15.1 Corporate formation and capital structure
5 min read•july 30, 2024
Corporate formation and capital structure are crucial aspects of business taxation. These elements determine how a company is taxed, its financial obligations, and its ability to raise funds. Understanding these concepts is key to navigating the complex world of corporate taxation.
When forming a corporation, businesses face important decisions about their structure and financing. These choices impact tax liabilities, shareholder responsibilities, and financial flexibility. From C corps to S corps, debt to equity, each option has unique tax implications that can significantly affect a company's bottom line.
Tax Implications of Incorporation
Legal and Tax Consequences
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- Incorporation creates a separate legal entity resulting in significant tax consequences for the business and its owners
- Typically qualifies as a tax-free transaction under IRC Section 351 if certain conditions are met
- Shareholders must contribute property in exchange for stock
- Contributors must control at least 80% of the corporation immediately after the exchange
- Subjects the business to corporate income tax rates and filing requirements
- C corporations file
- Corporate tax rates are currently a flat 21% at the federal level
- Leads to potential on corporate profits and dividends
- Corporation pays tax on its income
- Shareholders pay tax again when receiving dividends
Specific Tax Implications
- S corporations offer avoiding the double taxation issue
- Income taxed only at shareholder level
- Must meet eligibility criteria (100 or fewer shareholders, only certain types of shareholders allowed)
- Creates new payroll tax obligations for owner-employees previously self-employed
- Must withhold and pay payroll taxes on salary
- No longer pay self-employment tax
- Affects availability of certain tax deductions and credits specific to corporate entities
- Enhanced deductions for fringe benefits like health insurance
- Access to certain business tax credits unavailable to sole proprietors
Debt vs Equity Financing
Characteristics and Tax Treatment
- involves borrowing money while sells ownership stakes
- Interest payments on debt are generally tax-deductible for the corporation
- Reduces taxable income dollar-for-dollar
- Creates tax savings through the interest tax shield
- Dividends paid on equity are not tax-deductible for the corporation
- May qualify for preferential tax rates for individual shareholders (currently up to 20%)
- Debt creates fixed payment obligations while equity does not
- Failure to make debt payments can lead to default
- Equity payments (dividends) are at the discretion of the board
Tax Implications and Considerations
- Excessive use of debt can trigger thin capitalization rules or earnings stripping provisions
- May limit interest deductibility if is too high
- Section 163(j) limits interest deduction to 30% of adjusted taxable income
- Equity financing may dilute existing shareholders' ownership and control
- New shareholders gain voting rights and claim on profits
- Existing shareholders' percentage ownership decreases
- Choice between debt and equity impacts overall tax liability and utilization of tax attributes
- Debt can help preserve net operating losses by reducing taxable income
- Equity may be preferable if corporation has significant tax credits to use
Tax Consequences of Capital Contributions
Tax-Free Contributions
- Capital contributions by shareholders generally tax-free under IRC Section 351
- No gain/loss recognized by contributing shareholder
- Corporation takes carryover basis in contributed property
- Shareholder's stock basis increases by value of contribution
- Cash contributions increase basis dollar-for-dollar
- Property contributions increase basis by fair market value
- Contributions of cash are straightforward from a tax perspective
- No complex valuation or basis issues to consider
Special Considerations
- Property contributions may trigger recognition of built-in gains/losses if conditions not met
- Must meet control requirement (80% ownership after contribution)
- Liabilities assumed by corporation may trigger gain recognition
- Debt forgiveness by shareholder may be treated as capital contribution
- Can result in cancellation of debt income for corporation
- Complex rules determine tax treatment (Section 108)
- Contributions of services may result in immediate income recognition for contributing shareholder
- Cannot qualify for tax-free treatment under Section 351
- Taxed as compensation income to contributor
Timing and Structure Implications
- Timing and structure of contributions affect utilization of tax attributes
- Contributions near year-end can impact current year deductions/credits
- May affect ability to carry back/forward losses
- Future distributions to shareholders impacted by contribution structure
