Important Changes for 2002

Accounting methods.   For tax years ending on or after December 31, 2001, a qualifying small business taxpayer can choose to use the cash method of accounting for an eligible business and not account for inventories. A qualifying small business taxpayer is any taxpayer with average annual gross receipts of $10,000,000 or less that is not prohibited from using the cash method of accounting under section 448 of the Internal Revenue Code. Certain other requirements must be met. For more information, see Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18. Taxpayers with average annual gross receipts of $1,000,000 or less can use the cash method of accounting under Revenue Procedure 2001-10. For more information on the cash method of accounting and accounting for inventories, see Publication 538, Accounting Periods and Methods.

Tax schedules for corporations.   If a corporation's total receipts for the tax year and its total assets at the end of the tax year are less than $250,000, it is generally no longer required to complete Form 1120 Schedules L, M-1, and M-2 (Parts III and IV of Form 1120-A). For more information, see the Instructions for Forms 1120 and 1120-A.

Important Change for 2003

Reportable transactions.   New disclosure rules require corporations to file Form 8886, Reportable Transaction Disclosure Statement to report certain transactions entered into after 2002. For more information, see the tax shelter disclosure statement discussion in the Form 1120 instructions under Other Forms, Returns, and Statements That May Be Required.

Important Reminder

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

Introduction

This publication discusses the general tax laws that apply to ordinary domestic corporations. It explains the tax law in plain language so it will be easier to understand. However, the information given does not cover every situation and is not intended to replace the law or change its meaning.

Some corporations may meet the qualifications for electing to be S corporations. For information on S corporations, see the instructions for Form 1120S, U.S. Income Tax Return for an S Corporation.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:FP
1111 Constitution Ave. NW
Washington, DC 20224

We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.

Useful Items You may want to see:

Publication

• 535   Business Expenses
• 538   Accounting Periods and Methods
• 544   Sales and Other Dispositions of Assets
• 925   Passive Activity and At-Risk Rules

Form (and Instructions)

• 1096   Annual Summary and Transmittal of U.S. Information Returns
• 1099-DIV   Dividends and Distributions
• 1120   U.S. Corporation Income Tax
  Return
• 1120-A   U.S. Corporation Short-Form Income Tax Return
• 1120-W   (WORKSHEET) Estimated Tax for Corporations
• 1120X    Amended U.S. Corporation
  Income Tax Return
• 1138   Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback
• 1139   Corporation Application for
  Tentative Refund
• 2220   Underpayment of Estimated Tax by Corporations
• 3800   General Business Credit
• 4466   Corporation Application for Quick Refund of Overpayment of
  Estimated Tax
• 4562   Depreciation and Amortization
• 4626   Alternative Minimum Tax - Corporations
• 5452   Corporate Report of Nondividend Distributions
• 7004   Application for Automatic
  Extension of Time To File
  Corporation Income Tax Return
• 8109   Federal Tax Deposit Coupon
• 8582-CR   Passive Activity Credit
  Limitations
• 8832   Entity Classification Election

See How To Get Tax Help near the end of this publication for information about getting publications and forms.

Business Taxed as a Corporation

The rules you must use to determine whether a business is taxed as a corporation changed for businesses formed after 1996.

Business formed before 1997.   A business formed before 1997 and taxed as a corporation under the old rules will generally continue to be taxed as a corporation.

Business formed after 1996.   The following businesses formed after 1996 are taxed as corporations.

• A business formed under a federal or state law that refers to it as a corporation, body corporate, or body politic.
• A business formed under a state law that refers to it as a joint-stock company or joint-stock association.
• An insurance company.
• Certain banks.
• A business wholly owned by a state or local government.
• A business specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships).
• Certain foreign businesses.
• Any other business that elects to be taxed as a corporation by filing Form 8832.

For more information, see the instructions for Form 8832.

Exchange of Property for Stock

If you transfer property (or money and property) to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock, described later), and immediately afterward you are in control of the corporation, the exchange is usually not taxable. This rule applies both to individuals and to groups who transfer property to a corporation. It also applies whether the corporation is being formed or is already operating. It does not apply in the following situations.

• The corporation is an investment company.
• The property is transferred in a bankruptcy or similar proceeding in exchange for stock used to pay creditors.
• The stock is received in exchange for the corporation's debt (other than a security) or for interest on the corporation's debt (including a security) that accrued while you held the debt.

Both the corporation and any person involved in a nontaxable exchange of property for stock must attach to their income tax returns a complete statement of all facts pertinent to the exchange. For more information, see section 1.351-3 of the regulations.

Control of a corporation.   To be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock of the corporation.

Example 1.   You and Bill Jones buy property for $100,000. You both organize a corporation when the property has a fair market value of $300,000. You transfer the property to the corporation for all its authorized capital stock, which has a par value of $300,000. No gain is recognized by you, Bill, or the corporation.

Example 2.   You and Bill transfer the property with a basis of $100,000 to a corporation in exchange for stock with a fair market value of $300,000. This represents only 75% of each class of stock of the corporation. The other 25% was already issued to someone else. You and Bill recognize a taxable gain of $200,000 on the transaction.

Services rendered.   The term property does not include services rendered or to be rendered to the issuing corporation. The value of stock received for services is income to the recipient.

Example.   You transfer property worth $35,000 and render services valued at $3,000 to a corporation in exchange for stock valued at $38,000. Right after the exchange you own 85% of the outstanding stock. No gain is recognized on the exchange of property. However, you recognize ordinary income of $3,000 as payment for services you rendered to the corporation.

