Taxation of Business Outline

Class 1 – Formation of a Corporation: Pt 1
Notes:
o       Three entities are of concern to us in business tax: Subchapter C (C corp): two levels of tax, Subchapter S (S corp): one level of tax, and Subchapter K (partnership): one level of tax .
o       An LLC can be taxed as any one of the three entities.
o       One’s basis in cash is always face value of the cash
o       The holder of an appreciated asset will recognize gain unless one of the nonrecognition principles applies.
o       Capital asset – everything except inventory, depreciable property used in a trade or business, IP in hands of creator, accounts receivable, etc.
o       IRC §351 provides that property has to be transferred solely for stock immediately after transferor’s (collective) control.
o       The basis in a note is the face value of the note.
A.        Introduction to §351
            1.         Policy of §351
At the shareholder level, §351 provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for its stock if the transferor or transferors of property are in control of the corporation immediately after the exchange. §351 applies both to transfers to newly formed and preexisting corporations provided that the transferors of property have control immediately after the exchange.
            2.         Basic Requirements
The three major requirements to qualify for nonrecognition of gain or loss under §351 are as follows:
(1) One or more persons (including individuals, corporations, partnerships, and other entities) must transfer property to the corporation;
(2) The transfer must be solely in exchange for stock of the corporation; and
(3) The transferor or transferors, as a group, must be in control of the corporation immediately after the exchange.
Control for this purpose is defined by §368(c) 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 of the corporation.
            3.         Shareholder Basis & Holding Period
§358(a)(1) provides that the basis of the stock (nonrecognition property) received in a §351 exchange shall be the same as the basis of the property transferred by the shareholder to the corporation.
§1223(a) provides that where a transferor receives property with an exchanged basis (property having a basis determined in whole or in part by reference to other property held at any time by the person for whom the basis is to be determined) such as stock in a §351 exchange, the holding period during which he held the transferred property is determined by including the period during which he held the transferred property if the transferred property is a capital asset or a §1231 asset; if it is not, the transferor’s holding period begins on the date of the exchange.
            4.         Tax Consequences to Transferee Corporation
On the corporate side, §1032 provides that a corporation does not recognize gain or loss when it issues stock in exchange for money or property. Moreover, a corporation that receives property in exchange for its stock in a §351 exchange steps into the shoes of the transferor. §362(a) generally prescribes a transferred basis – i.e., the corporation’s basis in any property received in a §351 exchange is the same as the transferor’s basis, thus preserving the gain or loss inherent in the asset for later recognition by the corporation. And §1223(2) provides that if property has a transferred (i.e., carryover) basis to the corporation, the transferor’s holding period likewise will carry over.
            5.         Limitations of Built in Losses
If property with a net built in loss is transferred to a corporation in a §351 exchange transaction or as a contribution to capital, the transferee corporation’s aggregate adjusted basis of such property is limited to the fmv of the transferred property immediately after the transfer (§362(e)(2)). Transferred property has a net built in loss when the aggregate adjusted basis of the property exceeds its fmv. 
If multiple properties are transferred in the same transaction, some with built in gains and others with built in losses, the basis limitation only applies when there is a net built in loss.
If more than one property with a built in loss is transferred, the aggregate reduction in basis is allocated among the properties in proportion to their respective built in losses immediately before the transaction. Alternatively, the shareholder and the corporation may jointly elect to reduce the shareholder’s basis in the stock that it receives to its fmv. If the election is made, the assets continue to have a built in loss in the hands of the transferee corporation, but the loss will not be duplicated on the disposition of the shareholder’s stock.
B.        Requirements for Nonrecognition or Gain or Loss under §351
            1.         Control Immediately After the Exchange
The requisite control must be obtained by one or more transferors of property who act in concert under a single integrated plan. There is no limit on the number of transferors, and some may receive voting stock while others receive nonvoting stock. If the corporation issues more than one class of nonvoting stock, the IRS requires that the transferor group must own at least 80% of each class.
To be part of an integrated plan, the transfers need not be simultaneous. It is sufficient if the rights of the parties are previously defined and the agreement proceeds with an expedition consistent with orderly procedure.
Momentary control will not suffice if the holdings of the transferor group fall below the required 80% as a result of dispositions of stock in a taxable transaction pursuant to a binding agreement or a prearranged plan. But a voluntary disposition of stock, particularly in a donative setting, should not break control even if the original transferor or property parts with the shares moments after the incorporation exchange.
RR 2003-51 distinguished between prearranged dispositions of stock that are taxable and those that are nontaxable:
Treating a transfer of property that is followed by a prearranged sale of the stock received as a transfer described in §351 is not consistent with Congress’ intent in enacting §351 to facilitate rearrangement or the transferor’s interest in its property. Treating a transfer of property that is followed by a nontaxable disposition of the stock received as a transfer described in §351 is not necessarily inconsistent with the purposes of §351. Accordingly, the control requirement may be satisfied in such a case, even if the stock received is transferred pursuant to a binding commitment in place upon the transfer of the property in exchange for the stock.
            2.         Transfers of Property and Services
Property is broadly construed to include cash, capital assets, inventory, accounts receivable, patents, and, in certain circumstances, other intangible assets such as nonexclusive licenses and industrial know-how.
§351(d)(1) specifically provides that stock issued for services shall not be considered as issued in return for property.
The pure service provider is not considered a transferor of property and may not be counted as part of the control group for purposes of qualifying the exchange of §351. But if a person receives stock in exchange for both property and services, all of his stock is counted toward the 80% control requirement.
The regulations (§1-351-1(a)(1)(ii)) provide that the stock will not be treated as having been issued for property if the primary purpose of the transfer is to qualify the exchanges of the other property transferors for nonrecognition and if the stock issued to the nominal transferor is of relatively small value in comparison to the value of the stock already owned or to be received for services by the transferor.
Rev. Proc. 77-37 provides that property transferred will not be considered to be of relatively small value if the fmv of the property transferred is equal to, or in excess of, 10% of the fmv of the stock already owned (or to be received for services) by the transferor.
            3.         Solely for Stock
The final requirement for nonrecognition is that the transfers of property be made solely in exchange for stock of the controlled corporation. Stock generally means an equity investment in the company. If does not include stock rights or warranties.
Debt securities received in a §351 transaction, along with all forms of nonsecurity debt (e.g., a short term note), are treated as boot, leaving only stock to qualify as nonrecognition property.
Certain preferred stock with debt-like characteristics, labeled by §351(g)(2) as “nonqualified preferred stock” is treated as other property (i.e., boot) rather than stock for purposes of §351 and §356. Nonqualified preferred stock is generally defined as preferred stock with any of the following characteristics: (1) the stockholder has the right to require the issuing corporation or a related person to redeem or purchase the stock, (2) the issuer or a related person is required to redeem or purchase the stock, (3) the issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or (4) the dividend rate on such stock varies in whole or in part with reference to interest rates, commodity prices, or similar indices.
The erect of §351(g) is to treat debt-like preferred stock as boot, resulting in potential recognition of gain (but generally not loss) to the recipient under §351(b). A taxpayer is allowed to recognize a loss, however, if only nonqualified preferred stock is received in an exchange.
Formation of a Corporation – Part 2
C.        Treatme