Tax Planning When Funding a Business Entity

Cite this article as:"Tax Planning When Funding a Business Entity," in The Business Professor, updated June 2, 2017, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/tax-plan-when-funding-business-entity/.

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CORPORATIONS

What tax issues arise when funding a business entity?

The salient tax issues when funding a business entity concern the transfer of property to the entity in exchange for an ownership interest, the receipt of value other than an ownership interest, and shareholder’s basis in the funded business entity. Partnership-taxed entities and corporations (both C and S) vary in the tax treatment of these situations.

Does a shareholder incur a tax liability when transferring property to a corporation in exchange for equity?

IRC Section 351, a broad rule applying to corporations, generally defers from taxation any gain or loss incurred on property transferred to a corporation in exchange for stock. The requirements of IRC Section 351 are discussed below.

  • Example: Eric decides to contribute his heavy machinery to a newly formed corporation. He paid $100,000 for the equipment but has depreciated the equipment rapidly and his basis is now $50,000. The fair market value of the equipment is approximately $75,000. If he were to sell the equipment, he would recognize a gain on the sale. He instead contributes the property to the corporation in exchange for 100% of the stock of the corporation. Pursuant to IRC Section 351, Eric will not recognize a gain on the transfer of the equipment to the corporation. Likewise, pursuant to IRC Section 1032, the corporation will not pay any gain upon receipt of the equipment (discussed below).
  • Note: Shareholders may wish to transfer property with a fair market value that is less than the basis in the asset (i.e., a loss asset). Generally, IRC Section 351 does not allow for the recognition of losses on property transferred to the corporation. In order to recognize the losses on the transaction, the shareholders should transfer the loss assets in a transaction that does not qualify for deferral of IRC Section 351. Note, however, loss recognition is not allowed if the shareholder owns (or constructively owns) more than 50% of the corporation’s outstanding stock after the transaction. Alternatively, the shareholder could sell the asset, recognize the loss, and transfer the proceeds of the sale to the corporation.

Does a corporation incur a tax liability when receiving property in exchange for equity?

Generally, no. IRC Section 1032 excludes the recognition of any gain or loss on property by a corporation upon receiving property in exchange for equity.

  • Example: In the case of Eric above, pursuant to IRC Section 1032, the corporation will not pay any gain upon receipt of the equipment.

What are the requirements to defer tax liability when transferring property to a corporation?

IRC Section 351 has several requirements. First, it only applies to the exchange of property for voting stock in the corporation. If any shareholder involved in the transaction receives equity for services or something other than voting stock, the transaction may not qualify for tax deferral. Second, following the transaction, the individuals transferring property to the corporation must control 80% of the total voting stock and 80% of each class of stock.

  • Example: Alice, Cindy, and Jan transfer equipment to a new corporation. Each founder receives an equal portion of common stock of the corporation. The corporation does not issue a second class of stock or other security instruments. After the transaction, the three own 100% of the only class of stock of the corporation. The transaction qualifies under IRC Section 351, and the shareholder does not recognize gain on the transfer.
  • Note: If a single shareholder runs afoul of the IRC Section 351 requirements, the benefits may be lost for all of the shareholders participating in the transaction.

Can shareholder lose the tax deferment benefit when transferring property to a corporation?

This rule has numerous limitations to further protect against sham transfers that would otherwise violate the rule. The following shareholder action can forfeit the tax deferral benefit:

