CORPORATE TAXATION I

CORPORATE TAXATION I • Today • Quickly review some concepts used in the last class • Revisit Revenue Ruling 68-55 • Complete Problems on page 99 • Hempt Bros. v. United States • Revenue Ruling 95-74 • Black & Decker v. United States • Commissioner v. Fink

Revenue Ruling 68-55 X Corp Asset I FMV = $22K % of Total = 20% Basis = $40k Loss = $18K Recognized = Lesser of: $0 Gain or (20% x $10K) = $0 Asset II FMV = $33K % of Total = 30% Basis = $20k Gain = $13K Recognized = Lesser of: $13 Gain or (30% x $10K) = $3k ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Recognized =Lesser of: $30 Gain or (50% x $10K) = $5k Ordinary Income Allocation of the $10,000 Y Corp

Revenue Ruling 68-55 • X’s basis in the Y Corp Stock => $85K (transferred basis) less $10K (boot received) plus $8K (gain recognized) = $83K • What is X’s holding period for each share of stock? • 20% Long term capital asset • 30% Short term capital asset • 50% Ordinary • Answer: each share has a 20% holding period that tacks to the long-term character, 30% holding period that tacks to the short-term character, and 50% that does not tack. • Y’s basis in the Assets: • Asset I => $40K (transferred basis) • Asset II => $20K (transferred basis) plus $3K (gain recognized) • Asset II => $25K (transferred basis) plus $5K (gain recognized) • What is X’s recognized gain on the transfer = $8K

Amended Revenue Ruling 68-55 X Corp Asset I FMV = $22K % of Total = 20% Basis = $52k Loss = $30K Recognized = Lesser of: $0 Gain or (20% x $10K) = $0 LT Capital Asset Asset II FMV = $33K % of Total = 30% Basis = $53k Loss = $20K Recognized = Lesser of: $0 Gain or (30% x $10K) = $0k ST Capital Asset Asset III FMV = $55K % of Total = 50% Basis = $25k Gain = $30K Recognized =Lesser of: $30 Gain or (50% x $10K) = $5k Ordinary Income Allocation of the $10,000 Y Corp

Amended Revenue Ruling 68-55 • X’s basis in the Y Corp Stock => Do we start with $130K (transferred basis)? • NO! See page 61, Para. 2 • Alternative 1: Shareholder and Corporation can elect to reduce the shareholder’s basis • Thus, Basis of Shareholder is FMV of $110K less $10K (boot received) plus $5K (gain recognized) = $105K • Alternative 2: Corporation’s basis in the assets is decreased • Y’s basis in the Assets: • Asset I => $52K (transferred basis) minus a proportionate amount of the net built in loss of $20K (calculated in proportion to the net built in loss in each asset) [($20K x 30/50) = 12] = $40K • Asset II => $53K (transferred basis) minus a proportionate amount of the net built in loss of $20K (calculated in proportion to the net built in loss in each asset) [($20K x 20/50) = 8] = $45 • Asset II => $25K (transferred basis) plus $5K (gain recognized)

Amended Revenue Ruling 68-55 • What is X’s holding period for each share of stock? • 20% Long term capital asset • 30% Short term capital asset • 50% Ordinary • Answer: each share has a 20% holding period that tacks to the long-term character, 30% holding period that tacks to the short-term character, and 50% that does not tack. • What is X’s recognized gain on the transfer = $5K [Assumes the application of Tres. Reg. § 1.357-2(a)]

Problem Page 99 • 1(a) Gain Recognition • Basis in the property transferred = $40K • Liability Assumed = $30K • Recognized gain = $0 • 1(a) A’s basis in the stock • $40K (transferred basis) less $30K (debt assumed by the corporation) = $10K • 1(a) A’s holding period in the stock • FMV allocation of 1/5 with no holding period (inventory) and 4/5 with a long term holding period (land tacks)

