|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. §1.351-1(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. 74-502, 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. §1.351-1(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. §1.351-1(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. §1.351-1(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 pre-arranged 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. 70-140, annotated at ¶16,405.31).
See also ¶16,753.044 for a discussion of the step transaction doctrine.