TAX CONSEQUENCES – FORMATION
OF CONTROLLED CORPORATIONS
(CCH EXPLANATION)
Transfer to Controlled Corporation: Synopsis - transfer to controlled
corporation
When a corporation is organized, the value of the issued stock is usually the
same as the value of the property, including intangibles, transferred to the
corporation. Such value may be greater or less than the depreciated cost or other
basis of the transferred property to the transferor-stockholder. Therefore, the
transfer may result in gain or loss to the transferor measured by the difference
between the adjusted basis of the property and the value of the stock. Code Sec.
351 provides for the nonrecognition of such gain or loss provided that the
transferors are in control of the corporation after the exchange.
Nonrecognition is not limited to transfers in connection with the organization of a
corporation, it also applies to gain or loss on transfers to existing corporations if
the control test is met. Also, the law applies even though the transferors were in
control of the corporation before the transfer. That is, control need not be
acquired coincidentally with the transfer.
Transfer to Controlled Corporation: General rule
No gain or loss is recognized if one or more persons transfer property to a
corporation, other than an investment company, solely in exchange for its stock
if, immediately after the transfer, those persons are in control of the corporation
(Code Sec. 351(a)).
Losses. The provisions of Code Sec. 351 are not elective. If the statutory
requirements are satisfied, neither loss nor gain will be recognized. In certain
circumstances, it may be beneficial to the taxpayer to avoid qualification under
Code Sec. 351 in order to recognize a loss on the transferred property, obtain a
basis step-up in the transferred property or utilize loss carryovers (see
¶16,405.042).
The term persons includes individuals, partnerships, associations, companies,
corporations, estates and trusts (Reg. §1.351-1(a) and Reg. §301.7701-1(a)).
Property transferred to a controlled corporation generally includes all property,
tangible or intangible, with certain limitations, see ¶16,405.023. Services
rendered to the issuing corporation are not considered property, see
¶16,405.0234.
The general rule of Code Sec. 351 does not apply to transfers to an investment
company which result in diversification of the transferor's interests (Reg. §1.3511(c)(1), see ¶16,405.035).
Although the language of Code Sec. 351 states that property must be transferred
solely in exchange for stock, other consideration may be received without
destroying the essential tax-free nature of the transaction. If the transferor
stockholder receives other property or cash (boot), the gain is recognized (but
not the loss). Such gain is recognized, however, only to the extent of an amount
not in excess of the cash or the fair market value of the other property received
(see ¶16,405.05).
The stock of which the transferor must own 80% immediately after the exchange
means the issued and not the authorized stock (see ¶16,405.043).
The phrase immediately after the transfer does not require the simultaneous
exchange by two or more persons but that the prearranged exchange occurs in
an expeditious and orderly manner (Reg. §1.351-1(a)(1), see ¶16,405.041).
The term control is defined as the ownership of stock possessing at least 80% of
the total combined voting power of all classes of stock entitled to vote and at
least 80% of the total number of shares of all other classes of stock (Sec. 368(c),
see ¶16,405.04).
If property is transferred to a controlled corporation in an exchange upon which
gain is not recognized either partially or wholly and such exchange is not under a
plan of reorganization, then any transfer in such exchange by the controlled
corporation is generally subject to the Code Sec. 311 nonrecognition rule on
corporate distributions (see ¶16,405.045).
Business purpose. Although there is no specific statutory requirement, the IRS
requires a transfer to a controlled corporation to have a business purpose in
order for it to qualify as an exchange under Code Sec. 351 (see ¶16,405.044).
Exempt organizations are eligible to make Code Sec. 351 contributions to
subsidiaries (IRS Letter Ruling 9641008, at ¶16,405.335).
Generally, foreign corporations are not considered corporations for purposes of
determining the extent to which gain is recognized on the transfer of property by
a U.S. person to a foreign controlled corporation. For details, see ¶16,667.01 et
seq.
Requests for rulings. The IRS has issued a checklist questionnaire which
describes the information that must be included in requests for advance rulings
under Code Sec. 351 (see ¶16,405.48).
Transfer to Controlled Corporation: Property
Although there is no statutory definition of "property" for purposes of Code Sec.
351 exchanges, the term generally encompasses any tangible or intangible asset
that may be transferred. This includes: property (Haliburton, Dec. No. 9444-P, at
¶16,405.46); accounts receivable (Hempt Bros. Inc., 74-1 USTC ¶9188, at
¶16,612.12); stock or securities of another domestic corporation (Rev. Rul. 74502, at ¶16,405.61), or foreign corporation (Rev. Rul. 75-143, at ¶16,405.77);
inventory (IRS Letter Ruling 9731002, at ¶16,405.365, also see, Las Cruces Oil
Co., Inc., Dec. 32,758, at ¶16,612.295); installment obligations (see ¶16,612.28);
partnership interests (Rev. Rul. 81-38, ¶25,202.358); carved-out oil payment
(H.B. Zachary Co., Dec. 28,657, at ¶16,405.46); and certain patent (see
¶16,405.44) and "know-how" agreements (see ¶16,405.39).
With respect to intangibles, it may be necessary for all substantial rights to the
intangibles to be transferred (Dupont de Nemours & Co., 73-1 USTC ¶9183, at
¶16,405.44). The IRS has taken the position that the transfer of a nonexclusive
right to use a trade name is the transfer of a mere license and not Code Sec. 351
property (IRS Letter Ruling 9421014, at ¶16,405.39).
Stock issued for services (see ¶16,405.0234), indebtedness of the transferee
corporation not represented by a security, or interest on indebtedness of the
transferee corporation accruing on or after the transferor's holding period for the
debt will not be considered issued in return for property (Code Sec. 351(d)).
Transfer to Controlled Corporation: Accounts receivable and payable
A corporation could not deduct accounts payable of a cash-basis shareholder
received in an exchange as a business expense at the time the corporation pays
them (on the theory that they were not incurred in its trade or business or that the
assumption of liabilities represented a cost of acquiring the business). Moreover,
the transferor could not deduct them because he had not paid them. (See
Holdcroft Transportation Co., 46-1 USTC ¶9193, at ¶13,709.107; Merchants
Bank Building Co., 36-2 USTC ¶9378, at ¶9502.64; Stone Motor Co., Dec.
21,875(M), at ¶9502.64; and I.E. Doggett, Dec. 23,177(M), at ¶8520.138.)
However, the IRS has allowed corporations to deduct transferred accounts
payable in cases in which accounts receivable have also been assigned to the
corporation and in which the corporation agrees to report the collection of these
receivables as income. (See Hempt Bros. Inc. 74-1 USTC ¶9188, at ¶16,612.12;
Rev. Rul. 80-198, at ¶16,405.52; and Wham Construction Co., Inc., 79-2 USTC
¶9471, at ¶16,405.72.)
