Formation of the Corporation
C2-1 A new business can be conducted as a sole proprietorship, partnership, C corporation, or S corporation. There are tax and nontax advantages and disadvantages to each form. See pages C2-2 through C2-7 for a listing of the tax advantages and disadvantages of each form. A comparison of the C corporation, S corporation, and partnership alternative business forms is contained in Appendix F. pp. C2-2 through C2-7.
C2-2 Alice and Bill should consider forming a corporation and making an S election. An S election will permit the losses incurred during the first few years to be passed through to Alice and Bill and used to offset income from other sources. The corporate form allows them to have limited liability. Under the new check-the-box regulations, a noncorporate entity might elect to be taxed as a corporation and then make an S election. Such a possibility is unlikely to occur. As an alternative to incorporating, Alice and Bill might want to consider a limited liability company that is taxed as a partnership if their state laws provide for such an entity form. pp. C2-7 through C2-9.
C2-3 The only default classification for the LLC is to be taxed as a partnership. Because the LLC has two owners, it can not be taxed as a sole proprietorship. The entity can elect to be taxed as a C corporation or an S corporation. If such an election is made, Sec. 351 applies to the deemed corporate formation that occurs when the election is made to be taxed as a C or S corporation. pp. C2-7 through C2-9.
C2-4 The default classification for White Corporation is to be taxed as a C corporation. White Corporation can elect to be taxed as an S corporation if it makes the necessary election. The S election will cause the entity's income to be taxed to its owners. The S election is made by filing Form 2553 within the first 2½ months of the corporation's existence (see Chapter C11). pp. C2-7 through C2-9.
C2-5 The only default classification for the LLC is to be taxed as a proprietorship. Because the LLC has only a single owner, it can not be taxed as a partnership. The entity can elect to be taxed as a C corporation or an S corporation. If such an election is made, Sec. 351 applies to the deemed corporate formation that occurs when the election is made to be taxed as a C or S corporation. pp. C2-7 through C2-9.
C2-6 Some suggested items for this debate include:
PRO (Corporate formations should be taxable events):
1. A corporate formation is an exchange transaction; therefore, gains and losses should be recognized.
2. Making a corporate formation a taxable event increases tax revenues.
3. Simplification is achieved by eliminating one of the two options - whether a transaction is taxable or not. This change will make administration of the tax laws easier.
4. This change eliminates the need for taxpayers to artificially structure transactions to avoid Sec. 351 in order to recognize gains and/or losses.
CON (No change should occur to current law):
1. This change would hurt start-up corporations by reducing their capital through income tax payments made by transferors with respect to an asset transfer.
2. No economic gains or losses are realized. There has just been a change in the form of ownership (direct vs. indirect). Therefore, it is not appropriate to recognize gains and losses at this time.
3. Corporations will have to raise more capital in the capital markets since transferors of noncash property will have reduced capital to invest since monies will need to be diverted in order to pay taxes.
4. Taxpayers are prevented from recognizing losses under the current system, thereby increasing revenues to the government.
5. Businesses would be inhibited from incorporating because of the tax consequences and therefore economic growth in the U.S. would be adversely affected. pp. C2-10 through C2-12.
C2-7 If Sec. 351 applies, no gain or loss is recognized by either the transferor or transferee corporation when property is exchanged for stock. The transferor's realized gain or loss is deferred until the stock received is sold or exchanged unless boot property is received. If boot property is received, the recognized gain is the lesser of the amount of money plus the FMV of the nonmoney boot property received or the realized gain. No losses are recognized even if boot property is received. The transferor's basis for the stock received references his basis for the property that is transferred and is increased by any gain recognized and reduced by the amount of money plus the FMV of the nonmoney boot property received and the amount of any liabilities assumed or acquired by the transferee corporation. The basis of the boot property is its FMV. The transferee corporation recognizes no gain on the transfer. The transferee corporation's basis in the property received is the same basis that the transferor had in the properties that were transferred increased by any gain recognized by the transferor. pp. C2-10 through C2-12.
Property includes money and almost any other kind of tangible or intangible property including installment obligations, accounts receivable, inventory, equipment, patents, trademarks, tradenames, and computer software. Property does not include services
, an indebtedness of the transferee corporation that is not evidenced by a security, or interest on an indebtedness that accrued on or after the beginning of the transferor's holding period for the debt. p. C2-13.
Control requires the transferrers as a group to own 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. The nonvoting stock ownership is tested on a class-by-class basis. pp. C2-13 through C2-15.
Section 351 requires the transferors to have control of the transferee corporation immediately after the exchange, but does not specify how long this control must be maintained. The transferors, however, must not have a prearranged plan to dispose of their stock outside the group. If they have such a plan, the IRS may not consider the transferors to be in control immediately after the exchange. p. C2-16.
