1. Tax 4022/5022 Federal Income Tax II Chapter 18 Dr. Robert R. Oliva Ph.D., LL.M., J.D., CPA Professor and Chairperson Department of Accounting University of Arkansas at Little Rock Robert R. Oliva, Professor

2. IRC 351: Transfers to Controlled Corporations

3. INTRODUCTION CREATION OF A CORPORATION BY TRANSFERRING DEPRECIATED PROPERTY MAY TRIGGER REALIZED GAIN. REALIZED GAIN = AMOUNT REALIZED - ADJUSTED BASIS

4. IRC 1001(C): “EXCEPT AS OTHERWISE PROVIDED IN THIS SUBTITLE, THE ENTIRE AMOUNT OF THE GAIN OR LOSS,..., ON THE SALE OR EXCHANGE OF PROPERTY SHALL BE RECOGNIZED”

5. IRC 351 ONE OF THE EXCEPTIONS PROVIDED IN SUBTITLE TAX FREE TRANSFER OF PROPERTY TO A CONTROLLED CORPORATION.

6. TOPICS RATIONALE FOR IRC 351 IRC 351(A) ITS KEY ELEMENTS EFFECT TO TRANSFEROR AND TO TRANSFEREE

7. RATIONALE FOR IRC 351 “CONTINUITY OF INVESTMENT” : IT DOES NOT CLOSE THE TRANSFEROR’S INVESTMENT WITH SUFFICIENT ECONOMIC FINALITY A MERE CHANGE IN THE FORM OF OWNERSHIP, WITHOUT “CASHING- IN” OR “CLOSING-OUT” INVESTMENT.”

8. BEWARE NOT A PERMANENT EXEMPTION. NOT AN ELECTION. AVOIDANCE OF IRC 351 REQUIRES INTENTIONAL FAILURE OF ONE OF ITS ELEMENTS. IRC 351 APPLIES TO EXISTING CORPORATIONS AS WELL.

9. IRC 351(A): GENERAL RULE –NO GAIN OR LOSS SHALL BE RECOGNIZED IF PROPERTY IS TRANSFERRED TO A CORPORATION BY ONE OR MORE PERSONS SOLELY IN EXCHANGE FOR STOCK IN SUCH CORPORATION AND IMMEDIATELY AFTER THE EXCHANGE SUCH PERSON OR PERSONS ARE IN CONTROL (AS DEFINED IN SECTION 368(C)) OF THE CORPORATION.

10. KEY ELEMENTS TRANSFEROR (transferring shareholder) / TRANSFEREE (receiving corporation) PROPERTY SOLELY IN EXCHANGE STOCK IMMEDIATELY AFTER CONTROL

11. “PROPERTY”: IRC 317(a): “FOR PURPOSES OF THIS PART, “PROPERTY” MEANS....” HOWEVER, IRC 351 IS NOT WITHIN SAME PART AS IRC 317 PROPERTY = A LEGALLY DEFENSIBLE PROPERTY RIGHT. REAL, PERSONAL, INTANGIBLE, EQUITABLE INTERESTS.

12. IRC 351 (d): “PROPERTY” IS NOT: SERVICES UNSECURED DEBTS OF TRANSFEREE CORPORATION TRANSFEREE CORPORATION’S DEBT INTEREST ACCRUEING TO TRANSFEROR.

13. “PROPERTY” IS NOT “SERVICES” RATIONALE: –PREVENTS CONVERSION OF HUMAN CAPITAL INTO FINANCIAL CAPITAL –PREVENTS CONVERSION OF “ORDINARY INCOME” INTO “CAPITAL GAIN” EXCHANGE OF SERVICES FOR STOCK: FMV OF SERVICES OR STOCK IS ORDINARY INCOME

14. STOCK FOR PAST SERVICES TRANSFEROR CAUSES CORP TO TRANSFER STOCK TO EMPLOYEE FOR PAST/FUTURE SERVICES. TREATED AS ISSUED TO ORIGINAL TRANSFEROR FIRST. NO GOOD IF AN INTEGRATED TRANSACTION.

15. TRANSFERS OF PROPERTY AND SERVICES OK IF FMV OF TRANSFERRED PROPERTY IS “MORE THAN SMALL VALUE” WHEN COMPARED TO THE AMOUNT OF FMV TRANSFERRED SERVICES, E.G., NOT A SHAM.