- Return of capital treatment possible up to stock basis
- Affects characterization of gains on later stock sales
Corporate Structures: Benefits vs Limitations
C Corporations
- Face double taxation but benefit from flat 21% federal corporate tax rate
- Ability to retain earnings for growth without immediate shareholder taxation
- No limits on number or types of shareholders
- Allows for complex ownership structures
- Facilitates raising capital from diverse sources
Pass-Through Entities
- S corporations offer pass-through taxation avoiding corporate-level tax
- Restricted to 100 or fewer shareholders
- Only certain types of shareholders allowed (individuals, certain trusts)
- Partnerships provide pass-through taxation and allocation flexibility
- Can specially allocate income/losses among partners
- No limits on number or types of partners
- LLCs allow choice between partnership and corporate tax treatment
- Single-member LLCs can be disregarded entities for tax purposes
- Multi-member LLCs default to partnership taxation unless election made
Comparative Advantages and Limitations
- Different rules for fringe benefit deductibility across entity types
- C corporations generally most favorable for deducting benefits
- shareholder-employees face limitations on certain benefits
- Self-employment tax treatment varies by structure
- Partners/LLC members pay SE tax on all earnings
- S corporation shareholders can minimize SE tax through salary/distribution mix
- Ability to carry forward losses differs among structures
- NOLs now limited to 80% of taxable income per year
- Pass-through losses may be limited by basis, at-risk, and passive activity rules
- Conversion between structures can trigger significant tax consequences
- C to S conversion creates 5-year built-in gains tax period
- Partnership to corporation conversions may trigger gain recognition
Key Terms to Review (18)
Articles of Incorporation: Articles of Incorporation are formal documents filed with a governmental body to legally create a corporation. This document outlines essential information such as the corporation's name, purpose, duration, and the number of shares it is authorized to issue, playing a crucial role in establishing the entity's legal identity and operational framework.
Bylaws: Bylaws are the rules and regulations established by an organization to govern its internal management and operations. These rules typically outline how the organization will conduct its business, including details on meetings, voting procedures, and the roles of officers. Bylaws serve as a critical framework for ensuring orderly decision-making and compliance with legal requirements in corporate formation and capital structure.
C Corporation: A C Corporation is a legal structure for a corporation in which the owners or shareholders are taxed separately from the entity. This type of corporation can be beneficial for businesses that want to reinvest profits back into the company, allowing for unlimited growth potential. It also has distinct rules regarding capital structure, taxation, and how it handles gains and passive income, which affects its overall financial strategy.
Capital Surplus: Capital surplus refers to the amount by which the proceeds from the sale of a company's stock exceed its par value. It represents additional capital that a corporation has generated beyond the nominal value of its shares, and is an important part of the overall capital structure as it contributes to a company’s equity and financial stability.
Common stock: Common stock is a type of equity security that represents ownership in a corporation and gives shareholders voting rights and the potential to receive dividends. This form of stock is essential to a company's capital structure, as it allows corporations to raise funds for growth while also providing shareholders with a claim on the company's assets and earnings, albeit after creditors and preferred stockholders are paid.
Debt financing: Debt financing is the process of raising capital through borrowing, typically by issuing bonds or obtaining loans. This method allows a corporation to acquire funds while retaining ownership and control, as lenders do not gain equity in the company. Companies often use debt financing to leverage growth opportunities, balance their capital structure, and manage financial risks effectively.
Debt-to-equity ratio: The debt-to-equity ratio is a financial metric that compares a company's total liabilities to its shareholder equity, indicating the proportion of debt used to finance the company's assets. This ratio is crucial in assessing a company's financial leverage and risk, as it reveals how much debt is being utilized compared to the equity provided by shareholders. A higher ratio suggests greater reliance on borrowed funds, which can amplify returns but also increases financial risk during downturns.
