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SLEEPERS THAT TRAVEL WITH SECTION 351 TRANSFERS
Thomas R. White, 3rd*
T
HE incorporation of a going business is a transaction which has
come to be accepted as routine. Although the exchange of business assets for stock or securities of the new corporation frequently
involves the realization of gain, for almost fifty years' the tax law has
provided an exception from the usual requirement that realized gain be
taxed.2 This exception is based on the assumptions that incorporation
involves little more than a change in the form of ownership, producing
gain that is paper profit only, and that incorporation is a customary
business arrangement which ought to be facilitated.
Conflicting with the statutory purpose to free incorporations from
tax restraints is the notion that a corporation is an entirely new taxpayer, distinct from the preceding partnership or proprietorship. The
emerging entity is not only taxed at different rates but may also select
its own accounting period, 3 accounting method 4 and method of reporting inventory 5 or taking depreciation. 6 While recognition of the corporation as a distinct taxpayer does not necessarily require segregation
of tax attributes, carryover treatment-either selective or mandatory' Associate Professor of Law, University of Virginia. B.A., 1960 Williams College;
LL.B., 1963 University of Pennsylvania. This Article is based on a talk given at the
twenty-first Annual Virginia Conference on Federal Taxation, June 20, 1969.
1 The ancestor of INr. REV. CODE of 1954, § 351 was enacted on November 23, 1921.
Int. Rev. Code of 1921, Ch. X, § 202(c) (3), 42 Stat. 227, 230. For a discussion of the
background and purpose of § 351, see B. BrraxER & J. EusricE, FEDERAL INcoME TAxATION OF CORPORATIONS AN SHAREHOLDERS 64-69 (2d ed. 1966).
2 Irr. REv. CODE of 1954, § 1002 ("Except as otherwise provided in this subtitle, on
the sale or exchange of property the entire amount of the gain or loss . ..shall be
recognized.").
3 INT. REV. CODE of 1954, § 441. Compare INr. REv. CODE of 1954, § 706(b), requiring a new partnership, in general, to adopt the same taxable year as its "principal
partners."
4INT. REv. CODE of 1954, § 446.
5 Irr. REv. CODE of 1954, § 472. If the preceding proprietorship or partnership used
LIFO, however, the new corporation must also elect to use LIFO under § 472(a) or
it may lose the right to employ that method. Treas. Reg. § 1.472-3 (1958). See
Textile Apron Co., 21 T.C. 147 (1953).
6 INTr.
REv. CODE of 1954, § 167(e) (1). The corporation loses the right to use the
rapid methods of depreciation authorized by the 1954 Code with respect to property
purchased and put in use by the preceding proprietorship or partnership. See note
107 infra and accompanying text.
F37]
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similar to that provided for corporate reorganizations, 7 has not been
extended to include incorporations."
The result is a series of rules, principally protective of government
revenue, which may penalize unwary transferors. Since the effect of
many of these rules undercuts the professed objective of deferring
recognition of gain on incorporation to facilitate business transactions,'
they can easily escape attention until the rude awakening occasioned
by the visit of an Internal Revenue Agent. This Article examines some
of the problems or "sleepers" present in section 351 transactions. °
THE STATUTORY PROVISIONS
Section 351"
and its companion provisions require the deferral
7 INT. REv. CODE of 1954, § 381. This section is more comprehensive than technical
carryovers. It refers, for example, to the treatment of installment obligations transferred to the acquiring corporation, id. § 381(c) (8); to the determination of limits on
deductible contributions to qualified employee plans, id. § 381(c)(11); to items
recovered by the acquiring corporation which were deducted without tax benefit by
the distributing corporation, id. § 381 (c) (12); as well as to the use of depreciation, inventory and accounting methods. Id. §§ 381(c) (4)-(6).
8
Treas. Reg. §§ 1.381(a)-1(b) (1), -1(b) (3) (i) (1961). Since § 351 transactions are
not among those to which § 381 applies, the implication arises that items specifically
referred to in § 381(c) may not be carried over in § 351 transactions from the
transferor to the controlled corporation. The regulations themselves negate this inference:
In a case where section 381 does not apply to a transaction . . . by reason of
• . . [failure of the statute specifically to include itJ, no inference is to be
drawn from the provisions of section 381 as to whether any item or tax
attribute shall be taken into account by the successor corporation.
Treas. Reg. § 1.381(a)-1(b) (3) (i) (1960).
9 See S. REP. No. 275, 67th Cong., 1st Sess. (1921), reprinted in 1939-1 (pt. 2) Cum.
BULL. 181, 188-189. The emphasis on facilitating advance planning and promoting
"clarity and certainty in the law" was reiterated in the legislative history of the 1954
Code. See H. REP. No. 1337, 83d Cong., 2d Sess. 39 (1954).
10 For recent discussions of the tax problems encountered in transactions qualifying
under § 351, see Benjamin, Problems in Transition from Sole Proprietorshipor Partnership to Corporation,N.Y.U. 26TH INst. ON FED. TAx 791 (1968); Riebesehl, Tax-Free
Incorporations Under Section 351, 46 TAxEs 360 (1968); Weiss, Problems in the TaxFree Incorporation of a Business, 41 I-n. L.J. 666 (1966); Note, Section 351 of the
Internal Revenue Code and "Mid-Stream" Incorporations, 38 U. CIN. L. REv. 96
(1969).
11
INr. REv. CoDE of 1954, § 351 (a) provides:
No gain or loss shall be recognized if property is transferred to a corporation
(including, in the case of transfers made on or before June 30, 1967, an investment company) by one or more persons solely in exchange for stock or securities
in such corporation and immediately after the exchange such person or persons
are in control (as defined in section 368(c)) of the corporation. For purposes
of this section, stock or securities issued for services shall not be considered
as issued in return for property.
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Section 351 Tranmers
1970]
of recognition of gain or loss realized on the transfer of property to a
corporation controlled by the transferors. Thus, if only stock or securities-"nonrecognition property"-are received by the transferors
and the "control" requirements 2 are met, no gain or loss is recognized
on the exchange; each transferor's basis in the nonrecognition property
received by him from the corporation is the same as his basis in property transferred by him to the corporation; 3 and the corporation's basis
in property transferred to it remains the same as the basis of the property in the hands of the transferor.' 4
If the transferor receives property other than stock or securities in
the corporation-"boot"-the gain realized is recognized to the extent
of the value of the boot1" and is taxed as if realized by the transferor
ina sale or exchange of the property which he transferred to the corporation. 16 Each transferor's basis for the boot received by him is its
fair market value, and his basis for any nonrecognition property received is reduced by the amount of the boot and increased by the gain
recognized. 17 The corporation's basis in the transferred property is increased by the gain recognized.
12
[T~he term "control" means the ownership of stock possessing at least 80 percent of the 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 of stock
of the corporation.
Id., S 368(c).
13 Id. § 358 (a) (1).
'4Id.5 362(a) (1).
15 d. § 351(b). Under no circumstances is loss recognized in a transaction to which
§351(a) applies. Id. § 351 (b) (2).
10 Cf. Rev. Rul. 60-302, 1960-2 Cum. BuLL. 223, which holds that § 1239 applies to
certain gains taxable under § 351 (b). Since § 1239 requires a "sale or exchange," boot
taxed under § 351 (b) would have to be treated as received in exchange for the depreciable property. Also, Treas. Reg. § 1.351-2(d) (1955) implies that boot might be
taxable as a dividend. This could occur if property were transferred to an already
existing controlled corporation in exchange for securities and boot, but under such
circumstances it would seem more appropriate to treat the boot as a distribution
independent of the § 351 transaction. To produce dividend treatment, it seems likely
that the transaction would have to be recast under other provisions.
17For example, suppose T transfers to a newly formed corporation property with a
basis of 50x and a fair market value of 100x. He receives in exchange all of the
corporation's stock (nonrecognition property) and a short term note (boot). The
values of the note and the stock, respectively, are 20x and 80x. On these facts, the gain
realized (50x) is recognized to the extent of the value of the boot (20x). T's basis
for the note is its fair market value (20x), and his basis for the stock is the basis of the
property transferred to the corporation (50x) minus the value of the boot (20x) plus
the gain recognized (20x), or 50x. For a more complex example, see BNA, 54-3d TAx
MANAGEMENT
PoRTFOLIo,
Tai~xsFEas
TO CONTROLLED, CORPOR
XTIONS
A-48 to A-49 (Supp.