Transfer to Controlled Corporation: Assumption of liabilities
The assumption of liabilities by the issuing corporation is not to be regarded as
the receipt of cash or other property and generally has no effect on the
nonrecognition of gain or loss. For example, a vacation pay liability assumed in a
Code Sec. 351 exchange that would have been deductible by the transferring
corporation is deductible in the tax year in which the transaction occurred. An
amount received for the assumption of other liabilities was part of the overall
property received in exchange for the stock and was not includible in income in
the year of the transfer (IRS Letter Ruling 9716001, at ¶16,405.41).
However, if the liabilities assumed, or to which property transferred is subject,
exceed the transferor's basis in the property, then, to the extent of the excess,
the assumption is a gain from the sale or exchange of a capital asset (depending
on the type of asset that was transferred) (Code Sec. 357(c)(1)). The amount of
such assumed or "subject to" liabilities occurring in a transfer to a controlled
corporation does not include liabilities the payment of which would give rise to a
deduction or liabilities the payment with respect to which would be described in
Code Sec. 736(a) (relating to payments to retiring partners or the successor in
interest of a deceased partner) (Code Sec. 357(c)(3); see ¶16,522.04 and
¶16,522.05).
For cases dealing with the question of whether a payment is a dividend or a
capital gain under Code Sec. 351(b), see the annotations following ¶15,704.075.
Transfer to Controlled Corporation: Services
Services performed or to be performed for the issuing corporation will not be
treated as property (Reg. §1.351-1(a)(i)). However, if a person performs services
and also contributes property, all of the stock issued to him will be considered in
determining whether he is in control of the issuing corporation (Reg. §1.3511(a)(2), Example (3)).
Example 1: Ten shares of CHIB Corp. stock are outstanding. In exchange
for 40 shares of stock, valued at $20,000, Mike, a nonshareholder, performs
services for CHIB Corp. and also contributes to CHIB Corp. property with a
fair market value of $11,000 and a $1,000 adjusted basis. Since immediately
after the transaction Mike owns 80% of the outstanding stock of CHIB Corp.
no gain is recognized for the exchange of property for stock. However, Mike
realizes $9,000 of ordinary income as compensation for providing services.
Transfer to Controlled Corporation: Exchange
When the transfer is made by two or more persons, the interests of all the
transferors are aggregated in determining control of the issuing corporation.
There need be no prior association between the transferors and it does not
matter that the amount of stock received by each person is in substantially the
same proportion as the individual's interest in the property before such transfer.
However, if certain members of a transferring group own no stock in the
corporation and receive nothing other than securities in exchange for the
property transferred by them, they are not eligible for nonrecognition. This is
because control is defined in terms of stock ownership, and transferors without a
stock interest cannot be considered members of the control group (Reg. §1.3511(b)(1)).
The purchase of stock for cash at the same time that others transfer other
property for stock and as part of the same plan does not of itself defeat the
statutory control requirement. The transferor of the cash is included with the
other transferors in determining whether all of the transferors are in control of the
corporation immediately after the transaction (Rev. Rul. 69-357, at ¶16,405.46).
In order to qualify a transaction for Code Sec. 351 nonrecognition treatment, it
may be necessary to include an existing shareholder in the transferor group.
However, stock issued for a relatively small value in comparison to the amount of
stock already owned by an existing shareholder will not be treated as being
issued for property if the primary purpose of the transfer is to qualify for
nonrecognition treatment (Reg. §1.351-1(a)(2), Example (2)). For advance ruling
purposes the IRS has established that contributions of at least 10 percent of the
value of the stock already owned by a shareholder will not be considered
relatively small value (Rev. Proc. 77-37, at ¶16,405.46). Therefore, if an existing
shareholder owns stock with a fair market value of $100,000, he would need to
contribute property with a fair market value of at least $10,000 in order to be
considered part of the transferor group under Rev. Proc. 77-37.
Proposed regulations require that there is an exchange of net value, that is, a
surrender of net value and a receipt of net value, in the case of a Code Sec. 351
transaction. In particular, the proposed rules provide that stock will not be treated
as issued for property if either:
(1) the fair market value of the transferred property does not exceed the sum
of the amount of liabilities assumed by the corporation in connection with
the transfer, the amount of money and the fair market value of any other
propertt received by the transferor in the exchange; or
(2) the fair market value of the assets of the corporation does not exceed the
amount of its liabilities immediately after the transfer (Proposed Reg.
§1.351-1(a)(1)(iii)).
Underwriters. The fact that stock is purchased from an underwriter, and not
directly from a corporation, is disregarded for purposes of Code Sec. 351;
provided that the underwriter is an agent of the corporation or the underwriter's
ownership in the stock is transitory.
Transfer to Controlled Corporation: Definition of control
The word "control" is defined by Code Sec. 368(c) to mean 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. Non-issued but authorized stock is obviously
disregarded since it can give no control and is not existing stock (American
Bantam Car Co., 49-2 USTC ¶9471, at ¶16,405.56). Under this definition, stock
is divided into two classes: voting stock and nonvoting stock. Stock that was
received in a reorganization subject to an irrevocable right to vote for a five year
period was not voting stock (Rev. Rul. 72-72, at ¶16,753.375). See ¶16,405.043
for a discussion of stock for these purposes.
If transferors receive all the common stock of a newly formed corporation in
exchange for transfer of property to such corporation, but do not also acquire
ownership of 80% of its preferred stock, the requisite control is lacking.
The IRS has taken the position that ownership of 80 percent of each class of
outstanding nonvoting stock is required to meet the definition of control (Rev.
Rul. 59-259, at ¶16,753.365). Accordingly, ownership of 83 percent of voting
common stock, 83 percent of nonvoting common stock and 75 percent of
nonvoting preferred stock would not constitute control, even though 80 percent of
all outstanding nonvoting shares were owned.
In determining control, the fact that any corporate transferor distributes part or all
of the stock which it receives in the exchange to its shareholders is not taken into
account (Code Sec. 351(c)). However, under rules introduced by the Taxpayer
Relief Act of 1997 (P.L. 105-34), as part of the so-called repeal of Morris Trust
(see ¶16,466.0497), the definition of control is changed in a Code Sec. 355
distribution.
If the requirements of Code Sec. 355 are satisfied with respect to a distribution to
a shareholder, the shareholders are treated as in control of the corporation
immediately after the exchange if the shareholders own (immediately after the
distribution) stock possessing:
(1) more than 50 percent of the total combined voting power of all classes of
stock of such corporation entitled to vote, and
(2) more than 50 percent of the total value of shares of all classes of stock of
such corporation (Code Sec. 351(c)).
For certain divisive transactions that otherwise satisfy the Code Sec. 355
requirements, a technical correction clarifies the "control immediately after"
requirement of Code Sec. 351(c) for purposes of determining whether there has
been an acquisition of a 50-percent or greater interest in a corporation. In a
transaction in which a corporation contributes assets to a controlled corporation
and then distributes the stock of the controlled corporation, the fact that the
controlled corporation issues additional stock is not taken into account (Code
Sec. 351(c)(2)).
