Incorporating a single-owner business

Other than C and S corporations, there are two types of single-owner business entities — sole proprietorships and disregarded entities. The former is not a separate business entity, which is why sole proprietorships provide no liability protection for the owner, while the latter is a separate business entity. As a practical matter, single-owner disregarded entities often are synonymous with single-member LLCs (SMLLCs). Despite the difference in liability protection, the activities of an SMLLC are treated much the same as a sole proprietorship. In particular, an SMLLC is not required to file a separate income tax return. Instead, the owner reports the SMLLC's income and expenses on his or her return.

A key step in a successful sole proprietorship incorporation is to follow the tax-free incorporation guidelines of Sec. 351 and to establish a clear cutoff from operations as a proprietorship to operations as an incorporated entity.

In some cases, accounts receivable should be retained by the organizer and collected outside of the corporate structure. Cash could be retained by the organizer and loaned to the corporation as needed. Once cash or other assets are contributed to a corporation, it is difficult to transfer them back to the shareholder without triggering taxable income to either the shareholder or the corporation. However, the legal and business consequences of keeping assets outside of the corporation must also be considered.

Purchase stock

The first step is to have an incorporator incorporate the chosen entity and issue stock to the owner in exchange for cash. A typical scenario would be to issue 1,000 shares at $1 per share with a 10 cents-per-share par value. The new corporation now has $1,000 cash and $1,000 equity.

Determine key account balances

The next step is to determine the accounts receivable and accounts payable balances as of the chosen cutoff date. In addition, a depreciation schedule must be prepared that reflects depreciable basis and accumulated depreciation for each asset that is transferred to the new incorporated entity through the cutoff date.

Accounts receivable and payable

In a tax-free incorporation, a cash-basis transferee corporation reports income when accounts receivable are received and reports a deduction when accounts payable are paid. Although the incorporated entity does not have basis in the transferred receivables and payables, it should maintain separate account details to ensure the respective collection and payment.

Depreciable property

When depreciable property is transferred in exchange for stock of the new corporation, the basis in those assets is the same as in the hands of the transferor, which can be referred to as carryover basis. Therefore, the transferee corporation continues to depreciate the transferred assets, using the same depreciation basis, depreciation method, remaining depreciable life, and rate as the transferor.

Depreciable assets received by the corporation in a partially taxable exchange that have a basis determined by the adjusted basis of the assets in the hands of the transferor plus gain recognized by the transferor are depreciated as if each asset consisted of two separate parts, one being the adjusted basis of the asset and the other being the gain allocated to it (Sec. 168(i)(7)).

If an SMLLC is not incorporated under state law, it is automatically classified as a disregarded entity or can file Form 8832, Entity Classification Election, to be classified as a corporation. Under Regs. Sec. 301.7701-3(g)(1)(iv), if an SMLLC elects to be classified as a corporation, the owner is deemed to contribute the assets and liabilities of the business to the corporation in exchange for stock. This is generally a tax-free transaction under Sec. 351.

The entity's basis in the transferred assets equals the basis the owner had in those assets (Sec. 362). It also continues the owner's holding period for the assets (Sec. 1223(2)). On the other hand, the owner's basis in the stock received equals his or her basis in the contributed assets, reduced by any liabilities assumed by the entity (Sec. 358(a)). Also, to the extent the owner receives corporate stock in exchange for capital assets and Sec. 1231 property, the owner's holding period for the stock includes his or her holding period for the transferred assets (Sec. 1223(1)).

Example. Converting a single-owner disregarded entity to a corporation: A owns 100% of B LLC, an LLC classified as a disregarded entity for tax purposes. B owns a building and depreciable equipment with a total basis of $800,000 and a fair market value of $2.2 million. For nontax reasons, A decides to make a check-the-box election to treat B as a corporation for tax purposes.

As a result, A is deemed to contribute the building and equipment to a corporation in exchange for stock. A recognizes no gain or loss under Sec. 351 because she controls B after the transaction. B's basis in the building and equipment equals $800,000, which was A's basis in those assets. In addition, B continues A's holding period for those assets.

A's basis in the stock equals $800,000. Because the contributed property was Sec. 1231 property, A's holding period for the stock includes her holding periods for the contributed property.

Although this type of conversion can generally be accomplished tax-free, gain may be recognized if:

• The owner receives stock and other property (boot) in exchange for its assets. Under Sec. 351(b), gain recognized upon the receipt of boot is the lesser of the gain realized on the transfer or the amount of boot received. However, this scenario is unlikely to happen when a check-the-box election is made.
• Debt assumed by the corporation is treated as boot if the principal purpose of the transfer is to avoid federal income tax or if the transfer was not made for a bona fide business purpose (Sec. 357(b)).
• The corporation assumes liabilities (or takes property subject to liabilities) in an amount exceeding the basis of the contributed assets (Sec. 357(c)). However, liabilities such as accrued payroll that would give rise to a deduction when paid are excluded from the Sec. 357(c) calculation.

If an SMLLC elects to be classified as a corporation, the effective date specified on Form 8832 cannot be more than 75 days prior to the date the election is filed and not more than 12 months after the date it is filed. If an election specifies a date more than 75 days prior to filing the election, the effective date is 75 days prior to filing. If an election specifies an effective date more than 12 months from the date on which the election is filed, it is effective 12 months after the date it was filed (see Regs. Sec. 301.7701-3(c)(1)(iii)).    

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 33d Edition (April 2020), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).