Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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SECTION 11.7
CORPORATE FORMATION
When a taxpayer incorporates a business, he or she often transfers high-value, low-basis
property to the corporation in exchange for corporate stock. Thus, a substantial gain is
realized when the corporation is formed. Favorable tax treatment is available in certain
cases which allows many taxpayers to defer the gain realized in the year of formation.
To defer the gain, the taxpayer must meet certain requirements, including:
1. The taxpayer must transfer property or money to the corporation,
2. The transfer must be solely in exchange for stock of the corporation, and
3. The shareholder(s) qualifying for nonrecognition must own at least 80 percent of the
corporation’s stock after the transfer.
When the above requirements are met, losses as well as gains are not recognized on the
formation of the corporation.
The sharehol der must transfer property or cash to the corporation; performing services
for corporate stock does not qualify for nonrecognition treatment. The sha reholder per-
forming services must recognize income in an amount equal to the value of the stock
received. If the shareholder receives other property (boot) in addition to stock of the cor-
poration in exchange for the transfer of cash or other property, the transaction may still
qualify for partial nonrecognition treatme nt, provided the control requirement is met.
However, realized gain must be recognized to the extent of the boot received.
Liabilities
As a general rule, the assumption of shareholder liabilities by the corporation is not con-
sidered to be boot. For example, if a sharehol der transfers land to the corporation for stock
and the land is subject to a liability that is assumed by the corporation, no gain would nor-
mally be recognized on the transfer. However, if there is no business purpose for transfer of
the liability, or tax avoidance appears to be involved, the recognition of any realized gain is
required. Also, when the total liabilities transferred to the corporation by a shareholder
exceed the total basis of the property transferred by the shareholder, the excess amount
is a gain that must be recognized without regard to whether gain is realized.
EXAMPLE Robusta Corporation is formed by Max, who contributes property
with a basis of $12,000 in exchange for 100 percent of the company’s
stock. On the date of the contribution, the property contributed has a
fair market value of $120,000 and is subject to a liability of $20,000.
Max must recognize a gain of $8,000 on the transfer of the property
to the corporation since the liability transferred to the corporation
exceeds his basis in the property transferred. N
Self-Study Problem 11.6
Assume that Aspen Corporation in Problem 11.5 is owned by Janet Nall, who is
a 100 percent shareholder. Also, assume that the corporation has a valid S cor-
poration election in effect for 2010 and is not subject to any special taxes.
Using the relevant information given and assuming the corporation’s retained
earnings are $19,000, instead of $17,200, accounts payable are $24,000, rather
than $25,800, and no estimated tax payments are made, complete Form 1120S
on pages 11-19 through 11-22 for Aspen Corporation, and com plete Schedule
K-1 on pages 11-23 and 11-24 for Janet. Also complete Schedules K and L for
Aspen Corporation, assuming there were no cash distributions to Janet during
the year.
Section 11.7
Corporate Formation 11-17
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Shareholder’s Stock Basis
After the transfer, the shareholder’s basis in his or her stock is determined by the following
formula:
Basis of the property transferred $ xxxx
Less: boot received (xxxx)
Plus: gain recognized xxxx
Less: liabilities transferred
(xxxx)
Basis in the stock
$ xxxx
Corporation’s Basis in Property Contributed
The corporation’s basis in the property received from a shareholder in a transaction to
which nonrecognition treatment applies is the same as the basis of the property to the
shareholder, increased by any gain recognized by the shareholder on the transfer.
EXAMPLE A, B, and C form Hornbeam Corporation. A contributes property
with a basis of $25,000 in exchange for 40 shares of stock worth
$40,000. B performs services for the corporation in exchange for
10 shares of stock worth $10,000. C contributes property with a basis
of $10,000 in exchange for 45 shares of stock worth $45,000 plus
$5,000 cash. The stock described above is all of the outstanding stock
of the corporation. A and C qualify for complete or partial nonrecog-
nition treatment, since together they own 89 percent (85 of 95 shares)
of the stock after the transfer. B’s stock is not considered because it
was received in exchange for services.
1. A has a realized gain of $15,000 ($40,000 $25,000), but no
recognized gain since he received no boot.
2. B’s recognized income is $10,000, since he performed services
in exchange for the stock, and stock received for services does
not f all within the nonrecognition provisions.
3. C’s realized gain is $40,000 ($45,000 þ $5,000 $10,000), but his
recognized gain is $5,000, the amount of boot received.
4. A’s basis in the stock is $25,000 ($25,000 $0 þ $0 $0), B’s
basis in the stock is $10,000 ($0 $0 þ $10,000 $0), and C’s
basis in the stock is $10,000 ($10,000 $5,000 þ $5,000 $0).
5. Hornbeam Corporation’s basis in the property contributed by A is
$25,000 ($25,000 þ $0). The corporation’s basis in the property
contributed by C is $15,000 ($10,000 þ $5,000 gain recognized). N
Self-Study Problem 11.7
Tammy has a business which she decides to incorporate. She transfers to the
new corporation real estate with a basis of $75,000 and subject to a $34,000
mortgage in exchange for all of its stock. The stock is worth $125,000.