The constructive attribution rules of Code Sec. 318 are not applicable to Code
Sec. 351 (Code Secs. 318(a) and 368(c); also see ¶15,906.01). However, the
consolidated regulations require, for purposes of Code Sec. 351, that in the
determination of the stock ownership of any member of the affiliated group in
another corporation (the issuing corporation), stock owned by all members of the
group shall be considered (Reg. §1.1502-34). Therefore, if three members of an
affiliated group each own one third of the stock of the issuing corporation then for
purposes of Code Sec. 351 each of the three group members is considered in
control of the issuing corporation.
Transfer to Controlled Corporation: Immediately after the exchange
Among the conditions of Code Sec. 351 is the requirement that control be lodged
in the transferors immediately after the exchange. A question may arise as to
whether transferors have control when a series of transactions occurs which
ultimately result in control passing out of the hands of the original transferors. In
this case, is the control requirement met if the transferors have control
immediately after any given step in the overall transaction, or only if they have
control after all of the steps are complete and the dust has settled? Similarly, a
group of transferors who separately transfer property to a corporation pursuant to
a plan may wonder whether they have met the control requirement even though,
if viewed separately, the individual transfers do not satisfy the control
requirement. Each of these situations raises questions about whether a series of
transactions should be evaluated by the results produced by the overall
preconceived plan, or whether each step in the overall transaction should be
treated as separate and distinct.
Multiple transferors meeting the control requirement. The regulations indicate
that it is not necessary for multiple transferors to make simultaneous exchanges
in order for control to be vested "immediately after the exchange" (Reg. §1.3511(a)(1)). This means that several transferors in an integrated transaction can
combine their post-transfer holdings in order to meet the 80 percent control
requirement.
Subsequent transfers to an unrelated party --step transaction doctrine.The step
transaction generally means that steps in a transaction will not be considered
independently if they are part of a prearranged plan. As applied by the courts, the
step transaction has meant that momentary control of a corporation may not be
sufficient to meet the control requirement if the transferor entered the transaction
with the intention of handing off the stock as soon as it was obtained. Even
though there is literal compliance with Code Sec. 351, it does not necessarily
follow that the nonrecognition principles of that section will apply in this situation.
The step transaction doctrine has been used to deny nonrecognition where the
transferor lacks control soon after a transaction takes place as a result of a
binding agreement to sell or give the stock to a third party. In cases where a prearranged contract requires the transferor to sell a significant portion of stock of
the transferee corporation, the IRS and courts have found (for the most part) that
the Code Sec. 351 control requirement is not met. For example, control did not
exist when a prearranged binding contract required the transferor to later sell 40
percent of the stock of the transferee corporation (Rev. Rul. 79-70, at
¶16,405.31). The Tax Court reached a similar conclusion where an incorporator
irrevocably agreed to transfer 50 percent of the stock he received in exchange for
his transfer to an unrelated third party (Intermountain Lumber Co. and
Subsidiaries, 65 TC 1025, Dec. 33,670, annotated at ¶16,405.56). In many of the
sources annotated at ¶16,405.56, even though the transfer step of the
transaction appeared to literally comply with the statute, when all of the steps
were viewed as integral parts of a larger transaction it was found to no longer fit
within requirements of Code Sec. 351.
Multiple transferors combined with subsequent transfers of stock. Many
transactions do not fit neatly into either the multiple-transferor pattern (allowed)
or the transfer-and-sell pattern (disallowed). For example, multiple transferors
might agree to combine their stock in a newly formed business entity. The IRS
has issued multiple rulings based on variations of these facts. The rulings
attempt to justify Code Sec. 351 nonrecognition for transactions in which the
parties are incorporating an ongoing business, where the business is changing
form but there is no "cash in" by an owner. Transactions in which the transfer is
followed by a nontaxable disposition of the stock received (for example, in a
liquidating distribution to partners) are also likely to be approved as not
inconsistent with the purposes of Code Sec. 351. The following examples
describe transactions that have been specifically addressed by the IRS.
Example 2: Corporation A owns several different businesses: 6 lobby
newsstands, 3 downtown popcorn shops, and 4 florists. B, an unrelated
corporation, operates 4 florists through its wholly owned subsidiary, B1. A
and B decide to combine their florist operations within a new separate
holding company structure (a new subsidiary of B1). In order to do this, A
and B agree to execute a series of transactions. First, A forms an entirely
new corporation, C, by transferring all of its florist business assets to C in
exchange for C stock. Following this step, A then transfers all of its C stock
to B1 in exchange for B1 stock (the second transfer). B also contributes $3
million to B1 to meet the capital needs of the newly enlarged florist business
(the third transfer). As a fourth and final step, B1 transfers the $3 million plus
the florist assets to C, the new corporation formed for the purpose of
operating the florist business. The first transfer to corporation C satisfies the
control requirements of Code Sec. 351 even though A is under a binding
agreement to immediately transfer its C stock to B1 (see Rev. Rul. 2003-51,
annotated at ¶16,405.31).
Example 3: A partnership transfers all of its assets to a newly formed
corporation in exchange for all of the outstanding stock of the corporation.
The partnership then terminates by distributing all of the stock to its partners
in proportion to their interests. The partnership transfer to the corporation
qualifies under Code Sec. 351 despite the subsequent distribution of the
stock to the partners (Rev. Rul. 84-111, annotated at ¶16,405.43).
Example 4: Corporation A owns all of the stock of a subsidiary, A1. A
transfers assets to A1 solely in exchange for A1 stock. As part of the same
plan, A1 transfers the contributed assets to A2, a newly formed corporation
which is 80% owned by A1. Each transfer in this fact pattern (A to A1, and
A1 to A2) satisfies the requirements of Code Sec. 351 (Rev. Rul. 83-34,
annotated at ¶16,405.56).
Example 5: An individual, I, owns all of the stock of corporation A and also
operates a similar business through a sole proprietorship. Pursuant to an
agreement with B, an unrelated corporation, I transfers all of the sole
proprietorship assets to A in exchange for additional A stock. I then transfers
all of his A stock to B in exchange for B stock. In this fact pattern I's transfer
to A is transitory and does not qualify under Code Sec. 351 (Rev. Rul. 70140, annotated at ¶16,405.31).
See also ¶16,753.044 for a discussion of the step transaction doctrine.
Transfer to Controlled Corporation: Making property transfers taxable
The taxpayer may attempt to structure an exchange as a taxable sale and avoid
the application of Code Sec. 351 in order to recognize losses, obtain a basis
step-up, utilize capital loss carryforwards or other reasons. In Gunby, Inc. (41-2
USTC ¶9550, at ¶16,612.20), the taxpayer received a check in exchange for
property purportedly sold to a newly formed corporation, and, simultaneously,
gave his check to the corporation in exchange for the corporation's preferred
stock. Since the two checks virtually canceled out each other, the sale of
property was ignored and recast as a contribution of property for stock. Because
the taxpayer was in control of the corporation after the transfer, Code Sec. 351
was applied to make the transaction nontaxable (see also Kuldell, 38-2 USTC
¶9404, and Aqualane Shores, Inc., 59-2 USTC ¶9632, both at ¶16,405.49).
