Corporate Capital Contributions: Code 351 Transfers

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Corporate Capital Contributions Code 351
Transfers
Oceans 351
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IRC 351(a)

• "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 controlof the
  corporation."
• 351(a) does not apply to transfers of property
  to an investment company.

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8 Basic RequirementsTo Qualify For Nonrecognition

• A transfer
• Of property
• By one or more persons
• To a corporation
• In exchange for
• Stock of the corporation
• And the transferors must be in control of the
  corporation
• Immediately after the exchange

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Property

• includes cash,
• real or personal property,
• realized or unrealized receivables, intangibles,
• technical know-how, etc.
• It does not include services rendered!

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Stock

• The stock received by the transferor must be
  issued by the transferee corporation and may be
• common or preferred,
• voting or non-voting,
• participating or non-participating

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Non Qualified Preferred Stock Is
BootNonqualified Preferred

• Stockholder has the right to require the issuer
  or a related person to redeem or purchase the
  corporation stock,
• Issuer or a related person is required to redeem
  or purchase the corporation stock,
• On the issue date it is more likely than not that
  the right to redemption will be exercised, or
• Dividend rate varies with reference to interest
  rates, commodity prices, or other similar
  indices.
• Exceptions apply if the stock must be held for
  20 years or more before redemption, or in cases
  of death, disability or mental incompetence of
  the owner. Applies to transfers made after
  6/8/97. See IRC 351 for details. 

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Control

• Ownership of stock possessing
• at least 80 of the total voting power
• of all classes of stock
• entitled to vote
• at least
• 80 of the total number of shares
• of all other classes of stock.

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Control

• If a person receives stock
• for services rendered
• to the corporation,
• he must also contribute property
• to the corporation
• for his stock
• to be included in
• determination of whether
• the control test is met or not.

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An Example

• A B form a corporation.
• A contributes property with a fair market value
  of 35,000 for 350 shares of stock.
• B contributes services with a fair market value
  of 15,000 for 150 shares of stock.
• Section 351 does not apply since control does not
  exist because Bs stock is not included in the
  determination of whether control exists.
• 350 lt 80 x (350 150)

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Immediately After The Exchange

• Nonsimultaneous Transfers sufficient if all
  transfers are made under a prearranged plan
• Momentary Control If transferors lose control
  due to disposition or if corporation issues
  additional shares, 351 applies as long as not
  part of prearranged plan

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An Example

• A B form a corporation.
• A contributes property with a fair market value
  of 35,000 for 350 shares of stock on January 1.
• B contributes property with a fair market value
  of 15,000 for 150 shares of stock on March 15.
• Section 351 applies since transfer of property
  were made under prearranged plan and were carried
  out expeditiously
• 350 150 gt 80 x 500

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An Example

• A B form a corporation.
• A contributes property with a fair market value
  of 35,000 for 350 shares of stock.
• B contributes property with a fair market value
  of 15,000 for 150 shares of stock.
• B dies two weeks after the formation and leaves
  his 150 shares of stock to his son.
• Section 351 applies since control exists because
  Bs stock is included in the determination of
  whether control exists.
• 350 150 gt 80 x 500

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Tax Treatment

• The Stockholder

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Gain or Loss Recognition

• Realized Losses not recognized
• Realized Gains recognized to the extent of the
  boot received

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Realized Gains

• Character of Gain - determined by the nature of
  the asset in the hands of the transferor
• Liabilities Assumed by Corporation - assumption
  of transferors liabilities by the transferee is
  not considered to be boot

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Example

• Facts
• Taxpayer A transfers property with an adjusted
  basis of 10,000 and a FMV of 50,000 to a
  controlled corporation.
• Taxpayer A receives stock worth 30,000, cash
  of 10,000, and other property with a FMV of
  10,000

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Example (cont.)