Section 351 does not apply to the exchange because Peter is not considered a transferor of property. Even though he transferred $1,000 of money, this property is of nominal value--less than 10% of the value of the stock he received for services ($49,000). Therefore, only John and Mary transferred property and, since they own only 66-2/3% of the stock of New Corporation
, they are not in control. The 10% minimum is contained in Rev. Proc. 77-37 and applies only for advance ruling purposes. The shareholders may choose to enter into the transaction without an advance ruling
, report it as being tax-free and run the risk of being audited and have the IRS say the transaction is taxable. Alternatively, they might restructure the transaction by having Peter provide a larger amount of cash to the corporation and take more shares of stock. Another option would be for Peter to provide fewer services and the increased amount of cash and still receive 100 shares of stock. p. C2-15.
Section 351 does not require that the shareholders receive stock equal in value to the property transferred. Section 351 would apply to the transfer by Susan and Fred if all other requirements are met. However, Fred has probably either made a gift of 25 shares of stock, has paid compensation of $25,000, or repaid a $25,000 debt to Susan by transferring the Spade stock. p. C2-16.
Section 351 can apply to contributions to an existing corporation. However, the transferrers must be in control of the corporation after the exchange. In this example, Ken is not
in control since he owns only 75 out of 125 shares, or 60% of the North stock. Therefore, Sec. 351 does not apply. To qualify under Sec. 351, Ken can transfer enough property to acquire a total of 200 shares out of 250 (200 shares held by Ken and 50 shares held by Lynn) total outstanding shares. In this situation, Ken would own exactly 80% of North Corporation's stock (250 shares x 0.80 = 200 shares). A less expensive alternative would be for Lynn to transfer property equal to or in excess of $10,000 (50 shares owned x $2,000 per share x 10% minimum) to be considered a transferor. p. C2-15.
C2-14 A shareholder's basis in stock received in a Sec. 351 exchange is determined as follows (Sec. 358(a)):
Adjusted basis of property transferred to the corporation
Plus: Any gain recognized by the transferor
Minus: FMV of boot received from the corporation
Money received from the corporation
The amount of any liabilities assumed or acquired by the
Adjusted basis of stock received
Liabilities assumed by the transferee corporation are considered money and reduce the shareholder's basis in any stock received (Sec. 358(d)).
The shareholder's holding period for the stock includes the holding period of any capital assets or Sec. 1231 assets transferred. If any other property (e.g., inventory) is transferred, the holding period for any stock received begins on the day after the exchange date. This rule can cause some shares of transferee corporation stock to have two different holding periods. The shareholder's basis for any boot property is its FMV and the holding period begins on the day after the exchange date (Sec. 358(a)(2)). pp. C2-18 and C2-19.
C2-15 The transferee corporation's basis for property received is the transferor's basis plus any gain recognized by the transferor on the exchange (Sec. 362). The transferee corporation's holding period includes the period of time the property was held by the transferor (Sec. 1223(2)). p. C2-21.
C2-16 Two sets of circumstances may require recognition of gain when liabilities are transferred.
· All liabilities assumed or acquired by a controlled corporation are considered boot if the principal purpose of the transfer of any portion of such liabilities is tax avoidance or if there is no bona fide business purpose for the transfer (Sec. 357(b)).
· If the total amount of liabilities transferred to a controlled corporation by a transferor exceeds the total adjusted basis of all properties transferred by such transferor, the excess liability amount is considered to be gain that is taxable to the transferor without concern as to whether the transferor had a realized gain or loss (Sec. 357(c)).
Under the second set of circumstances gain is recognized, but the excess liabilities are not considered to be boot. Special rules are found in Sec. 357(c)(3) for cash and hybrid method of accounting transferors who transfer excess liabilities to a corporation. pp. C2-21 through C2-24.
C2-17 The IRS would initially look at the reason for incurring the liability (e.g., did the liability relate to the transferor's trade or business). In addition, the IRS would be concerned with the length of time between when the liability was incurred and the transfer date. If the liability was incurred in connection with the taxpayer's trade or business, then most likely there would be no Sec. 357(b) problem even if it was incurred shortly before the transfer date. p. C2-22.
If Mark does not receive any boot, no depreciation recapture is required (Secs. 1245(b)(3) and 1250(d)(3)). The recapture potential is transferred to Utah Corporation. If Mark does
receive boot and must recognize gain, the recognized gain is ordinary income but not in excess of the recapture potential. Any remaining recapture potential is transferred to Utah Corporation. If Utah Corporation sells the property at a gain, it must recapture depreciation taken by Mark and not recaptured at the time of transfer as well as depreciation that it has claimed. Depreciation in the year of transfer must be allocated between the transferor and transferee according to the number of months the property is held by each. The transferee is considered to have held the property for the entire month in which the property was transferred. pp. C2-24 through C2-25.
The assignment of income doctrine can apply to a transfer of unearned income. However, the assignment of income doctrine does not apply to a transfer of accounts receivable by a cash method of accounting transferor in a Sec. 351 exchange if (1) the transferor transfers substantially all the assets and liabilities of a business; and (2) a business purpose exists for the transfer. (See Rev. Rul. 80-198, 1980-2 C.B. 113.) p. C2-26.