1968). Although it has been held that there cannot be a negative basis, see Easson
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EFFECT OF ASSUMPTION OF LIABILITIES
The taxation of boot and the corresponding basis adjustments are
complicated if liabilities are assumed by the corporation. In general,
section 357(a) provides that if a liability of the transferor is assumed
by the corporation-including a transfer of property subject to a liability-the liability is not treated as boot under section 351 (b). For purposes of basis adjustments, however, the assumption of a liability is
treated as a distribution of money to the transferor and thus the basis of
nonrecognition property received by the transferor is reduced by the
amount of the liability."8
There are two exceptions to this general rule. First, if the transferor's
principal purpose in entering the transaction is tax avoidance or is not
a bona fide business purpose, all liabilities assumed will be treated as
money received on the exchange and therefore taxable as boot. 0 This
restriction prevents a tax free transfer of property which has been
heavily mortgaged shortly before the transaction. Efforts by the Commissioner to treat assumed liabilities as boot under this provision, however, have met with limited success, as illustrated by Easson v. Colnmissioner,20 in which the transferor's objective of retaining a "liquid
position" was found to be a sufficient business purpose.
The second exception has greater impact. Under section 357 (c) the
excess of liabilities assumed in the aggregate over the basis of the property transferred is treated as gain from the sale or exchange of the
property transferred. 2' To illustrate the possible effect of section 357
v. Commissioner, 294 F.2d 653 (9th Cir. 1961), the computation prescribed by the
statute may be made even though in the process there is a negative figure, that is, the
value of the boot exceeds the basis of the property transferred to the corporation.
Cf. Rev. Rul. 68-434, 1968 INT. REv. BunLl. No. 33, at 15 (computation of basis under
§ 334(c)).
18 INT. Rxv. CODE of 1954, § 358(d); Treas. Reg. 1.358-3 (1955).
10 INT. REv. CODE of 1954, § 357 (b). If "bad purpose" can be shown with respect to
any one of the liabilities of the transferor assumed by the corporation, then all of the
liabilities of the transferor assumed in the transaction are treated as boot. Treas. Reg.
§ 1.357-1(1961).
20294 F.2d 653 (9th Cir. 1961). In Drybrough v. Commissioner, 376 F.2d 350
(6th Cir. 1967), a liability incurred four years prior to incorporation was held not
to violate § 357(b), but a liability incurred three months before incorporation did run
afoul of that provision. The taxpayer's "business purpose" seems questionable since
a large portion of the former liability and all of the latter were used to purchase taxexempt securities.
21 In Rev. Rul. 66-142, 1966-1 Cumr. BuLL. 66, the IRS ruled that § 357(c) applies to
each transferor separately. Thus, the provision applies to the transferor if his liabilities
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1970]
Section 3Y
Transfers
(c), assume that a sole proprietor (P), who uses the cash basis of accounting for tax purposes, wishes to incorporate his business by transferring all of its assets to a new corporation in exchange for all of its
stock and assumption of all liabilities of the business. Assume further
that the only assets to be transferred to the corporation are accounts
receivable and the only liabilities to be assumed are accounts payable.
Although disregarding other assets greatly oversimplifies the problem,
it helps emphasize the point. The face value of the receivables is $50,000
and the face amount of the payables is $30,000; P has neither taken the
$50,000 into income nor deducted the $30,000.
Since under current income tax concepts the receivables have a zero
basis,2 2 the liabilities assumed by the corporation, $30,000, clearly exceed the basis of the assets transferred to it. Therefore, section 357 (c)
applies, requiring the excess of liabilities over basis-$30,000-to be
treated as gain from the sale or exchange of the property transferred.
Since the character of the gain is determined by the nature of the assets
transferred, and since receivables were the only assets in the simplified
example, the transaction results in the taxation of $30,000 of ordinary
income to P. Such a tax disaster actually befell a taxpayer in the
Peter Raich case.23
Under sections 358 and 362, P receives a basis of zero for his stock
in the corporation-the amount of gain recognized ($30,000) minus
the amount of the liabilities assumed ($30,000)-and the corporation
receives a basis for the receivables equal to the amount of gain recognized, $30,000. The net effect of this incorporation, therefore, is to
tax the full $50,000 of the receivables as ordinary income-$30,000 to
P and $20,000 to the corporation upon subsequent collection-and to
build in a further capital gain represented by P's net equity in the corporation which, immediately after the transfer, is $20,000.
assumed in the transaction exceed the basis of the assets transferred by him to the
corporation, regardless of what the other transferors may have done.
22
See Ray Franconi, 34 P-H Tax Ct. Mem. 503 (1965); Treas. Reg. § 1.166-1(e)
(1960). This rule is really common sense; since basis offsets income, basis should
include all amounts attributable to the asset which have previously been included in
income.
2346 T.C. 604 (1966), appeal dismissed (9th Cir. 1968); accord, De Felice v. Commissioner, 386 F.2d 704 (10th Cir. 1967), aff'g 35 P-H Tax Ct. Mem. 941 (1966);
Rev. Rul. 69-442, 1969 TNT. REv. BULL. No. 34, at 9; Treas. Reg. § 1.357-2(b)(1961).
The opinion in N. F. Testor, 40 T.C. 273 (1963), aff'd, 327 F.2d 788 (7th Cir. 1964),
is cryptic, but it appears that receivables and payables of a cash basis proprietorship
were also involved in that case. For a more complete discusssion of the problem, see
Note, Section 357(c) and the Cash Basis Taxpayer, 115 U. PA. L. REv. 1154 (1967).
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If P operated on the accrual basis, the results would be radically different. Since P would have already taken the receivables into income,
giving them a basis of $50,000 in his hands, and deducted the payables,
there would be no tax on the incorporation since P's basis for the receivables transferred would exceed the liabilities assumed. P would have
a basis of $20,000 for his stock in the corporation-the basis of the receivables minus liabilities assumed-and the corporation would have a
basis of $50,000 for the receivables. Although the corporation's payment of the payables is not deductible by it, neither is its collection of
the receivables taxable; thus, the corporation need not use taxable income to make payment. Under these circumstances, the net effect of
the transaction is to tax $20,000 of ordinary income to P.24
Such a radical difference in tax result solely because of accounting
method is hard to justify, particularly since the effect on the cash basis
transferor is to produce a result most accounting systems are designed
to prevent-the taxation bf income without offsetting deductions for
costs incurred in earning it. The IRS has now taken the position that
the Peter Raih 5 decision is correct, and section 357(c) will be applied
in section 351 transactions where receivables are transferred by and payables assumed from a cash basis taxpayer. 26 Analysis of the statute will
not yield a different result without substantial twisting of the statutory
language, and it seems unlikely, therefore, that a court will be persuaded to upset the IRS's piresent position. Obviously, where cash basis
taxpayers are concerned; payables should be handled with great care.
TREATMENT OF BAD DEBT RESERVES
An accrual basis taxpayer is not without problems. Nlost ac24By taking the receivables into income ($50,000)
($30,000), P was taxed on $20,000 of ordinary income.
2546 T.C. 604 (1966),
and deducting the liabilities
appeal diszissed (9th Cir. 1968).
See note 23 supra and ac-
companying text.
26
Rev. Rul. 69-442, 1969 IN. Riv. BULL. No. 34, provides:
The Internal Revenue. Service will apply section 357(c) of the Code to
other situations involving similar facts inasmuch as section [sic] literally applies
and the legislative history clearly supports the application of that section under
such circumstances. However, the Service wishes to point out that the trade
accounts receivable would not have had a zero basis if the taxpayer had been
on the accrual method of accounting prior to the transfer of the business
under section 351 of the Code.
Id. at 9.
2T
7 For an argument that § 357(c) should never apply to payables, see Note, U. P.A.
L. REv., supra note 23, at 1165-69. The proponent of such an argument must overcome
not only specific statutory language but also the now considerable judicial authority
supporting the Commissioner's position. See cases cited in note 23 supra.
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19701
Section 351 Transfers
crual basis taxpayers maintain a bad debt reserve with respect to their
receivables under section 166(c) .28 Since the purpose of such a reserve
is to anticipate deductions for future losses on receivables already taken
into income, and since disposition of the receivables to the corporation
means that the taxpayer will not suffer the loss for which he took the
deduction, the Commissioner, relying on the tax benefit theory, maintains that any disposition requires restoration to income of the amount of
the reserve. 0 Courts have sustained the Commissioner in sale-of-
receivables cases, even though the loss on disposition of receivables for
less than their face amount might not be recognized because of section
337.30 The Commissioner's extension of the tax benefit theory to section
351 transactions 3' has recently been extensively litigated with mixed
results. The Tax Court 2 and the Fifth Circuit33 have agreed with the
Commissioner, but the Ninth Circuit3 4 and every district court that has
considered the question 35 have not.
