation is liquidated with Joe receiving $10,000 and other property having a $12,000 FMV. Joe's basis in his stock is $16,000. Joe's amount realized is $22,000 ($12,000 + $10,000). He must recognize a $6,000 ($22,000 - $16,000) gain on the liquidation. EXAMPLE #2: Assume the same facts as above except that Joe also assumes a $2,000 debt attached to the other property. Joe's amount realized is reduced by the $2,000 liability assumed and is $20,000 ($22,000 - $2,000). The recognized gain on the liquidation is now only $4,000 ($20,000 - $16,000).H. Stock Acquired at Various Times 1. The shareholder's stock basis may have been acquired at different times. If this occurs, then the shareholder must calculate the gain or loss separately for each share or block of stock that is owned.I. Partially Liquidating Distributions 1. Liquidating distributions are often received in the form of a series of partially liquidating distributions. 2. §346(a) provides that a series of partially liquidating distributions received in complete liquidation of the corporation are taxed under the §331 liquidation. 3. In a revenue ruling the IRS permits the shareholder's basis to be recovered first and then requires the recognition of gain once the basis of a particular share or block of stock has been fully recovered. 4. A loss cannot be recognized with respect to a share or block of stock until the final liquidating distribution has been received or until it becomes clear that there will be no more liquidating distributions. (Rev. Rul. 68-348; 1968-2 C.B. 141.)

EXAMPLE #1: Joe owns 1,000 shares of X Corporation stock purchased for $40,000 in 1999. Joe receives the following liquidating distributions: 1. July 23, 2014, $25,000; 2. March 12, 2015, $17,000; and 3. April 5, 2016 $10,000. No gain is recognized in 2016 since Don's $40,000 basis is not fully recovered by year-end. The $15,000 ($40,000 - $25,000) unrecovered basis that exists after the first distribution is less than the $17,000 liquidating distribution that is received on March 12, 2015, and therefore a $2,000 gain must be recognized in 2015. An additional $10,000 gain is recognized in 2016 when the final liquidating distribution is received. EXAMPLE #2: Assume the same facts as above, except that Joe has a basis of $60,000 in his stock. The receipt of each of the liquidating distributions is tax free, since $60,000 basis exceeds the $52,000 ($25,000 + $17,000 + $10,000) total of the distributions. An $8,000 loss ($52,000 - $60,000) is recognized in 2016 when Joe receives the final liquidating distribution.J. Basis of Property Received in the Liquidation 1. §334(a) provides that the basis of any property received under the general liquidation rules is its FMV on the distribution date. The holding period for the asset starts on the day after the distribution date.K. Subsequent Assessments against the Shareholders 1. The shareholders may be required at a date subsequent to the liquidation to pay a contingent liability of the corporation or a liability that is not anticipated at the time of the liquidating distribution (e.g., an income tax deficiency determined after the liquidation is completed or a judgment that is contingent at the time the final liquidation distribution is made). 2. The additional payment does not affect the reporting of the initial liquidating transaction. 3. The tax treatment for the additional payment depends on the nature of the gain or loss that was originally reported by the shareholder and not on the type of loss or deduction that would have been reported by the liquidating corporation if it had instead paid the liability.