ALLOCATION OF PRE CONTRIBUTION GAIN

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ALLOCATION OF PRE- CONTRIBUTION GAIN

• Page 438 This is a mandatory allocation not
  subject to change by the partners. To
  illustrate, see problem 10-3(a), page 438 Clara
  must recognize the BIGain of 100,000 on the
  jewelry the rest of the gain is split equally
  between Clara and Durwood.
• In (b) there was no BILoss when Clara contributed
  the jewelry, so the loss is shared equally
  between Clara and Durwood.
• In c the BILoss of 100,000 when Clara
  contributed the other assets goes to Clara and
  the rest 50,000 is split equally.
• d the gain is split equally since there was
  only a built in loss at the time of contribution.
• Note how depreciation is allocated away from the
  one who contributes BIG depreciable property, to
  equalize between partners see page 439.

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LOOPHOLE CLOSERS

• 704(c)(1)(a), 707(A)(2)(b) and 737 are the
  seldom seen loophole closing provisions that can
  create gain on distributions.
• Before these statutes were enacted, partners
  would arrange swaps through partnerships to avoid
  tax on a sale. Normally, an exchange of stock for
  stock is taxed. Neither stocks nor partnership
  interests can be like-kind property for 1031
  purposes. Say A contributes 100 of General
  Motors stock and B contributes 100 of Ford stock
  to a partnership then they reverse ownership
  through distributions where A gets Ford stock and
  B gets GM stock. Before the enactment of
  704C1a, no gain was recognized.

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LOOPHOLE CLOSERS CONTINUED

• 704(c)(1)(a) applies when contributed property
  is distributed to a different partner within 7
  years if that occurs the contributing partner
  must recognize gain or loss equal to the
  difference between fair market value and his
  basis at the time of the contribution.
• 707(a)(2)(B) a transfer followed by a
  distribution of money, like in the Otey case,
  within 2 years.
• 737. A partner who transfers appreciated
  property gets other property in return may have
  gain if received within 7 years see p. 447.

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704 LOOPHOLE CLOSER

• Problem 10-4, page 440.
• a 100,000 of ordinary income to Clara when
  the jewelry is distributed to Durwood.
• b no tax effect since the basis was of the
  jewelry was 300,000 when contributed.
• c 100,000 loss to Clara because the other
  assets had a 100,000 built in loss.
• d no tax effect since no loss occurs.
• e After 7 years the 704 loophole closer no
  longer applies.

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724 LOOPHOLE CLOSERS

• Problem 10-5, pages 441-442.
• a 9000 12,000-3000 basis of ordinary
  income as it was an inventory item in Saras
  hands.
• b 2000 ordinary loss.
• c 2500 ordinary income 5,500 - 3000 basis
• d 1000 ordinary loss.
• e 3000 loss basis is limited on personal use
  property to its fair market value on the date of
  contribution, 10,000
• f 1000 ordinary income original basis
  applies to a gain.

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OTEY V COMMISSIONER

• Otey was in partnership to develop his property
  with Thurman he transferred some land to the
  firm, then the partnership borrowed on the land,
  and from the loan proceeds Otey took 65,000
• IRS says he sold his land Otey says it was a
  capital contribution followed by a distribution
  of an amount of money which was less than his
  outside basis the court found that Otey made a
  contribution and not a sale. Remember, he was
  liable on the bank debt and could have been stuck
  to pay it.

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OTEY AGAIN

• Section 707, IRC is important and mentioned on
  page 445. A partner can deal with the
  partnership in a capacity other than as a
  partner. Thus a partner can sell property to the
  firm, or become an employee of the partnership,
  or borrow money from the firm. The sale, or
  employment relationship or loan will be treated
  as with one who is a stranger.

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OTEY CONCLUDED

• Congress stepped in to overrule Otey with the
  enactment of 707a2b, subject to a
  confusing fact matter. See p. 446.
• a Would the transfer (the payment of 65,000 in
  cash) have been made if Otey did not transfer the
  land? Of course not indeed it could not have
  been made because the land was the security for
  the loan.
• b But, was the subsequent transfer (the money
  payment to Otey) subject to the risk of the
  partnership. Well, perhaps, as Otey might have
  to pay the bank on his personal guarantee if the
  partnership failed.

