Introduction to the S Corporation - General Rules
What is an S corporation and how is it taxed?
In effect, an S corporation conducts business as a regular corporation but is essentially taxed as a partnership. Unlike a C corporation, the S corporation generally does not pay a corporate tax on income. Rather, the S corporation passes income, losses, deductions, and credits through to its shareholders, who report the items and calculate the tax on their individual returns.
If you create an S corporation and transfer property to it in exchange for stock, what are the tax consequences?
Generally, no gain or loss when issued stock
In general, an S corporation does not recognize gain or loss when it issues stock. As for the shareholder, he or she generally does not incur immediate tax consequences when issued stock for transferred property because gain or loss will be determined later when the stock is sold or otherwise disposed of.
Property transfer for stock under IRC Section 351
However, it can be a different story if you transfer appreciated or depreciated property to a corporation. Normally, if you transfer appreciated property to a corporation, tax consequences will result. You will recognize a gain or loss. Section 351 of the Internal Revenue Code provides an exception to this general rule, however. This section codifies a philosophy that the incorporation of a business should generally be tax free both to the shareholders and to the corporation. Specifically, Section 351 states that no gain or loss is recognized when property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation, provided that the transferors are in control of the corporation immediately after the exchange. This code section applies to S corporations and C corporations alike.
When creating a corporation, the incorporators (owners) typically deposit money into a corporate bank account in return for shares of stock. However, property other than cash may be transferred, as well. For instance, you could transfer land, a building, a vehicle, a patent, or a partnership interest to a corporation in return for its stock.
Example(s): Bill incorporated his construction business (Micro-House, Inc.) and transferred a building with a $200,000 fair market value to Micro-House, Inc. Bill had a tax basis in the building of $150,000. In return for the building, Micro-House, Inc. issued Bill 100,000 shares of stock.
Example(s): Without Section 351, the Internal Revenue Service would treat this exchange as a sale of the building by Bill. In other words, he'd have a taxable gain of $50,000 ($200,000 fair market value minus $150,000 basis). Fortunately, however, Bill can invoke Section 351 and recognize no gain at present.
To receive nonrecognition treatment of gain or loss, however, you must comply with all of the requirements set forth in Section 351.
What does "solely in exchange for stock" mean?
The transfer must be solely in exchange for the stock of the transferee corporation. Therefore, you cannot receive such items as cash, stock warrants, or stock rights from the corporation.
Although Section 351 mandates that property be transferred solely in exchange for stock of the corporation, this does not mean that the entire exchange will be taxable if you do receive cash or other property ("boot") in addition to stock. Rather, the "boot" may trigger partial gain recognition. That is, you'll recognize gain (but not loss) to the extent of the fair market value of the boot.
What does it mean to be "in control of the corporation" immediately after the exchange?
Must own certain percentage of shares
The persons making the transfer, taken as a group, must be in control of the corporation immediately following the exchange. This means that they must own at least 80 percent of the new corporation's shares after the transfer. More specifically, they must own (1) at least 80 percent of the total combined voting power of all voting stock, and (2) at least 80 percent of the total number of shares of all nonvoting stock issued by the corporation. In a typical incorporation, the transferors receive 100 percent of the stock in exchange for cash or other property, so this requirement usually does not pose a problem.
No limit to number of transferors
There is no prescribed limit on the number of transferors or the timing of the transfers. The transfers of property do not have to be simultaneous. They may be aggregated as long as they are part of a prearranged plan and are carried out reasonably close to one another.
Note that stock issued in exchange for services is not treated as having been issued in return for property.
Example(s): Assume Julie, Lisa, and Rob want to incorporate a small broadcasting business--Minneapolis Cable News, Inc. Julie and Lisa transfer $200,000 in equipment to the business in return for 75 percent of the shares of stock. Because Rob is well known in the community and can bring in other investors, Minneapolis Cable News, Inc. gives Rob 25 percent of the shares of stock outright. Rob contributed nothing to the business, but it is expected that his name recognition as a shareholder will generate some interest in the community. This transaction will fail the Section 351 test because Julie and Lisa are the only ones who transferred property to the business and only owned 75 percent of the stock after the transfer.
If you exchange property for stock, what will be your basis in the stock?
In the simplest situation (i.e., an exchange under Section 351 of property solely for stock), your basis in the stock will be the same as your basis in the property transferred. This is referred to as a substituted basis. Likewise, if you're trying to place a value on your stock, refer to the value of the property you exchanged for it.
Example(s): Lou owns a building with a tax basis of $100,000. Today, it is worth $200,000. When Lou incorporates his bowling business, he transfers the building to his corporation in return for 50,000 shares of stock (the stock is worth $4 per share). Lou's basis in the stock will be $100,000 (since that was his basis in the building).
If, however, the exchange did not satisfy the requirements of Section 351 (in other words, you immediately recognized gain or loss), the basis of the stock would be its cost (i.e., the fair market value of the property given up) rather than your basis in the property. Furthermore, if you receive cash or "boot" in addition to the stock, this calculation becomes a bit more complicated.
What happens if there is a disproportionate receipt of stock?
In general, each shareholder should receive stock in proportion to the fair market value of the property he or she transferred. However, this is not always required by Section 351 as a condition for nonrecognition treatment. The regulations provide that the transaction may be recast "in accordance with its true nature." In other words, the transaction can be viewed as an initial proportionate issuance of stock, followed by an immediate transfer between the shareholders in the nature of a gift or compensation.
Example(s): Assume Bob and Emily transfer property of equal value to the newly formed Corbin Corporation. In exchange, Bob is given 60 shares of Corbin stock, and Emily is given 40 shares. The transaction may be treated as if Bob and Emily each initially received 50 shares of stock and then Emily transferred 10 shares to Bob. If Bob and Emily are related family members, then Emily's transfer may be treated as a gift to Bob (which could, in certain circumstances, be subject to gift tax). Alternatively, if Emily is indebted to Bob for services, Emily's "transfer" may be viewed as compensation (taxable income) to Bob or relief of indebtedness to Emily.
If you create a corporation and transfer property to it in exchange for stock, what are the tax consequences to the corporation?
Section 351 mandates that a controlled corporation will not recognize gain if it transfers only stock or securities to a shareholder in return for property. If the shareholder is given appreciated property, however, the corporation will recognize gain (but not loss).
As for the holding period, the corporation can tack on the transferor's holding period for each of the assets transferred to the corporation under Section 351.
What basis will the corporation take in the property received?
Corporation basis allocated among assets
The corporation assumes a substituted basis in the assets received as a result of a Section 351 transaction, calculated as the sum of (1) the transferor's basis in the property and (2) any gain recognized by the transferor. In those cases where multiple assets are transferred to a corporation in return for stock, experts disagree regarding how basis should be allocated among the assets. Therefore, it would be wise for you to consult an accountant or other financial professional in such cases.
Example(s): Assume Emily transfers a piece of equipment with a basis of $10,000 and a fair market value of $10,000 to her new corporation, and then transfers another asset with a basis of $20,000 and a fair market value of $50,000 to the corporation at the same time. She transfers these two items in return for stock, receiving a $30,000 basis in the stock. The question is: Does the corporation assume a $10,000 basis in one asset and a $20,000 basis in the other asset, or does it divide the aggregate $30,000 basis between the two assets in proportion to their fair market values? Although it seems reasonable to step into the shoes of the transferor regarding basis, it would be wise to consult an experienced accountant or tax advisor to make a final determination.