Congress enacted Sec. 385 in 1969 in an attempt to clarify the debt vs. equity issue. Section 385 suggests that the following factors be taken into account in determining whether an amount advanced to a corporation should be characterized as debt or equity capital:
· Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,
· Whether there is subordination to or preference over any indebtedness of the corporation,
· The ratio of debt to equity of the corporation,
· Whether there is convertibility into the stock of the corporation, and
· The relationship between holdings of stock in the corporation and holdings of the interest in question.
Although Congress enacted Code Sec. 385 in 1969 in an attempt to provide statutory guidelines for the debt/equity question, the lack of a subsequent set of interpretative regulations has required taxpayers, the IRS, and the courts to continue to use these statutory factors and other factors identified by the courts in ascertaining whether an instrument is debt or equity. Amendment of Sec. 385 in 1989 to permit part-debt and part-equity corporate instruments may lead to the creation of a set of regulations that interpret the Sec. 385 statutory guidelines. See also the O.H. Kruse Grain & Milling v. CIR
case cited in the text which lists additional factors that the courts might consider. pp. C2-27 and C2-28.
Some of the advantages of debt include: interest is deductible by the payor while a dividend payment is not deductible; and the repayment of an indebtedness is generally treated as a return of capital while a stock redemption is generally treated as a dividend. Disadvantages of using debt include that dividend payments are eligible for a dividends-received deduction when received by a corporate shareholder; stock can be received tax-free as part of a corporate formation and/or reorganization while the receipt of debt is usually treated as boot
; a distribution of stock to shareholders can be a tax-free stock dividend while a distribution of an indebtedness usually results in dividend income; and worthless stock results in an ordinary loss under Sec. 1244 while a worthless debt instrument generally results in a capital loss. pp. C2-28 through C2-30.
A corporation does not recognize any income when it receives money or property as a capital contribution from a shareholder (Sec. 118). The corporation's basis in any property received is the shareholder's basis for the property increased by any gain recognized by the shareholder. A corporation does not recognize any income if it receives money or property from nonshareholders unless the property is received in exchange for goods or services or as a subsidy to induce the corporation to limit production. The corporation's basis in property received from a nonshareholder is zero. If money is received from nonshareholders, the basis of property acquired with the money during the next 12 months is zero. If any such money is not spent within 12 months, the basis of other corporate property must be reduced by the amount not spent (Sec. 362(c)). pp. C2-31 and C2-32.
The advantage of satisfying the Sec. 1244 small business stock requirements is the ordinary loss treatment that is available for individual shareholders and certain partnerships reporting up to $50,000 (or $100,000 if married and filing jointly) of losses incurred on a sale or exchange of the stock. Ordinary loss treatment is available only if: the loss is incurred by a qualifying shareholder who acquired the stock from the small business corporation; the corporation was a small business corporation at the time the stock was issued (i.e., a corporation whose aggregate money and other property received for stock is less than $1 million); the stock was issued for money or property (other than stock or securities); and the issuing corporation derived more than 50% of its aggregate gross receipts from active sources during the most recent five tax years ending on the date when the stock was sold or exchanged. pp. C2-32 and C2-33.
The two advantages of business bad debt treatment are (1) a business bad debt deduction can be claimed for partial worthlessness, and (2) a business bad debt can be deducted as an ordinary loss. A nonbusiness bad debt can be deducted only in the year in which total worthlessness occurs. No partial writeoffs of nonbusiness bad debts are permitted. A nonbusiness bad debt can only be deducted as a short-term capital loss. These losses can offset capital gains or be deducted by individuals up to $3,000 in a tax year. No limit exists on business bad debt deductions and, if such losses exceed income, they can be carried back as part of a net operating loss. In order to claim a business bad debt deduction, the holder must show that the dominant motivation for making the loan was related to the taxpayer's business and was not related to the taxpayer's investment activities. pp. C2-33 and C2-34.
Shareholders might want to avoid Sec. 351 if they are transferring property on which they have a gain or loss that they want to recognize. They may be able to avoid Sec. 351 by violating one or more of its requirements: for example, by selling the property to the corporation for cash
, by selling the property to a third party who contributes it to the corporation, or by receiving sufficient boot to recognize the gain. pp. C2-34 through C2-36.
Every person who receives stock, securities, or other property in a Sec. 351 exchange must attach a statement to his tax return for the period that includes the date of the exchange. The statement must include all the facts pertinent to the exchange (see Reg. Sec. 1.351-3(a)). Similarly, the transferee corporation must attach a statement to its tax return for the year in which the exchange took place (see Reg. Sec. 1.351-3(b)). The transferee's statement requires a description of the property and liabilities received from the transferors and the stock and property transferred to the transferors in exchange for the property. pp. C2-36 and C2-37.
Issue Identification Problems
· Does the property transfer meet the Sec. 351 requirements?