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HOW TO AVOID 707a2B

• As they say in show biz, timing is everything.
  Would Otey have had income if he first borrowed
  65,000 on the property and then contributed the
  land it to the partnership? Of course not.
  Borrowed money is not income.
• To place Thurman and the bank in the same
  position they were in the original case and
  before Congress enacted 707a2B, have
  Thurman and the partnership guarantee the loan at
  the bank.
• Finally, there was no loophole under the original
  facts of the case. As the partnership earns
  income the partners will be taxed.

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737 and PROBLEM 10-6, P. 447

• a i. 10,000 gain as the lesser of the gain
  on the distribution or on the gain built into
  Sauls contribution. 40,000 - 30,000 10,000.
• ii no gain as the value of the land 40,000
  does not exceed his basis of 90,000.
• iii Section 737 will not apply where Saul is
  not contributing built in gain property. Saul
  takes a 40,000 basis in the property and his
  outside basis is reduced to 140,000.
• We skip b since it is overly complex and
  today no one will deliberately contribute
  property and then immediately remove other
  property.

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PARTNERSHIP ANTI-ABUSE RULE, p. 448

• These terribly inexact rules, created only from
  regulations and for that reason subject to
  challenges to their validity, have never been
  cited in any decided case.
• In reality the regulation does little more than
  spell out the business purpose doctrine and the
  requirement of substance over form, principles
  that have always been applied by the courts in
  tax cases.

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5 WAYS TO HAVE GAIN ON DISTRIBUTIONS

• 1. A distribution of cash in excess of outside
  basis.
• 2. A non- proportionate distribution of hot
  assets.
• 3. A 704c1A swap or distribution
• 4. A 737 swap.
• 5. A 707a2B transfer or property like
  in Otey with a distribution within 2 years.

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CORPORATE ACQUISITIONS

• P. 453 The title of this chapter should be as
  above or, in the real world, Mergers
  Acquisitions, a/k/a MA. There are two ways to
  purchase a corporations business, that is, buy
  either stock from its shareholders or assets from
  the corporation.
• This chapter deals with a purchase of assets
  the next chapter deals with with tax free
  acquisitions for stock.
• The method used to acquire a company or its
  assets is decided by the golden rule he who has
  the gold rules.
• Buyers usually rule, and they always insist on an
  asset purchase since 1986.

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THE COST OF AN ASSET SALE TO THE SELLER

• Assume a C corporation has assets of 1,340,000
  with a basis of 340,000 the stockholder, who
  wants to retire, has a basis in his stock of
  50,000. The buyer pays 1,340,000 to the
  corporation, which then liquidates, as it must.
  Why must it liquidate? Remember the Personal
  Holding company rules?
• The corporation will pay a tax of, say, 340,000,
  leaving 1,000,000 to distribute in liquidation.
  The stockholder has a capital gain of 950,000
  and pays tax of 142,500 the total tax to the
  corporation and the shareholder is 382,500.
  Before the 15 tax rate on dividends the total
  tax cost to the corporation and shareholder would
  have been about 550,000

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THE SAME EXAMPLE FOR AN S CORPORATION

• The corporation has a gain of 1,000,000 which is
  passed on to the shareholder. If is is all taxed
  at ordinary income rates the tax will be around
  330,000. If this were all capital gain the tax
  would be 150,000. It is likely to be part
  ordinary and part capital gain. The shareholders
  basis in his stock is increased by the gain to
  1,050,000. The distribution of the 1,340,000
  from the S corporation produces a further gain of
  290,000 to the shareholder which is illusory
  since his original basis of 50,000 would likely
  have been increased substantially by the amount
  in income taxed to him.

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WILLIAMS V MCGOWAN

• The type of gain, capital or ordinary, is
  determined on an asset by asset basis in case of
  a sale of assets by any person, partnership,
  corporation or other entity.
• A sale of the stock of a corporation will always
  yield capital gain now that the collapsible
  corporation statute has been repealed.
• A sale of a partnership interest will be capital
  gain, except for the gain attributable to hot
  assets, i.e., inventory, unrealized receivables
  and potential depreciation recapture.