Property of relatively small value.   The term property does not include property of a relatively small value when it is compared to the value of stock and securities already owned or to be received for services by the transferor if the main purpose of the transfer is to qualify for the nonrecognition of gain or loss by other transferors.

Property transferred will not be considered to be of relatively small value if its fair market value is at least 10% of the fair market value of the stock and securities already owned or to be received for services by the transferor.

Stock received in disproportion to property transferred.   If a group of transferors exchange property for corporate stock, each transferor does not have to receive stock in proportion to his or her interest in the property transferred. If a disproportionate transfer takes place, it will be treated for tax purposes in accordance with its true nature. It may be treated as if the stock were first received in proportion and then some of it used to make gifts, pay compensation for services, or satisfy the transferor's obligations.

Money or other property received.   If, in an otherwise nontaxable exchange, you also receive money or property other than stock, you may have to recognize gain. You recognize gain only up to the amount of money plus the fair market value of the other property you receive. The rules for figuring the recognized gain in this situation generally follow those for a partially nontaxable exchange discussed in Publication 544 under Like-Kind Exchanges. If the property you exchange includes depreciable property, the recognized gain may have to be reported as ordinary income from depreciation. No loss is recognized. See chapter 3 of Publication 544.

Nonqualified preferred stock.   Nonqualified preferred stock is treated as property other than stock. Therefore, there could be gain. See Money or other property received, earlier. Generally, it is preferred stock with any of the following features.

• The holder has the right to require the issuer or a related person to redeem or buy the stock.
• The issuer or a related person is required to redeem or buy the stock.
• The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised.
• The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.

Liabilities.   If the corporation assumes your liabilities, the exchange is generally not treated as if you received money or other property. There are two exceptions to this treatment.

• If the liabilities the corporation assumes are more than your adjusted basis in the property you transfer, gain is recognized up to the difference. However, if the liabilities assumed give rise to a deduction when paid, such as a trade account payable or interest, no gain is recognized.
• If there is no good business reason for the corporation to assume your liabilities, or if your main purpose in the exchange is to avoid federal income tax, the assumption is treated as if you received money in the amount of the liabilities.

For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example.   You transfer property to a corporation for stock. Immediately after the transfer you control the corporation. You also receive $10,000 in the exchange. Your adjusted basis in the transferred property is $20,000. The stock you receive has a fair market value of $16,000. The corporation also assumes a $5,000 mortgage on the property for which you are personally liable. Gain is recognized as follows.

Fair market value of stock received	$16,000
Cash received	10,000
Liability assumed by corporation	5,000
Total received	$31,000
Minus: Adjusted basis of property transferred	20,000
Realized gain	$11,000
Recognized gain	$10,000

The liability assumed is not treated as money or other property. The recognized gain is limited to $10,000, the amount of cash received.

Loss on exchange.   If you have a loss from an exchange and own, directly or indirectly, more than 50% of the corporation's stock, you cannot deduct the loss. For more information, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.

Basis of stock or other property received.   The basis of the stock you receive is generally the adjusted basis of the property you transfer. Increase this amount by any amount treated as a dividend, plus any gain recognized on the exchange. Decrease this amount by any cash you received, the fair market value of any other property you received, and any loss recognized on the exchange. Also decrease this amount by the amount of any liability the corporation or another party to the exchange assumed from you, unless payment of the liability gives rise to a deduction when paid.

Further decreases may be required when the corporation or another party to the exchange assumes from you a liability that gives rise to a deduction when paid after October 18, 1999, if the basis of the stock would otherwise be higher than its fair market value on the date of the exchange. This rule does not apply if the entity assuming the liability acquired either substantially all of the assets or the trade or business with which the liability is associated.

The basis of any other property you receive is its fair market value on the date of the trade.

Basis of property transferred.   A corporation that receives property from you in exchange for its stock generally has the same basis you had in the property, increased by any gain you recognized on the exchange. However, the increase for the gain recognized may be limited. For more information, see section 362 of the Internal Revenue Code.

Capital Contributions

This section explains the tax treatment of contributions from shareholders and nonshareholders.

Paid-in capital.   Contributions to the capital of a corporation, whether or not by shareholders, are paid-in capital. These contributions are not taxable to the corporation.

Basis.   The corporation's basis of property contributed to capital by a shareholder is the same as the basis the shareholder had in the property, increased by any gain the shareholder recognized on the exchange. However, the increase for the gain recognized may be limited. For more information, see section 362 of the Internal Revenue Code.

The basis of property contributed to capital by a person other than a shareholder is zero.

If a corporation receives a cash contribution from a person other than a shareholder, the corporation must reduce the basis of any property acquired with the contribution during the 12-month period beginning on the day it received the contribution by the amount of the contribution. If the amount contributed is more than the cost of the property acquired, then reduce, but not below zero, the basis of the other properties held by the corporation on the last day of the 12-month period in the following order.

1. Depreciable property.
2. Amortizable property.
3. Property subject to cost depletion but not to percentage depletion.
4. All other remaining properties.

Reduce the basis of property in each category to zero before going on to the next category.

There may be more than one piece of property in each category. Base the reduction of the basis of each property on the ratio of the basis of each piece of property to the total bases of all property in that category. If the corporation wishes to make this adjustment in some other way, it must get IRS approval. The corporation files a request for approval with its income tax return for the tax year in which it receives the contribution.

First | Next

Publication Index | 2002 Tax Help Archives | Tax Help Archives | Home