Tax Implications
The initial shareholders normally contribute cash or property to the corporation in exchange for shares in the corporation. The corporation doesn't usually recognize gain or loss when issuing shares and the shareholder doesn't recognize gain or loss when shares are purchased with cash.
As any good tax advisor will tell you, for almost every tax rule, there is a tax rule exception. In this case, a taxpayer is usually required to recognize gain or loss upon the sale or exchange of property - except for acquiring stock. This exception is provided for in Code Section 351. The following factors must be present to apply this exception:
- The property must be transferred to the corporation solely in exchange for stock,
- The stock purchasers must control the corporation immediately after the exchange,
- The exchange must have a valid business purpose; and
- The corporation must not be an investment company.
One mistake a lot of small business people make when setting up their corporation is to assign tax free shares in exchange for services to the corporation. This transfer of services is not considered a transfer of property for tax free exchanges under Section 351. If a stockholder receives stock in exchange for services provided to the corporation, that stockholder must claim the stock as income based on the fair market value of the stock received.
Section 1244 Stock
If both shareholders and the corporation quality, it may be advantageous for a new corporation to issue Section 1244 small business stock at its inception. This can be important in attracting initial investors, because if the new business should fail, the investor is not limited to the $3,000 a year capital loss limit you read about earlier.
An individual can claim a Section 1244 stock loss as an ordinary loss of up to $50,000 as a single taxpayer or $100,000 when filing as married filing jointly. Ordinary loss can be subtracted directly from other earned income (such as salaries) that the taxpayer may have. Any remaining loss is treated as capital loss, reported on Schedule D and subject to the $3,000 year limit. The carryover basis in the stock is generally equal to the money and the basis of the property contributed to acquire the original stock.
In order to qualify for Section 1244 stock:
- The stock must be issued when the corporation was a small business corporation, which is defined as money and other property received for stock, contributions to capital, or paid-in surplus does not exceed $1 million. Contributed property is based on adjusted basis reduced by any liability it was subject to at the time of contribution.
- The stock can only be issued to the original investors to the corporation. If the stock is sold, given as a gift, or transferred to a trust or estate, it loses its Section 1244 status.
- The corporation cannot derive more than 50 percent of its gross receipts from certain sources, such as royalties, rents, dividend, interest, annuities, and stock or security sales.
The testing period for the above qualifications is the five taxable years immediately preceding the year in which the loss was sustained. For corporations in business less than five years, the testing period is the corporation's taxable years preceding the loss year.