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MARTIN ICE CREAM COMPANY

• Arnold sold ice cream to grocery stores. He
  organized the corporation MIC for that purpose.
  Haagen-Dazs contracted with Arnold to market its
  ice cream with supermarkets and Arnold did so
  superbly.
• Nine years later Pillsbury bought out
  Haagen-Dazs soon thereafter Pillsbury sought to
  buy our Arnold and MICs rights to distribute
  Haagen-Dazs. A three party contract Arnold, MIC
  and Pillsbury was signed and payment of
  1,200,000 was paid for sellers rights and
  300,000 for records. No allocation between
  Arnold and MIC was found in the agreement.

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MARTIN ICE CREAM V CIR CONTINUED

• Issue what did Arnold sell to Pillsbury? IRS
  says his corporation sold all its assets for 1.5
  million and then distributed the cash to Arnold
  as a dividend IRS wants to impose a double tax
  one on the corporation on the sale of the assets
  and another on Arnold as a dividend.
• The court finds that the corporation only
  transferred assets with a value of 141,000.
  The balance of the payment was for goodwill.
  But whose goodwill?
• Arnold, not the corporation, owned the goodwill,
  so there is but a single tax on the goodwill, and
  the proceeds of the sale are capital gain. There
  is gain to the corporation resulting from the
  sale of assets and a liquidating distribution of
  whatever is left to Arnold.

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GOODWILL AND INTANGIBLES

• To avoid the double tax the seller claims he was
  personally paid for either goodwill or a covenant
  not to compete either may only may only be
  amortized by the buyer over 15 years even though
  a covenant usually lasts for a much shorter
  period.
• Another way around the double tax on the sale of
  assets is to pay the seller a consulting fee.
• All these gimmicks are subject to the rule of
  substance v form are they really what they seem
  to be? We tried one in the tax court in 2002
  which modified the proposed adjustment and it
  was affirmed on appeal. Bemidji Distributing v.
  CIR. 91 AFTR2d 2003-912 CA 8th

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BEMIDJI DISTRIBUTING

• The total purchase price for this beer
  distributor was 2.17 million. The taxpayers
  accountant proposed that the price should be
  allocated as follows 200,000 to a consulting
  contract, 1 million to a covenant not to compete
  and 817,000 for the corporations operating
  assets. The courts adjusted only the covenant
  not to compete, valuing it at 334,000. The
  balance, 666,000, was income to the corporation
  and a dividend to the sole shareholder. It
  wasnt really double taxed as the covenant not to
  compete was ordinary income to the shareholder
  anyway. Not a good plan. I would have advised a
  S election in 1986 in which case there would have
  been, most likely, a single tax.

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RESIDUAL METHOD OF ALLOCATION

• You will stress with your clients whether you
  represent the buyer or the seller that each
  asset category must be valued in the sales
  agreement.
• The residual method simply means that anything
  left over after assigning value to the tangible
  assets will be goodwill, now amortized over 15
  years on the straight line method.
• To settle a case involving allocations, an
  appeals conferee allowed me to allocate the
  values any way I wanted to, so long as they were
  the same for both buyer and seller. We allocated
  as much as we could to depreciable assets well
  above original cost. Why?

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IRS Technical Advice 9721002

• What is a Technical Advice Memo?
• Acquiring bought Target for cash assumed its
  liabilities. One such liability was a golden
  parachute contract for senior management.
• IRS ruled that the Acquiring corporation could
  currently deduct the cost of the golden parachute
  payments as it was not a matured liability at the
  time of the takeover. Had the obligation been
  fixed, the Acquiring corporation would have had
  to treat the amount as a part of the purchase
  price of the assets and recover the cost through
  depreciation.

