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Tax Accounting: Tax Treatment of Shareholders and IRS Rules for Partnerships

1. What are the major advantages of bona fide loans from shareholders and other debt instruments over stock?
2. What conditions need to be met to avoid IRS classification of loans from shareholders as equity (contributions to capital)?
3. What is the tax treatment of losses from worthless stock or securities?
4. What is the tax consequence if an eligible entity elects to change from being treated as a corporation to being treated as a partnership or proprietorship?
5. What IRS form needs to be prepared for an eligible entity to elect to be taxed as a corporation?
6. When does a partner recognize gain on a contribution of property to a partnership?
7. What is the partnership's basis in property contributed to the partnership by a partner?
8. When is a partnership considered terminated?
9. What are the IRS rules for determining the tax year of a partnership?
10. How are start-up expenses and organization expenses handled for a new partnership?

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1. What are the major advantages of bona fide loans from shareholders and other debt instruments over stock?

Loans from shareholders are easy to obtain without the hassles of bank loans with qualifying, presentation of financial statements and approval procedures. Lenders charge fees and other loan costs, and often prefer collateralized loans. Shareholder loans can easily be rewritten for changes to either term or interest rate with no formal procedures. Obviously shareholder loans are easier than other debt instruments, but funding from stock sales is entirely different.

With the sale of stock comes issues of control (percentage of shares held) and dilution. If you were a 60% shareholder before a sale of stock to a third party, you could be a 40% shareholder after the sale, and you may no longer have control over the entity. Second issue relating to a stock sale is the matter of valuation. Stock issued after an entity has become successful will not have the same value as stock issued at the outset. For a company not publicly traded, valuing the stock can be a difficult exercise.

2. What conditions need to be met to avoid IRS classification of loans from shareholders as equity (contributions to capital)?

First, you might wonder why anyone would care if their loans were reclassified as contributed capital? Any interest payments would also be reclassified as dividends rather than interest expense. Remember that dividends to shareholders are not deductible to the corporation, and are therefore double-taxed. Then any reclassification from debt to equity could change the ownership percentages. Those percentages might have been used for other allocations which would be wrong if debt was reclassified.

To avoid a re-characterization of debt to equity, the debt must follow the rules that other debts would have: a signed note, a stated interest rate, periodic payments and possibly include collateral.

3. What is the tax treatment of losses from worthless stock or securities?

With one notable exception, the loss on the disposition of stock or securities is a capital transaction. It could be a short or a long term transaction, but capital nonetheless. Even companies which file Chapter 7 bankruptcy create a capital loss transaction for worthless ...

Solution Summary

The responses to the questions are 2 to 4 paragraphs each for a total of 1318 words. Most of the questions are cited responses.

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