Chapter 2 Flashcards
What does §351(a) say?
It provides that no gain or loss is recognized by the transferor of property to a corporation in exchange for stock.
What does §1032 say in regard to forming a corporation?
Provides that the recipient corporation will not recognize gain or loss on the transfer of its stock in exchange for property- Even if §351(a) makes the transfer taxable to the transferor.
What does §358(a)(1) say?
Provides the mechanism whereby the tax-deferred gain will ultimately be recognized at some point in the future. The transferor’s basis in the stock received takes a basis equal to the transferor’s basis in the property transferred.
This is substituted basis.
What does §362(a) provide?
Provides the corporation with a carryover basis in the assets received
This means the corporation will have the exact same basis in the asset that the transferor had.
Jim is a sole proprietor. He has been advised that it would make sense to transfer his business to a newly formed corporation in order to shelter his personal investment assets from the risks of the business. As such, Jim forms a corporation and transfers all the assets from his sole proprietorship to the new corporation in exchange for 100% of the new corporation’s stock. Note that Jim’s business has no liabilities. The FMV of the assets transferred is $500,000. Jim’s basis in these assets amounts to $200,000 on the date of transfer. What are the tax consequences?
First of all, if Jim had simply sold these assets, he’d have a taxable gain of $300,000.
- §351(a) – no gain or loss to Jim. Jim’s realized gain is $300,000 but none of this gain is recognized
- §1032 – the corporation does not recognize a gain on the issuance of its stock in exchange for the assets of Jim’s business
- §358(a)(1) – though the stock Jim receives in the exchange is presumably worth something near $500,000, his basis in the stock will only be $200,000. This preserves the gain of $300,000 that was not recognized by Jim upon transfer of his business to the corporation
- §362(a) – the corporation takes the assets with the same basis Jim had in the assets (or $200,000)
- Note that prior to the transfer, Jim had a $300,000 built-in gain in the assets. He still has this built-in gain in the stock he currently holds. Note; however, that a second built-in gain has been created at the corporate level – this built-in gain is also $300,000!!!
If a shareholder receives boot, how is it taxed?
The shareholder will be taxed on the:
- Lesser of the fair market value of the boot, OR,
- The realized gain on the §351 transfer.
What are the 4 “Requirements” of §351(a)?
- There must be a transfer
- The transfer must be of property
- The consideration given for the transfer must solely be stock
- The transferor(s) must be in control of the corporation following the transfer, as defined by §368(c)
What are the 2 exceptions to the definition of ‘property’ in §351(a)?
- Property does not include past services or promises to provide future services. The taxation of services is controlled by §83.
- Any receivables transferred into the corporation that are due from the corporation will trigger taxable income at the shareholder level- this is the same as the shareholder getting paid for the receivable.
What are the 5 issues with the “solely for stock” requirement of §351(a)?
- The transfer of property to an existing corporation by the 100% owner of such corporation does NOT have to be effected with stock. The issuance of such stock would be a meaningless exercise since the transferor already owns 100% of the stock.
- Securities (long-term debt obligations) are treated as “boot” since they are debt not equity (i.e., they won’t qualify as “stock”)
- Qualified preferred stock (under §351(g)) is treated as stock. However, preferred stock that does not qualify as “qualified preferred stock” (i.e., nonqualified preferred stock) will be treated as “boot” since it possesses characteristics akin to debt.
- Preferred stock will be nonqualified preferred stock if:(only one has to be met)
- The holder of such stock has the right to require the issuer or a related person to redeem or purchase the stock
- The issuer or a related person is required to redeem or purchase such stock
- The issuer or the related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or
- The dividend rate on such stock varies in whole or in part with reference to interest rates, commodity prices, or other similar indices.
- Stock warrants or other stock rights do not constitute “stock” for purposes of §351
What are the elements of “control” specified in §351(a)?
- For purposes of the “control” test, we look to the group of transferors
- Such group of transferors must be in “control” of the corporation “immediately after the exchange”
- “Control” is defined in §368(c) which defines control to mean ownership of:
- At least 80% of the total combined voting power of the corporation and
- At least 80% of the total number of shares of each class, taken separately, of nonvoting stock
- Until further clarification, nonqualified preferred stock is treated as stock for purposes of the control test!-Even though it’s treated as boot.
- “Immediately after the exchange” does not mean that all transferors must transfer their property simultaneously – they must be linked as part of an overall plan
- How long must a transferor hold the stock in order to meet the “control” test?
- What if there is a binding commitment to dispose of the stock shortly after the transfer under §351?
- Step transaction doctrine
- Binding commitment test
- Interdependence test
- End result test
What are the issues and holding of the Intermountain Lumber case?
Shook sold 50% of his business to Wilson in order to get more capital, and they formed a new corporation to do so.