· Has property been transferred by Peter and Mary? Does the fact that Peter controls Trenton Corporation prior to the transfer change the general Sec. 351 rules?
· Are the transferors in control of the corporation following the transfer?
· Do the transferors receive transferee corporation stock?
· What is each shareholder's recognized gain?
· What is each shareholder's basis for his/her stock?
· What is each shareholder's holding period for his/her stock?
· Does Trenton Corporation recognize gain when it issues its stock?
· What is Trenton Corporation's basis for the property received from Mary?
· What is Trenton Corporation's holding period for the property received from Mary?
The property transfer meets all of the Sec. 351 requirements. Peter and Mary are considered to own all 195 of the Trenton shares immediately after the exchange. Peter's contribution of cash for stock is not considered to be a nominal amount according to the IRS rules for private letter rulings (i.e., it equals or exceeds 10% of the value of Peter's prior stock holdings) and permits his stock to be counted towards the 80% minimum stock ownership for control. Mary recognizes no gain on the asset transfer, and takes a $50,000 basis for the Trenton shares she receives. The holding period for the Trenton shares includes her holding period for the property transferred. Trenton recognizes no gain when it issues its stock, and takes a $50,000 basis for the property. pp. C2-11 through C2-31.
· Does the property transfer meet the Sec. 351 requirements?
· Has property been transferred to Carl and his son?
· Are the transferors in control of the corporation following the transfer?
· Do the transferors receive transferee corporation stock?
· Does the property contribution/receipt of stock as outlined in the facts reflect the true nature of the transaction? Or, has a gift or other event occurred?
· What is each shareholder's recognized gain?
· What is each shareholder's basis for his stock?
· What is each shareholder's holding period for his stock?
· If a gift has occurred, has Carl made a taxable gift to his son? (This question could be rewritten for events other than a gift (e.g., repayment of a loan.)
· What is Cook Corporation's basis for the property received from Carl?
· What is Cook Corporation's holding period for the property received from Carl?
The contribution is tax-free since it meets all of the Sec. 351 requirements, and Carl and Carl, Jr. own all of the Cook stock. Carl, Jr. receives a disproportionate amount of stock when compared to his $20,000 capital contribution. It appears that the transaction should be recast so that Carl receives 80 shares of stock, each valued at $1,000. He then gifts 30 shares to Carl, Jr. The gift leaves each shareholder with 50 shares of stock. Neither shareholder recognizes any gain, and Carl takes a $50,000 adjusted basis for the 80 shares he receives. He recognizes no gain on the transfer of 30 shares to Carl, Jr., and $18,750 [(30/80) x $50,000] of his basis accompanies the gifted shares. Carl's basis for his remaining 50 shares is $31,250 ($50,000 - $18,750). Carl, Jr.'s basis for his 50 shares is $38,750 ($20,000 + $18,750). pp. C2-10 through C2-27.
· Was the stock sold to a related party (Sam) as defined by Sec. 267(b)? If so, the loss cannot be recognized and the remaining issues do not have to be examined. If not, then...
· Is the stock a capital asset?
· Is Bold Corporation a qualifying small business corporation?
· If a qualifying small business corporation, does the stock qualify for Sec. 1244 stock treatment?
· If Sec. 1244 stock, what is Bill's marital and filing status?
· Has Bill's basis for the stock changed from its initial acquisition cost?
· What is the amount and character of Bill's recognized loss?
Bill's stock sale results in a $65,000 ($100,000 - $35,000) long-term capital loss, provided the purchaser was not a related party. If the purchaser is a related party, Sec. 267(a) prevents Bill from recognizing any loss. Since Bill is the original holder of the stock, the loss may characterized as ordinary under Sec. 1244 if the various requirements of Sec. 1244 are satisfied. pp. C2-32 and C2-33.
C2-30 a. Alice does not recognize her $25,000 realized gain.
b. Alice's basis in her Star shares is $15,000. Her holding period begins in 1996.
c. Bob does not recognize his $5,000 realized loss.
d. Bob's basis in his Star shares is $45,000. His holding period begins in 1995.
e. Charles must recognize $20,000 of ordinary income.
f. Charles's basis for his Star shares is $20,000 and his holding period commences on the day after the exchange date in 1998.
g. Star Corporation has a basis of $15,000 in the land and $45,000 in the machinery. Both assets have a carryover holding period from 1996 and 1995, respectively. The services, if capitalized, would have a $20,000 basis and a holding period starting in 1998. pp. C2-12 through C2-21.
a. Since Sec. 351 does not apply because 30% of the stock is issued for services, Ed must recognize $20,000 ($35,000 - $15,000) of capital gain.
b. Ed's basis in his shares is $35,000 and his holding period begins on the day after the exchange date.
c. Fran recognizes a $10,000 ($35,000 - $45,000) Sec. 1231 loss.
d. Fran's basis in her shares is $35,000 and her holding period begins on the day after the exchange date.
e. George must recognize $30,000 of income.