  • Voting Class of Stock – As previously stated, following the transaction, shareholders transferring property to the corporation in exchange for equity must control 80% of all existing classes of stock. This includes non-voting stock, such as preferred shares. In that sense, shareholders involved in the transaction must make certain to identify and calculate ownership percentage for each stock class.
  • Minimum Participation – For existing corporations, existing shareholders must take part in the property transfer to meet the 80% ownership requirements of IRC Section 351. To make certain that existing shareholders do not nominally participate (i.e., play a minimal role in the transaction to allow other shareholders to satisfy IRC Section 351 requirements), existing shareholders participating in the transaction must contribute property with a value equal to at least 10% of the total value of the stock owned by those existing shareholders.
    • Example: Tom, Al, and Mary are equal owners of 100% of the only class of shares of Small Corp, Inc. Smith wants to become a shareholder and wishes to exchange equipment for an ownership interest in the corporation. In exchange for his contribution, Smith wants to receive 10% of the post-contribution shares. This will dilute Tom, Al, and Mary to 90% owners. Unless Tom, Al, and Mary take part in the transaction (i.e., provide additional property in exchange for shares of stock) then IRC Section 351 will not apply. To meet the IRC Section 351 requirements, Tom, Al, and Mary must contribute property equaling 10% of the total value of their ownership interest along with Smith’s contribution. This will allow Smith to be part of the group owning 80% or more of the corporation immediately following the transfer.
  • Immediate Disposition of Corporate Stock – If the corporation immediately sells or transfers property transferred to the corporation for stock, this action can forfeit the IRC Section 351 benefits for shareholders. This situation makes it appear that shareholders transferred property to the corporation as a funnel to avoid personally recognizing gains or losses associated with personally selling the property. This may be advantageous, as the corporation may have a lower tax rate or be able to offset any gains or losses on the property.

What is the result if the shareholder receives some form of value in addition to corporate shares?

IRC Section 351 permits a shareholder to contribute property and receive some form of value in addition to corporate shares. Additional value received is commonly known as “boot”. The shareholder, however, will have tax liability for the non-stock value received from the corporation. Specifically, the shareholder will recognize a gain in the transaction equal to the lesser of the fair market value of the additional value received or the “built-in-gains” in the property transferred to the corporation by the shareholder. The shareholder cannot recognize losses on property transferred to the corporation.

  • Example: Tim transfers equipment to the corporation that has a basis of $100,000 and a fair market value of $200,000. He receives a 10% stock interest in the corporation valued at $100,000 and $100,000 in cash. In this case, Tim will recognize a gain of $100,000 on the transfer of property, which is the fair market value of the boot ($100,000) and the amount of built-in-gains in the property ($100,000). If, instead of $100,000 in cash, Tim had received property from the corporation that had a fair market value of $90,000, he would have recognized gain of $90,000 (the fair market value of the boot received), which is less than $100,000 (the built-in gains in the property).
  • Note: Types of additional value received by a shareholder include, cash, notes, bonds, non-voting securities, etc.

What is the shareholder’s basis in the stock following the transfer?

Pursuant to IRC Section 358, the shareholder’s basis in the corporate stock will equal the basis in the property transferred to the corporation, plus any gain that the shareholder recognizes in the transaction, minus the fair market value of any boot received from the corporation. This is known as a “substitute basis”. If, however, the property transferred to the corporation has a fair market value of less than the shareholder’s basis in the property, IRC Section 362(e) limits the ability of the shareholder and the corporation to recognize a loss on the transaction. In this case, the corporation and shareholders can agree on the allocation of basis. Further, rather than the shareholder maintaining a basis equal to her basis in the property transferred, the parties can agree that the basis in the newly acquired stock will equal the fair market value of the property transferred to the corporation. In this case, the corporation’s basis in the newly acquired property will equal the shareholder’s basis prior to transfer.

  • Example: Michelle transfers equipment to the corporation in exchange for stock and a $1,000 computer. Her basis in the equipment is $10,000. The $1,000 computer received by Michelle is boot, which she will recognize as gain. Generally, her basis in the stock will be $10,000 ($10,000 basis + $1,000 gain recognized – $1,000 boot received). If the equipment transferred to the corporation was worth only $8,000, Michelle cannot recognize the $2,000 loss on the equipment at the time of transfer. The shareholder and corporation can, however, agree that Michelle will take an $8,000 basis (the FMV of the property) in the stock and the corporation’s basis in the property will be $10,000 (the shareholder’s prior basis in the equipment). As such, Michelle takes a lower basis and the corporation gets the stepped up basis.