Right after the transfer, 50% of the shares were in escrow which were ultimately acquired by Wilson.
The Issue: Whether Shook maintained control after the 351 transfer or whether giving 50% of the shares to Wilson after the formation made two equal owners, neither of which owned at least 80% or more, which would make the 351 transfer not valid.
The Holding: The court held that the transaction failed the control requirment, and was deemed a failed 351 transaction.
What are the 2 reasons an accomodation transfer will be disregarded?
- If the value of the property transferred is relatively small compared to the value of the stock already owned by the same transferor, and
- The primary purpose of this transaction is to qualify the transfer by others for 351 nonrecognition purposes.
What happened in the Kamborian case?
Two trustee transferor’s transferred $5,000 in exchange for more shares of a company they already owned 13% of.
They transferred the money as part of a bigger deal involving all of the shareholders, and the transaction as a whole was treated as a 351.
The IRS said that it wasn’t a 351 because the trustee’s portion of the transaction was simply an accomodation transfer and as such it fails as a valid 351.
The IRS decision was based on the fact that the transferors transfer only amounted to 0.83% of the amount of stock they already owned in the corporation, which made it an accomodation transfer.
According to Revenue Procedure 77-37, the transfer has to make up at least 10% or more of the value of what the transferor currently owns.
Revenue Ruling 79-194
- Corporation Z and a group of investors, pursuant to a binding agreement between them, transferred property to a newly organized corporation, Newco, in exchange for all of Newco’s stock
- Z received 80% of the Newco stock and the group of investors received 20% of the stock
- Pursuant to the agreement, Z sold an amount of its Newco stock to the group of investors to bring its ownership down to 49%
- The investors’ transfer to Newco was conditioned on the sale by Z of its Newco shares to the group of investors
**Issue: **Is this a valid §351 transaction after considering the binding commitment of Z to sell Newco shares to the group of investors (taking Z’s ownership below the requisite 80% )?
WHY?
Yes. This is a valid §351 transaction. Both Z and the group of investors are considered transferors since both parties made significant contributions to Newco. Given that both are considered transferors, their combined ownership is 100% both before and after the sale.
Revenue Ruling 79-194
- X, a domestic corporation, operates a branch in a foreign country.
- The foreign country required that the foreign branch be incorporated and that its citizens be the majority shareholders of the corporation (Newco)
- As such, X and a group of investors (who were residents of the foreign country) entered into a binding agreement in which each would transfer assets to Newco
- Following the transfers, X owned 99% of Newco and the investors owned 1% of Newco
- As part of the overall agreement, X sold a sufficient number of shares to the investors such that X owned 49% of Newco while the investors ended up owning 51%
Issue: Is this a valid §351 transaction after considering the binding commitment of X to sell Newco shares to the group of investors (taking X’s ownership below the requisite 80% )?
No. Since the amount contributed by the investors was “relatively small” when compared to the total stock value received by the investors following the sale, the contribution is viewed as an accommodation transfer. As such, the investors are not treated as transferors.
At the shareholder level, what are the 3 elements of ‘boot’?
- “Boot” = cash and other property (other than qualified stock of the transferee)
- Boot is taxable to the lesser of:
- The realized gain on the §351 property transferred or
- The FMV of the boot received
- Realized losses remain unrecognized even if boot is received
At the corporate level, what are the 4 elements of ‘boot’?
- §311(b) controls whether or not the corporation recognizes gain on the issuance of boot
- A corporation recognizes gain to the extent the FMV of the boot exceeds its related basis
- No gain is recognized by the corporation on the issuance of its own debt or on the issuance of nonqualified preferred stock
- A corporation does NOT recognize loss on the issuance of boot depreciated in value
What are the steps to follow to allocate boot under Revenue Ruling 68-55?
- Determine FMV of each asset transferred
- Calculate the relative percentage to the total for each asset based on its relative FMV
- For each asset, determine the lesser of the realized gain (not recognized gain) or the FMV of the boot allocated to the asset. As such, realized losses will not be recognized.
- The amount determined in step 3 is the recognized gain for each asset
- The character of the gain is dependent on the type of gain that would have been recognized by the transferor had the transferor sold the asset rather than transferring it to the corporation
What are the 3 elements of basis for boot at the shareholder level, and the 3 impacts it has at the shareholder level?
Basis:
- General rule: substituted basis (§358(a)(1))
- Realized gain is not recognized
- Deferred gain is preserved in the lower stock basis
Impact:
- Gain recognized will increase basis of assets (boot) received in exchange
- Property treated as boot will have a basis of FMV in the shareholder’s hands
- Ultimately, the deferred gain is reduced by the amount of gain recognized as the result of boot distribution
What are the elements of basis(3) and impact(2) of boot at the corporate level?