16. Making a service TFOR an “IRC 351 TFOR”: TRANSFER OF PROPERTY > “SMALL VALUE” IF: –PROPERTY TRANSFERRED > 10% OF THE VALUE OF STOCK TO BE RECEIVED FOR SERVICES.

17. ESTABLISHED CORPORATIONS: TRANSFER OF PROPERTY > “SMALL VALUE” IF: –PROPERTYTRANSFERRED > 10% FMV STOCK OWNED BY TRANSFEROR.

18. NOTE: THESE ARE IN CONNECTION WITH PLR’S REQUESTS. TODAY A PLR WILL NOT BE ISSUED ON THAT QUESTION. STOCK FOR SERVICES WILL BE TAXED AS ORDINARY INCOME

19. STOCK FOR SERVICES TO OTHERS SERVICES TO A MEMBER OF THE “CONTROL GROUP” PROHIBITION IS ONLY TO SERVICES RENDERED TO CORP. BUT: LOOK FOR TRUE NATURE –ORIGINAL TRANSFEROR WOULD HAVE TO RECOGNIZE GAIN IF PAID WITH STOCK WHOSE AB < FMV OF DEBT.

20. “SOLELY IN EXCHANGE FOR STOCK” “SOLELY”: IT DOES NOT MEAN “ONLY“ IRC 351(b) SPECIFICALLY PERMITS THE RECEIPT OF OTHER THAN STOCK; “If subsection (a) would apply... but for the fact that there is received, in addition to the stock... other property....”

21. “OTHER PROPERTY” = “BOOT” BOOT RECOGNITION = RECOGNIZE BOOT UP TO THE GAIN BUT 351 TRANSACTION DOES NOT FAIL.

22. BOOT ALLOCATION NECESSARY IF >1 PROPERTY TRANSFERRED AKA “SEPARATE PROPERTIES APPROACH”. REV. RUL. 68-55

23. EXAMPLE 1: BOOT ALLOCATION (p.1) THREE PROPERTIES TRANSFERRED: A, B, C FMV/AB OF PROPERTIES: 22K/40K, 33K/20K, 55K/25K FOR 100K IN STOCK AND 10K IN CASH HOW MUCH GAIN RECOGNIZED?

24. ALLOCATION (p.2): FMV 22 33 55 % ON FMV 20% 30% 50% ALLOC. BOOT: 2 3 5 ALLOC. STOCK: 20 30 50 TOTAL RECEIVED 22 33 55

25. ALLOCATION (p.3): TOTAL RECEIVED 22 33 55 LESS AB - 40 - 20 -25 GAIN(LOSS) RLZD -18 13 30 RECOGNIZED 0 3 5

26. “EXCHANGE” “PROPERTY” = A BUNDLE OF RIGHTS MUST EXCHANGE ALL SUBSTANTIAL RIGHTS NOT A LICENSE, BUT NOT AN “EXCHANGE” EITHER THUS, RETENTION OF SOME RIGHTS IS PERMISSIBLE.

27. “STOCK” EQUITY INVESTMENTS –VOTING PREFERRED –NON-COMPENSATORY, NON- ASSIGNABLE, CONTINGENT RIGTHS W/ BUSINESS PURPOSE. REV. RUL. 66-112; REV. PROC. 67-13 NOT STOCK RIGHTS/WARRANTS RATIONALE: TO ENSURE CONTINUITY OF INTEREST

28. “IMMEDIATELY AFTER” IT DOES NOT MEAN “SIMULTANEOUS TRANSFERS”

29. WHAT DOES IT MEAN? OK TO HAVE TRANSFERS AT DIFFERENT TIMES, AS LONG AS IT WAS ALL PART OF AN INTEGRATED TRANSACTION.

30. ISSUES DID EARLIER TRANSFERORS TRANSFER PROPERTY WITH THE EXPECTATION THAT LATTER TRANSFERORS WERE GOING TO TRANSFER PROPERTY ALSO? OR, WAS THE LATTER TRANSFERS “OUT-OF-THE-BLUE”, E.G., UNPREMEDITATED?

31. “CONTROL” IRC 368(c): “... AT LEAST 80 PERCENT OF TOTAL COMBINED VOTING POWER OF ALL CLASSES OF STOCK ENTITLED TO VOTE AND AT LEAST 80 PERCENT OF THE TOTAL NUMBER OF SHARES OF ALL OTHER CLASSES....”