The Commissioner contends that a bad debt reserve is essentially an
accounting method for anticipating deductions for losses on receivables
or loans held by the taxpayer. It has no existence independent of the
assets to which it relates since the losses are not yet realized, and when
the assets are transferred in a transaction to which section 381 does
2 See generally Ohl, The Deduction for Bad Debts: A Study in Flexibility and
inflexibility, 22 TAx LAW. 579, 584 (1969); BNA, 19-4th TAx MANAGEMENT PORTFOLIO,
BAD DEBts A-50 to A-58 (Supp. 1968). The reserve method of reporting bad debts is not
limited to accrual basis taxpayers; however, since a cash basis taxpayer does not include
receivables in income, his tax basis for them is zero and any loss resulting from their
worthlessness is not deductible. Obviously, use of the reserve method has limited
utility for most cash basis taxpayers. Compare Robert P. Hutton, 53 T.C. No. 6
(Oct. 13, 1969). Accordingly, the discusssion in the text focuses on the problem posed
by the transfer of receivables which have previously been taken into income.
29 Rev. Rul. 65-258, 1965-2 Cuma. BuLL. 94; Rev. Rul. 57-482, 1957-2 CuM. BULL. 49.
30West Seattle Natel Bank v. Commissioner, 288 F.2d 47 (9th Cir. 1961); John T.
Dodson, 52 T.C. 386 (1969); Bird Management, Inc., 48 T.C. 586 (1967); J. E. Hawes
Corp., 44 T.C. 705 (1965).
31 Rev. Rul. 62-128, 1962-2 CuM. BuLL. 139.
32 Robert P. Hutton, 53 T.C. No. 6 (Oct. 13, 1969); Max Schuster, 50 T.C. 98 (1968),
appealpending, (2d Cir. 1969).
33 Nash v. United States, 414 F.2d 627 (5th Cir. 1969), cert. granted, 38 U.S.L.Mr.
3254 (U.S. Jan. 12, 1970) (No. 678).
34 Estate of Schmidt v. Commissioner, 355 F.2d 111 (9th Cir. 1966), rev'g 42 T.C.
1130 (1964).
35
Scofleld v. United States, 23 Am. Fed. Tax R.2d 1447 (C.D. Cal. 1969); Rowe v.
United States, 23 Am. Fed. Tax R.2d 443 (W.D. Ky. 1969); Birmingham Trust Nat'l
Bank v. United States, 22 Am. Fed. Tax R.2d 5202 (N.D. Ala. 1968), rev'd sub nom.
Nash v. United States, 414 F.2d 627 (5th Cir. 1969), cert. granted, 38 U.SJ,.LAV. 3254
(U.S. Jan. 12, 1970) (No. 678).
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not apply,"o the potential realization of loss is eliminated. Hence, the
purpose for the reserve is extinguished, and adjustment by restoring
the amount of the previous deduction to income is required.37 Moreover, section 351 expressly forbids the recognition of losses on qualifying transfers. 3 8 A bad debt reserve may be regarded as a discount from
the value of receivables to reflect uncollectability-that is, a method
of allowing a current deduction for unrealized depreciation in value.
Since assets transferred to controlled corporations under section 351
take the same basis as they had in the hands of the transferor, allowing
the transferor to retain the benefit of his bad debt reserve would in
effect be recognizing the loss on the transferred assets.30
The opposing argument stresses the practical factors implicit in the
use of a bad debt reserve at the expense of technical tax considerations. A
bad debt reserve should not be characterized as an accounting method
for anticipating deductions for unrealized losses; rather, it is a technique
for revaluation of outstanding receivables or loans. The aggregate basis
of a portfolio of receivables or loans would then comprise two elements: one representing the amount which will be repaid or collected,
and one representing the discount due to potential worthlessness. A
reserve is used to determine the "discount" on the basis of overall experience rather than by allocating worthlessness to particular assets.40
With respect to receivables, a bad debt reserve represents a technique
for preventing over-realization of income. The accrual basis taxpayer
should not be required to pay tax on income neither he nor anyone
else can reasonably expect to collect. Even in situations where the reserve does not represent uncollectable income-that is, where it is maintained against loans-it does represent amounts which have been "lost"
3
0See INT. Rs,. CODP of 1954, § 381(a); Treas. Reg. § 1.381(a)-l(b)(3)(i)(1960).
Among the "items" that are to be taken into account by a successor corporation is the
"method of accounting" of the predecessor, INT. REv. CODE of 1954, 1 381 (c) (4), which
the regulations interpret to include bad debt reserves. Treas. Reg. § 1.381-(c) (4)-
1(b)(1), example (1)(1964). Such specific mention tends to support the inference
that bad debt reserves are among the items which cannot be carried over in a transac-
tion to which § 381 does not apply. For a conflicting interpretation, see note 8 supra.
87 See Robert P. Hutton, 53 T.C. No. 6 (Oct. 13, 1969).
aa INr. REv. CoDE oF 1954, § 351(b) (2) ("[N]o loss to such recipient shall be recognized.').
39
See Nash v. United States, 414 F.2d 627, 629 (5th Cir. 1969), cert. granted, 38
U.S.L.W. 3254 (U.S. Jan. 12, 1970) (No. 678).
40 It is a rare case where the amount of the reserve may properly be computed on
the basis of particular loans or receivables which are likely to become worthless. See
Calavo, Inc. v. Commissioner, 304 F.2d 650 (9th Cir. 1962) (potential worthlessness of
one large debt may be taken into account); Ohl, supra note 28, at 587-90.
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19701
Section 351 Transfers
by the transferor in the sense that the transferor made the loans which
will not be repaid to anyone. Furthermore, when the transferor receives stock in a controlled corporation in exchange for the receivables
or loans, he does not receive value for the uncollectable items.4 1 Therefore, the substance of the transaction is a transfer of the net value of
the receivables or loans for stock, and the transferor should not have
taxable gain because the face value of the receivables or loans, which
exceeds their net value, will be the basis of the receivables or loans in
the hands of the corporation.4
In Robert P. Hutton,43 the Tax Court's most recent decision on the
problem, the proprietor of a small loan business using the cash basis
transferred his assets to a controlled corporation under section 351.
The Commissioner required him to restore to income at the time of the
transfer the bad debt reserve he had maintained against his loan portfolio. In upholding the Commissioner's determination, the Tax Court
observed that losses on the portfolio, which in fact would not be sustained by the transferor, had been deducted from other income. From
this fact the court concluded that failure to restore the reserve to income would produce a distortion because the transferor had not been
taxed on income that he in fact had received.
Technically, this position appears sound. Yet, it is difficult to perceive
how the transferor has received value for the loans which will prove to
be uncollectable, and receipt of value is the proper justification for
requiring restoration.4 4 If the transferor has not received value, he has
41 The value of stock received for assets in a § 351 transaction must necessarily
depend on the value of the assets. In the usual case, receivables or loans are discounted
from face value because of the risk of worthlessness. When the bad debt reserve has
been properly calculated and thus reflects an accurate estimate of the potential loss due
to worthlessness, the value of the stock received should be determined by taking into
account the amount of the reserve. Under these circumstances, since the transferor
has not received any value for the amount in the reserve, there has been no "recovery"
to which the tax benefit rule can apply.
42 If accounts receivable are sold in a taxable transaction, the bad debt reserve must
be restored to income by the seller. However, the amount paid for the receivables
will usually be less than their face value, with a deductible loss realized by the seller.
This loss will offset, in whole or in part, the amount of the inclusion, with the result
that the seller will not be taxed on the amount of the reserve for which he has not been
paid. If § 337 applies to the sale, the loss is unrecognized and will not offset income
resulting from restoration of the reserve to income. See cases cited in note 30 supra;
Stoffel, Treatment of Reserve Accounts on Incorporation and Liquidation, N.Y.U. 26TH
INsr. o- FED. TAx 773, 775-78 (1968). The latter result seems to be an unnecessarily
rigid application of the statute and basically unfair.
4353 T.C. No. 6 (Oct. 13, 1969).
44
See note 41 supra.
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in fact suffered the loss for which he is allowed the deduction just as
much as if the loans had actually gone sour while he owned them. Because it is too early to know which loans will go bad, a bad debt reserve
is used to determine the amount of the deduction.
Where receivables are concerned, there is an additional consideration.
Once the function of the bad debt reserve is recognized to be prevention of over-recognition of gain, it follows that income distortion can
be avoided only by concluding that net, not gross, accounts receivable
are transferred. Otherwise the transferor must report income that will
probably never be received, and the corporate transferee will be allowed
deductions for establishing a reserve for losses it will never sustain.
In spite of the fact that section 351 transfers do not qualify for the
benefits of section 381, it should be possible to justify transfer of the
bad debt reserve to the controlled corporation since it is the same
business with the same assets; all that has changed is the form of ownership. 45 The issue is now before the Supreme Court in Nasb v. United
States,48 and the problem may be resolved.
Accou rs
RECEIVABLE
Where the accounts receivable of a cash basis proprietor have been
transferred under section 351 and are subsequently collected by the
corporation, the amounts collected should be taxable to the corporation.