Attempts to avoid technically meeting the 80 percent control requirement have
also been ignored when transferors actually controlled the transferee corporation
(see Dunn, at ¶16,405.31, in which stock placed in trust was ignored). (Note also
that deduction of losses in transactions between a shareholder and a more than
50 percent controlled corporation may be disallowed under Code Sec. 267. See
¶14,161.01)
Transfer to Controlled Corporation: Stock
The stock of which the transferor must own 80 percent immediately after the
exchange is not specifically defined in Code Sec. 351 or the regulations.
However, Code Sec. 351(d) does provide that stock issued for services,
indebtedness of the transferee corporation not represented by a security, or
interest on indebtedness of the transferee corporation accruing on or after the
transferor's holding period for the debt will not be considered issued in return for
property. Stock rights and stock warrants are not included in the term stock (Reg.
§1.351-1(a)). For advance ruling purposes, the IRS has established a safe
harbor under which stock that is not immediately issued, contingent stock rights,
and stock placed in escrow will be considered stock for purposes of Code Sec.
351 (Rev. Proc. 77-37, at ¶15,452.17).
When a shareholder transfers property to a wholly-owned corporation, it is not
necessary that stock actually be issued since that would be a meaningless
gesture (S. Lessinger, 89-1 USTC ¶9254, at ¶16,405.33).
Securities. The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239)
deleted securities from the application of Code Sec. 351 so that only stock could
be received tax-free in exchange for property. Thus, the distinction between
stock and securities is critical in determining the tax consequences of a
transaction in which the transferor receives instruments having some of the
elements of stock and some elements of debt (for the meaning of securities see
¶16,433.036).
Generally, securities received in transfers to controlled corporations are treated
as boot. This treatment generally conforms the tax consequences of the receipt
of securities in such a transaction to the tax consequences accorded securities
received in a transaction qualifying as a tax-free reorganization. A transferor who
receives securities in a transfer to a controlled corporation does not continue an
investment in the transferred assets to the extent of the securities received.
Thus, the transaction is characterized as a taxable sale (to the extent of the
securities received) rather than as a tax-free exchange. Similarly, a transferor
that transfers appreciated property to a controlled corporation in exchange for
stock and a debt obligation of the corporation that is a security generally must
recognize gain (see ¶16,405.05).
Nonqualified preferred stock. Code Sec 351(g) addresses the effect of
nonqualified preferred stock on the general nonrecognition rule provided by Code
Sec 351(a). In general, nonqualified preferred stock (NQPS) includes preferred
stock which:
(1) provides the holder the right to redeem or purchase the stock,
(2) requires the issuer or a related person to redeem or purchase the stock,
(3) provides the issuer or a related person the right to redeem or purchase
the stock and it is more likely than not at the issue date that such right will
be exercised, or
(4) has a dividend rate that varies with reference to interest rates, commodity
prices, or similar indices (Code Sec. 351(g)(2)(A)).
There are several limitations and exceptions to the above definition (see Code
Sec. 351(g)(2)(B) and (C)). In general, however, nonqualified preferred stock
includes stock which can be viewed as more secure than the average share of
preferred stock.
For purposes of Code Sec. 351, preferred stock is stock that is limited and
preferred as to dividends and does not participate in the corporate growth to any
significant extent. Stock is not to be treated as participating in the corporate
growth to any significant extent unless there is a real and meaningful likelihood of
the shareholder actually participating in the earnings and growth of the
corporation. In addition, if there is not a real and meaningful likelihood that
dividends beyond any limitation or preference will actually be paid, the possibility
of such payments will be disregarded in determining whether stock is limited and
preferred as to dividends (Code Sec. 351(g)(3)(A), as amended by the Gulf
Opportunity Zone Act of 2005 (P.L. 109-135)).
The "real and meaningful likelihood" requirement for purposes of determining
whether stock participates in the corporate growth to any significant extent was
added by the American Jobs Creation Act of 2004 (P.L. 108-357), effective for
transactions after May 14, 2003, to thwart possible attempts by some taxpayers
to avoid characterization of an instrument as NQPS by including illusory
participation rights or including terms that the taxpayers could argue create an
"unlimited" dividend. According to the Senate Committee Report to P.L. 108-357
(at ¶16,402.056), no inference is intended with respect to the present law
treatment (that is, prior to October 22, 2004, the effective date of P.L. 108-357) of
stock that has stated unlimited dividends or participation rights but, based on all
the facts and circumstances, is limited and preferred as to dividends, and does
not participate in corporate growth to any significant extent (S. Rep. No. 108192). P.L. 109-135 later clarified that the "real and meaningful likelihood"
requirement also applies for purposes of determining whether stock is not stock
that is limited and preferred as to dividends. The clarifications added by both P.L.
108-357 and P.L. 109-135 apply to transactions after May 14, 2003.
For the most part, NQPS will be considered to be stock for the purposes of the
"solely in exchange for stock" requirement of Code Sec 351(a), unless and until
regulations provide otherwise (Conference Committee Report to the Taxpayer
Relief Act of 1997 (P.L. 105-34)). Therefore, a transfer will qualify for
nonrecognition even if both common stock and NQPS are issued in exchange for
property. Although gain will be recognized to the extent of the fair market value of
the NQPS received (Code Sec. 351(b)), the nonrecognition rules will still be
applicable to the extent of the common stock transferred, i.e. the inclusion of the
NQPS in the exchange will not preclude nonrecognition treatment (Code Sec.
351(g)(1)).
If, however, solely NQPS is received in exchange for property, the
nonrecognition provisions of Code Sec 351(a) will not apply (Code Sec.
351(g)(1)(B)) and gain or loss may be recognized.
While an overall transaction may qualify for Code Sec 351(a) nonrecognition
because the aggregate transferors transfer both common and NQPS, a particular
transferor in the same transaction may receive solely NQPS. In this case, the
particular transferor would recognize any loss under Code Sec. 1001, and the
basis of the NQPS and of the property in the hands of the transferee corporation
would be determined as if that particular transferor had received solely "other
property" (Senate Committee Report, IRS Restructuring and Reform Act of 1998
(P.L. 105-206)).
Example 6: Honus Wagner and Pie Traynor each own 50% of Pyrate
Corporation. In a contribution otherwise qualifying under Code Sec. 351,
Wagner contributes property with a basis of $100,000 to Pyrate for preferred
stock and Traynor contributes property for common stock. The preferred
stock is considered nonqualified preferred stock and is valued at $80,000.
Wagner recognizes a loss of $20,000 ($80,000, value of other property
received, less $100,000, basis). Since the nonqualified preferred stock is
treated as stock for purposes of qualifying for nonrecognition under Code
Secs. 351(a) and 368(c), the contribution qualifies as a Code Sec. 351
contribution. Therefore, Traynor does not recognize gain or loss for his
contribution. [NOTE: Other Code provisions may still disallow or defer
recognition of a loss. For example, losses in transactions between
corporations and controlling shareholders can be disallowed under Code
Sec. 267].