32. INTERPRETATION OF CONTROL: “TRANSFEROR GROUP” MUST OWN 80% OF THE AGGREGATE OF ALL VOTING CLASSES AND 80% OF EACH NONVOTING CLASS. Rev. Rul. 59-259.

33. EXAMPLE 2: 100 SHARES O/S IN EACH CLASS VOTING CLASS A: X OWNS 40, Y OWNS 40 VOTING CLASS B: X OWNS 0, Y OWNS 80 NONVOTING CLASS C: X OWNS 80; Y OWNS 0 NONVOTING CLASS D: X OWNS 0; Y OWNS 80

34. ANSWER: “TRANSFEROR GROUP” OWNS 160/200 OF CLASSES A AND B, 80/100 OF CLASS C, AND 80/100 OF CLASS D.

35. LOSS OF CONTROL NO 351 IF PRECONCEIVED PLAN OR BINDING AGREEMENT GIFTS: OK B/C NO OBLIGATION FOR GIFTS. BUT: TRANSACTION MUST BE GIVEN ITS TRUE NATURE, E.G., GIFT TAX.

36. DISPROPORTIONATE EXCHANGES NO SUCH REQUIREMENT BUT: TRANSACTION MUST BE GIVEN ITS TRUE NATURE, E.G., GIFT TAX.

37. EFFECT ON TRANSFERORS IF 351: NO GAIN NOR LOSS; IRC 351(a) BOOT RECOGNITION: IRC 351(b) ASSUMPTION OF LIABILITY : IRC 357 CARRYOVER AB: IRC 358(a)(1) AND (2)

38. ASSUMPTION OF LIABILITY: IRC 357(a) EXCEPT AS PROVIDED IN SUBSECTION (b) AND (c), IF –(1) THE TAXPAYER RECEIVES PROPERTY... WITHOUT RECOGNITION OF GAIN... AND

39. (2)... ANOTHER PARTY... ASSUMES A LIABILITY... THEN (IT) SHALL NOT BE TREATED AS MONEY OR OTHER PROPERTY....

40. Tfror trfrs PTY = 100; AB =60; MTG =40 TFEE: ASSUMES MTGE; C/S = 60 AR = 60 +40=100 LESS AB –60 GAIN REALIZED=40 GAIN RECOGNIZED = 0

41. Tfror trfrs PTY = 100; AB =60; TFEE: ASSUMES MTGE; C/S = 60 + CASH 40 AR = 60 +40=100 LESS AB –60 GAIN REALIZED= 40 GAIN RECOGNIZED = 40

42. 1ST EXCEPTION: IRC 357(b)(1) IF... IT APPEARS THAT THE PRINCIPAL PURPOSE OFTHE T/P –(A) WAS A PURPOSE TO AVOID FEDERAL INCOME TAX... OR –(B) IF NOT..., WAS NOT A BONA FIDE BUSINESS PURPOSE, THEN SUCH ASSUMPTION... SHALL... BE CONSIDERED AS MONEY RECEIVED BY THE T/P....

43. BURDEN OF PROOF AND EFFECT OF 357(b)(1) 357(b)(2):... BURDEN IS ON THE TAXPAYER... BY THE CLEAR PREPONDERANCE OF THE EVIDENCE EFFECT OF IRC 357(b)(1): ASSUMPTION IS TREATED AS BOOT.

44. 2ND EXCEPTION: IRC 357(c)(1) IRC 357(c) LIABILITIES IN EXCESS OF BASIS “... IF THE SUM OF THE... LIABILITIES ASSUMED... EXCEED THE TOTAL OF THE ADJUSTED BASIS OF THE PROPERTY TRANSFERRED... THEN SUCH EXCESS SHALL BE CONSIDERED A GAIN....

45. Tfror trfrs PTY = 100; AB =60; MTG =65 TFEE: ASSUMES MTGE = 65 AR = 65 MTGE + 35 C/S =100 LESS AB –60 GAIN REALIZED=40 GAIN RECOGNIZED = 5 ``Excess of MTGE over AB

46. TWO EXCEPTIONS TO IRC 357(c)(1) IRC 357(C)(2)(A): IRC 357(c)(3)(B); 357(c)(3)(A):

47. 1ST EXCEPTION: IRC 357(c)(2)(A) IGNORE IRC 357(c)(1) IF IRC 357(b)(1) APPLIES.