Nevertheless, under some circumstances it is not clear that this is the
proper result. If an account receivable is derived from the performance
of personal services, or is transferred separately from the asset which
generated it, the Commissioner may seek to apply assignment of income
45This argument is supported by the rationale of two recent cases involving reorganizations of savings and loan associations. Everett v. United States, 24 Am. Fed.
Tax R.2d 5736 (D. Kan. 1969); Home Say. & Loan Ass'n v. United States, 223 F. Supp.
134 (SD. Cal. 1963). Although § 381 would apply to the transactions in these two
cases, the courts seemed to be persuaded that the need for the reserve would continue
after the transaction since the same business was involved, and that requiring restoration by the transferor and allowing a deduction to the transferee would conflict with
business reality. Although the Tax Court in Robert P. Hutton stated that the corporation's bad debt reserve would be determined from different factors than those applicable to the transferor's reserve, the corporation could probably rely on the prior
experience of the business to justify a reserve equal to that existing at the time of the
§ 351 transfer.
46414 F.2d 627 (5th Cir. 1969), cert. granted, 38 U.S.L.W. 3254 (U.S. Jan. 12, 1970)
(No. 678). The Government has also authorized appeals in Scofield v. United States,
23 Am. Fed. Tax R.2d 1447 (C.D. Cal. 1969), and Rowe v. United States, 23 Am.
Fed. Tax R.2d 443 (WD. Ky. 1969).
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Section 351 Transfers
concepts47 and require taxation of the amounts collected to the transferor who earned the right to receive the income, s or who owns the
asset from which the income is derived.49 Research has revealed only
two casesz0 applying assignment of income concepts to business con-
nected receivables, and both held that the amounts collected were taxable to the corporation. The two cases do not resolve the problem,
however, since both involved multiple issues, and assignment of income
principles do not appear to have been argued in either case. In Arthur
L. Kniffen, the more interesting of the two, a real estate rental and
sales business was incorporated. Included among the assets transferred
to the corporation was a note payable to the transferor as evidence of
a commission earned by him in a prior transaction. When the note was
collected, the proceeds were held to be taxable to the corporation.
Arguably, the commission arose out of the ordinary conduct of the
business, but the transaction would seem to be vulnerable to an assignment of income attack.
Assignment of income principles would probably not override section 351 and require recognition of gain on the transfer of the "prop-
erty"-the right to receive payment-to the corporation. For example,
a contract right to receive insurance commissions would seem to qualify
for nonrecognition treatment on the exchange. Confusion arises from
the tendency to cast the assignment of income argument in terms of
whether the right to receive payment is "property" as distinguished
47
See Helvering v. Horst, 311 U.S. 112 (1940); Helvering v. Eubank, 311 U.S. 122
(1940); Lucas v. Earl, 281 U.S. 111 (1930). Similar arguments have been made with
considerable success in other areas, a factor which supports the applicability of these
principles in appropriate § 351 cases. See, e.g., Tatum v. Commissioner, 400 F.2d 242
(5th Cir. 1968) (contribution of crop rents to charity held taxable to donor when
sold by charity); Jones v. United States, 395 F.2d 938 (6th Cir. 1968) (endowment
policies to charity held taxable to donor when payment received by charity); George
D. Seyburn, 51 T.C. 578 (1969) (partnership interest in partnership being liquidated to
charity held donor taxable as payments received); Rev. Rul. 69-102, 1969 INT. Rav. BmL.
No. 10, at 5 (endowment policies to charity held taxable when payment received by
charity). See also Williamson v. United States, 292 F.2d 524 (Ct. Cl. 1961), in which
uncollected service fees were taxed to a cash basis corporation on liquidation. For a
discussion of the applicability of assignment of income theories to § 351 transactions,
see Note, 38 U. CIN. L. REv., supra note 10, at 106-14.
48Brown v. Commissioner, 115 F.2d 337 (2d Cit. 1940) (legal fee); Clinton Davidson,
43 B.T.A. 576 (1941) (insurance commissions).
49Adolph Veinberg, 44 T.C. 233 (1965), aff'd sub norm. Commissioner v. Sugar
Daddy, Inc., 386 F.2d 836 (9th Cir. 1967), cert. denied, 392 U.S. 929 (1968) (growing
crops, or proceeds from the sale of growing crops, without the land).
50 Arthur L. Kniffen, 39 T.C. 553 (1962), acquiesced in 1965-2 Cum. BULL. 5; Thomas
WV.
Briggs, 25 P-H Tax Ct. Mem. 349 (1956).
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48
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from pure income? 1 What is at stake in the income shifting problem
is the incidence of taxation on a subsequent receipt, not on the avoidance of tax on the exchange itself.52 Something that is "pure income"
may be transferred to a controlled corporation under section 351 without the recognition of gain, although subsequent payment to the corporation may be taxed to the transferor. The definition of "property"
for each purpose, therefore, should not be treated as identical.
These problems are illustrated by the recent Tax Court decision in
H. B. Zaclhry, Co., 5 3 where the parent corporation carved out and
transferred a production payment in exchange for all of the stock of a
newly formed subsidiary. The Commissioner asserted that the exchange
54
was taxable either because, under Co~mnissioner v. P. G. Lake, Inc.,
an income right could never be exchanged without recognizing gain
or because the carved-out production payment was solely a right to
income and therefore not "property." The Tax Court rejected both
arguments. First, the court reasoned that P. G. Lake involved the applicability of section 1031, which has a more limited scope than section
351, and therefore was not precedent for overriding section 351. Second, "property" in section 351 has a broad meaning and could include
51 See, e.g., Tatum v. Commissioner, 400 F.2d 242, 248 (5th Cir. 1968):
[Ilt is enough to say that crop shares are potential income assets, not property,
and that a landlord may not avoid taxation by assigning his rights to the
income prior to the reduction of the crop shares to money or its equivalent.
52 There is also a problem involving when the income should be taxed. The Commissioner argues that when an income right is exchanged for stock or securities in a
transaction which would otherwise qualify, taxation is immediate, rather than at the
time the corporation actually receives payment. But this argument is of doubtful
validity. In cases where an assignment of income argument is appropriate, as it may
be when payment is made on the oil payment in Zachry, see text at note 53 infra, the
Commissioner has the best chance of requiring taxation to the transferor of the amount
received by the corporation at the time of receipt. See Helvering v. Eubank, 311 U.S.
122 (1940) (insurance renewa! commissions assigned in 1926 and 1928 taxed to
assignor when received in 1933 by assignee); cf. Jones v. United States, 395 F.2d 938
(6th Cir. 1968); Rev. Ru. 69-102, 1969 Nr. REv. Buu.. No. 10, at 5. This result would
not be affected by application of § 351 to the original transfer of the income right
to the corporation.
13 49 T.C. 73 (1967), appeal dis-nissed per stipulation, (5th Cir. 1968).
54 356 U.S. 260 (1958). In one of the cases decided with the Lake case, Fleming
v. Commissioner, 241 F.2d 78 (5th Cir. 1957), rev'd sub norm. Commissioner v. P. G.
Lake, Inc., 356 U.S. 260 (1958), the taxpayer had exchanged a carved-out oil payment
for ranch land. The Court held that the oil payment was not property "of a like
kind" to the ranch land, and therefore § 1031 did not apply. In contrast, there is no
"like kind" restriction on property transferred to a controlled corporation under
§ 351.
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Section 351 Transfers
a right to pure income. Whether the income received by the subsidiary
upon satisfaction of the production payment should be taxable to the
parent was not decided, although the existence of the issue was noted:-,
Treatment of installnent Obligations
A somewhat similar problem is presented by the transfer of installment obligations to a controlled corporation. Under section 453(d)
any disposition of an installment obligation precipitates acceleration of
the gain realized but deferred under section 453. Certain transactions,
not including section 351 transfers, are excepted from this rule. "6 The
regulations provide, however, that in section 351 transfers not involving
the receipt of boot, no gain or loss is recognized by reason of the disposition of the installment obligation to the corporation. 57 Support for
this result is found in some older cases, 58 and implicitly in the legislative
history to the original installment sales provision in the Revenue Act of
1928.19 Notwithstanding recent judicial criticismC' the IRS seems unlikely to depart from the rule.
55 49 T.C. at 80 n.5.
56
INT. REv. CoDE of 1954, 15 453 (d) (3), (d) (4).
57 Treas. Reg. §§ 1.453-9(c) (2), -9(c) (3) (1958).
58Portland Oil Co. v. Commissioner, 109 F.2d 479 (1st Cir.), cert. denied, 310 U.S.