What is the corporation’s basis in the property following the transfer?

Pursuant to IRC Section 358, the corporation’s basis in the property following the IRC Section 351 transaction equals the shareholder’s basis in the contributed property, plus any gain recognized by the shareholder in the transaction. If the fair market value of the property transferred to the corporation is less than the shareholder’s basis in the transferred property, the corporation’s basis will equal the fair market value of the stock. As stated above, an exception to this rule is where the corporation and shareholder agree that the shareholder’s basis in the stock will not be higher than the fair market value of the stock. This effectively places the lower basis value on the shareholder. The corporation’s basis will then be the shareholder’s basis in the property at the time of the transaction.

  • Example: Donna transfers equipment with a basis of $3,000 and a fair market value of $5,000 to the corporation in exchange for stock. Assume the transaction qualifies under IRC Section 351. The corporation will take Donna’s basis in the equipment, which is $3,000. If Donna elects to recognize $2,000 in gain, then the corporation’s basis in the property would be $5,000. If the fair market value of the equipment at the time of transfer is $2,000 (rather than $5,000), the corporation would have a $2,000 basis and the shareholder’s basis in the stock received would be her original basis of $3,000. Donna and the corporation may agree, however, to allocate the higher basis of $3,000 to the property and Donna will take a basis in the stock equal to the fair market value of the equipment ($2,000).

What happens if the corporation assumes shareholder debt associated with the transferred property?

IRC Section 351 allows for the assumption by the corporation of shareholder debt associated with property transferred to the corporation. Pursuant to IRC Section 357, the amount of debt assumed reduces the shareholder’s basis in the property. If, however, the amount of debt assumed by the corporation exceeds the shareholder’s basis in the contributed property, the amount of debt above the shareholder’s basis in the property is treated as gain to the shareholder. The corporation’s basis in the property is the amount of the assumed debt. A shareholder may lose the benefits of IRC Section 351 if the principle purpose of transferring the property and debt to the corporation was tax avoidance rather than a valid business purpose. Assuming additional debt on property prior to transferring it to the corporation is evidence that there was not a valid business purpose. Lastly, if the shareholder also remains responsible for the debt that is jointly assumed by the corporation, it will not change the situation described above and will not destroy the exemption as long as the corporation is expected to pay the debt.

  • Example: Winston transfers equipment with a value and a basis of $10,000 to the corporation. The equipment is subject to a promissory note owed to the dealer in the amount of $6,000. The corporation assumes the debt. Winston’s basis in the newly acquired stock will be $4,000 ($10,000 basis – $6,000 debt assumed). If, however, Winston’s basis in the property is $5,000, he will recognize a gain of $1,000 ($6,000 debt assumed – $5,000 debt shareholder basis). If Winston takes out loans against the property prior to transferring it to the corporation, it may be evidence that he was attempting to avoid the recognition of gain and gain may be imputed to him in the transaction.
  • Note: If the shareholder transfers assets to the corporation that secures a debt, but the debt is also secured by property not transferred to the corporation, the corporation’s basis in the property will be reduced by the value of the non-transferred property securing the debt to the extent of the security interest.

What happens if the equity received by the shareholder is in exchange for services to the corporation?

Providing services to a corporation in exchange for stock is generally a taxable event. Pursuant to IRC Section 83(a), the shareholder receiving the stock will be attributed with income equal to the fair market value of the stock at the time of issuance. There is an exception to this rule under IRC Section 83(b). This section allows shareholders to defer the recognition of the income until a later date if certain conditions exist. In summary, the shares awarded to the shareholder must face a “substantial risk of forfeiture”. This means that there are provisions in the agreement that keeps ownership of the shares from vesting in the shareholder for a period of time. The most common type of restrictions is a stock award that is subject to vesting schedules and forfeiture provisions. This will allow the shareholder to defer recognition of the income until the substantial risk of forfeiture is no longer in place. This may occur once ownership of the shares of stock has fully vested in the shareholder. The downside is that shareholder will be taxed on the value of the stock at the time the substantial risk of forfeiture is gone. If the stock rises dramatically in value, the shareholder will face a much higher tax liability.