What is Tammy’s realized gain? $ ____________
What is Tammy’s recognized gain? $ ____________
What is Tammy’s basis in her stock? $ ____________
What is the corporation’s basis in the real estate? $ ____________
11-18 Chapter 11
The Corporate Income Tax
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 11.7
Corporate Formation 11-19
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
11-20 Chapter 11
The Corporate Income Tax
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 11.7
Corporate Formation 11-21
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
11-22 Chapter 11
The Corporate Income Tax
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 11.7
Corporate Formation 11-23
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
11-24 Chapter 11
The Corporate Income Tax
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
SECTION 11.8
CORPORATE ACCUMULATIONS
In many cases, taxpayers have established corporations to avoid paying individual income
taxes by allowing earnings to be accumulated by the corporations. To prevent that practice,
Congress has enacted two special taxes which may be applied to certain corporations; the
accumulated earnings tax and the personal holding company tax.
Accumulated Earnings Tax
The accumulated earnings tax is designed to prevent the shareholders of a corporation
from avoiding tax at the shareholder level by retaining earnings in the corporation. The
tax is a penalty tax imposed in addition to the regular corporate income tax. The tax is
imposed at a rate of 15 percent on amounts that are deemed to be unreasonable accumu-
lations of earnings. For all corporations except service corporations , such as ac counting,
law, and health-care corporations, the first $ 250,000 in accumulated earnings is exempt
from tax. Service corporations will not be taxed on their first $150,000 of accumulated
earnings. Even if the accumulated earnings of a corporation exceed the exemption amount,
the tax will not be impos ed on accumulations that can be shown to be necessary to meet the
reasonable needs of the business.
EXAMPLE Alder Corporation is a manufacturing corporation that has accumu-
lated earnings of $625,000. The corporation can establish reasonable
needs for $450,000 of this accumulati on. Alder Corporation would be
subject to the accumulated earnings tax on $175,000 ($625,000
$450,000). The amount of the accumulated earnings tax is $26,250
(15% of $175,000). N
Personal Holding Company Tax
Personal holding companies, which are corporations with few shareholders and with income
primarily from investments, are subject to a 15 percent tax on their undistributed earnings.
The tax is imposed in addition to the regular corporate income tax; however, a corporation
cannot be subject to both the accumulated earnings tax and the personal holding company
tax in the same year. If both taxes are imposed, the taxpayer pays only the personal holding
company tax. The rules for the personal holding company tax are very complex.
SECTION 11.9
THE CORPORATE ALTERNATIVE MINIMUM TAX
For tax years beginning after 1997, the corporate alternative minimum tax does not apply
to small corporations. A ‘‘small corporation’’ is one with average annual gross receipts of
less than $5 million for the corporation’s first 3-year period beginning after December 31,
Self-Study Problem 11.8
Sugarbush Corporation, an accounting corporation, has accumulated earnings
of $340,0 00, and the corporation cann ot establish a reasonable need for any
of that amount. Calculate the amount of accumulated earnings tax (if any)
that will be imposed on Sugarbush Corporation.
$ ____________
Section 11.9
The Corporate Alternative Minimum Tax 11-25
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
1994. Thereafter, average annual gross receipts for all 3-year periods beginning after 1993
must not exceed $7.5 million.
The corporate alternative minimum tax is calculated in a manner similar to the individ-
ual alternative minimum tax. The tax is imposed at a rate of 20 percent on the alternative
minimum tax base. The alternative minimum tax base is equal to the corporation’s regular
taxable income increased or decreased for certain adjustments, increased by tax preference
items, and decreased by the exemption amount. Corporations with al ternat ive minimum
taxable income of $150,000 or less receive an exemption of $40,000. The exemption
is phased out at a rate of 25 cents for every $1.00 by which the corporation’ s alternative
minimum taxable income exceeds $150,000. Therefore, corporations with alternative min-
imum taxable income of $310,000 or more receive no exemption.
EXAMPLE Yew Corporation has regular taxable income of $75,000 and a regular
tax liability of $13,750 during 2010. Yew Corporation is not a ‘‘small
corporation.’’ The company has tax preferences of $45,000. Yew’s
alternative minimum tax would be calculated as follows:
Regular taxable income $ 75,000
Corporate tax preferences
45,000
Alternative minimum taxable income $120,000
Less: exemption
(40,000)
Alternative minimum tax base $ 80,000
Tax rate
20%
Gross alternative minimum tax $ 16,000
Less: regular corporate tax
(13,750)
Alternative minimum tax due
$ 2,250
N
Tax Preferences and Adjustments
The tax law defines adjustment and tax preference items for the corporate alternative min-
imum tax. The more common corporate tax adjustments and preferences include:
1. accelerated depreciation on real estate,
2. accelerated depreciation on personal property,
3. certain tax-exempt bond interest,
4. percentage depletion in excess of the property’s adjusted basis, and
5. seventy-five percent of the difference between adjusted current earnings and alterna-
tive min imum taxable income determined before this adjustment and the alternative
tax net operating loss deduction.
Self-Study Problem 11.9
In 2010, Plum Corporation has regular taxable income of $70,000 and a regular
tax liability of $12,500. The corporation also has $55,000 of tax preference
items. Calculate Plum Corporation’s alternative minimum tax liability. Assume
Plum Corporation is not a ‘‘small corporation.’’
$ ____________
11-26 Chapter 11
The Corporate Income Tax
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.