650 (1940); Wobbers, Inc., 26 B.T.A. 322 (1932), not acquiesced in XI-2 Cum. BULL. 18
(1932). In Wobbers a partnership transferred deferred payment sales contracts on
which gain was reported on the installment basis to a controlled corporation prior to
the effective date of the installment sales provision. The taxpayer asserted that the
transfer to the corporation was a taxable event, but the Board of Tax Appeals held
that the payments on the contract were also taxable to the corporation on the installmen basis. The non-acquiescence is unexplained.
59See, e.g., H.R. REP. No. 2, 70th Cong., 1st Sess. (1927), reprinted in 1939-1
Cum. BULL. 384:
Whether or not the gain or loss realized under the section is recognized for
tax purposes, depends upon general principles of law embodied in the income
tax provisions, the exchange of installment obligations in connection with taxfree exchanges, for instance, being cared for by section 112.
Id. at 395.
60 In Jack Ammann Photogrammetric Eng'rs, Inc. v. Commissioner, 341 F.2d 466
(5th Cir. 1965), the transferor had sold the assets of his business to the taxpayer corporation, in which he owned 78% of the stock, in exchange for an installment note.
The transferor later exchanged the note for more stock of the taxpayer in a transaction
that qualified under § 351, and the taxpayer cancelled the note. The Commissioner asserted that the cancellation of the note was a "disposition" of an installment obligation,
resulting in gain to the taxpayer, an argument which was rejected by the court on
the ground that the transferor should have been taxed on the disposition of the installment obligation.
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TRATMENT OF SERVICES
The effect of assignment of income principles on the taxation of a
transferor in section 351 transactions may be similar to that encountered
when the transferred "property" is derived from services rendered by
the transferor in connection with the formation of the corporation.
Since the statute specifically states that stock or securities issued for
services cannot qualify, gain will be recognized when stock is issued for
services. Furthermore, the stock issued for services rendered by a transferor who does not contribute property with a significant value in relation to the value of stock received will not be counted in determining
whether the transferors are "in control." 61
According to the regulations "services" means services rendered or to
be rendered to the issuing corporation, 2 but this definition may not be
so limited in actual practice.6 In United States v. Frazell,64 for examample, the taxpayer had a contingent right to an interest in a partnership which he had earned by performing services as a geologist. Transfer of this contract right to a corporation in exchange for stock failed
to qualify under section 351 because the stock was issued for services
rendered.
The question whether stock has been issued for property or for
services is most sharply presented by cases involving patent rights
and know-how.6 The rights to the patent which are exchanged for
stock will qualify under section 351 only if a taxable disposition of
such rights would have constituted a sale or exchange of property for
purposes of determining the character of gain or loss. Similarly, in
nonpatent cases the right transferred to the corporation for stock
should not qualify under section 351 if a taxable disposition of that
right would yield compensation for tax purposes. Hence, where the
01 Treas. Reg. §§ 1.351-1(a) (1), -1(a) (2), example (3) (1967). See note 12 supra.
Treas. Reg. § 1.351-1 (a) (1) (i) (1967).
62
03 In Elihu B. Washburne, 37 P-H Tax Ct. Mem. 641 (1968), the taxpayer was the
manager of the business. Acting as agent for the owner, he found a purchaser and
was given stock in the corporation formed to acquire the assets in exchange for his
"option" to purchase. The court held that this arrangement was compensatory. In
this case, the services were rendered to both the buyer and seller by bringing them
together, rather than to the corporation.
G4335 F.2d 487 (5th Cir. 1964), cert. denied, 380 U.S. 961 (1965).
I5 The IRS has recently ruled that cases involving know-how are to be decided by
analogy to the treatment of patent rights under § 1235. Rev. Rul. 69-156, 1969 INrT. REv.
BuLL. No. 14, at 12; see Rev. Rul. 64-56, 1964-1 CuM. Bu.. 133 (A transfer of "all
substantial rights" to secret processes and formulas is a transfer of "property.");
B. Birxar
& J. EusncE, supra note 1, at 71-72; Riebesehl, supra note 10, at 361-62.
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19701
Section 351 Transfers
6
interest to be transferred is derived from personal services-as in Frazell"
-it is not "property" for section 351 purposes.
DEFINITION OF SECURITY
Under section 351(b) the receipt of any property other than stock
or securities can produce recognizable gain. Apart from the question
of what constitutes "stock," 17 an obligation of the corporation might
not qualify as a "security" and may thus fall outside the scope of section 351 (a). If the intent of the transferor is to obtain payment as
quickly as possible, even though it is to come from income earned by
the corporation, the obligation he receives on incorporation may produce immediate taxable gain, 8 and, if ordinary income assets have been
transferred to the corporatiofi, part of the tax would be at ordinary
rates.69
Recent cases show a trend toward liberalizing the test of what constitutes a "security." Thus, a debt obligation which evinces an intention on the part of the debt holder to continue to participate in the
affairs of the corporation may be treated as a security notwithstanding
its short term 70 or requirement of installment payments.7 ' Classification
GGIn Frazell the court was influenced by the fact that had Frazell's contingent right
to a partnership interest vested, he would have been taxed on its value as compensation. Treas. Reg. S1.721-1 (b) (1956).
7 See Treas. Reg. § 1.351-1 (a) (1) (1967); James C. Hamrick, 43 T.C. 21 (1964); vacated and remanded per stipulation, 17 Am. Fed. Tax R.2d 357 (4th Cir. 1965); TAx
MANAGEMENT PoR-OLIO, supranote 17, at A-23 to A-25.
8 INT. REv. CODE of 1954, § 351 (b).
See Peter Raich, 46 T.C. 604 (1966), appeal dismissed, (9th Cir. 1968). In addition
to stock, the transferors received a short term promissory note which was paid
within 3% years. The court held that this was not a security: "Such rapid payment
is inconsistent with the proposition that the note was intended to represent a proprietary interest in the corporation." Id. at 613. Since the assets transferred to the corporation were all ordinary income assets (accounts receivable, prepaid rent, depreciable
equipment subject to § 1239), all of the recognized gain was ordinary.
70 United States v. Mills, 399 F.2d 944 (5th Cir. 1968). There the taxpayer transferred
assets and liabilities for all of the corporation's stock and a promissory note due one
year later. After two renewals, the note was exchanged for notes receivable -owned by
the corporation because the corporation's interest deduction had been disallowed. The
court held that the note was a security because of the transferor's intent not to have
the corporation pay the note, and therefore the nominal term of the note could be
disregarded. As a result, no gain was recognized on. the original transfer to the
corporation.
71 Compare United States v. Hertwig, 398 F.2d 452 (5th Cir. 1968) (121/ years), and
George A. Nye, 50 T.C. 203 (1968), acquiesced in 1969 INT. REv. BULL. No. 45, at
5 (10 years), 'with Varren H. Brown, 27 T.C. 27 (1956), acquiesced in 1957-2 CUM.
BULL. 4 (10 years). In Hertwig most payments, were not made as due, but in Nye
09
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of a debt as a security, however, may not always be to the taxpayer's
advantage. If the transfer is treated as a "sale," it may be possible to
achieve such desirable results as recognition of losses 72 or an increase
in the basis of assets "sold" to the corporation. 73 Thus, to the extent
that classifying a debt obligation as a security disqualifies the transaction as a sale, an expansive test will have unfavorable effects. Consequently, as a matter of tax planning, prompt payment would be the
best policy for a taxpayer who desires to avoid classification of a debt
as a security.
Classifying an obligation of a corporate transferee as debt, rather
than equity, does not solve the question whether a "sale" to the corporation has occurred. 4 Some cases would support an inference that
the two issues should be treated alike 7 -that is, finding the obligation to be debt would mean that the transaction was a "sale." Yet,
section 351(a) applies to property transferred "in exchange for"
securities, and literally it would not seem to matter that the parties
might call the transaction a "sale." The distinction between the two
issues may be illustrated by George A. Nye, 6 in which the Tax Court
held that an installment note obtained by the individual taxpayers from
their corporation in exchange for operating assets was actually debt,
not equity as the Commissioner contended. Nevertheless, the debt
all payments were made when due. In both cases, the courts were persuaded by the
businesses' need for the assets transferred for the notes and by the close relationship
between the transfer and the formation of the corporation.
72Even if the transaction is characterized as a "sale" for tax purposes, to deduct a loss
a taxpayer must still avoid the impact of INT. RFv. CODE of 1954, § 267 (disallowing
losses from the sale or exchanges of property in certain situations).
7- In the event of a sale, of course, the basis of the assets would be their cost. INT.
REV. CODE of 1954, § 1012.
74For a full discussion of the problem posed by a "sale" of assets to a controlled
corporation in exchange for its debt obligations, see Ellis, Tax Problems in Sales to
Controlled Corporations,21 VANt. L. REV. 196 (1968); Comment, Section 351 Transfers
to Controlled Corporations: The Forgotten Tern-"Securities," 114 U. PA. L. Rav. 314
(1965). If the debt is characterized as a "security," then gain (but not loss) will be
recognized to the extent of the value of the security as if a sale had taken place. Cf.