  • Example: John receives stock in exchange for his services to New Corp, Inc. The stock award agreement states that ownership in a certain percentage of the shares will vest over several years. If John fails to meet certain performance levels or leaves the employ of New Corp, then all non-vested shares are forfeited. This would be sufficient to constitute a substantial risk of forfeiture. John will recognize income when the shares vest and there is no longer a risk of forfeiture in place.

How can a shareholder elect to immediately recognize as income shares that are subject to a risk of forfeiture?

IRC Section 83(b) allows a shareholder receiving stock for services that is subject to a substantial risk of forfeiture to recognize the value of the stock as income in the year distributed. This allows the shareholder to recognize the stock as income before the stock increases in value. This is incredibly valuable for startup entrepreneurs who expect rapid growth of the corporation and value of the shares of stock. The risk associated with making an IRC Section 83(b) election is that the value of the stock will decrease, as there is no subsequent deduction allowed to the taxpayer. In such a case, the shareholder incurs income tax on the higher value.

  • Example: Sarah agrees to work for the corporation in exchange for salary and an equity holding in the company. She will receive 1% ownership stake in the company at the end of each year for 3 years (her vesting schedule). If she leaves the company prior to the end of 3 years, all of her stock interest is forfeited back to the corporation. The contingency that Sarah stay at the company 3 years before owning her equity interest constitutes a substantial risk of forfeiture. Under IRC Section 83(a), Sarah can defer recognition of the stock award as income until the end of year 3. If, however, she chooses to recognize the stock award as income at the time that it vests (at the end of each year), she can elect to do so under IRC Section 83(b). Electing to recognize the income in the year awarded may lower her tax liability, as the stock will likely rise in value. If she waits until the end of year 3 to recognize the total value of the vested stock, she will pay income on the present value of the stock at that time.

• Note: Shareholders may not want or be able to pay the taxes on issues of stock for services, as she does not receive any cash along with the stock. In such a case, the shareholder may negotiate with the corporation to provide a bonus, known as a “gross up payment”, to cover the taxes on the value of the stock received.

PARTNERSHIP – TAXED ENTITIES

What is the tax liability of the partnership when property is transferred to the entity in exchange for an ownership interest?

Pursuant to IRC Section 721, partners generally do not recognize gain or loss on the contribution of property to the business entity. Partnership taxed entities include partnerships and LLCs. I will refer to business owners collectively as partners.

  • Example: Cliff transfers property to a partnership in exchange for a 30% ownership interest in the partnership. If the transaction qualifies under IRC Section 721, Cliff will not recognize a gain or loss on the transfer to the partnership.

What are the requirements for an exemption from the recognition of gains in an IRC Section 721 transaction?

IRC Section 721 is generally easier to navigate than IRC Section 351 in that there are no formal requirements for the transaction to qualify under the tax section. Particularly, the IRC Section 351 requirements that the contributing shareholders control more than 80% of the interest after the transaction and the concerns over voting versus non-voting shares are not applicable.

  • Example: In the case of Cliff above, the transaction will likely qualify under IRC Section 721. If Cliff had transferred the property to a corporation, the transaction would have failed to qualify as an IRC Section 351 transaction. Cliff would not have control of more than 80% of the corporation following the transaction and would therefore have to recognize any gain or loss on the transfer.

What is the partner’s basis in the ownership interest following the transfer?

Under IRC Section 722, the partner’s basis in the partnership acquired in exchange for property contributed to the partnership in an IRC Section 721 transaction equals the partner’s basis in the contributed property, plus any gain recognized. This is known as “outside basis”.

  • Example: In the case of cliff above, Cliff’s basis in the partnership will equal his basis in the property contributed to the partnership. If Cliff’s basis in the property is lower than the value of the partnership interest received, Cliff may be able to recognize a gain on the transaction. Any recognition of gain will raise Cliff’s basis in the partnership by that amount.