Basis:
- General rule: carryover basis (§362)
- Transfer to corporation creates a second built-in gain subject to tax when the corporation disposes (sells) the contributed asset
- Deferred gain is preserved in the lower asset basis
Impact:
- Gain recognized will increase basis of assets contributed to the corporation
- Ultimately, the deferred gain is reduced by the amount of gain recognized as the result of boot distribution
What does §362(e)(2) do?
- Requires that the corporation holds the built-in loss property at its FMV on the date of the transfer, which eliminates the second built-in loss.
- Alternatively, the corporation and the shareholder may jointly elect to have the shareholder step down the basis of his/her/its stock to FMV and leave the built-in loss intact in the corporation (thus eliminating the built-in loss at the shareholder level)
- Under §362(e)(2), the test for built-in loss is not made on an asset-by-asset basis but rather on an aggregate basis
- If the aggregate basis of assets transferred exceeds their aggregate FMV, the step-down is allocated to the assets based on their relative built-in losses
What are the 4 elements of the assumption of liabilities?
What is the impact on shareholder basis?
What are the exemptions to tax-free treatment under §357(a)?
- General Tax Law: if one is relieved of a liability, it is as though the party received cash and paid off the liability.
- In a sale or** **exchange transaction, the relief of liability (debt) would be treated as a portion of the sales price
- Absent §357(a), the relief of debt in a §351 transaction would trigger “cash” boot
- Fortunately, §357(a) does NOT treat the relief of debt as boot – in general, a shareholder may contribute encumbered property (or property along with liabilities such as accounts payable) tax –deferred in a §351 transfer!!
Impact on Shareholder’s Basis
- The shareholder’s basis (under §358(a)(1)) is reduced by the amount of liabilities assumed by the corporation
Exceptions to Tax-Free Treatment under §357(a)
- Tax avoidance purpose or lack of business purpose (§357(b))
- Liabilities in excess of basis (of assets transferred) (§357(c))
What happened in the Drybrough case?
Drybrough had a few pieces of land with mortgages on them which he used to buy tax-exempt securities.
A fifth mortgage was clearly used to prep for a 351 transfer and was deemed to be improper under 357(b)
What are the elements of §357(c)?
§357(c) – Liabilities in Excess of Basis
- Business purpose does NOT play a role in this calculation
- §357(c) prevents the shareholder in taking a negative basis in the stock received
- Both recourse and non-recourse liabilities are considered in the calculation
- If both §357(b) and §357(c) apply, §357(b) will control
- §357(c) is applied to each transferor separately
- The gain recognized will bring the shareholder’s basis in its stock to zero
- §357(c) gain recognized is not treated as gain from “boot”. The gain increases the basis of assets contributed to the corporation and such gain is allocated among the assets contributed based on their relative FMVs (however, no asset will take on a basis in excess of its FMV)
- §357(c)(3) provides that cash basis payables will NOT be treated as liabilities for purposes of §357(c)
Revenue Ruling 95-74
Facts:
- Corporation P is an accrual basis corporation engaged in various operating businesses
- One business includes a manufacturing plant.
- The plant is located on land purchased by P many years ago.
- As a result of the plant’s operations the land has become contaminated and P is now subject to certain environmental liabilities (soil and groundwater remediation, etc.)
- P contributes all assets and liabilities associated with the manufacturing business to a new corporation S. Such assets includes the plant and the contaminated land
- Two years later, S undertakes the soil and groundwater remediation work
What are the issues and holdings?
Issues:
- Are the environmental liabilities assumed by S treated as liabilities for purposes of §§ 357(c)(1) and 358(d)?
- Once assumed by S, how will the environmental liabilities be treated?
Holdings:
- The environmental liabilities are not treated as liabilities under §357(c) or §358(d)
- The expenses are deducted or capitalized as though S had held the land and business since day one
General rule of §358 basis is:
- The basis of the property transferred
- Decreased by cash and FMV of boot received
- Decreased by debts assumed (treated as cash for this purpose) other than debts excluded under §357(c)(3)
- Increased by amount of gain recognized by transferor
Potential methods to avoid a §357(c) gain:
Potential methods to avoid the §357(c) gain:
- Transferor retains liability rather than transferring liability to corporation (i.e., the liability is not transferred to the corporation)
- Additional high basis assets are contributed to the corporation
- What about having the transferor guarantee the debt transferred to the corporation? Does this take the loan out of §357(c)? – See the Owens case
- What about transferring a personal note (of the transferor) to the corporation? What is the basis of such a note? – See the Peracchi case (next video)
Owen vs Commissioner facts, issue, and holding:
Facts:
- Owen participated in several business ventures with McEachron (on an equal basis)
- They were equal owners in Western Explorations, Inc.
- They formed a seismic drilling business called McO Investments
- In 1981, they decided to sell both businesses
- They were advised by their attorney to put all the assets in one corporation.