In addition, for purposes of determining whether the transferors in an otherwise
qualifying transfer are "in control of the corporation" pursuant to Code Sec.
351(a), the stock ownership of an individual who transfers property and only
receives NQPS would, presumably, be considered in determining whether the
persons making the transfer are in control.
Stock described as nonqualified preferred stock in Code Sec. 351(g)(2) will be
considered NQPS regardless of the date on which it was issued. However, Code
Sec. 351(g) does not apply to transactions occurring prior to June 9, 1997. Nor
does it apply to transactions after that date that are (1) subject to a written
agreement binding on June 8, 1997, and at all times thereafter, (2) described in a
ruling request submitted to the IRS on or before that date, or (3) described in a
public announcement or a Securities and Exchange Commission filing on or
before that date. See Reg. §1.351-2(e), referring to Reg. §1.356-7.
Transfer to Controlled Corporation: Business purpose
Even though neither Code Sec. 351, nor the regulations thereunder, specify a
business purpose requirement, the IRS requires a transfer to a controlled
corporation to have a business purpose in order for it to qualify as an exchange
under Code Sec. 351 (Rev. Proc. 83-59, Sec. 4.06, at ¶16,405.48). The IRS's
position is ultimately based on certain portions of the reorganization regulations
under Code Sec. 368. In this regard, the IRS deems the provisions (Reg. §1.3681(b), Reg. §1.368-1(c) and Reg. §1.368-2(g)) equally applicable in determining
whether a transaction qualifies as a tax-free transaction under Code Sec. 351
(see Rev. Rul. 55-36 and IRS Letter Ruling 8045001, at ¶16,405.26). One court
has expressly stated that the Code Sec. 368 reorganization business purpose
rules also apply to Code Sec. 351 transactions (Caruth Corp., 88-2 USTC ¶9514,
at ¶16,405.26). The business-purpose requirement under Code Sec. 368 is
discussed at ¶16,753.046.
Transfer to Controlled Corporation: Receipt of Property: Money or other
property received
Generally, the tax-free organization of a business will not be wholly negated if the
transferor owners receive additional property along with their stock when they
transfer property to the corporation. However, the owners are taxed on any
additional property received ("boot"). Thus, gain will be recognized, but only to
the extent of the cash plus fair market value of the other property received. Of
course, no loss will be recognized on the transfer (Code Sec. 351(b); Reg.
§1.351-2(a)).
Example 7: A stockholder transferred merchandise (which cost him
$40,000) to a corporation for 1,000 shares of common stock (worth $45,000)
and $5,000 cash. Immediately after the exchange he owned 8,000 shares
out of a total issued common stock of 10,000 shares, and all of the
corporation's preferred stock. He was in "control" of the corporation
immediately after the exchange. The transaction qualifies as a tax-free
transfer even though "boot" ($5,000) is received. Thus, of the $10,000 gain
realized on the exchange $50,000 ($5,000 cash plus $45,000 stock) minus
$40,000 merchandise, only $5,000 is recognized.
Securities received in a Code Sec. 351 transfer are treated as boot (see
¶16,433.036 for a discussion of securities). "Nonqualified preferred stock" is
treated as boot for purposes of a Code Sec. 351 transfer (Code Sec 351(g)). For
a complete discussion of nonqualified preferred stock, see ¶16,433.037.
Whether the portion of gain recognized as "boot" is taxed as ordinary income or
capital gain depends on the character of the property transferred to the
corporation. But for certain property transfers, the law dictates ordinary income
treatment even though a depreciable asset is transferred (Code Sec. 1239,
¶30,733.025), while in others, gain (ordinary income) will be recognized
regardless of the character of the property transferred (see Code Secs.
617(d)(1), 1245 and 1250).
Transfer to Controlled Corporation: Receipt of Property: Multiple asset
transfers
Suppose several assets are transferred to a corporation in a Code Sec. 351
transaction in which "boot" is also received. In determining the amount of gain
recognized under Code Sec. 351(b), each asset transferred must be considered
separately (Rev. Rul. 68-55, ¶16,405.76). The fair market value of the
consideration received must be separately allocated to the transferred assets in
proportion to the fair market values of the transferred assets. Moreover, the
bases and holding periods of the consideration received may not be determined
by designating specific property to be exchanged for particular stock (Rev. Rul.
85-164, ¶16,405.76.50). This means that where, as a result of such an allocation,
one of the transfers results in a loss, the separate allocation prevents recognition
of that loss.
Example 8: X transfers three assets to Y Corporation in exchange for Y stock
worth $100,000 and $10,000 cash. The transaction qualifies as a Sec. 351
transfer. The character of each asset, and its fair market value and adjusted
basis is as follows: (1) Asset A is a capital asset held for more than 12
months, with a fair market value of $22,000 and an adjusted basis of $40,000;
(2) Asset B is a capital asset held for less than 12 months with a fair market
value of $33,000 and an adjusted basis of $20,000; and (3) Asset C is Sec.
1245 property (¶30,909.021) with a fair market value of $55,000 and an
adjusted basis of $25,000.
The amount of gain X recognizes on the exchange would be computed, under
Rev. Rul. 68-55, in the following manner:
Fair market value of
asset transferred
Percent of total FMV
FMV of Y stock
received in exchange
Cash received in
Total
Asset A
Asset B
Asset C
$110,000
$22,000
20%
$33,000
30%
$55,000
50%
100,000
10,000
20,000
2,000
30,000
3,000
50,000
5,000
exchange
Amount realized
Adjusted basis
Gain (loss) realized
$110,000
$22,000
40,000
($18,000)
$33,000
20,000
$13,000
$55,000
25,000
$30,000
The $18,000 loss realized on the exchange of Asset A is not recognized
(Code Sec. 351(b)(2)). This loss cannot be used to offset the gains realized
on the other asset exchanges. The $13,000 gain on the exchange of Asset B
is recognized (as short-term capital gain), but only to the extent of the $3,000
cash received. And the $30,000 gain realized on the transfer of Sec. 1245
property will also be recognized (as ordinary income, assuming that
depreciation subject to recapture exceeds the amount of gain that would be
recognized on a sale of Asset C at fair market value), but only to the extent of
the $5,000 cash received.
Assumption of Liabilities
Except where the principal purpose is tax avoidance (¶16,522.021, below) or
where liabilities assumed by the transferee exceed the transferor's basis (see
¶16,522.04), assumption of liabilities (or taking property subject to them) does
not prevent the following transactions from being tax-free:
(1) transfers under Code Sec. 351 to a corporation controlled by the
transferor; or
(2) exchanges of property by a corporation in a reorganization under Code
Sec. 361 solely for stock or securities of another corporation a party to the
reorganization.
If a transaction would have been tax-free under one of the foregoing provisions
except for the receipt of "other property or money" (boot), liabilities assumed will
not be treated as "other property or money." Exchanges other than the classes
listed above are not affected by Code Sec. 357. In such other transactions, as,
for instance, an exchange of properties of like kind under Code Sec. 1031,
assumption of indebtedness would represent "other property or money," at least
to the extent that the indebtedness was paid by the transferee in the year of the
exchange.
