Tax-Free Contribution to Corporation in Exchange for Stock

“Control” means the ownership of 80 percent of the voting power of the voting stock of the corporation’s voting stock and 80 percent of the number of shares in each class of non-voting stock. One important exception is that a transferor who has entered into a binding commitment to dispose of stock to be received for the transfer of property does not count towards the 80 percent “control” requirement. No loss is recognized by the taxpayer for this type of transfer, even if property other than stock is received from the corporation.

As discussed in more detail under the “Distribution and Redemption” section below, not only will this arrangement not do any good for the investor, but it also could harm other shareholders of the issuing corporation. Sellers may insist upon a stock sale to avoid the corporate-level tax imposed by an asset sale. Although less certain, the NewCo stock received by the purchaser could still be considered as QSBS even if NewCo is being used as a holding company by the purchaser to acquire target stock. Note, however, that a stock sale is unlikely to offer any asset basis step-up unless an election under Sec. 338 or Sec. 336(e) is allowed.

If I Only Provide Personal Services In Exchange For Stock, Would That Qualify For Tax-Free Contribution Treatment?

As such, buyers may be even more likely to acquire the assets of a target through a NewCo instead of purchasing stock directly from a seller. In an asset purchase, not only can the purchaser receive a basis step-up for the target’s assets, but also, if the purchaser contributes cash to a NewCo in exchange for originally issued stock and then has NewCo purchase the target assets, the NewCo stock the purchaser received may be QSBS if all the other requirements are met. The Biden administration has announced a number of changes it is considering to U.S. federal tax law. For example, long-term capital gains of high-income individual taxpayers are currently taxed at 20%, but the Biden administration is considering an increase in the tax rate to 39.6% for taxpayers with taxable income exceeding $1 million (and the rate could go up to 43.4% when taking into account the net investment income tax of 3.8%). If this proposal is enacted, Sec. 1202 will offer a federal tax saving of 43.4% for founders and investors.

• The inverse is also true; the less the stock is purchased, the more the price will decrease.
• For loss and deduction items, which exceed a shareholder’s stock basis, the shareholder is allowed to deduct the excess up to the shareholder’s basis in loans personally made to the S corporation.
• Nonbusiness bad debts are treated as a short-term capital loss and are subject to the netting rules seen on Schedule D, Capital Gains or Losses, of Form 1040, U.S.
• The corporation’s basis for the property that you obtain in exchange for shares of the same company is the same basis that you had in the property when it was transferred.
• The taxable amount of a distribution is contingent on the shareholder’s stock basis.

Taxpayers may be able to find clear guidance from Sec. 1202 if the fact patterns involved are relatively straightforward. One could argue that the Sec. 1202 rules are not yet sufficiently clear to address complicated M&A situations, and the language under Sec. 1202 contains uncertainty and ambiguity. As Sec. 1202 continues to grow in popularity for investors and more controversies arise, it is probable that regulatory, judicial, and administrative guidance will soon be developed. Regardless of if you are starting a new corporation by yourself or with other partners, or you are getting involved in a corporation that is already existing, as per the Section 351(a) you can defer the tax consequences that come up. When a person owns stock, they have a share of ownership in a company and are entitled to a share of the company’s assets or earnings. This “substantially all” requirement leaves open the possibility that a brief period — perhaps less than 20% of the total life of the corporation — as an S corporation will not preclude stock in the corporation from meeting the definition of QSB stock, provided that the stock was issued while the corporation was a C corporation.

What Is “Control” For The Purposes Of This Tax-Free Contribution Rule?

In the tax-free reorganization context, the acquiring corporation in a Sec. 368(a)(1)(C) acquisition must acquire substantially all of the assets of the target corporation. To prevent abuse of Sec. 1202 whereby shareholders attempt to exclude gain attributable to preinvestment appreciation, special rules are prescribed for determining a shareholder’s initial https://online-accounting.net/ basis in QSB stock. As part of the law known as the Tax Cuts and Jobs Act (TCJA),1 Congress reduced the corporate tax rate from a high of 35% to a flat 21%. This change has led many to speculate that C corporations, long the entity choice of last resort courtesy of the double taxation that is the hallmark of Subchapter C,2 are poised for a resurgence.

As a result of the Sec. 351 transaction, the shareholder will increase stock basis, which was zero, by the adjusted basis in the debt. If the issuance of additional stock would be a meaningless gesture, e.g., the shareholder owns 100% of the S corporation, additional shares need not be issued. However, if there is more than one shareholder and a shareholder contributes debt to the corporation while not receiving stock in exchange, there may be a deemed gift to the other shareholders as the value of their interest in the corporation has increased. With an understanding of a stock swap, let us get back to why the section 351 exists and what it is about. Usually, the process of transferring property into a corporation in exchange for shares is something that is taxed by the IRS.