48. 2ND EXCEPTION: IF THE LIABILITY DID NOT CREATE/INCREASE OF BASIS IN ANY PROPERTY, EXCLUDE AMOUNT OF THE FOLLOWING LIABILITIES FROM THOSE ASSUMED: –LIABILITY WHOSE PAYMENT WOULD GIVE RISE TO A DEDUCTION – LIABILITY FOR PAYMENT TO RETIRED OR DECEASED PARTNERS

49. NOTE: IRC 357(c)(1) CONSIDERS ALL LIABILITIES AND ALL AB TRIGGERS GAIN IRRESPECTIVE OF HAVING ANY GAIN REALIZED

50. TRANSFEROR’S ADJUSTED BASIS ON STOCK RECEIVED (a) IN THE CASE OF AN EXCHANGE TO WHICH SECTION 351... APPLIES- –(1) NONRECOGNITION OF PROPERTY. THE BASIS OF THE PROPERTY PERMITTED TO BE RECEIVED.... WITHOUT THE RECOGNITION OF GAIN OR LOSS SHALL BE THE SAME AS THAT OF THE PROPERTY EXCHANGED....

51. IRC 358(a)(1)(A) (A) DECREASED BY –(i) THE FMV OF ANY OTHER PROPERTY (EXCEPT MONEY)... –(ii) THE AMOUNT OF MONEY RECEIVED..., AND –(iii) THE AMOUNT OF THE LOSS TO THE TAXPAYER WHICH WAS RECOGNIZED...

52. IRC 358(a)(1)(B) (B) INCREASED BY –(i) THE AMOUNT WHICH WAS TREATED AS A DIVIDEND –(ii) THE AMOUNT OF THE GAIN TO THE TAXPAYER WHICH WAS RECOGNIZED...NOT INCLUDING ANY PORTION... TREATED AS A DIVIDEND

53. AB AND ASSUMPTION OF TRANSFEROR’S LIABILITY –IRC 358(d)(1): “WHERE... ANOTHER PARTY... ASSUMED A LIABILITY OF THE TAXPAYER..., SUCH ASSUMPTION...SHALL, FOR PURPOSES OF THIS SECTION BE TREATED AS MONEY RECEIVED” –IRC 358(e): “EXCEPTION: THIS SECTION SHALL NOT APPLY TO THE AMOUNT OF ANY LIABILITY EXCLUDED UNDER SECTION 357(c)(3).”

54. SUMMARY: TRANSFEROR’S AB (STOCK) ORIGINAL AB + GAIN RECOGNIZED - FMV BOOT AND MONEY RECEIVED - TRANSFEROR’S LIABILITIES ASSSUMED BY THE CORP. ALLOCATE AB IF > 1 CLASS IS RECEIVED

55. TRANSFEROR’S AB ON BOOT RECEIVED IRC 358(a)(2) OTHER PROPERTY. THE BASIS OF ANY OTHER PROPERTY (EXCEPT MONEY) RECEIVED BY THE TAXPAYER SHALL BE ITS FAIR MARKET VALUE.

56. TRANSFEROR’S HOLDING PERIOD SUBSTITUTED AB = SUBSTITUTED HP

57. EXAMPLE 3: DEBT ASSUMED BY TFREE < AB TFROR TRANSFERS: FMV=$80K; AB=$50K; MTG=$30K; FOR $50K IN STOCK GAIN REALIZED=50K STOCK + 30K RELEASE - 50K AB = $30K TFROR AB= 50K ORIGINAL - 30K RELEASE = $20K ENDING AB

58. EXAMPLE 4: DEBT ASSUMED BY TFREE > AB SAME, BUT NOW MTG=$60K GAIN REALIZED=20K STOCK + 60K RELEASE -50K AB = 30K GAIN RECOG.: IF IRC 357(b) DOES NOT APPLY, 357(c) REQUIRES RECOGNITION OF $10K. TFROR AB=50K ORIGINAL -60K RELEASE + 10K GAIN = $0 END AB

59. EXAMPLE 5: DEBTS ASSUMED BY TFREE > AB FMV/AB: INV 10K/20K; LAND 40K/20K; LAND MTGE 30K; FOR 20K IN STOCK GAIN REALIZED: 20K STOCK + 30K RELEASE - 40K AB = 10K GAIN RECOGNIZED: $0 NOTE THAT TOTAL AB=20K+20K=40K; 40K AB > 30K ASSUMPTION

60. EXAMPLE 5 CONTINUES: AB & HP 40K ORIGINAL - 30K MTGE = 10K; SPLIT 50/50 B/C OF NET FMV OF INV AND LAND HP –LAND: CARRYOVER / TACKED ON. – INVENTORY: AS OF DATE OF EXCHANGE