Example 9: A partnership with assets which have a total cost basis of
$750,000, and a present value of $950,000, wishes to change to a corporate
form for sound business reasons. It has business liabilities of $250,000, and
a book net worth of $500,000. Assume that there are two equal partners.
The partnership may transfer its assets to the corporation for all the latter's
stock (amounting to $500,000 par value) and then distribute the stock
equally to the partners in dissolution, both steps being without recognition of
any gain, despite the corporation's assumption of liabilities. The
corporation's basis for the assets is the same as that of the partnership. Or
the partnership may first dissolve, without recognition of any gain or loss,
and the partners may distribute the assets thus received to the corporation
for its stock.
Assume, as an additional factor in the above example, that the partners owe
accrued federal income taxes, their sole income having been from (partly
undistributed) profits of the partnership. These taxes aggregate $100,000, and it
is contemplated that the new corporation will assume them, for the partners
would be unable to pay them except from the partnership assets or profits. The
additional assumption by the new corporation of the partners' accrued income tax
liabilities would not make the exchange taxable. The assumption actually makes
the exchange possible and protects against a tax lien on the transferred assets
due to the partners' possible income tax deficiencies, i.e., it permits and protects
a new business formed for sound business reasons. (See J.G. Stoll, Dec.
25,493, at ¶16,522.68, below, where a sole proprietor's estimated income tax
liability and other liabilities were refinanced and the new loan assumed by a
newly created controlled corpora tion which received all the assets and business
of the proprietorship in exchange for its stock and assumption of the liability.)
If the partnership itself makes the transfer to the corporation, the partnership
would first have to assume the liabilities, which in turn could be assumed by the
corporation. In most cases, dissolution of the partnership in kind would occur first
and be followed by transfer of the business assets to the corporation, which
would assume the business debts and the partners' related tax liabilities.
While an assumption of liabilities need not always be incident to the transfer of a
business in a tax-free exchange, it should be closely related to the taxpayer's
business or motivated primarily by business, not personal, considerations
(Campbell, Jr. v. Wheeler, 65-1 USTC ¶9294, at ¶16,522.68, below). However,
an assumption of a liability by a corporation in a tax-free exchange may have a
valid business purpose, even though the debt may have originally been incurred
for other than clearly business purposes (J.G. Stoll, Dec. 25,493, at ¶16,522.63).
The assumption of the partners' income tax liability in the example above, thus,
should be distinguished from a situation where the assumption is not motivated
primarily by business considerations. Take, for example, a partner who owns a
nine percent partnership interest and whose share of partnership distributions for
the year is insufficient to cover the income tax on his allocable share of the
partnership earnings for the year. Although his share of the partnership's
undistributed profits is sufficient to cover his current income tax liability, he
decides to borrow funds to pay his taxes, rather than suffer embarrassment by
seeking to withdraw his share of the undistributed profits. The partner obtains a
loan from a bank, assigning as security a three percent interest in the
partnership. He transfers the encumbered partnership interest to X corporation,
which he has created and controls, in exchange for all its capital stock and
assumption of his personal note to the bank. The assumption serving only a
personal purpose of one partner (without business purpose to the assuming
corporation), and not "following in the ordinary course from the conversion of one
business form to another," must be treated as boot by the taxpayer partner
(Campbell, Jr. v. Wheeler, 65-1 USTC ¶9294, at ¶16,522.68).
Assumption of Liability: Tax saving as purpose
If it appears that the principal purpose of the taxpayer, in the light of all the facts,
in arranging for assumption of liabilities rather than receipt of cash, for instance,
was the avoidance of income taxes, or if the purpose was not a bona fide
business purpose, the assumption of liabilities shall be considered as other
property or money, unless the taxpayer can prove to the contrary by a clear
preponderance of the evidence in any suit or proceeding where the burden of
proof is on the taxpayer.
If tax saving was the purpose of the assumption of the liability or acquisition of
property subject to the liability, the amount to be considered as money received
on the exchange is the total amount of the liability assumed or acquired, and not
merely a particular liability with respect to which the tax avoidance purpose
existed. Thus, the gain realized may exceed the amount of liability assumed. It is
not as clear, however, that recognition of gain on assumption of liability or
transfer of property subject to liability due to lack of a good faith business
purpose requires treatment of the total liabilities assumed or acquired as money
received.
Assumption of Liability: Liabilities exceeding basis
Gain is recognized by the corporate transferor to the extent that liabilities
assumed by the transferee in a transfer to a controlled corporation under Code
Sec. 351, or in a Code Sec. 368(a)(1)(D) divisive reorganization involving Code
Sec. 355 distribution, exceed the total of the adjusted basis, in the hands of the
transferor, of the properties transferred (Code Sec. 357(c)). The American Jobs
Creation Act of 2004 (P.L. 108-357) excluded from the application of Code Sec.
357(c) acquisitive "D" reorganizations that occur on or after October 22, 2004.
According to the Senate Committee Report to P.L. 108-357 (at ¶16,520.02), the
acquisitive "D" reorganizations have been excepted from this gain recognition
rule because, unlike the divisive "D" reorganizations, the former result in a
complete liquidation of the corporate transferor. Since the transferor's liabilities
are limited to its assets, which are transferred to the subsidiary corporation in the
transaction, and the transferor ceases to exist, the assumption of liabilities may
not enrich the transferor in any way. The new rule conforms the treatment of
acquisitive "D" reorganizations to that of other acquisitive reorganizations.
The IRS has also ruled that Code Sec. 357(c)(1) does not apply to a transaction
that qualifies as an "A", "C", acquisitive "D" or acquisitive "G" reorganization and
that is also subject to Code Sec. 351 (Rev. Rul. 2007-8, I.R.B. 2007-7, January
16, 2007, at ¶16,522.33). Consistent with that holding, Rev. Rul. 75-161, 1975-1
CB 114, and Rev. Rul. 76-188, 1976-1 CB 99, have been obsoleted, and Rev.
Rul. 78-330, 1978-2 CB 147 (at ¶16,522.37), has been modified to the extent it
holds that Code Sec. 357(c)(1) is applicable to a transaction that qualifies as an
"A" reorganization or an acquisitive "D" reorganization (Rev. Rul. 2007-8).
The gain to each transferor is the excess of the sum of the amount of his
liabilities assumed by the corporation over the adjusted basis of all property
transferred by him pursuant to the exchange, determined without regard to the
adjusted basis and liabilities of any other transferors (Rev. Rul. 66-142 at
¶16,522.49). This determination must be made separately as to each transferor.
The excess is considered as gain from the sale or exchange of a capital asset or
a noncapital asset, as the case may be, depending on the nature of the
encumbered property transferred. Thus, the regulations say, if half the assets
(measured by fair market value at the time of the transfer) transferred are capital
assets, then half of the excess of the amount of the liability over the total
adjusted basis of the property transferred will be capital gain, and the remainder
will be gain from the sale or exchange of assets other than capital assets.