- As such, they transferred all the assets and liabilities of McO Investments to Western Explorations, Inc.
- At the time of the transfer, McO’s liabilities exceeded the basis of its assets
- Owens had guaranteed the loans against the property and was still a guarantor after the transfer to Western
Issue:
Given that Owen remained liable on the debt secured by the assets transferred, are such liabilities treated as liabilities under §357(c)
Holding:
Yes!!
Peracchi Case Facts, Issue, and Holding
Peracchi transferred in building with high liabilities and then a personal note to step up his basis so that he didn’t have to pay tax according to 357(c).
The issue was whether him writing a personal note to his corporation really gives him extra basis to negate 357(c)
The holding was that Peracchi did have basis in the note equal to its face value.
Issues of incorporating an existing business (2 of them)
- Non-deductibility of business expenses incurred but not paid by a cash method taxpayer and later paid by the transferee corporation. Should the transferee be allowed to deduct the expenses (given that they were NOT incurred by the corporation)?
- What about cash basis accounts receivable? Should they be taxed to the transferor immediately prior to the transfer? If not, isn’t this an “assignment of income” problem?
Hempt Brothers Case
Facts:
- A cash method partnership engaged in the business of quarrying and selling stone, sand, gravel, etc.
- The partnership transferred its assets to a newly formed corporation under §351
- Among the assets transferred were cash basis accounts receivable with a face amount of $663k
- It appears that the corporation collected the receivables but didn’t report any income upon collection on the theory that the income was earned by the partnership and the transfer of the receivables should have generated a tax at the partnership level
Issue:
Given that we have a conflict between §351 and the “assignment of income doctrine”, which of the two rules (controls)?
Holding:
§351 overrules the “assignment of income doctrine”. The partnership was not taxable on the transfer of the cash basis receivables. The corporation was taxable upon collection of the receivables.
Facts, Issues, and Holding of Revenue Ruling 80-198
Facts:
- Individual A conducted a medical practice as a sole proprietor using the cash basis method of accounting
- A formed a new corporation under §351 and transferred all of the assets of the sole proprietorship to the corporation in exchange for 100% of the corporate stock and the assumption by the corporation of the sole proprietorship’s liabilities (including cash basis accounts payable)
- This is a fact pattern very similar to the Hempt Bros case – this time the focus is primarily on the treatment accorded the accounts payable
Issues:
How are the accounts payable treated in this circumstance
Holding:
- The transfer of the sole proprietorship is tax-deferred under §351
- The cash basis accounts payable are not treated as liabilities for purpose of testing §357(c)
- When paid, the corporation will deduct the amounts paid (in satisfaction of the accounts payable)
Two situations based on Rev Ruling 80-198 when the general rules of Hempt Bros and the ruling would not apply.
The revenue ruling points out two situations in which the general rules of Hempt Bros and Rev Rul 80-198 would not apply:
- A taxpayer transfers to a corporation cash basis accounts receivable under what would otherwise qualify as a §351 transfer but no other business assets are transferred
- Manipulating the timing of deductions and recognition of income such that the transferor pays off the accounts payable before the transfer and intentionally avoids collection of the accounts receivable until after the transfer
In other words, if steps are taken to inappropriately minimize tax, the IRS could well apply the doctrine of “assignment of income” or §482 (“clear reflection of income”) to undue the steps taken by the taxpayer.
What are organization, business start up, and sydnication expenses?
- Organization Costs: Costs incurred incident to the creation of the corporation, chargeable to capital account and of a character that would be amortizable over the life of the corporation if the life were ascertainable
- Business Start Up Costs: Costs of creating or investigating the creation or acquisition of an active trade or business
- Syndication Costs: Costs incurred in connection with the issuance and marketing of the corporation’s stock including legal, accounting, underwriting and registration costs
What are the elements of organization costs?
- Taxpayer may elect to deduct currently up to $5,000 under §248
- Costs in excess of $5,000 are amortizable over a period of 180 months (15 years)
- To the extent that total organization costs exceed $50,000, each dollar in excess of $50,000 reduces the $5,000 highlighted in “1” above dollar-for-dollar. As such, if total organization costs exceed $55,000, the corporation cannot deduct anything currently and the entire cost will be amortized over 180 months (beginning on the date of organization)
Elements of business start up costs:
- Taxpayer may elect to deduct currently up to $5,000 under §195
- Costs in excess of $5,000 are amortizable over a period of 180 months (15 years)
- To the extent that total start up costs exceed $50,000, each dollar in excess of $50,000 reduces the $5,000 highlighted in “1” above dollar-for-dollar. As such, if total start up costs exceed $55,000, the corporation cannot deduct anything currently and the entire cost will be amortized over 180 months
Elements of syndication costs:
Syndication costs are neither deductible nor amortizable. These costs simply sit on the balance sheet
