Tax 4022/5022 Federal Income Tax II Chapter 18

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 . . . .