What is the partnership’s basis in the property following the transfer?

Pursuant to IRC Section 723, the partnership assumes the basis of the transferring partner in the subject property, increased by any gain recognized by the partner in the transaction. This is known as the “inside basis”. Unlike IRC Section 351, IRC Section 721 does not place limits on the ability to transfer property with a loss to the entity; however, the partner’s basis in the partnership can never go below zero.

  • Example: In the case of Cliff above, the Partnership’s basis will equal Cliff’s basis in the property at the time of transfer. If Cliff recognizes gain on the transaction, the partnership’s inside basis in the property will consist of Cliff’s basis, plus the gain Cliff recognizes on the transaction.

What is the result if a partner receives some form of value in addition to an ownership interest?

Unlike IRC Section 351, IRC Section 721 does not permit the transfer of boot in the transfer of property to a partnership in exchange for an ownership interest. If a partner transfers property to a partnership in exchange for an ownership interest, the entire transaction will be treated as if it were a sale of the property to the partnership. Notably, in such a situation, the partner may recognize a loss on property transferred to the partnership. Loss recognition on the transaction is not available, however, if the partner is a 50% or more owner of the partnership (this includes a holder of a 50% or great earnings interest). Further, if the property transferred to the partnership is something other than a capital asset or is a depreciable asset, then any gain recognized by the partner owning more than 50% in the transaction will be taxed as ordinary income.

  • Example: Garth transfers equipment to the partnership with a basis of $5,000 and a fair market value of $7,000. This transaction would qualify under IRC Section 721 and there is no recognition of gain. If, however, the partnership transfers a partnership interest worth $5,000 and a computer worth $2,000, the entire transaction will be treated as a sale of the property to the partnership. The transfer of the equipment will be treated as a sale and Garth will recognize a gain of $2,000 ($7,000 sale – $5,000 basis).

What happens if the partnership assumes shareholder debt associated with the transferred property?

The partnership may assume debt along with the transfer of property to the partnership. If the assumption of debt reduces the partner’s obligation then the partnership’s assumption of debt is treated as a payment of cash to the partner to the extent of her debt reduction. This lowers the partner’s basis. If the debt assumed is greater than the partner’s basis, she is taxed on the difference as a gain as if the property were sold for the amount of the assumed debt.

  • Example: Victoria contributes property to the partnership with a basis of $5,000 in exchange for an interest in the partnership. The value of the property is $10,000 and there is an outstanding loan on the property of $10,000. The partnership assumes the $10,000 loan as part of the transfer of ownership. Victoria will recognize a gain on the transfer of $5,000. Victoria’s basis in the partnership will be $0 ($5,000 original basis – $5,000 debt assumed).

What happens if the partner contributes property to the partnership with gain that is later sold by the partnership?

As previously stated, the partnership’s basis in property received from a partner is the same as the partner’s basis. If the fair market value of the property is higher than the partner’s basis, then the gain in the value of the asset is not recognized. The partnership, however, must track the basis in the property for tax purposes. If the partnership later sells the property, it will have to report any amount of the sale above the basis in the property. The contributing partner is allocated gain to the extent of the built-in-gain of the asset at the time the partner transferred it to the corporation. The tricky part of this situation is that the partnership may depreciate certain property each year. As previously stated, if property is sold for higher than the basis, the gain will be attributed to the contributing partner to the extent of the built-in-gain at the time of transferring it to the corporation. Due to the depreciation of the asset, the amount of gain attributable to the partner equals the depreciated book value minus the depreciated tax basis.

  • Example: Property with value of $300 and basis of $100 is contributed. The inside tax basis is $100. The contributing partner’s inside built-in gain is $200 ($300 FMV – $100 basis). First year book value depreciation is $30 and tax basis depreciation is $10 (both are 10% of total). If the property is sold next year for $280, the total gain on the sale is $190 (280 sale price – 90 tax basis). Contributing partner’s internal basis is $180 ($270 Book Value – $90 tax basis). Of the total gain, $180 is attributed to contributing partner. The other $10 of gain is distributed equally among all partners.