The impact of the election is that the S corporation’s items of income, loss, deductions and credits flow to the shareholder and are taxed on the shareholder’s personal return. Remember that the par value of a stock is usually a small amount (e.g., $0.10 or $0.01) that appears on stock certificates. Par value indicates the minimum value at which a company may sell its shares to investors. On the other hand, the market value of shares is determined by the transactions occurring in the market. Contributed capital may also refer to a company’s balance sheet item listed under stockholders’ equity, often shown alongside the balance sheet entry for additional paid-in capital.

M&A transactions: The value of sell-side tax diligence

If a shareholder has S corporation loss and deduction items in excess of stock basis and those losses and deductions are claimed based on debt basis, the debt basis of the shareholder will be reduced by the claimed losses and deductions. In computing stock basis, the shareholder starts with their initial capital contribution rules of trial balance to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the pass-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.

With everything clear about the section 351 and its requirements, you can now easily enjoy a tax-free exchange of shares the next time you are about to sell a property or issue shares in your company. But to do all this, do not forget to keep a records of all the shares in your company on your cap table. With all this clear, you might still wonder how control is defined under Section 351.

Taxation of S Corporations

The common stock account is also known as share capital account, and the additional paid-in capital account is also known as the share premium account. Contributed capital can be compared with additional paid-in capital, and the difference between the two values will equal the premium paid by investors over and above the par value of the company’s shares. The par value is merely an accounting value of each of the shares to be offered and is not equivalent to the market value that investors are willing to pay.

QSBS must be originally issued to the shareholder by the issuing corporation (the original-issuance requirement) for money or other property (not including stock) or as compensation for services.6 Therefore, a secondary purchase from existing shareholders would not qualify. If the Sec. 351 requirements are not met, the general rule of Sec. 1001 will apply. Here, the tax treatment of the sale or exchange depends on whether the debt is in writing. If the debt is in writing, the shareholder is treated as having received an amount realized equal to the fair market value (FMV) of the S corporation stock. If that amount is greater than the adjusted basis in the debt, the shareholder recognizes a capital gain. If the amount is less than the shareholder’s debt basis, the shareholder may be disallowed the loss under the Sec. 267 related-party rules.

Taxation of C Corporations

The standard range for state corporate income tax rates is between 1-12%, with most state rates averaging somewhere in the middle. A corporate tax, also known as a corporation or company tax, is a type of fee the federal government imposes on a business’s profits. According to the Federal Tax Cuts and Jobs Act of 2017, the current federal corporate tax rate is 21%. After all business expenses have been deducted, a corporation will be required to pay the federal government 21% of its total revenue when filing a federal corporate tax return.

Now that you have started your business, have you thought of how issuing shares may affect your taxes? As a matter of fact, most entrepreneurs choose limited liability companies for the incorporation of their businesses mainly for the tax benefits of and structure of an LLC. 62Note, however, that if the redemption is significant, it might disqualify stock issued by the corporation from the definition of QSB stock.

If the persons transferring the property (together) do not “control” the corporation immediately after the transfer, each transferor recognizes gain or loss equal to the difference between his or her basis in the transferred property and the value of the stock received. Note, however, that even if loss is recognized, it will not necessarily be deductible. First, the IRS concludes, consistent with the extensive case law on the meaningless gesture doctrine, that in each of Situations 1 and 2, the shareholder recognizes no gain or loss on the transfer of property on Aug. 1, year 1, under Sec. 351(a), “even though Shareholder does not receive any additional stock.” 70In applying the cumulative and annual limitations, the partner or shareholder is treated as having a basis in the shares of QSB stock sold by the passthrough entity equal to the partner or shareholder’s interest in the partnership.

Contributed Capital: Definition, How It’s Calculated, Example

In general, if one transfers property to a corporation in exchange solely for the corporation’s stock, and immediately after the transfer, the transferor, together with all other persons who also transferred property as part of the same transaction, are in “control” (defined below) of the corporation, the transferor will not recognize gain or loss. However, it is significant to note that persons who receive stock for services do not count towards the control requirement, even if they also transfer a nominal amount of property. As mentioned above, C corporation stock acquired from a secondary purchase (shareholder to shareholder) will not be QSBS in the hands of the purchaser, although the seller of that stock may be eligible for Sec. 1202 benefits if all the requirements are met.