f. George's basis in his shares is $30,000. His holding period commences on the day after the exchange date.
g. Jet Corporation has a $35,000 basis in the land and a $35,000 basis in the machinery. Its holding period for each asset begins on the day after the exchange date. The services, if capitalized, would have a $30,000 basis.
h. Since Sec. 351 would now apply to the exchange, the answers change as follows:
a. Ed does not recognize any gain or loss.
b. Ed's basis is $15,000. His holding period begins in 1994.
c. Fran does not recognize any loss.
d. Fran's basis is $45,000. Her holding period begins in 1994.
e. George must recognized $25,000 of ordinary income.
f. George's basis for his shares is $30,000 ($5,000 cash + $25,000 FMV of services) and his holding period begins on the day after the exchange date.
g. Jet Corporation's basis in the land and machinery are $15,000 and $45,000, respectively. Jet's holding period for both properties begins in 1994. The services, if capitalized, would have a $30,000 basis.
pp. C2-12 through C2-21.
C2-32 a. The 80% control requirement has not been met.
b. The property transferred by Robert is more than a nominal amount. The 80% control requirement has been met since all of Robert's stock is counted for this purpose.
c. The control requirement has not been met since Sam owns only 33-1/3% of the Vast stock immediately after the exchange. No attribution of the stock ownership occurs from Sam's parents to Sam.
d. The control requirement has been met since Charles and Ruth own 100% of the Tiny stock. The transfers do not have to be simultaneous.
e. The control requirement is not met because Charles had a prearranged plan to sell a sufficient amount of shares to cause the control requirement not to be met. Only if Sam were considered to be a transferor (i.e., the sale took place as part of a public offering) would the transaction come under Sec. 351. pp. C2-12 through C2-16.
C2-33 a. The control requirement has been met. The property transferred by Fred is not considered to be nominal relative to the total value of the property and services transferred, therefore, Fred and Greta are considered to own 100% of the New stock.
b. The control requirement has not been met. For advance ruling purposes, Maureen's shares are not counted towards determining if the control requirement has been met because the property she contributed was nominal (i.e., does not meet the 10% property minimum of Rev. Proc. 77-37) when compared to the total value of the property and services transferred. The taxpayer may choose to enter into the transaction without an advance ruling, report it as being tax-free, and run the risk of being audited and have the IRS say the transaction is taxable. Alternatively, Maureen can contribute additional property so that the amount of property equals or exceeds the 10% minimum described earlier. The minimum property contribution is $5,333 [$5,333 = ($48,000/0.90) - $48,000]. pp. C2-12 through C2-16.
a. No, the transaction does not qualify as tax-free under Sec. 351. Al and Bob do not have control of West Corporation. (Al owns only 1,000/1,300 = 76.9% of the voting common stock while Bob owns 100% of the nonvoting preferred stock). Al must recognize $25,000 of gain on the transfer of the patent. His basis in his West stock is $25,000. Bob does not recognize any gain or loss since he contributed cash. His basis in the preferred stock is $25,000. Carl must recognize $7,500 of ordinary income. His basis in his West stock is $7,500. West Corporation recognizes no gain or loss on the exchange. Its basis for the assets are: cash, $25,000; patent, $25,000; and services, $7,500.
b. The transaction now qualifies under Sec. 351 (i.e., Al and Bob together own 1,200/1,500 = 80% of the voting common stock and 100% of the nonvoting preferred stock). Al does not recognize any gain or loss. His basis in his West stock is -0-. Bob does not recognize any gain or loss. His basis in his West stock is $25,000. Carl must recognize $7,500 of ordinary income. His basis in his West stock is $7,500. The consequences to West Corporation are the same as in part (a) except that the basis for the patent is $-0- instead of $25,000.
c. The transaction apparently would qualify under Sec. 351. Assuming that the $800 of cash contributed is acceptable under Rev. Proc. 77-37 since it meets the 10% property minimum for advance ruling purposes, Al and Bob would not recognize any gain or loss. Carl would recognize $6,700 of ordinary income. The consequences to West Corporation are the same as in part (b) except the cash contributed by Carl takes an $800 basis and the services have a $6,700 basis. pp. C2-12 through C2-16.
FMV of Assets
% of Total Value
FMV of Stock Received
Plus: Boot Property
Minus: Adj. Basis of
Gain (Loss) Realized
Allocation of Boot
a. Gain recognized:
$21,818 Gain on equipment, ordinary income (recapture on Sec. 1245
6,000 Gain on land, Sec. 1231 gain
$27,818 Total gain recognized
b. Basis in stock:
Adj. basis of property transferred $140,000
Minus: FMV of boot received ( 40,000)
Plus: Gain recognized by transferor 27,818
Basis in stock $127,818
Basis in interest-bearing notes: $ 40,000
c. Basis in the properties received
Tom's Basis Recog. Gain Total
Cash $ 5,000 + -0- = $ 5,000
Equipment 60,000 + 21,818 = 81,818
Building 51,000 + -0- = 51,000
Land 24,000 + 6,000 = 30,000
Total $140,000 + $27,818 = $167,818
pp. C2-12 through C2-21.
