I know that you are considering incorporating your business. Here are some tips on what you need to do and how to avoid paying taxes on the incorporation.
To qualify for a tax-free incorporation, you must exchange property for stock and be in control of the corporation immediately after the exchange. To meet the control requirement, everyone who exchanged property for stock (i.e., the “control group”) must have ownership of at least 80 percent of the voting shares and 80 percent of the total shares of all classes of stock.
If you receive stock in exchange for both property and services in the same transaction, then all the stock received counts for purposes of control of the corporation, provided the value of the stock transferred for property is at least 10 percent of the total value of the total stock transferred.
For example, say you contributed $4,000 in cash and $16,000 in services for $20,000 in stock. Since the stock received for property is at least 10 percent of the total value of the stock transferred, all of your stock shares are part of the control group.
Your Receipt of the Stock
If you transfer property for stock in the corporation, here’s what happens:
- You recognize neither gain nor loss upon transfer.
- Your basis in the stock received is the adjusted basis of the property transferred.
- Your holding period in the stock includes your holding period for the property transferred if the property you transferred was a capital asset or Section 1231 property in your hands.
The Corporation’s Receipt of the Property
The following applies to the corporation’s receipt of the property:
- The corporation recognizes neither gain nor loss when it receives cash or property in exchange for its stock.
- The corporation’s basis in the property received is its adjusted basis.
- The corporation’s holding period in the property includes your holding period.
As with everything in the tax code, there are exceptions. Here are three that can cause unexpected taxes:
1. Stock for services. If you receive stock for services, the entire value of the stock received for services is taxable income to you, regardless of tax-free incorporation.
2. Receipt of boot. Say that your transaction involves an exchange of property. This could require that you receive cash from the corporation to ensure an equal exchange. The cash received in an exchange is known as “boot.” If you receive boot in a tax-free incorporation, you must recognize gain to the extent of the boot received.
3. Debt relief exceeding basis. If the corporation assumes your liabilities in a tax-free incorporation, and if those liabilities exceed the adjusted basis of the property you transferred, then you must recognize the difference as gain as if the difference were from the sale or exchange of property.