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KIMBALL DIAMOND

• Kimball-Diamond wanted the business of Whaley
  Mill. It bought all the Whaley stock of that
  corporation from its shareholders for 210,000
  and promptly liquidated Whaley. The assets of
  Whaley had a basis of 328,736 and Kimball
  Diamond wanted to depreciate that amount. In a
  332 liquidation of a controlled subsidiary the
  parent takes over the subsidiaries basis in its
  assets. IRS objected, claiming that in reality
  Kimball-Diamond had bought the assets for
  210,000 and that should be its basis. The
  Supreme Court agreed with the IRS.

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KIMBALL DIAMOND CONCLUDED

• Kimball Diamond was a famous case, but is now
  totally obsolete. The doctrine here was ruined
  in 1986 by Rostenkowsky.
• Until 1986 it mattered little whether a buyer
  bought stock or assets.
• After Kimball Diamond was decided in 1950 an
  elaborate statutory scheme (former 337) was
  enacted to accomplish parity between stock and
  asset purchases. The double tax on the sale of C
  corporations was almost entirely avoided.
• Today, a corporation can buy stock and then step
  up the basis of the assets to the purchase price,
  just as in Kimball-Diamond, but only at the cost
  of a tax on the appreciation in value of the
  assets. 338, IRC. It will seldom be done.

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SECTION 338 ELECTION

• To step up the basis of the assets to the
  purchase price of the stock, the corporate buyer
  of stock must file an election the effect of the
  election is to treat the new subsidiary as having
  sold its assets to itself.
• . Ideally the election approximates the result
  of an asset purchase. See the slide on Example
  11 E, P. 484. Note, however, that the buyer is
  exposed to any unknown liabilities of the target.

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EXAMPLE 11-E, PAGE 484

• In this example, the target is deemed to sell
  its assets to itself for their fair market value,
  1,340,000, and has a gain, after subtracting
  basis of 340,000, of 1 million. It will pay
  tax on that gain of 340,000, and now has a basis
  step-up to 1,340,000.
• At a tax rate of 34 (which is used throughout
  the example) the election saves 340,000 in taxes
  over the period deductions are allowed, which
  could be as much as 39½ years. Still, that is
  the same as buying the assets for 1,000,000 but
  if you buy stock you take a chance that the
  corporation has contingent liabilities.

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EXAMPLE 11-E CONCLUDED

• Why is the purchase of stock for 1,000,000
  followed up by a 338 election the same as an
  asset purchase? Because the total cost to the
  purchaser is 1,340,000, i.e., the purchase
  price plus the tax paid at the time of the
  election. That is the amount the buyer would pay
  for the assets in an asset sale. In either case
  the buyer has a basis in the assets of
  1,340,000.
• Buyers do not want the risk of contingent
  liabilities so they prefer to buy assets.

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A DIFFERENT 338 EXAMPLE

• The target corporation has assets worth
  1,000,000 with a basis of 300,000 If the
  assets were sold the tax on the gain would be
  200,000. Paul is the sole shareholder of Target
  and his basis in his stock is 250,000.
  Acquiring is willing to pay 1,000,000 to acquire
  target.
• Scene 1 Acquiring buys Pauls stock for
  800,000 and causes the Target to elect 338
  that causes a 700,000 gain and a 200,000 tax to
  Target, but now Targets basis in those assets is
  1,000,000. Paul has a 550,000 capital gain on
  the sale of his stock.

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DIFFERENT EXAMPLE CONCLUDED

• Scene 2 Acquiring buys Targets assets for
  1,000,000 which becomes its basis. Target has a
  700,000 gain and a tax of 200,000. Target
  liquidates and distributes its remaining asset,
  800,000 to Paul who has a 550,000 capital gain.
• As you can see, in this classroom example there
  is no difference between an asset sale and a
  stock sale with a 338 election.

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A SUMMARY OF THE TAXATION OF THE SALE OF ENTITIES

• The sale of assets of a C corporation triggers
  two taxes, with personal holding company
  implications if the Target is not liquidated.
  There will be some ordinary income and some
  capital gain.
• The sale of the assets of an always S or a 10
  year old election S corporation usually results
  in a single tax it is likely there will be
  some ordinary income and some capital gain.
• The sale of the stock of an S or a C yields
  capital gain.
• The sale of a partnership interest results in a
  single tax, with ordinary income to the extent of
  hot assets.

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