Ann must recognize $15,000 ($25,000 - $10,000) of gain on the exchange. To comply with the advance ruling requirements Sec. 351 (e.g., Rev. Proc. 77-37), Fred must receive more than a nominal amount of stock in exchange for his property. If Fred obtained additional stock worth at least 10% of the value of the stock he already owned (i.e., at least five shares of stock in exchange for $5,000), his stock would likely be counted for control purposes and Sec. 351 would apply. Ann may choose to enter into the transaction without increasing her property contribution so as to acquire at least 80% of Zero's stock or having Fred increase his contribution to at least $5,000, proceed without an advance ruling, and report it as being tax-free. Ann and Fred then run the risk of being audited and having the IRS say the transaction is taxable. p. C2-15.
Lucy must recognize $4,000 gain on the exchange ($12,000 - $8,000) since she owns less than 80% of the stock after the exchange [(50+10)/110=55.5%]. To qualify under Sec. 351:
(1) Lucy could contribute additional property for enough additional stock to obtain 80% control. She would have to purchase an additional 150 shares in order to own 200 shares (of the 250 shares outstanding) to meet the 80% control requirement.
(2) Marvin could exchange enough property as part of the same transaction to qualify as a transferor under Sec. 351. For advance ruling purposes under Rev. Proc. 77-37, Marvin would have to contribute at least $6,000 for an additional five shares of stock to be considered a transferor of property for purposes of Sec. 351. The taxpayers may choose to enter into the transaction without Lucy and Marvin increasing their property contributions, proceed without an advance ruling, and report it as being tax-free. They would run the risk of being audited and have the IRS say the transaction is taxable. p. C2-15.
a. Neither Jerry nor Frank recognize any gain or loss on the exchange since Sec. 351 applies.
b. Since the exchange is disproportionate, it is likely that Frank has made a gift of 25 shares of Texas stock to Jerry. Jerry's basis in his 75 shares is $44,000 ($28,000 basis in property transferred by Jerry + $16,000 basis in the 25 shares received from Frank). This calculation presumes that no gift taxes are paid on the transfer. If gift taxes are paid, a second basis adjustment may be needed for the portion of the gift tax attributable to the appreciation.
c. Frank's basis in his 25 shares is $16,000 [$32,000 basis in property transferred x (25/50)]. p. C2-16.
C2-39 a. Amount realized $150,000
Minus: Basis in land ( 50,000)
Realized gain $100,000
Boot received (bond and note) $ 50,000
Gain recognized (capital gain) $ 50,000
b. Basis of stock and ten-year bond:
Basis of stock: $50,000 + $50,000 - $50,000 = $50,000
Basis of bond: $30,000 (FMV)
Basis of short-term note: $20,000 (FMV).
c. Basis of land to Jones Corporation is: $50,000 + $50,000 = $100,000.
pp. C2-17 through C2-20.
C2-40 a. Karen and Larry do not recognize any gain or loss under Sec. 351 since they receive only stock. Joe must recognize a $7,000 ($15,000 - $8,000) capital gain because he receives only bonds in the transaction and therefore does not qualify for Sec. 351 treatment.
b. Joe's basis in the bonds is $15,000. Karen's basis in the stock is $18,000. Larry's basis in the stock is $25,000.
c. Gray Corporation's basis in the land is $15,000. Gray's basis in the equipment is $18,000. The $10,000 of depreciation recapture potential is assumed by Gray since Karen does not recognize a gain on the asset transfer. pp. C2-17 through C2-20.
C2-41 a. Dana realizes a $10,000 gain [($18,000 + $7,000) - $15,000] and must recognize a gain of $7,000; the amount of the boot (note) received. All of the gain is ordinary income recaptured under Sec. 1245.
b. Dana's basis for the note is $7,000; its FMV. Dana's basis for the stock is $15,000 ($15,000 + $7,000 gain - $7,000 FMV of note).
c. Booth Corporation's basis for the machinery is $22,000 ($15,000 + $7,000 gain recognized). pp. C2-17 through C2-20.
a. Jim has a $3,500 [($5,000 + $1,000 + $2,000) - $4,500] realized gain and a $3,000 recognized gain. The $2,000 education loan assumed by Gold Corporation has no apparent business purpose and, therefore, all liabilities transferred to Gold are considered boot under Sec. 357(b). All of Jim's gain is ordinary income recaptured under Sec. 1245.
b. Jim's basis for his stock is $4,500 ($4,500 + $3,000 - $3,000).
c. Jim's holding period for the additional shares includes his holding period for the automobile.
d. Gold Corporation's basis in the automobile is $7,500 ($4,500 + $3,000). pp. C2-21 and C2-22.