Problem Page 99 • 1(b) Gain Recognition • Basis in the property transferred = $25K • Liability Assumed = $30K • Recognized gain = $5 (§357(c) gain) • Allocation • Relative FMV => $10 (inventory) & $40K (land) • $1K allocated to the inventory (gain recognized, see handout) • $4K allocated to the land (recognized as a long-term Capital Gain) • What about allocating in proportion to the appreciation of the assets? (see Footnote 8 on page 83 – be consistent!) • 1(b) A’s basis in the stock • $25K (transferred basis) less $30K (debt assumed by the corporation) plus $5K (recognized gain)= $0 • 1(c) A’s holding period in the stock • FMV allocation of 1/5 with no holding period (inventory) and 4/5 with a long term holding period (the land tacks)

Problem Page 99 • 1(d) X’s basis in the properties • Following the theory of Treasury Reg. 1.357-2(b): • Land => $5K (transferred basis) plus 4/5 x $5K (gain recognized) = $9K • Inventory => $20K (transferred basis) plus 1/5 x $5K (gain recognized) = $21K • Following the “more rational” approach: • Land => $5K (transferred basis) plus 100% x $5K (gain recognized) = $10K • Inventory => $20K (transferred basis) • 1(e) Could A have contributed a $5K note ala Peracchi? • See Alderman v. Commissioner, 55 T.C. 662 (1971)

Problem Page 99 • 2(a) Facts: • Building with a Basis of $100k and FMV of $400k • Two notes: • First, for $80K incurred for business reasons • Second, for $10K incurred for personal reasons 2 weeks before the incorporation of X corp. • Issue: Is this a prohibition on “Stuffing”? • Was there a tax avoidance motivation or “non-bona fide” business purpose for the taking out of the loan? • Absent more information, the entire $90K is taxable as boot in under §357(b) • Burden is on B to prove by clear preponderance of the evidence no tax avoidance motivation or a bona fide business purpose

Problem Page 99 • 2(a) Character of Gain and Basis in B’s stock • Building gain is ordinary gain under §1239 • B’s basis => $100K (transferred basis) less $90K (assumed liabilities) plus $90K (gain recognized) = $100K

Problem Page 99 • 2(b) New Facts • Building with a Basis of $100k and FMV of $400k • One notes for $80K incurred for business reasons • No “Stuffing” • Gain recognized on the transfer = $10k • B’s Basis in the stock => $100K (transferred basis) less $80K (assumed liabilities) plus $10K (additional boot – the cash) plus $10K (gain recognized) = $20K

Hempt Brothers v. United States • Facts: Partnership transferred accounts receivable to a newly formed corporation. • Issues: • Were the accounts receivable “property” for purposes of §351? • Was the corporation taxable on the “income” of the partnership? • Holding: • Yes, only services are not “property” for purposes of §351? • Yes, the court focuses on the damage that excluding accounts receivable would do to the purposes of §351 as set forth by congress.

Hempt Brothers v. United States • Contrast Hempt where the court states that one can assign accounts receivables with the policy that prohibits service from qualifying as “property.” • Page 69: Section 351(d)(1) specifically provides, however, that stock issued for services shall not be considered as issued in return of property. This rule makes good sense… [i]nasmuch as the stock is compensation for those services, the tax consequences are property determined under Sections 61 & 83. • If the worry is the conversion of ordinary income, taxable under Sections 61 & 83 into capital gains, why do we allow that same person to convert his receivables into stock (capital assets)?

Revenue Ruling 95-74 • Facts: Corporation P has environmental waste incurred by P in its manufacturing on the land. If clean-up is done by P, the cost would be deductible under §162 and capital expenditures under §263. Land is transferred to S corporation in a §351 exchange, prior to P deducting or capitalizing the clean-up expenses. • Issues: • Are the Liabilities assumed by S “liabilities” for purposes of §357(c)(1) and §358(d)? • If so, once assumed by S, how will the liabilities be treated when later paid by S?