Whether a transfer has occurred that triggers Code Sec. 357(c) is determined by
applicable state law (S. Lessinger, 89-1 USTC ¶9254, at ¶16,522.41). Thus gain
did not have to be recognized for a purported transfer of real estate from a
partnership to an S corporation that did not satisfy state law requirement that to
be effective a conveyance of real estate had to be in writing (F.D. Doe, 97-1
USTC ¶50,460, at ¶16,522.51).
Assumption of Liability: Liability defined
In the case of a Code Sec. 351 exchange in which liabilities are assumed by the
transferee in a transfer to a controlled corporation, certain liabilities may be
excluded from any gain recognized by the transferor (whether the transferor is on
the cash or accrual basis). Liabilities excluded are those the payment of which by
the transferor would give rise to a deduction (i.e., trade accounts payable and
other liabilities, such as interest and taxes, which relate to the transferred trade
or business) and those the payment with respect to which would be described in
Code Sec. 736(a) (i.e., distributive share or guaranteed payment to a retiring
partner or a deceased partner's successor in interest) (Code Sec. 357(c)(3)).
The assumption of contingent environmental liabilities are not considered
assumed liabilities for purposes of Code Sec. 357 (Rev. Rul. 95-74, at
¶16,522.31).
It should be noted that the definition of the term "liabilities" for Code Sec. 357(a)
and (b) is not affected by the special excluded liability rule in Code Sec.
357(c)(3), which applies for purposes of determining liabilities in excess of basis
under Code Sec. 357(c)(1).
A liability would not be excluded under this provision if:
(a) it has already been deducted by the transferor, or
(b) if the incurrence of the liability resulted in the creation of, or increase in,
the basis of any property.
An example of (b), above, is where a cash-basis taxpayer purchases small tools
on credit and, before paying for the tools, transfers them along with the related
obligation to a new corporation in a Code Sec. 351 transaction. While the
transferor would have been entitled to a deduction if he paid the obligation,
pending payment he would have a basis in the tools equal to the amount of the
unpaid obligation. Such obligation would constitute a liability for purposes of
Code Sec. 357(c), but the amount of such liability would be offset by the basis in
the transferred tools (Senate Committee Report to P.L. 95-600).
The amount of excluded liabilities under Code Sec. 357(c)(3) does not reduce
the transferor's basis in stock received in the Code Sec. 351 exchange (Code
Sec. 358(d)(2)). Such excluded liabilities are not treated as liabilities assumed or
to which property is subject for purposes of Code Sec. 358(d).
The law essentially codifies the position taken by the Tax Court in D.D. Focht,
Dec. 34,421, at ¶16,522.91, which overruled the court's previous position that the
term "liabilities" has an all-inclusive meaning. In that case, the Tax Court said
that the deductible obligations of a cash-basis transferor were not the kind of
liabilities that Congress intended to be taken into account in determining whether
gain should be recognized under Code Sec. 357(c). To a large extent, the Tax
Court based its decision on the Supreme Court's landmark decision in Crane (471 USTC ¶9217, ¶29,313.60), which involved a transfer of real estate subject to a
mortgage on which interest was in arrears. While the transferor was required to
include the mortgage in the amount realized even though the transferee did not
assume personal liability for it, the Supreme Court recognized that the interest (a
deductible item) should not be included in the amount realized.
The definition of "transferred subject to a liability" has had different
interpretations. In S. Lessinger (89-1 USTC ¶9254, at ¶16,522.41), the language
of Code Sec. 357(c) was construed to avoid imposing gain recognition on the
taxpayer who contributed his own genuine promissory note in the amount of the
excess of the transferred liabilities over the basis of the transferred assets. A
number of other cases have applied Code Sec. 357(c) suggesting that it is not
necessary to consider whether, as a practical matter, the transferor has been
relieved of the transferred liability (D. Rosen, 62 TC 11, Dec. 32,530; W.F. Owen,
Jr., CA-9, 89-2 USTC ¶9476). Regulations indicate that the amount of the liability
is included in the calculation whether or not the underlying liability is assumed by
the controlled corporation (Reg. §1.357-2(a)).
The basis of the property in the hands of the controlled corporation equals the
transferor's basis in such property, increased by the amount of gain recognized
by the transferor, including Code Sec. 357(c) gain.
Definition of "subject to a liability" clarified. For certain transfers of property after
October 18, 1998, Code Sec. 357(d)(1) applies a facts-and-circumstances test to
determine the extent to which any liability, including a nonrecourse liability, is
treated as assumed (Code Sec. 357(d)(1)(A)).
Thus, for example, a transferee would not be treated as assuming a liability if the
transferor indemnifies the transferee against the possibility of foreclosure.
Similarly, the fact that a lender retains a security interest in property securing a
recourse liability would not cause the transferee to be treated as assuming the
liability if the transferor remains solely liable on the debt without a right of
contribution against the transferee.
This provision may render moot the controversy following Peracchi (D.J.
Peracchi, CA-9, 98-1 USTC ¶50,374, 153 F3d 487), regarding whether a
transferor can have basis in his own promissory note issued for the purpose of
avoiding gain under Code Sec. 357(c).
Generally, if nonrecourse debt is secured by more than one asset, and any
assets securing the debt are transferred subject to the debt without any
indemnity agreements, then for all purposes the transferee is treated as
assuming an allocable portion of the liability based upon the relative fair market
values of the assets securing the liability. This allocation is determined without
regard to Code Sec. 7701(g), which treats the fair market value of an asset, in
determining such gain or loss, as not being less than the amount of nonrecourse
debt to which the property is subject (Code Sec. 357(d)(2)).
Example 10: D.B. Marks borrows $8,000 on a non-recourse basis, secured
by two assets of equal value. Marks transfers one asset with a basis of
$3,000 and a fair market value of $6,000 to XYZ Corporation. Marks would
recognize $1,000 of gain on the transfer because $4,000, the allocable
portion of the debt (i.e., one half of $8,000) exceeds basis of $3,000 by
$1,000. XYZ would hold the asset at a basis of $4,000 ($3,000, the basis in
the hands of the transferor, plus the recognized gain of $1,000 (see Code
Sec. 362(a)).
Example 11: Assume the same facts as in Example 10, except the $8,000
debt was borrowed on a recourse basis, Marks remains personally liable
after the transfer and Marks indemnifies XYZ against the possibility of
foreclosure. In this case, XYZ is not be treated as assuming a liability and
Marks does not recognize gain on the transfer.
Under prior law, it could have been argued that if property which is crosscollateralized with other assets is transferred, then each of those assets is
"subject to" the entire amount of the liability, even where the transferor has not
been relieved of the liability.
The rules of Code Sec. 357(d) apply to determine the amount of liabilities
assumed for purposes of the Code Sec. 361(b)(3) limitation on tax-free transfers
to creditors in divisive "D" reorganizations (Code Sec. 357(d)(1), as amended by
the Gulf Opportunity Zone Act of 2005 (P.L. 109-135); see ¶16,582.01 for a
discussion of the limitation rule).
