Business Resources / Corp. Tax Issues

CORPORATE CREATION TAX CHECKLIST

I. Form of Organization.

A. Consider whether a corporation is the most advantageous form of organization from both a tax and a nontax perspective.

B. The decision to transfer property, and particularly real property that may appreciate in value, to a corporation should not be made without careful consideration.

1. Although property can be transferred to a corporation in a tax-free exchange under IRC §351, it may not be possible to remove the property from a corporation without incurring income tax.

2. If the corporation is a C corporation, the tax imposed when the property is removed will be imposed at both the corporate and shareholder levels, resulting in double taxation.

3. If the corporation elects to be taxed as an S corporation, there may still be a single tax when property is withdrawn from the corporation.

II. Capital Structure.

A. Consider whether the corporation should issue stock or debt instruments to investors in the corporation.

1. Since only stock can be issued in exchange for property in a tax-free IRC §351 transaction,  stock will normally be issued for property.

2. However, if cash is to be transferred to the corporation by shareholders or others and it is not intended that this cash be retained by the corporation permanently, the cash transfers might be structured as loans.

a. Loans should be structured to avoid equity treatment.

b. IRC §7872 generally requires that an interest rate be charged on loans from a shareholder to a corporation at a rate equal to or greater than the appropriate applicable federal rate.

B. Consider having shareholders retain ownership of some assets to be used in the business of the corporation and lease those assets to the corporation or give the corporation a license to use those assets in order to be in a position to remove pretax dollars from the corporation.

III. IRC §351 Qualification.

A. Structure transfers of property to the corporation by the prospective shareholders to qualify for nonrecognition treatment under IRC §351 to the extent such treatment is desired.

1. IRC §351 applies automatically to transfers of property to controlled corporations in exchange for stock.  No election is required.

2. If the corporation will have more than one shareholder, transfers by the group of shareholders should be structured such that the shareholders, as a group, will have "control" of the corporation immediately after the transfer of property to the corporation.

B. If tax-free treatment is not desired, the transfer of property to the corporation will need to be carefully structured to attempt to fall outside IRC §351.

IV. IRC §1244.

A. No plan is required to obtain ordinary loss treatment on losses on stock in small business corporations held by individuals under IRC §1244.

B. However, stock will not qualify as Section 1244 stock if more than $1,000,000 of cash and property is received by the corporation in exchange for its stock.

C. If more than $1,000,000 will be contributed to the corporation in exchange for stock, consider limiting the initial contributions to $1,000,000, and having additional consideration transferred in a later taxable year in order to qualify the stock issued initially as Section 1244 stock.

V. IRC §1202.

A. IRC §1202 provides an exclusion from gross income of 50% of the gain realized on the sale or exchange of qualified small business stock held by a noncorporate taxpayer for more than five years.

B. Qualified small business stock is stock issued by a domestic C corporation that meets certain gross asset requirements and engages in one of several types of qualified small businesses.

C. Of concern at the time of the creation of the corporation is the requirement that the corporation be a C corporation to issue qualified small business stock.

1. If a corporation is initially organized as an S corporation and subsequently converts to a C corporation, the initial stock issued by the corporation will not qualify for the IRC §1202 capital gains exclusion because an S corporation cannot issue qualified small business stock.

2. If pass-through tax treatment is desired during the early stages of a business's existence in order to pass losses through to the principals, consideration should be given to organizing the business initially as a limited liability company. If this is done, the business can later be incorporated as a C corporation when it become profitable, and all of the stock that is issued initially ill be qualified small business stock if the corporation meets the other requirements for application of IRC §1202.

VI. S Corporation Election.

A. Consider having the corporation elect to be taxed as an S corporation.

1. An S corporation election may be particularly appropriate for a new business that is being incorporated since start-up losses can be passed through for deduction by the shareholders.

2. In order to elect to be taxed as an S corporation, the corporation must meet certain eligibility requirements.

B. If an S corporation election is to be made for the first taxable year of the corporation, it must be filed with the IRS not later than the 15th day of the third month of the corporation's first taxable year.

1. The period for filing the election is measured from the date the corporation has shareholders, owns assets, or starts business, whichever is first.

2. There are substantial advantages to having an S election become effective for the first taxable year, including avoidance of the limitations and tax on passive investment income. Therefore, it is important that attention be paid to the period for filing.

3. Responsibility for filing the S corporation election can easily be misplaced as between the attorney who handles the incorporation and the accountant who files the tax returns. It should be clearly understood, in advance, who will be responsible for the filing.

VII. Other Tax Elections.

A. Tax elections other than the S corporation election are generally the concern of the person who will be filing the income tax returns of the corporation, and this will ordinarily not be the attorney.

1. However, it may be desirable for the attorney to be certain that someone is considering these elections.

2. Some elections will be integral to the preincorporation tax planning for the corporation. For example, certain types of corporations are restricted in their selection of tax years. In addition, the application of the assignment of income doctrine or tax benefit rule to override IRC §351 may be affected by the selection of a tax year for a corporation.

B. Select or plan for the selection of a tax year for the corporation. The tax year is elected on the first timely-filed return of the corporation.

C. Determine what tax accounting methods will be elected by the corporation and consider how the necessary elections will be made.  Some elections must, for example, be made on the first return of the corporation.

VIII. Personal Holding Company Tax.

A. Consider whether the corporation may be treated as a personal holding company for purposes of the personal holding company tax.

B. If personal holding company classification is likely, consider various means of avoiding this penalty tax, including making an S corporation election; careful monitoring of dividend distributions to avoid accumulation of personal holding company income; and use of an alternative form of business organization such as a limited partnership or a limited liability company.

IX. Collapsible Corporation Provisions.

A. Consider whether the corporation's business plan may cause it to run afoul of the collapsible corporation provisions.

B. If the collapsible corporation provisions may be applicable, consider whether a better tax result might be achieved if some other form of business organization were used.