• Amount realized under 1001(b)
• a. Stock 30,000
• b. Cash (boot) 10,000
• c. Other property (boot) 10,000
• d. Total 50,000
• Less adjusted basis
• of property transferred 10,000
• 3. Gain realized under 1001(a) 40,000
• 4. Gain recognized (line 1b,
• plus line 1c or line 3,
• whichever is less) 20,000

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Liabilities Transferred

• The general rule of 357 (a) provides that the
  transferee corporations assumption of liability
  or its acquisition of property subject to a
  liability is not treated as money or other
  property, and thus is not boot under 351 (b).

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Example

• Facts
• A transfers property with a basis of 40,000 and
  a fair market value of 100,000 to controlled
  corporation X.
• Property is subject to a mortgage of 30,000.
• A receives stock worth 70,000.
• X assumes the mortgage.

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Example (cont.)

• A realizes gain of 60,000 (the value of the X
  stock plus assumption of As debt, 100,000 less
  As 40,000 basis for the property).
• As recognized gain is zero, since 357(a)
  provides that the assumed liability is not boot
  under 351(b).
• As basis for his stock, however, is 10,000,
  rather than 40,000, under 358 (property basis
  of 40,000 less the assumed liability of
  30,000).
• Xs basis for the property will be 40,000 under
  362(a)(1), same as it would have been without a
  debt assumption.

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Liabilities Transferred - 357(b) Tax-Avoidance
Transactions

• Although the principle of 357(a) makes good
  sense as a general rule, it might tempt the
  transferor of the appreciated property under
  351 to borrow against the property just before
  the exchange, with the intention of keeping the
  borrowed funds and causing the corporation either
  to assume the liability or to take the property
  subject to the liability. For the transferor,
  this chain of events could be the equivalent of
  receiving cash boot from the corporation in
  exchange for unencumbered property but if the
  general rule of 357(a) were applicable, the
  corporations assumption of the liability or
  acquisition of the property subject to the
  liability would not be treated as boot.

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Liabilities Transferred in Excess of Basis
357(c)

• Unlike the exception found in 357(b), provides
  a more objective way to tax gain when liabilities
  are transferred. To the extent the aggregate debt
  assumed, or to which the transferred property is
  subject, exceeds the transferors aggregate basis
  for the property transferred, 357(c) applies.

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Liabilities Transferred in Excess of Basis
357(c)

• If the liabilities assumed by the corporation
  exceed the adjusted basis of the property
  transferred, the excess is treated as a
  recognized gain from the sale or exchange of the
  property under 357(c).

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Computation of Amount of 357(c) Gain

• In determining whether 357(c) is applicable,
  the aggregate amount of the liabilities is
  compared with the aggregate adjusted basis of the
  assets transferred.

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Example 1

• A transfers property with a basis of 10,000 and
  a fair market value of 100,000 to controlled
  corporation X.
• Property is subject to a mortgage of 30,000.
• A receives stock worth 70,000.
• X assumes the mortgage.
• A recognizes gain of 20,000.If, in the previous
  example, A had transferred not only property with
  a basis of 10,000 subject to a mortgage of
  30,000 but also unencumbered property with a
  basis of 10,000, the gain to be reported would
  be only 10,000 (liability of 30,000 less
  aggregate basis of 20,000).

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Example 2

• A transfers property with a basis of 10,000 and
  a fair market value of 100,000 to controlled
  corporation X.
• A transfers additional cash of 20,000.
• Property is subject to a mortgage of 30,000.
• A receives stock worth 90,000.
• X assumes the mortgage.
• A does not recognize any gain the liability is
  not greater than the aggregate basis of the
  assets transferred.

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Reducing Excess of LiabilitiesOver Basis

• Transferors holding property subject to
  liabilities in excess of basis can avoid
  recognizing income under 357(c) by
• Reducing or paying off the excess liabilities
  before entering into a 351 exchange.
• Getting the creditors to agree to look for
  payment from the transferors personally or to
  property that is not to be transferred.
• Contributing additional assets.

