AND CAPITAL STRUCTURE
SOLUTIONS TO PROBLEM MATERIALS
Some of the tax-related issues that should be considered are:
It is the responsibility of J’s adviser to ensure that J realizes that incorporation
may cause the income earned by the boutique to be taxed twice, once at the corporate level and once again
when it is distributed. Although the double tax is avoided whenever the corporation is able to make a
deductible distribution (e.g., salary, rents, or interest), these opportunities may not always exist (e.g., J is
already receiving a reasonable salary). Double taxation problems can also occur if appreciated property is
transferred to the corporation or is acquired by the corporation. If appreciated property is distributed as a
dividend or in liquidation, the corporation must recognize gain on the distribution, which in turn yields a
corporate level tax. When this tax is coupled with the tax at the shareholder level, double taxation results.
As demonstrated in the Chapter 5 discussion of liquidations (see tax planning section), this phenomenon
exacts a large penalty when the owner of a closely held corporation decides to sell his or her business.
This double tax penalty on the sale of a business is a severe disadvantage of the C corporation form. For
this reason alone, owners of closely held businesses often elect to operate as an S corporation. Here, it is
assumed that J has made the decision to incorporate as a C corporation, so attention to specific aspects of
the incorporation process are examined below.
Transfer of property.
J should recognize that the tax law has important implications on the
method employed by the corporation for obtaining use of business assets. Not all assets and liabilities
currently associated with her boutique need to be transferred outright to the corporation in exchange for
stock. Some of the assets could be retained and leased to the corporation (e.g., where the depreciation
deduction would provide greater benefits to J than the corporation). Alternatively, some of the assets might
be sold to the corporation. A different tax result occurs depending on which method is used. For example,
the basis of the property that will be depreciated in future years may be altered, depending on the manner
in which the property is obtained (e.g., if in exchange for stock, a carryover basis results, while a sale
yields a step up in basis but at the cost of a tax).
Exchange for stock or debt.
Consideration should be given to whether the property should be
contributed in exchange for stock and/or debt as well as other property. In this regard, it should be noted
that the tax consequences differ dramatically if the corporation should not succeed (e.g., § 1244 stock
yields ordinary loss, while a worthless security usually results in a capital loss).