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
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INTRODUCTION

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

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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

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IRC 351

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

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TOPICS

• RATIONALE FOR IRC 351
• IRC 351(A)
• ITS KEY ELEMENTS
• EFFECT TO TRANSFEROR AND TO TRANSFEREE

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RATIONALE FOR IRC 351

• CONTINUITY OF INVESTMENT IT DOES NOT CLOSE
  THE TRANSFERORS INVESTMENT WITH SUFFICIENT
  ECONOMIC FINALITY
• A MERE CHANGE IN THE FORM OF OWNERSHIP, WITHOUT
  CASHING-IN OR CLOSING-OUT INVESTMENT.

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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.

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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.

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KEY ELEMENTS

• TRANSFEROR (transferring shareholder) /
  TRANSFEREE (receiving corporation)
• PROPERTY
• SOLELY IN EXCHANGE
• STOCK
• IMMEDIATELY AFTER
• CONTROL

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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.

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IRC 351 (d) PROPERTY IS NOT

• SERVICES
• UNSECURED DEBTS OF TRANSFEREE CORPORATION
• TRANSFEREE CORPORATIONS DEBT INTEREST ACCRUEING
  TO TRANSFEROR.

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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

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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.

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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.

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Making a service TFOR an IRC 351 TFOR

• TRANSFER OF PROPERTY gt SMALL VALUE IF
• PROPERTY TRANSFERRED gt 10 OF THE VALUE OF STOCK
  TO BE RECEIVED FOR SERVICES.

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ESTABLISHED CORPORATIONS

• TRANSFER OF PROPERTY gt SMALL VALUE IF
• PROPERTYTRANSFERRED gt 10 FMV STOCK OWNED BY
  TRANSFEROR.

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NOTE

• THESE ARE IN CONNECTION WITH PLRS REQUESTS.
  TODAY A PLR WILL NOT BE ISSUED ON THAT QUESTION.
  
• STOCK FOR SERVICES WILL BE TAXED AS ORDINARY
  INCOME

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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 lt FMV OF DEBT.

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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 . . .
  .

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OTHER PROPERTY BOOT

• BOOT RECOGNITION RECOGNIZE BOOT UP TO THE GAIN
• BUT 351 TRANSACTION DOES NOT FAIL.

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BOOT ALLOCATION

• NECESSARY IF gt1 PROPERTY TRANSFERRED
• AKA SEPARATE PROPERTIES APPROACH.
• REV. RUL. 68-55

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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?

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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

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ALLOCATION (p.3)

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

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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.

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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

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IMMEDIATELY AFTER

• IT DOES NOT MEAN SIMULTANEOUS TRANSFERS

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WHAT DOES IT MEAN?

• OK TO HAVE TRANSFERS AT DIFFERENT TIMES, AS LONG
  AS IT WAS ALL PART OF AN INTEGRATED TRANSACTION.

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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?

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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 . . .
  .

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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.

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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

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ANSWER

• TRANSFEROR GROUP OWNS 160/200 OF CLASSES A AND
  B, 80/100 OF CLASS C, AND 80/100 OF CLASS D.

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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.

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DISPROPORTIONATE EXCHANGES

• NO SUCH REQUIREMENT
• BUT TRANSACTION MUST BE GIVEN ITS TRUE NATURE,
  E.G., GIFT TAX.

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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)

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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

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

• PTY 100 AB 60 MTG 40
• TFEE ASSUMES MTGE C/S 60
• AR 60 40100
• LESS AB 60
• GAIN REALIZED40
• GAIN RECOGNIZED 0

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Tfror trfrs

• PTY 100 AB 60
• TFEE ASSUMES MTGE C/S 60 CASH 40
• AR 60 40100
• LESS AB 60
• GAIN REALIZED 40
• GAIN RECOGNIZED 40

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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 . . .
  .

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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.

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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 . . . .

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Tfror trfrs

• PTY 100 AB 60 MTG 65
• TFEE ASSUMES MTGE 65
• AR 65 MTGE 35 C/S 100
• LESS AB 60
• GAIN REALIZED40
• GAIN RECOGNIZED 5
• Excess of MTGE over AB

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TWO EXCEPTIONS TO IRC 357(c)(1)

• IRC 357(C)(2)(A)
• IRC 357(c)(3)(B) 357(c)(3)(A)

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1ST EXCEPTION IRC 357(c)(2)(A)

• IGNORE IRC 357(c)(1) IF IRC 357(b)(1) APPLIES.

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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

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NOTE

• IRC 357(c)(1) CONSIDERS ALL LIABILITIES AND ALL
  AB
• TRIGGERS GAIN IRRESPECTIVE OF HAVING ANY GAIN
  REALIZED

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TRANSFERORS 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 . . . .

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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 . . .

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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

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AB AND ASSUMPTION OF TRANSFERORS 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).

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SUMMARY TRANSFERORS AB (STOCK)

• ORIGINAL AB
• GAIN RECOGNIZED
• - FMV BOOT AND MONEY RECEIVED
• - TRANSFERORS LIABILITIES ASSSUMED BY THE CORP.
  
• ALLOCATE AB IF gt 1 CLASS IS RECEIVED

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TRANSFERORS 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.

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TRANSFERORS HOLDING PERIOD

• SUBSTITUTED AB SUBSTITUTED HP

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EXAMPLE 3 DEBT ASSUMED BY TFREE lt AB

• TFROR TRANSFERS FMV80K AB50K MTG30K FOR
  50K IN STOCK
• GAIN REALIZED50K STOCK 30K RELEASE - 50K AB
  30K
• TFROR AB 50K ORIGINAL - 30K RELEASE 20K
  ENDING AB

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EXAMPLE 4 DEBT ASSUMED BY TFREE gt AB

• SAME, BUT NOW MTG60K
• GAIN REALIZED20K STOCK 60K RELEASE -50K AB
  30K
• GAIN RECOG. IF IRC 357(b) DOES NOT APPLY, 357(c)
  REQUIRES RECOGNITION OF 10K.
• TFROR AB50K ORIGINAL -60K RELEASE 10K GAIN
  0 END AB

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EXAMPLE 5 DEBTS ASSUMED BY TFREE gt 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 AB20K20K40K 40K AB gt 30K
  ASSUMPTION

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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

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EXAMPLE 6 SAME BUT LANDS AB5K

• AGGREGATE AB 20K 5K 25K
• 30K MTGE gt 25K MTGE RECOGNIZE IRC 357(c)(1) GAIN
  OF 5K
• AB ORIGINAL 25K -30K 5K GAIN 0

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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.

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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 gt AB,
• THEN GAIN SHALL BE RECOGNIZED . . . AS IF . . .
  SOLD . . . AT ITS FMV

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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

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TRANSFEREES 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 . . .
  .

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TRANSFEREES HP IRC 1223(2)

• CARRYOVER FROM TRANSFEROR

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Summaries and Examples
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Basis Computation for Sec. 351 Exchange (slide 1
of 2)

• Shareholders 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)

• Corporations basis in assets
• Adjusted basis of transferred assets
• Gain recognized by transferor shareholder
• Basis of asset to corporation

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Assumption of Liabilities(slide 1 of 2)

• Liabilities ARE treated as boot for determining
  basis in acquired stock

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Assumption of Liabilities(slide 2 of 2)

• Liabilities are NOT treated as boot for gain
  recognition unless
• Liabilities gt 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

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Formation with Liabilities Example (slide 1 of 2)

• Property transferred has
• Fair market value 150,000
• Basis 100,000
• Realized Gain 50,000

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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)

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Shareholders 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

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Corporations 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