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Reducing Excess of LiabilitiesOver Basis

• The Service has rejected the transferor-note
  route around 357(c), on the ground that a note
  has zero basis in the debtors hands, so that the
  excess of the liabilities over the
  debtor-transferors basis for the transferred
  property is not diminished by the note.

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Deductible Liabilities of Cash Basis Taxpayers

• Liabilities of cash basis transferor that will
  be deductible when paid are exempted by
  357(c)(3) from the liabilities-in-excess-of-basis
  principle of 357(c).

• While the cash-basis taxpayers are the prime
  beneficiaries of 357(c)(3)(A), it could also
  cover the liabilities of an accrual-basis
  taxpayer that
• Are not presently accruable under the all-events
  test because contingent or contested
• Are delayed under economic performance occurs
  under 461(h)

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Character of 357(c) Gain

• The excess is considered as a gain from the sale
  or exchange of the capital asset or a non-capital
  asset, as the case may be.

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Basis

• The basis of stock
• received by the transferor
• is the basis of the property transferred
  increased by any recognized gain and decreased by
  the amount of boot received and by the
  liabilities assumed
• by the corporation.

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Holding Period

• The holding period of the stock received by
  the transferor includes the holding period of the
  property transferred if the property transferred
  was a capital asset or Section 1231 property in
  the hands of the transferor and the basis of the
  property received was determined by reference to
  the basis of the property transferred to the
  corporation.
• Boot Received the holding period of any boot
  received begins on the date of the exchange

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Tax Treatment

• The Corporation

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Corporation

• Gain or Loss Recognition
• No Gain or Loss is recognized when the
  corporation receives money, other property, or
  services in exchange for its stock.
• Basis
• The Basis of property received by the corporation
  is the basis of the property in the hands of
  transferor increased by any recognized gain by
  the transferor
• Holding Period
• The Holding Period of the assets received by the
  corporation includes the holding period of the
  transferor

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Tax Treatment

• Illustrations

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Illustration 1

• A, B, and C form a corporation
• A contributes inventory with a fair market value
  of 75,000 and an adjusted basis of 60,000 for
  150 shares of stock.
• B contributes 30,000 in cash for 60 shares of
  stock.
• C contributes services with a fair market value
  of 45,000 for 90 shares of stock
• Section 351 does not apply since control does not
  exist (15060) / 300 lt 80

• A
• Realized Gain
• 75,000 60,000 15,000
• Recognized Gain
• 15,000
• Stock Basis
• 75,000
• B
• Stock Basis
• 30,000
• C
• Ordinary Income
• 45,000
• Stock Basis
• 45,000
• Corporation
• Inventory Basis
• 75,000

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Illustration 2

• A, B, and C form a corporation
• A contributes inventory with a fair market value
  of 75,000 and an adjusted basis of 60,000 for
  150 shares of stock.
• B contributes 30,000 in cash for 60 shares of
  stock.
• C contributes services with a fair market value
  of 27,000, equipment with a fair market value of
  18,000, and an adjusted basis of 10,000 for 90
  shares of stock
• Section 351 applies since control exists
• (1506090)/300 gt 80

• A
• Realized Gain
• 75,000 60,000 15,000
• Recognized Gain
• 0
• Stock Basis
• 60,000
• B
• Stock Basis
• 30,000
• C
• Ordinary Income
• 27,000
• Realized Gain
• 18,000 - 10,000 8,000
• Recognized Gain
• 0
• Stock Basis
• 10,000 27,000 37,000

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Illustration 3

• A and B form a corporation
• A contributes inventory with a fair market value
  of 100,000 and an adjusted basis of 70,000 for
  200 shares of stock.
• B contributes equipment with a fair market value
  of 50,000 and an adjusted basis of 60,000 for
  100 shares of stock
• Section 351 applies since control exists
• (200100)/300 gt 80