61. EXAMPLE 6: SAME BUT LAND’S AB=$5K AGGREGATE AB= 20K + 5K = 25K 30K MTGE > 25K MTGE: RECOGNIZE IRC 357(c)(1) GAIN OF $5K AB = ORIGINAL 25K -30K + 5K GAIN = $0

62. EFFECT ON TRANSFEREE CORP IRC 1032: “NO GAIN OR LOSS... RECOGNIZED... ON THE RECEIPT OF MONEY OR OTHER PROPERTY IN EXCHANGE FOR STOCK... OF SUCH CORPORATION....” HENCE, EVEN IF NO 351 FOR TRANSFEROR, TRANSFEREE PROTECTED BY IRC 1032.

63. EFFECT OF IRC 311(b)(1) “IF (A) A CORPORATION DISTRIBUTES PROPERTY... (O/T ITS DEBT)... TO A SHAREHOLDER IN A DISTRIBUTION TO WHICH SUBPART A APPLIES, AND (B) THE FMV > AB, THEN GAIN SHALL BE RECOGNIZED... AS IF... SOLD... AT ITS FMV”

64. EFFECT OF DISTRIBUTING A LIABILITY IRC 311(b)(2): TREATMENT OF LIABILITIES. RULES SIMIALR TO THE RULES OF SECTION 336(b) SHALL APPLY....” IRC 336(b): “IF ANY PROPERTY DISTRIBUTED... IS SUBJECT TO A LIABILITY..., THE FMV OF SUCH PROPERTY SHALL BE TREATED AS NOT LESS THAN THE... LIABILITY”

65. TRANSFEREE’S AB: IRC 362 “IF PROPERTY WAS ACQUIRED... BY A CORPORATION... IN CONNECTION WITH... SECTION 351... THEN THE BASIS SHALL BE THE SAME AS IT WOULD BE IN THE HANDS OF THE TRANSFEROR, INCREASED IN THE AMOUNT OF GAIN RECOGNIZED TO THE TRANSFEROR....”

66. TRANSFEREE’S HP; IRC 1223(2) CARRYOVER FROM TRANSFEROR

67. Summaries and Examples

68. Basis Computation for Sec. 351 Exchange (slide 1 of 2) Shareholder’s basis in stock: Adjusted basis of transferred assets + Gain recognized on exchange - Boot received - Liabilities transferred to corporation = Basis of stock received by shareholder

69. Basis Computation for Sec. 351 Exchange (slide 2 of 2) Corporation’s basis in assets: Adjusted basis of transferred assets + Gain recognized by transferor shareholder = Basis of asset to corporation

70. Assumption of Liabilities (slide 1 of 2) Liabilities ARE treated as boot for determining basis in acquired stock

71. Assumption of Liabilities (slide 2 of 2) Liabilities are NOT treated as boot for gain recognition unless: –Liabilities > basis in assets transferred Gain recognized = Excess amount (liabilities - basis) –Liabilities incurred for no business purpose or as tax avoidance mechanism Boot = Entire amount of liability

72. Formation with Liabilities Example (slide 1 of 2) Property transferred has: Fair market value = $150,000 Basis = 100,000 Realized Gain = 50,000

73. Formation with Liabilities Example (slide 2 of 2) Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $80,000 $120,000 $120,000 Boot None $20,000 $120,000 Gain Recognized None $20,000 $ 50,000* *(Gain is lesser of $50,000 realized gain or boot)

74. Shareholder’s Basis in Stock in Last Example Adjusted Basis of transferred assets: $100,000 Liabilities assumed by corp. (independent facts): Business Business No Business Purpose Purpose Purpose Liability: $ 80,000 $120,000 $120,000 Basis in assets Transferred $100,000 $100,000 $100,000 + Gain recognized None 20,000 50,000 - Liab. Transferred (80,000) (120,000) ( 120,000) Basis in stock $ 20,000 -0- $ 30,000

75. Corporation’s Basis in Assets Received in Last Example Liabilities assumed by corp. (Independent facts): Business Business No Business Purpose Purpose Purpose Liability: $80,000 $120,000 $120,000 Basis of trans- ferred assets: $100,000 $100,000 $100,000 Gain recognized by shareholder None 20,000 50,000 Basis to Corp. $100,000 $120,000 $150,000