Double taxation: Double taxation refers to the taxation of the same income or financial transaction in more than one jurisdiction. This concept is particularly relevant in corporate settings where income is taxed at both the corporate level and again at the individual level when dividends are distributed to shareholders. Understanding double taxation is crucial for evaluating corporate structures, tax obligations, and the overall financial implications for businesses and their owners.
Equity financing: Equity financing is the method of raising capital by selling shares of a company to investors, who then become partial owners. This form of financing enables businesses to acquire funds without incurring debt and involves giving up a portion of ownership and control in exchange for investment. It is a crucial aspect of corporate formation and capital structure as it determines how a company is funded and how profits are distributed among shareholders.
Form 1120: Form 1120 is the U.S. Corporation Income Tax Return used by C corporations to report their income, gains, losses, deductions, and credits to the IRS. This form is crucial for corporate taxation as it reflects the financial status of the corporation and determines its tax liability, connecting directly to how corporations structure their capital and how their income taxes are calculated.
Form 2553: Form 2553 is the IRS form used by eligible small businesses to elect S corporation status for federal tax purposes. By filing this form, corporations can enjoy pass-through taxation, allowing income, losses, deductions, and credits to be passed directly to shareholders, avoiding double taxation at the corporate level. This election is crucial for small businesses seeking tax benefits while maintaining a corporate structure.
Paid-in Capital: Paid-in capital refers to the total amount of money that shareholders have invested in a corporation through the purchase of stock, over and above the par value of the stock. This term reflects the additional contributions made by investors to a company, and it's crucial in understanding how a corporation is financed and how its capital structure is formed. It can come from common and preferred stock issuances, as well as additional paid-in capital, which is any amount received from shareholders that exceeds the stock's par value.
Pass-through taxation: Pass-through taxation is a tax structure where the income generated by a business entity is not taxed at the corporate level but instead 'passes through' to the owners or shareholders, who report it on their individual tax returns. This method helps avoid double taxation, making it an appealing option for various business entities, including partnerships and S corporations.
Preferred Stock: Preferred stock is a type of equity security that gives shareholders a higher claim on assets and earnings than common stockholders. This means preferred stockholders receive dividends before common stockholders and often have a fixed dividend rate, providing a level of predictability in returns. Preferred stock can also include features like convertibility into common shares or redemption rights, which adds to its appeal in corporate capital structure.
Return on Equity: Return on equity (ROE) is a financial metric that measures a corporation's profitability in relation to shareholders' equity, calculated by dividing net income by average shareholders' equity. This ratio provides insights into how effectively a company is using its equity base to generate profits, making it crucial for assessing the financial performance and capital structure of a business.
S Corporation: An S Corporation is a special type of corporation that meets specific Internal Revenue Code requirements, allowing it to be taxed as a pass-through entity, which means that income, losses, deductions, and credits flow through to the shareholders' personal tax returns. This structure provides the limited liability of a corporation while avoiding double taxation on corporate income, making it an attractive option for small businesses. The election to be treated as an S Corporation can influence its capital structure and tax implications, including restrictions on built-in gains and passive income.
S Election: An S Election is a tax status that allows a corporation to be taxed under Subchapter S of the Internal Revenue Code, enabling it to avoid double taxation on corporate income. This election allows income, deductions, and tax credits to pass directly to shareholders, who report this income on their personal tax returns. By doing so, the corporation retains the benefits of limited liability while enjoying a simpler tax structure similar to that of a partnership.
Section 351 Exchange: A Section 351 exchange allows for the transfer of property to a corporation by one or more individuals in exchange for stock, without recognizing any immediate gain or loss for tax purposes. This provision is significant as it encourages investment in new corporate ventures by deferring tax liability until a later event, such as the sale of the stock received in exchange. The key requirements include that the transferors must control the corporation immediately after the exchange and that the property transferred must not be cash or stock received from the corporation.