• A
• Realized Gain
• 100,000 70,000 30,000
• Recognized Gain
• 0
• Stock Basis
• 70,000
• B
• Realized loss
• 50,000 60,000 10,000
• Recognized Loss
• 0
• Stock Basis
• 60,000
• Corporation
• Inventory Basis
• 70,000
• Equipment Basis

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Illustration 4

• A
• Realized Gain
• 125,000 70,000 55,000
• Recognized Gain
• 55,000 or 25,000 25,000
• Stock Basis
• 70,000 25,00025,000 70,000
• B
• Realized Gain
• 15,000 10,000 5,000
• Recognized Gain
• 0
• Stock Basis
• 35,000 10,000 45,000
• Corporation
• Inventory Basis
• 70,000 25,000 95,000
• Equipment Basis

• A and B form a corporation
• A contributes inventory with a fair market value
  of 125,000 and an adjusted basis of 70,000 for
  200 shares of stock and 25,000 in cash.
• B contributes 35,000 in cash and equipment with
  a fair market value of 15,000 and an adjusted
  basis of 10,000 for 100 shares of stock.
• Section 351 applies since control exists
• (200100)/300 gt 80

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Illustration 5

• A
• Realized Loss
• 125,000 131,000 (6,000)
• Recognized Loss
• 0
• Stock Basis
• 131,000 25,000 106,000
• B
• Realized Gain
• 15,000 10,000 5,000
• Recognized Gain
• 0
• Stock Basis
• 35,000 10,000 45,000
• Corporation
• Inventory Basis
• 131,000
• Equipment Basis

• A and B form a corporation
• A contributes inventory with a fair market value
  of 125,000 and an adjusted basis of 131,000 for
  200 shares of stock and 25,000 in cash.
• B contributes 35,000 in cash and equipment with
  a fair market value of 15,000 and an adjusted
  basis of 10,000 for 100 shares of stock.
• Section 351 applies since control exists
• (200100) gt 80 x 300

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Illustration 6

• A
• Realized Gain
• 125,000 70,000 55,000
• Recognized Gain
• Lesser of 55,000 or 75,000 55,000
• Stock Basis
• 70,00055,00075,000 50,000
• B
• Realized Gain
• 15,000 10,000 5,000
• Recognized Gain
• 0
• Stock Basis
• 85,000 10,000 95,000
• Corporation
• Inventory Basis
• 70,000 55,000 125,000
• Equipment Basis

• A and B form a corporation
• A contributes inventory with a fair market value
  of 125,000 and an adjusted basis of 70,000 for
  100 shares of stock and 75,000 in cash.
• B contributes 85,000 in cash and equipment with
  a fair market value of 15,000 and an adjusted
  basis of 10,000 for 200 shares of stock.
• Section 351 applies since control exists
• (200100)/300 gt 80

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Illustration 7

• A
• Realized Gain
• 125,000 70,000 55,000
• Recognized Gain
• 0
• Stock Basis
• 70,000 25,000 45,000
• B
• Realized Gain
• 85,000 20,000 65,000
• Recognized Gain
• 35,000 20,000 15,000
• Stock Basis
• 20,000 15,000 35,000 0
• Corporation
• Inventory Basis
• 70,000
• Equipment Basis

• A and B form a corporation
• A contributes inventory with a fair market value
  of 125,000 and an adjusted basis of 70,000 and
  subject to a 25,000 liability for 200 shares of
  stock.
• B contributes equipment with a fair market value
  of 85,000 and an adjusted basis of 20,000 and
  subject to a 35,000 liability for 100 shares of
  stock.
• Section 351 applies since control exists
• (200100)/300 gt 80

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Illustration 8

• A forms a corporation
• A contributes inventory with a fair market value
  of 100,000 and an adjusted basis of 70,000 for
  common stock with a fair market value of 60,000
  and preferred stock with a fair market value of
  40,000
• Section 351 applies since control exists