Enola C. Hartley, 36 P-H Tax Ct. Mem. 202 (1967); Sylvan Makover, 36 P-H Tax Ct.
Mem. 313 (1967). In these cases, transfers of cash to the corporation for short term
notes after incorporation were treated as loans-that is, as entirely separate transactions.
75 See, e.g., Stanley, Inc. v. Schuster, 23 Am. Fed. Tax R.2d 715 (S.D. Ohio 1969):
Reduced to the simplest of terms, the question becomes one of whether the
subject transaction created a debtor-creditor relationship or a stockholder relationship between the transferee and transferor.
Id. at 716; accord, Burr Oaks Corp., 43 T.C. 635 (1965), aff'd, 365 F.2d 24 (7th Cir.
1966), cert. denied, 385 U.S. 1007 (1967).
7 50 T.C. 203 (1968), acquiesced in 1969 INT. REv. BULL. No. 45, at 5.
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Section 351 Transfers
qualified as a security; therefore, section 351 applied, and an increase
in basis for the assets transferred to the corporation was denied.
Successful characterization of the exchange of corporate obligations
for assets as a sale, on the other hand, would necessitate a showing that
the exchange involved was independent of the formation of the corporation, a difficult burden where the assets "sold" are operating assets
owned by the transferors and necessary to the operation of the business. Proper segregation of these distinct issues will make it more difficult to classify transactions of this kind as sales not within the purview
of section 351. Several recent Tax Court cases 77 suggest that a significant variation between the transferors and those interested in the corporation will be effective, but even under such circumstances the
potential for litigation is strong.
ALLOCATION PROBLEMS
If boot is received in a section 351 transaction, it must be allocated
among the various assets transferred to the corporation, since, in effect,
each separate asset has been exchanged. 7 The idea that the incorporation of a going business is a transfer of separate assets rather than an
integrated whole stems from Williams v. McGowan,79 which treated
the sale of a business as a sale of its component assets for the purpose
of allocating total consideration. This allocation is important because
it affects the determination of such matters as the basis of the transfered assets in the hands of the corporation; 0 the amount of recapture
in the event that depreciable property is transferred; 8 character of gain
77 Stevens Pass, Inc., 48 T.C. 532 (1967), appeal dismissed per stipulation, (9th Cir.
1968); Charles E. Curry, 43 T.C. 667 (1965), acquiesced in 1965-2 CuM. BULL. 4, not
acquiesced in on this issue, 1968 INT. REv. BuLL. No. 33, at 7. In Curry the ownership
of corporate stock varied only among the family of the transferors. The Tax Court's
adverse holding is indicative of the difficulty the Commissioner faces in trying to prevent avoidance of S 351. See Comment, 114 U. PA. L. REv., supra note 74, at 321-22.
7SRev. Rul. 68-55, 1968-1 CuM. BULL. 140. Cf. Rev. Rul. 68-23, 1968-1 Cumv.
BULL.
144 (similar method of allocation in "C" reorganizations). For a full discussion of the
problems involved in allocating boor, see Rabinovitz, Allocating Boot in Section 351
Exchanges, 24 TAx L. REv. 337 (1969).
79, 152 F.2d 570 (2d Cir. 1945); accord, Rev. Rul. 55-79, 1955-1 Cum~s. BULL. 370.
80 The basis of each asset is increased by the amount of gain recognized to the
transferor of that asset. IN-r. REv. CODE of 1954, 1 362(a).
81
INT. REv. CoD of 1954, §§ 1245(b) (3), 1250(d) (3); Treas. Reg. § 1.1245-4(c) (1),
-4(c) (2) (ii) (1965). The regulation requires allocation of consideration on the basis
of fair market value, thereby requiring allocation of a proportionate share of boot to
assets subject to depreciation recapture. This is consistent with Rev. Rul. 68-55,
1968-1 CUM. BULL. 140.
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to be recognized, including application of section 1239; and the appropriate holding period for each assetA2 Accordingly, it seems curious
that neither the statute nor the regulations give any guidance 83 concerning the method to be used, and that it was not until 1968 that the
IRS even attempted to clarify the point by issuing Revenue Ruling
68-55. 84
Under this ruling, each item of consideration received by the transferor is to be allocated pro rata on the basis of fair market value to
each of the assets transferred to the corporation. The determination of
the amount of gain realized, and the amount and character of the gain
to be recognized is then made on an asset-by-asset basis, with the total
gain recognized under section 351(b) equal to the sum of the gains
recognized on each individual asset. Since the rule prohibits the recognition of a loss in a transfer governed by section 351, a loss which is
realized on one or more of the assets transferred to the corporation will
not offset gains realized on other assets. As a result, if there is sufficient
boot, the gain recognized could exceed the aggregate gain realized.
To illustrate the application of this rule, assume that in addition to the
$50,000 in accounts receivable in the earlier example, 85 P has real estate
with a basis of $5,000 and afair market value of $25,000, and depreciable
personal property subject to recapture with a basis of $15,000 and a fair
market value of $25,000. P incorporates, transferring these assets in
exchange for the stock of the corporation and a short term note for
$30,000 which is not a security since P intends to have the corporation
pay it off in the near future."' On this exchange, there is an aggregate basis of $20,000 for the assets transferred to the corporation and an
aggregate realized gain of $80,000; $30,000 of boot is received on the
transaction. Under the Revenue Ruling, the allocation would be as
follows1954, § 1223 (1)..
83 The only reference to allocation of boot in the regulations is in Treas. Reg.
§ 1.357-2(b) (1961), which deals with allocation of gain recognized because the liabilities
assumed exceed the basis of assets 'transferred. The regulations there provide that
the gain recognized is to be allocated on the basis of fair market value of assets transferred, a method which is inconsistent with Rev. Rul. 68-55, 1968-1 Cum. BULL. 140,
at 141, and which is criticized in Rabinovitz, supra note 78, at 360-65.
82 INT. REv. CODE of
84 1968-1 Gum. BULL. 140.
85 See text at notes 21-23 srtpra.
86 See notes 70-71 supra and accompanying text.
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Section 351 Transfers
Assets
Receivables
Real Estate
Depreciable Personal
Property
$25,000
$ 5,000
$20,000
$25,000
$15,000
$10,000
Market value .......
Basis ..............
Gain realized ........
$50,000
0
$50,000
Stock ..............
Other property .....
Gain recognized .....
Consideration
$35,000
$17,500
$17,500
$15,000
$ 7,500
$ 7,500
87
$15,000(ord.) $ 7,500(cap.) $ 7,500(ord.)
If the real estate has a basis of $25,000 instead of $5,000, the result
changes. The aggregate gain is now $60,000, but the allocation of stock
and boot remains the same. Since no gain is realized with respect to the
real estate, the $7,500 of boot allocated to the real estate will not be
taxed. Under this variation, only gain derived from the receivables and
the depreciable personal property is recognized and only to the extent
of $22,500, even though both the amount of boot and the aggregate
gain realized exceed that amount.
The ruling deals only with the computation of gain and allocation of
boot among certain fixed assets in the absence of gain derived from the
assumption of liability.88 For the proprietor contemplating incorporation, this answer is incomplete inasmuch as most businesses have going
concern value or goodwill in excess of the value of their assets. If each
asset must be valued separately in a section 351 exchange because of
the presence of boot, the Commissioner may, as suggested by his past
practice in other areas,8 9 insist on allocation of boot to goodwill-a result
which is generally undesirable. 90
87 On this exchange, P wound up with more than 80% of the stock of his corporation. Therefore, § 1239 applies to the transfer of the depreciable property and requires
taxation of recognized gain on this asset as ordinary income. See Rev. Rul. 60-302,
1960-2 CuM. BtIL. 223. If § 1239 did not apply, the gain recognized would be taxed
as ordinary income under § 1245 to the extent of depreciation recapture and thereafter
as capital gain.
88 See Rabinovitz, supra note 78, at 344-46.
89
See, e.g., Philadelphia Steel & Iron Corp., 33 P-H Tax Ct. Mem. 614 (1964), aff'd
per curiam, 344 F.2d 964 (3d Cir. 1965); Fox & Hounds, Inc., 31 P-H Tax Ct. Mem.
1344 (1962). These cases are distinguishable since they involve a definite consideration
paid for assets whose value can be determined with reasonable accuracy. Thus, the fact
that a premium has been bargained for and paid strongly supports the Commissioner's
position. In contrast, there is no determinable premium and no bargaining in the
typical
§ 351 situation.