Basis of Property or of Stock or Securities Received in Tax-Free Exchanges
or Distributions: Synopsis - basis of property received in tax-free
exchanges or distributions
In general, if permitted property is received in a "tax-free" exchange --one in
which no gain or loss is recognized for tax purposes --the basis of such permitted
property will be the same as the adjusted basis of the property transferred, as of
the time of the exchange. The tax-free exchanges to which this "substituted
basis" rule applies include:
(1) a Code Sec. 351 exchange of property solely for stock of a "controlled"
corporation (see ¶16,405.01 et seq.);
(2) a Code Sec. 354 exchange of stock or securities solely for stock or
securities in a reorganization (see ¶16,433.01 et seq.);
(3) a Code Sec. 356 exchange of stock or securities for stock or securities
and other property (i.e., boot) in a reorganization (see ¶16,493.01 et seq.);
(4) a Code Sec. 361 exchange of property by one corporation for stock or
securities of another corporation that is a party to the reorganization (see
¶16,582.01 et seq.); and
(5) an exchange of stock and/or securities for stock or securities in a Code
Sec. 355 distribution, or a Code Sec. 355 distribution where no exchange
occurs because the distributee retains his old stock and securities (see
¶16,466.01 et seq.).
Permitted property includes stock or securities that are allowed to be received
without recognition of gain or loss in the exchange under Code Secs. 351, 354,
355, 356 or 361.
If only stock and securities are received in exchange for stock and securities
under Code Sec. 354 or 355, then the sum of the basis of the new stock and
securities received in the exchange plus the basis of any old stock and securities
retained in the exchange will equal the aggregate basis of the old stock and
secuirities held immediately before the exchange. If no stock is surrendered in a
Code Sec. 355 distribution of a controlled corportation stock, the aggregate basis
of the old and the new stock after the transaction will equal the basis of the old
stock. In the case of a Code Sec. 351 or 361 exchange, the basis of the received
stock and securities will be the same as the basis of all properties transferred in
the exchange (Reg. §1.358-1(a)). In any of these cases, the basis so determined
must be allocated among the new stock and securities received the exchange, or
among the new stock received and the old stock retained in the exchange (see
¶16,553.033).
The substituted basis of the nonrecognition property received in the exchange is
subject to adjustments if money or other property (i.e., boot) is also received in
the exchange (see ¶16,553.021). Where a liability of the taxpayer is assumed by
another party to the reorganization the amount of the liability is generally treated
as money received by the taxpayer (see ¶16,553.034). Special basis rules apply
to triangular reorganizations (see ¶16,553.041 et. seq.). In addition, special basis
rules apply to Code Sec. 354 or 356 exchanges of foreign corporation stock in
certain triangular reorganizations involving foreign corporations (Reg. §1.367(b)13; see discussion at ¶16,667.029).
The basis rules of Code Sec. 358 do not apply to property or stock acquired in a
tax-free reorganization in exchange for the acquiring corporation's stock or its
parent's stock. In such cases, the carryover basis rules under Code Sec. 362
apply (see ¶16,612.01 et seq.).
In the case of a distribution of stock of one member of an affiliated group of
corporations to another member to which the nonrecognition rules of Code Sec.
355 apply, the IRS is authorized under Code Sec. 358(g) to provide adjustments
to the basis of any group member's stock to appropriately reflect the proper
treatment of the distribution (see ¶16,466.0498 for a discussion of the perceived
concerns with the present basis rules).
Basis of Property or of Stock or Securities Received in Tax-Free Exchanges
or Distributions: Money or other property received in addition to stock or
securities
If, together with the stock and/or securities permitted to be received upon an
exchange without gain or loss recognition, the distributee receives money or
other property (i.e., boot), then the basis of the permitted property received in the
exchange, which is generally the same as the basis of the property exchanged, is
subject to adjustments. Such basis is decreased by the amount of money
received, the fair market value of any "other property" received, and any loss
recognized on the exchange. The basis is also increased by any amount that is
treated as a dividend and by the amount of any gain recognized as a result of the
exchange (excluding that portion of the gain that is treated as a dividend) (Code
Sec. 358(a)(1)). The basis so determined is allocated among the stock and
securities permitted to be received without the recognition of gain or loss (Code
Sec. 358(b)(1); Reg. §1.358-2; see ¶16,553.033). The basis of any "other
property" received in the exchange is its fair market value (Code Sec. 358(a)(2)).
Corporate Basis in Contributed Property
If a corporation acquires property in a reorganization (see ¶16,753.01), or in a
transfer from controlling stockholders (see ¶16,405.01), the property so acquired
keeps the same basis as it had in the hands of the transferor. To this carryover
basis is added any gain recognized to the transferor under the law applicable to
the year in which the transfer was made. The same carryover basis rule applies
to property acquired as paid-in surplus or a contribution to capital (Code Sec.
362(a) and (b)).
In a community property state, stock which is held as community property is
considered as being owned one-half by each spouse. Therefore, unless the
property which is transferred to the corporation in return for its stock is also
equally owned by each spouse, the 80 percent control test under Code Sec. 351
would not be met and the transfer would be taxable, resulting in a fair market
value basis in the transferred property (see ¶16,612.03).
Example 12: H owns 100% of the stock in corporation X, but the stock is
community property. As a result, H actually owns only 50% of the stock
(under local law). If he transfers separate property (property which is not
held as community property) to the corporation in exchange for its stock, the
transaction will be taxable, since the 80% control test is not met.
Note, however, that this could be a desirable result under some circumstances,
since it might result in a stepped-up basis to the corporation. See ¶16,612.21.
In light of the Supreme Court's J.G. Nash decision (70-1 USTC ¶9405,
¶21,005.412), the Commissioner has taken the position that the basis of
accounts receivable transferred in a Code Sec. 351 transaction is their net value
(face value less previously deducted additions to the reserve for bad debts) (Rev.
Rul. 78-280, ¶16,612.12).
Special basis rules, rather than the carryover rules, apply in the cases where a
net built-in loss is imported in the U.S. in a tax-free transfer by persons not
subject to U.S. tax, and where built-in loss property is transferred by persons
subject to U.S. tax in a Code Sec. 351 transaction (Code Sec. 362(e), see
¶16,612.021).
The carryover basis rule of Code Sec. 362 does not apply if the acquired
property consists of stock or securities in a corporation that is a party to the
reorganization unless such property was acquired in exchange for stock
(including treasury stock) or securities of the transferee or its parent (Code Sec.
362(b)). If the carryover basis rule does not apply, then the substituted basis rule
applies (see¶16,553.01 et seq.).
In the case where a corporation purchases property by issuing stock, the basis of
the property generally is the fair market value of the stock at the time of the
transfer (see ¶16,612.03). If property is contributed to capital by
nonshareholders, a zero basis generally results (Code Sec. 362(c)(1), see
¶16,612.032).