What happens if property contributed to the partnership is later distributed to other partners?

If property contributed by a partner is later distributed to a non-contributing partner, it is treated as having been sold for its fair market value. This is true if the property is distributed within 7 years of the date it is contributed to the partnership. As in the above situation, any gain on the property will be attributed to the contributing partner to the extent of her built-in gain.

  • Example: Bernice contributes property with a basis of $500 and a fair market value of $700 to the partnership. Bernice’s built-in-gains in the partnership is $200. If the property is later distributed to a partner for $800, the first $200 of gain is attributed to Bernice. The remaining $100 gain is distributed equally among the partners.

How do partnerships allocate losses on the sale of property with a built-in-gain?

If property with a fair market value that is higher than the partner’s basis is contributed to the partnership, the partner has a built-in gain. If the partnership later sells the property for an amount that is less than the book value (fair market value at time of contribution – depreciation), then there is a book loss to the partnership. There is, however, still a recognizable gain to the original partner if the sale price is above the partner’s tax basis. In this situation, there are two ways to allocate the gains and losses. First, the entire gain (sale price – tax basis) can be attributed to the contributing partner. In this situation, the book loss is ignored. Second, the entire built-in gain in the property can be attributed to the contributing partner (book value – tax basis). This amount will also equal the realized gain, plus the amount of book losses. Since the contributing partner pays taxes on the entire amount, the book losses can be distributed to the other partners.

  • Example 1: Thomas, a partner, contributes property worth $300 with $100 basis to the partnership. The partnership’s inside basis is $100 equal to Thomas’ basis at the time of contribution. After one year of depreciation (10% annual depreciation rate), the book value of the property is down to $270 and the tax basis is down to $90. That year, the property is sold for $240. This yields a gain of $150 ($240 sale price – $90 inside tax basis). The entire $150 of gain is attributed to Thomas, who has a built-in gain of $180 ($270 book value – $90 tax basis).
  • Example 2: In the above scenario, the sale of the property yields a gain of $150, but a book loss of $30 ($270 book value – $240 sale price). If the property were sold at book value, the total gain would have been $180 ($270 book value – $90 tax basis). In such a situation, the partners may choose to allocate the entire $180 hypothetical gain to the contributing partner and split up the $30 loss between all partners.

What happens if the equity received by the partner is in exchange for services to the partnership?

As discussed in Chapter 4, when a partner receives an ownership interest in exchange for services to the business, the partner is taxed on the value of the fair market value of the partnership interest received. This situation gives rise to “phantom income”, as the new partner does not actually receive any cash for her services. The partnership may award an interest that is subject to a vesting schedule and a substantial risk of forfeiture. The partner does not recognize income until the substantial risk of forfeiture is gone. If the partner wishes to recognize the value of the partnership interest as income at the time that it vests, she can make an IRC Section 83(b) election. This provision functions identically as in the corporation scenario.

  • Example: Venus performs services to the partnership and receives a 10% partnership interest in exchange. The value of the partnership is $100,000. Venus will be taxed on the $100,000, even though she did not actually receive any funds. Venus may receive the ownership interest on a vesting schedule with forfeiture provisions if Venus leaves the partnership for any reason. As such, she will pay taxes on the value of the interest at the time it vests.
  • Note: Unlike IRC Section 351 applicable to corporations, the distribution of equity for services as part of a IRC Section 721 transaction involving the contribution of property does not destroy the ability to defer the recognition of gain or loss on the contribution.
  • Note: Rather than giving an ownership interest to individuals providing services to the business, partnership often award a profits interest in the business. A profits interest is a contractual right to share in the profits of the partnership pursuant to the terms of the profits interest agreement. The notable difference between an ownership interest and a profits interest is that the profits interest does not entail the other rights and liabilities associated with ownership.

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