90
1n most cases, goodwill has a zero basis and therefore all boot allocated to it will
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A more technical problem involves the treatment of gain recognized
under section 357 (c), which provides for the recognition of gain to the
extent that the liabilities assumed exceed the aggregate basis of the property transferred to the corporation. The regulations under section 357
provide that the excess of aggregate liabilities over aggregate basis-the
gain recognized-is to be allocated on the basis of the fair market value
of the assets transferred.9 1 The difficulty with this method is that it may
produce an allocation of gain to an asset on which no gain, or in fact
a loss, is realized. As to that asset, the potential loss is thereby increased
-by an increase in the basis of the asset-but at the cost of a tax
to the transferor, a result which does not make sense. To illustrate,
assume in the example that the corporation assumes the accounts payable
instead of distributing a short term note, and that the real estate has a
basis of $25,000 and is subject to a liability of $20,000. Since the liabilities, $50,000, exceed total basis, $40,000, there is boot of $10,000 which
is less than the gain realized and thus taxable in full. The situation may
be represented as follows:
Assets
Real Estate
Depreciable Personal
Property
$25,000
$25,000
0
$25,000
$15,000
$10,000
2
ConsiderationP
$25,000
$12,500
$12,500
Receivables
Market value ........
Basis ...............
Gain realized ........
Stock ..............
Liabilities
assumed ...........
Gain recognized .....
$50,000
0
$50,000
$25,000
$12,50093
$12,500
$ 5,000 (ord.) $ 2,500 (cap.) $ 2,500 (ord.)
produce recognized gain. Furthermore, although the corporation acquires a basis for
the goodwill, the basis will not be depreciable. But see Peter Raich, 46 T.C. 604 (1966),
appeal dismissed, (9th Cir. 1968). If the taxpayer had argued that the business transferred to the corporation had goodwill and that some of the boot should have been
allocated to goodwill, some of the recognized gain might have been taxed as capital
gain.
91Treas. Reg. § 1.357-2(b) (1961). This must be done for each transferor. Rev. Rul.
66-142, 1966-1 CuM. BULL. 66.
92Allocated as provided in Rev. Rul. 68-55, 1968-1 CuM. BULL. 140.
93
This allocation seems artificial. Assumption of the liability to which the real
estate is subject should logically be allocated to the real estate. Hopefully, the allocation rule which emerges will be flexible enough to cope with such contingencies in
an internally consistent manner.
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19701
Under this method of allocating gain, the real estate would now have a
basis of $27,500 to the corporation, even though its market value is only
$25,000. As a practical matter, the uncertainty posed by this problem
would prove troublesome only in the circumstances described above, but
it does indicate that allocation of boot remains partly unexplored despite
recent efforts to clarify the area.
Allocation by the Parties
As pointed out earlier, 94 the impact of section 351 can sometimes be
avoided by isolating a "sale" or a "loan" of particular assets. A "sale"
or "loan" is treated as an entirely separate transaction and does not affect
the computations required by section 351 and its companion provisions? 5
A similar effect might be achieved if the boot received in a section 351
transaction could be allocated to specific assets, as contrasted with the
requirement of Revenue Ruling 68-55 that boot be allocated pro rata
according to market value.
To illustrate, assume that B transfers two assets to a controlled corporation, for stock and a short term debt not qualifying as security, as
follows:
Assets
Asset #1
$100
$ 50
Market value ............
Basis ...................
Asset #2
$100
$ 40
$ 50
Gain realized ...........
$ 60
Consideration
Allocated by the Parties
(B and the corporation)
Allocated under Revenue
Ruling 68-55
Stock ............
Debt ............
0
$100
#2
$100
0
#1
$50
$50
#2
$50
$50
Gain recognized ...
$ 50
$ 0
$50
$50
#1
91 See text at notes 72-77 supra.
95 In Enola C. Hartley, 36 P-H Tax Ct. Mem. 202 (1967), for example, a subsequent
transfer of accounts receivable to the corporation for a note was treated as a "loan,"
and therefore not taxable. Had it been part of the § 351 transfer, the note may have
been taxable as "other property." In Hartley the taxpayer was apparently successful
because she was able to show that the transfer of accounts receivable was an afterthought to provide temporary working capital.
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Under either method, the gain recognized with respect to Asset #1 is
$50, the basis of that asset in the hands of the corporation is $100 and
the basis of the debt in B's hands is $100. Conversely, the result with
respect to Asset #2 and the stock received by B are strikingly different;
no gain would be recognized as to Asset #2 (as opposed to $50) and
the stock would have a basis of $40 (as opposed to $90). In this situation, the tax effect is the same under B's allocation as it would be had
B "sold" Asset #1 to the corporation, and this identity of result foreordains the Commissioner's opposition. If the debt were not a security,
and if the exchange cannot be broken apart into separate transactions,
such an allocation is arbitrary because there is no independent elementsuch as bargaining between adverse parties-to justify it.96 Absent such
justification, it is unlikely that a non-pro rata allocation would be sus97
tained over the Commissioner's objection.
EFFECTS OF INCORPORATION ON CONTINUITY
In addition to the intricacies of qualifying the transfer under section
351, there are problems with respect to continuity in the operation of a
going business after the transition to the corporate form.
Recapture of Depreciation and Investment Credit
If the business has depreciable property, there may be recapture of
either depreciation or investment credit or both. Sections 1245 and 1250
provide an exception for transactions that qualify under section 351,
except insofar as gain is actually recognized on the transfer." Accordingly, the amount of recapture partly depends on whether or not boot
9
GIn Rev. Rul. 68-13, 1968-1 CuM. BULL. 195, the IRS took the position that, in a
sale of a going concern in which some of the assets could qualify for deferral of
recognition of gain under § 453, the selling price and payments in the year of sale could
be allocated by agreement to each of the assets sold to determine which would be treated
as installment sales. One crucial ingredient seemed to be the presence of bargaining
between adverse parties, with the implication that, absent such bargaining, allocation
would be pro rata. See Andrew A. Monaghan, 40 T.C. 680 (1963), acquiesced in
1964-2 Cum. BULL. 6.
97 Professor Rabinovitz suggests that it may be possible for the parties to allocate
basis among stock and securities received by the transferors by assigning particular
certificates to particular assets transferred to the corporation. This problem involves
identification after allocation for purposes of determining the amount of recognized
gain, and would not alter the immediate tax effects of the transaction itself. Rabinovitz,
supra note 78, at 365-71.
98INT. REv. CoDE of 1954, §§ 1245(b) (3), 1250(d) (3); Treas. Reg. § 1.1245-4(c) (1),
-4(c) (2) (ii) (1965).
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has been received by the transferors and the allocation of the recognized
gain, if any.
Although the investment credit has recently been extinguished,.9
recapture problems will persist. Under section 47(b) and the corresponding regulations, there will be recapture of the investment credit
whether or not gain is realized or recognized, 100 unless the transfer is
only "a mere change in the form of conducting the
. . .
business." ll
For a transfer to qualify as a mere change in form, not only must the
transferor retain a substantial interest 10 2 in the trade or business, but the
basis of the section 38 property involved must be determined, at least in
part, under section 362103 and "[s]ubstantially all the assets... necessary to operate such trade or business" must be transferred to the new
corporation, even though the assets referred to are not section 38 property. 104 Hence, the business must be transferred substantially intact to
the corporation, although it may not be necessary that all transfers to
the corporation qualify for nonrecognition under section 351. Whether
this requirement means that current assets such as cash or accounts receivable must also be transferred is unclear. Moreover, if such a transfer
does qualify as a "mere change in form," subsequent disposition of the
property by the corporation prior to the end of the property's useful
life for credit purposes will produce recapture for the transferor. 0 5
Problems involving depreciation extend beyond possible recapture.
Since depreciable property transferred to a corporation in an exchange
under section 351 will not be property whose original use commenced
with the corporation, the corporation will not be entitled to use double
declining balance or sum-of-the-years-digits methods in computing depreciation. 0 6 Moreover, use of 150 percent declining balance method
is contingent upon a proper election by the corporation, since under the
99
Tax Reform Act of 1969, § 703(a) (1969), amending § 49 of the INT. REv. CODE of
1954.
100 All that is required for recapture of the credit is disposition of the qualifying
property, whether or not gain is realized on the disposition, prior to the end of the
useful life employed in computing the credit. INT. REv. CoDE of 1954, 5 47 (a).
101 INT. REv. CODE of 1954, § 47 (b); Treas. Reg. § 1.47-3(f) (1967).
02
1
Treas. Reg. 5 1.47-3 (f) (2) (1967). According to the regulations, a 45% interest is
"substantial." Treas. Reg. § 1.47-3 (f) (6), example (1) (1967).
03
1
Treas. Reg. § 1.47-3 (f) (ii) (d) (1967).