• A
• Realized Gain
• 100,000 70,000 30,000
• Recognized Gain
• 0
• Common Stock Basis
• 60,000 / (60,000 40,000) x 70,000 42,000
• Preferred Stock Basis
• 40,000 / 100,000 x 70,000 28,000
• Corporation
• Inventory Basis
• 70,000

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Illustration 9

• A forms a corporation
• A contributes 10,000 in cash and accounts
  receivable with a fair market value of 55,000
  and an adjusted basis of 0 from his cash basis
  business for 500 shares of stock
• The corporation assumes accounts payable with a
  fair market value of 15,000 and an adjusted
  basis of 0 from his business.
• Section 351 applies since control exists

• A
• Realized Gain
• 55,000 - 0 55,000
• Recognized Gain
• 0
• Stock Basis
• 10,000
• Corporation
• Accounts Receivable Basis
• 0

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Information Reporting Transferor

• A statement, attached to an income tax return,
  must include
• A description of the property transferred and a
  statement of the cost or other adjusted basis at
  the date of the transfer
• A description of the stock of the transferee
  corporation received in the exchange, including
  any preference, the number of shares of each
  class of stock received, and the fair market
  value per share of each class as of the date of
  the exchange.
• A description of each item of boot received,
  including the amount of money and the fair market
  value of each other item as of the exchange date,
  and in the case of a corporate transferor, the
  adjusted basis of the boot in the hands of the
  transferee corporation immediately before the
  distribution to the transferor
• A description of the nature of the transferor's
  liabilities that are assumed by the transferee
  corporation, the date upon which and under what
  circumstances the liabilities were created, the
  corporate business reasons for the assumption by
  the transferee corporation, and whether such
  assumption eliminates the transferors primary
  liability.

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Information Reporting Transferee
The transferee-corporation must include with its
tax return for the taxable year in which the
nonrecognition transaction is completed and
retain permanent records of the following
information

• A description of all the property received from
  the transferors, including the cost or other
  basis of such property in the hands of the
  transferors, adjusted to the date of the transfer
• A description of each class of stock, including
  the total number of issued and outstanding shares
  immediately before and after the exchange, and
  the number of shares of each class of stock
  issued to each transferor in the exchange, the
  number of shares of each class of stock owned by
  each transferor immediately before and
  immediately after the exchange, and the fair
  market value of the stock issued to each
  transferor as of the date of the exchange.
• A description of the boot distributed in the
  exchange, including the amount of money and the
  fair market value of each separate item as of the
  date of the exchange, and in the case of a
  corporate transferor, the adjusted basis of each
  separate item in the hands of the transferee
  corporation immediately before the transfer
• A description of the liabilities assumed by the
  transferee corporation, including the amount
  thereof, the circumstances under which and the
  date each liability was created, and the
  controlled corporations business reasons for the
  assumption.
• The transferee corporation must retain permanent
  records of this information

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Incorporation of an Existing Partnership or LLC
3 Methods
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Method 1

• In a partnership asset transfer, all of the
  assets and liabilities of the partnership are
  transferred to a newly organized corporation in
  exchange for all its outstanding stock (and the
  assumption of the liabilities), followed by the
  partnerships distribution of the shares to the
  partners in complete liquidation of the
  partnership.

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Method 2

• In a partner asset transfer, the partnership can
  distribute all of its assets and liabilities in
  complete liquidation to its partners, who then
  can contribute the assets and liabilities to a
  corporation in exchange for its stock (and the
  assumption of liabilities.

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Method 3

• In a partnership interest transfer, all partners
  transfer their partnership interests to a
  corporation in exchange for its stock. Because
  there is only one partner after the transfer, the
  partnership terminates by operation of law and
  the transferee-corporation directly owns all of
  its assets and liabilities

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Although the economic consequences of the three
methods are identical, the IRS has agreed to
follow the form of most transactions in
determining their tax consequences.
Accordingly, the form that the transaction
takes can have significant impact on the amount
and character of the gain recognized by the
transferors and the basis of the property to the
transferee corporation.