a. Stock (FMV) $17,000
Release from liability 28,000
Amount realized $45,000
Minus: Basis of property
Money 10,000 (25,000)
Realized gain $20,000
Liability assumed $28,000
Minus: Basis of all property transferred (25,000)
Recognized gain (Sec. 357(c)) $ 3,000
The gain is ordinary income recaptured under Sec. 1245.
b. Property transferred $25,000
Minus: Boot received (including liability) (28,000)
Plus: Gain recognized 3,000
Basis in Moore stock $ -0-
c. Barbara's basis for the machine $15,000
Plus: Barbara's recognized gain 3,000
Total basis in machinery $18,000
d. Sam does not recognize any gain or loss.
e. Sam's basis is $17,000, the amount of money he contributed to Moore for the stock.
f. Barbara's holding period for her stock includes her holding period for the machinery (Sec. 1231 property). Sam's holding period starts on the day after the exchange date.
g. Sec. 351 would not apply so the answers would change as follows:
a. Barbara recognizes $20,000 of ordinary income recaptured under Sec. 1245.
b. Barbara's basis in stock is $17,000, its FMV.
c. Moore's basis in machinery is $35,000, its FMV.
d. Sam has $17,000 of ordinary income from compensation.
e. Sam's basis in the Moore stock is $17,000, its FMV.
f. Barbara's and Sam's holding period for their stock both start on the day after the exchange date.
pp. C2-23 and C2-24.
a. Marty realizes a $17,000 [($30,000 + $15,000) - $28,000] gain, but he does not recognize any gain on the exchange since the liabilities are not considered to be boot.
b. Marty's basis in his Silver stock is $13,000 ($28,000 - $15,000).
c. Silver's basis in the property is $28,000.
d. a. Marty must recognize a $2,000 gain ($30,000 - $28,000) under Sec. 357(c).
b. Marty's basis in his Silver stock is -0- ($28,000 + $2,000 - $30,000).
c. Silver's basis in the property is $30,000 ($28,000 + $2,000).
pp. C2-23 and C2-24.
a. Ted's realized gain is $70,000 ([$60,000 + $35,000 + $15,000] - [$5,000 + $35,000]). No gain or loss is recognized by Ted. Section 357(c)(3) prevents Ted from having to recognize a gain because of his "excess" liability situation (i.e., liabilities that total $50,000 exceeding the $40,000 total bases of the assets).
b. Ted's basis in the stock received is $25,000 ($40,000 - $15,000). No reduction in basis is required for liabilities assumed by the corporation when coming under Sec. 357(c)(3).
c. The corporation's basis in the assets is the same $40,000 basis that Ted had ($5,000 in the cash, -0- in the accounts receivable, and $35,000 in the equipment).
d. The corporation must recognize the income from the receivables when they are collected. The corporation can also deduct the current liabilities when they are paid (Rev. Rul. 80-198, 1980-2 C.B. 13). pp. C2-23, C2-24, and C2-26.
a. Mary's realized gain is $50,000 ($110,000 - $60,000). Mary's recognized gain is $10,000 (amount of boot received). The gain is ordinary income recaptured under Sec. 1245.
b. Mary's basis in the Green stock is $60,000 ($60,000 + $10,000 - $10,000). Her holding period for the stock begins on March 3, 1994. Mary's basis in the two-year note (boot) is $10,000, its FMV. Her holding period for the note begins on the day after the exchange date, or January 11, 1997.
c. Green Corporation recognizes no gain or loss.
d. Green Corporation's basis for the machine is $70,000 ($60,000 basis to Mary + $10,000 gain recognized by Mary). Green Corporation's holding period begins on March 3, 1994. pp. C2-17 through C2-20, and pp. C2-24 through C2-25.
a. Ace Corporation does not report any income.
b. The basis of the land is -0-.
c. Ace Corporation does not report any income when it receives the cash. The basis of the equipment purchased with the $100,000 contribution is its $250,000 purchase price minus the $100,000 of contributed funds, or $150,000. pp. C2-31 and C2-32.
C2-48 a. Reggie must report a dividend of $70,000 and Jackson Corporation must report taxable income of $120,000. Jackson may not deduct the dividend paid to Reggie.
b. Reggie must report interest income of $20,000. The principal repayment is not taxable to Reggie. Jackson Corporation must report taxable income of $100,000 since it gets a $20,000 deduction for the interest paid to Reggie. pp. C2-28 through C2-30.
a. The loss with respect to the stock investments should be a capital loss for both Tom and Vicki since they did not purchase the stock from the corporation. Since the $25,000 debts are secured by bonds, the worthless security rules of Sec. 165(g)(3) will apply and cause their losses to be capital losses.
b. Vicki's loan is related solely to her stock investment and should be a nonbusiness bad debt that is deductible as a short-term capital loss (up to $3,000 a year after netting capital losses against capital gains). An argument can be made that Tom's loss relates to an attempt to maintain his employment with Guest Corporation and, therefore, has a substantial business purpose. Such a loss would be deductible as an ordinary loss if the dominant motive for making the loan related to his employment activities.
c. The loss with respect to the stock investment should be an ordinary loss under Sec. 1244 for both Tom and Vicki up to the $100,000 annual limit for the couple since the stock was purchased directly from Guest Corporation. The $50,000 loss in excess of the $100,000 Sec. 1244 limit is a capital loss. The worthless security rules of Sec. 165(g)(1) still apply to the $25,000 losses on the bond investments. These losses are capital in nature. pp. C2-32 through C2-34.