Revenue Ruling 95-74 • Holdings: • The Liabilities assumed by S are NOT “liabilities” for purposes of §357(c)(1) and §358(d) because the contingent liabilities assumed by S has not been taken into account by P (prior to the transfer) and therefore had neither given rise to a deduction for P nor resulted in the creation of basis (or increase in) basis in any property of P. • Once assumed by S, since the liabilities would have been deductible and/or capital expenditures, when paid by P, they are deductible/capital expenditures under § 162 and §263 respectively to S.

Problem Page 110 Architect Land Basis = $60K FMV = $120K A-R Basis = $0K FMV = $60K Supplies Basis = $0K FMV = $20K 100 shares of Design plus assumption of $20K of A-P to creditors and a $30K bank loan Design

Problem Page 110 • 1(a) • What is Architect’s basis in his Design Stock? • Boot = $30K in assumed loans (the $70K is not a liability for purposes of §357(c)(1) or §358(d)). Therefore, Architect’s basis in the stock => Transferor's basis in the assets ($60K) minus the boot ($30K) plus any gain recognized ($0) = $30K • What is Architect’s holding period for each share of stock? • Based on FMV, 60% tacks to land, 10% tacks to the Supplies, and 30% of each share takes no holding period (i.e. zero days). • What is Design’s basis in the assets that it receives? • Land => Transferor’s carryover basis ($60K) plus any gain recognized ($0K) = $60K. • A-R => Transferor’s carryover basis ($0K) plus any gain recognized ($0K) = $0K. • Supplies => Transferor’s carryover basis ($0K) plus any gain recognized ($0K) = $0K. • What is Design’s holding period for each asset? • Tacks to Architect’s

Problem Page 110 • 1(b) Design Corporation (see Hempt Bros and Rev. Rul. 80-198) • 1(c) Yes (see Rev. Rul. 95-74) • 1(d) Under the Assignment of Income Doctrine, the income can be assigned to Architect when the A-R is paid. • 1(e) If Architect is an accrual basis taxpayer, then the Income and Expenses would already have been taken into account in Architect’s basis and the question becomes moot. The corporation gets no deduction when it pays the A-P and gets no income when it collects the A-R. • 1(f) Skip!

Black & Decker v. United States • Facts: B&D transferred $561MM in cash to BDHMI in a §351 transfer. BDHMI also assumed $560MM of liabilities for B&D’s benefit claims. The claims which, ala Rev. Rul. 95-75, had not been taken into account by B&D prior to the transfer. B&D claimed that, since the payment of the liability would have given rise to a deduction, the basis in its stock of $561MM. The Service argued that the basis in BDHMI had to be adjusted for the liability assumed despite the reasoning of Rev. Rul. 95-75. • Issue: Must the liability be deductible to the transferor (B&D) or the transferee (BDHMI) in order to be excluded in determining the amount of the liability to be excluded under §357(c)(3)(A)?

Black & Decker v. United States • Holding: Court, based on the legislative history that specifically noted “payment by the transferor”, ruled for B&D. • Case is a good example of the distinction between capital gains and ordinary income noted by Scott in lecture I. • Holding in B&D is now overruled by §358(h) statute which says that, if a transfer to a corporation does not include the trade or business with which the liability is associated (or substantially all the assets of that trade or business) and the basis of the assets transferred are less than the FMV of the stock, then the basis is reduced to by the amount of any liability assumed (a stepped-down basis).

Commissioner v. Fink • Does a surrender of stock by a majority shareholder amount to a contribution to capital of the corporation or an immediate loss to the shareholder? • Court holds that it is not an immediate loss subject to recognition, but rather a contribution to capital and the basis in the stock surrendered is allocated to the remaining shares. • The holding is limited to “majority” shareholders meaning those who hold more than 50% of the outstanding shares.

CORPORATE TAXATION I