' 0 4 Treas. Reg. S 1.47-3 (f) (ii) (c) (1967).
,105 Treas. Reg. § 1.47-3 (f) (5), -3 (f) (6), example (2) (1967).
106 INT. REv. CODE of 1954, § 167(c)(2); Treas. Reg. §5 1.167(c)-1(a)(2),-1(a)(6)
(1956); Rev. Rul. 56-256, 1956-1 CuM. BuLL. 129. See Rev. Rul. 67-286, 1967-2 CuM.
BuLL. 101.
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IRS's interpretation of section 167, an improper election will relegate
the corporation to the straight line method.0 7 Furthermore, additional
first year depreciation under section 179 will not be available since a
section 351 exchange is not a "purchase." 10'
Accounting Adjustments
Inventory
The notion that a corporation is an entity distinct from its predecessor
partnership or proprietorship may be troublesome if the Commissioner
requires accounting adjustments in the corporation's first taxable year. 10
In computing opening inventory, for example, the corporation must use
its predecessor's closing inventory since it must also use its predecessor's
basis for assets acquired in a section 351 transfer. 10 Moreover, when the
use of inventories is required by the Commissioner clearly to reflect
income, no relief under section 481 is available because the corporation
does not have a "preceding taxable year" for purposes of section 481 (a).
Thus, the new corporation is deprived of benefits which might have
been available to its predecessor under section 481 had the Commissioner
required similar adjustments to the predecessor's inventory. In Ezo
Products Co.,"' for example, the preceding partnership had not been
using inventories and had been computing income on the cash basis. After
107 See Rev. Rul. 67-338, 1967-2 Cum. BULL. 102; Rev. Rul. 67-50, 1967-1 Cum. BULL.
60; Rev. Rul. 57-352, 1957-2 CuM. BULL. 150. All that is required for a proper
election is for the corporation to use the appropriate method (150% declining balance)
in computing depreciation for its first return. Treas. Reg. § 1.167(c)-i(c) (1956). Use
of the wrong method (200% declining balance) is an improper election. With respect
to inventory methods, proper election to use LIFO must also be made. See note 5 supra.
108 INr. REv. CODE of 1954, §§ 179(d) (1) (B), 179(d) (2) (C) (i); Treas. Reg. § 1.1793 (c)
(iii) (1960).
109
INr. REv. CODE of 1954, §§ 446(b), 471.
II0 See Dearborn Gage Co., 48 T.C. 190 (1967) (inclusion of overhead costs);
Connolly Tool & Engineering Co., 33 P-H Tax Ct. Mem. 1339 (1964) (use of inven-
tories). The results were the same under the 1939 Code. Frank G. Wikstrom & Sons,
Inc., 20 T.C. 359 (1953) (inclusion of overhead costs). In Commissioner v. Joseph E.
Seagram & Sons, Inc., 394 F.2d 738 (2d Cir. 1968), rev'g 46 T.C. 698 (1966), the
parent corporation transferred inventory to its subsidiary in a transaction governed
by § 351. Both parent and subsidiary used LIFO. The court held that not only did
the subsidiary take the parent's basis for the inventory transferred but it also had to
use the parent's LIFO layers in computing the cost of the goods sold. The court reasoned that use of these layers was required so that the subsidiary's inventory would be
computed in "accord with the best accounting practice for the purpose of clearly and
consistently reflecting income," and, therefore, the Commissioner's determination was
authorized bv Treas. Reg. § 1.471-2(d) (1958).
11'37 T.C. 385 (1961).
394 F.2d at 742.
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Section 351, Transfers
incorporation, the Commissioner required the use of inventories, necessitating a shift to the accrual basis. In computing its taxable income for
its first year, however, the corporation had an opening inventory of
zero-the basis of the inventory assets transferred to it by its predecessor.
In effect, the adjustment postponed deduction of amounts in the corporation's closing inventory while permitting no adjustment for amounts
previously deducted by the partnership, thereby inflating income for the
corporation's first taxable year.
Receivables
This rule also applies to other items affected by adjustments in the
corporation's first taxable year. Accounts receivable of a cash basis proprietor transferred to a corporation under section 351 have a basis of
zero in the corporation's hands,112 and are income to the corporation
when collected.1 3 If the Commissioner properly requires the corporadon to use the accrual method and accrue receivables for its first taxable
year, section 481 does not apply, and the corporation will have income
both from collection of the predecessor's receivables and from accrual
of its own receivables.. 4 Since there seems to be no way under the
present statutory framework to justify a carryover of accounting attributes for purposes of section 481, caution dictates careful examination
of possible accounting difficulties prior to transfer of inventory or receivables to a controlled corporation.
Impact of Subchapter S
A possible exception to these rules seems to have been developing
for corporations which elect to use subchapter S for the first year following incorporation." 5 The Commissioner's position has been consistent; a corporation, even though it elects subchapter S, is a different
taxpayer from its predecessor and therefore section 481 does not apply
to adjustments made in the first taxable year of the corporation. The
Tax Court, however, has not accepted this argument,"06 rejecting the
112 PA. Birren & Son, Inc. v. Commissioner, 116 F.2d 718 (7th Cir. 1940); Pittsfield
Coal & Oil Co., 35 P-H Tax Ct. Mem. 12 (1966). See Peter Raich, 46 T.C. 604 (1966),
appeal dismissed, (9th Cir. 1968).
113 See text at notes 51-56 supra.
"14See Ezo Prod. Co., 37 T.C. 385 (1961).
115 See White, Recurring and New Problems Under Subchapter S, N.Y.U. 27TH
INsT. ON FED. TAx, 755, 757-62 (1969).
110 See Paul H. Travis, 47 T.C. 502 (1967), rev'd in part, aff'd in part, 406 F.2d 987
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Commissioner's position on the ground that the adjustments affected the
income of the same taxpayers-that is, the shareholders of the new subchapter S corporation. While this rationale potentially extends to other
problems, such as the election by the corporation of an accounting
method different from that of its predecessors, extension is unlikely
since the corporation is viewed as a different taxpayer and its ability
to elect subchapter S treatment is purely accidental. This kind of judicial exception not only lacks statutory support" 7 but also demonstrates
the policy weakness in failing to provide tax attribute carryovers in
exchanges which qualify under section 351. Accordingly, a subchapter
S election will probably not protect taxpayers from readjustments in
the first taxable year of the corporation; it will certainly not shield
them from litigation.
Other Adjustments
Expenses incurred by the transferor and subsequently paid by the
transferee are not deductible by the transferee." 8 Such a payment, if
made in exchange for acquisition of assets, is a capital expenditure and
not an expense. If, however, the common ownership requirement of
section 482 is met, and if an expense is properly attributable to either
transferor or corporation but is deducted by the other, the Commissioner
has authority under section 482 to reallocate the deduction." 9 Thus,
section 482 will prevail over section 351 in appropriate cases.
CONCLUSION
This Article by no means exhausts the potential difficulties which may
arise in tax planning under section 351; additional problems include such
matters as the impact of section 367120 and the meaning of "investment
(6th Cir. 1969) (dance studio); E. Morris Cox, 43 T.C. 448 (1965), not acquiesced in on
this issue 1965-2 Cum. BL. 7 (investment advisory services).
117See White, supra note 115, at 757-59.
118
Holdcroft Transp. Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946); T. Jack
Foster, 35 P-H Tax Ct. Mem. 1556, 1568-69, 1590-91 (1966), appeal pending (10th
Cir.).
" 9 Treas. Reg. § 1.482-1(d) (5) (1968), citing National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir.), cert. denied, 320 U.S. 794 (1943); Estate of Walling
v. Commissioner, 373 F.2d 190 (3d Cir. 1967); Rooney v. United States, 305 F.2d 681
(9th Cir. 1962).
•120 ITr. REv. CODE of 1954, § 367 requires that for § 351 to apply to a transfer to a
foreign corporation, the transferor must obtain a ruling before the transaction takes
place that the transfer is not for the principal purpose of tax avoidance. For discus-
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Section 351 Transfers
company." 1 The problems discussed, however, illustrate that the objectives of section 351-certainty of result and removal of tax barriers to
business arrangements-have yet to be achieved.
sions of the difficulties in obtaining such rulings, see Herskovitz, New Objective Tests
Established by 1RS for FavorableSection 367 Rulings, 29 J. TAXA-ION 148 (1968); Weiss,
supra note 10.
121 Section 351 (a) does not apply to a transfer to an "investment company" after
June 30, 1967, see INT. REv. CoDE of 1954, S 351(d), but the statute does not attempt to
define "investment company." See Treas. Reg. § 1.351-1(c) (1967). For a discussion of
the numerous problems raised by this provision, see Shechtman, Economic and
Equity Implications of the Recent Legislation Concerning Swap Funds, 45 TAXEs 550
(1967).
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