C2-50 Harry: Ordinary loss under Sec. 1244 of $50,000 and long-term capital loss of $75,000.
Susan: Long-term capital loss of $175,000.
Big Corporation: long-term capital loss of $125,000. pp. C2-32 through C2-34.
C2-51 a. Lois's loss is $52,000 ($28,000 - $80,000 basis). $50,000 is an ordinary loss under Sec. 1244 (the limit for a single taxpayer). The remaining $2,000 loss is a long-term capital loss.
b. Lois's loss is still $52,000 ($28,000 - $80,000 basis). However, for purposes of computing the Sec. 1244 loss, Lois's basis in the stock is $70,000. Therefore, the ordinary loss under Sec. 1244 is $42,000 ($28,000 - $70,000). The remaining $10,000 loss is a long-term capital loss. pp. C2-32 through C2-34.
The entire loss is a capital loss because Sue was not the original owner of the stock
; therefore, the stock is no longer Sec. 1244 stock. pp. C2-32 through C2-34.
a. No gain will be recognized by Donna when she transfers the land to Development Corporation. Development Corporation's basis in the land will be $150,000. All gain on the subsequent sale will be ordinary income to Development Corporation. This alternative results in the pre-contribution gain that accrued prior to Donna's transfer and the post-contribution profit originating from subdividing the land being taxed at a 34% marginal tax rate.
b. Donna could transfer the land to Development Corporation in exchange for stock and $330,000 of debt instruments. In this case, Donna would recognize $330,000 of long-term capital gain and Development Corporation's basis in the land would be $480,000. The $330,000 of pre-contribution capital gain (net of any capital losses that Donna has recognized) is taxed at a 28% maximum tax rate. The step-up in basis permits Development Corporation to use the additional basis to offset income earned from subdividing the land that would otherwise be taxed at a 34% marginal tax rate. Author's Note: The basic scenario would apparently permit Donna's gain to be reported using the installment method. However, sale of the land by a related person (a corporation that is controlled by Donna) within two years of the transfer date prevents deferral of the installment gain (Sec. 453(e)). pp. C2-34 through C2-36.
a. Yes, the transaction meets the requirements of Sec. 351. Transferors of property (Alice, Bob, and Carla) own 88.2% (750/850 = 0.882) of the Bear stock.
b. Alice must recognize a $10,000 gain, the amount by which the $60,000 mortgage assumed by Bear exceeds the $50,000 basis ($12,000 + $38,000) of all the assets transferred by Alice. The character of the gain is Sec. 1231 gain. Bob must recognize $10,000 of gain (the lesser of his realized gain of $15,000 or the boot received of $10,000). The gain is ordinary income recaptured under Sec. 1245. Carla does not recognize any gain or loss even though she received cash since she realized a $5,000 loss. Dick must recognize $10,000 of ordinary income as compensation for his services. Bear Corporation does not recognize any gain or loss on issuing its stock or the note.
c. Alice's basis in her stock is -0- ($12,000 + $38,000 - $60,000 liabilities + $10,000 gain). Her holding period for the stock includes her holding period for the land and building. Each share of stock, therefore, has a split holding period. Bob's basis is $25,000 ($25,000 + $10,000 gain - $10,000 boot). His holding period for his stock includes his holding period for the equipment. Carla's basis for her stock is $10,000 ($15,000 - $5,000 boot). Her holding period for the stock includes her holding period for the van. Dick's basis for his stock is $10,000. His holding period begins on the day after the exchange date.
d. Bear Corporation's basis in the assets received is: land $15,000 [$12,000 + (0.30 x $10,000)] and building $45,000 [$38,000 + (0.70 x $10,000)]. [The gain is allocated between the land and building according to the two assets' relative FMVs as is suggested by the Sec. 357 Regulations.] The holding period for the land and building includes the time Alice held these properties. Equipment - $35,000 ($25,000 + $10,000). Holding period includes the time that Bob owned the properties. Van - $15,000. Holding period includes the time that Carla held the property. The accounting services are deductible by Bear Corporation if incurred after operations have commenced. If the expenses are pre-operating expenses, they should be amortizable under Sec. 248. pp. C2-12 through C2-27.
Case Study Problems
(See Instructor's Guide)
(See Instructor's Guide)
(See Instructor's Guide)
Tax Research Questions
C2-58 (See Instructor's Guide)
C2-59 (See Instructor's Guide)
C2-60 (See Instructor's Guide)
C2-61 (See Instructor’s Guide)