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Corporate Taxation
University of Connecticut School of Law
Mason, Ruth

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III.           CORPORATE FORMATION[1] a.     Non-recognition Treatment:Congress didn’t want to impede corporate formations; hence, most routine formations are tax deferred (“non-recognition”)[2] under §351. 
                                                            i.      SH Level: At the SH level, 351(a) 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”  (this applies to new and pre-existing corporations).
                                                         ii.      Corporate Level: At the corporate level, §1032(a) provides that a corporation shall not recognize gain or loss on the receipt of money or other property in exchange for its stock (including treasury stock).
1.     POLICY: The transaction is viewed as a mere change in the form of a shareholder’s investment
a.    When it makes sense: Sole proprietor who decides to incorporate and doesn’t cash out—the envelope his investment is wrapped in just changes form.
b.    When it stops making sense: If you get one million transferors together, their investment has changed substantially; everyone gets a little piece of everyone else’s investments—diversification occurs.  It’s like an interest in a mutual fund, so the justification has its limits.
                                                     iii.      Carry-Over Bases: This is done via §358(a)(1) which provides that the basis of the stock received in a Section 351 exchange shall be the same as the basis of the property transferred by the shareholder to the corporation.
1.     LIMITATIONS ON TRANSFER OF BUILT-IN LOSSES Congress decided to fuck the Corporation.
a.    For Corporation: If property with a net built-in loss is transferred to a corporation in a §351 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.
                                                                                                                                     i.      WHEN MULTIPLE PROPERTIES TRANSFERRED: If multiple properties are transferred in the same transaction, some with built-in gains and other with built-in losses, the basis limitation only applies when there is a net built-in loss, §362(e)(2)(A)(ii). 
                                                                                                                                  ii.      MULTIPLE LOSS PROPERTIES TO ALLOCATE NET LOSS TO? If more than one property has built-in loss, AND the aggregate result of the transfers is a NET BUILT-IN LOSS then the aggregate reduction in basis is allocated among the properties in proportion to their respective built-in losses immediately before the transaction. You can also flip the treatment and allow the corporation to have the built-in loss on its books while the shareholders takes a basis of FMV in the stock received (either way, the duplication of built-in loss is prevented). 
                                                       iv.      Holding Periods
1.     SH Level: If property transferred to corporation was a capital asset, then SH’s HP tacks. If not, SH’s HP begins anew upon receipt of the corporate stock, §1223(1).
a.    Statutory Authority: §1223(1) provides that where a transferor receives property with an “exchanged basis” such as stock in a §351 exchange, the holding period of that property is determined by including the period during which he held the transferred property IF the transferred property is a capital asset (as defined at § 1221) or a §1231 asset; if it is not, the transferor’s holding period begins on the date of the exchange.
b.      Asset Types
                                                                                                                                     i.      Unimproved Land = real or depreciable property used in trade or business is NOT a capital asset, BUT § 1231 “property used in the trade or business” includes real and depreciable property used in the trade or business which has been held for more than one year (provided it is not inventory or stuff you generally sell to customers).
                                                                                                                                  ii.      Inventory = not a capital asset according to § 1221 (no inventory or property of a kind that is generally for sale to customers in the ordinary course of business).
2.     HP for Corp: tacks on to transferor SH’s HP when receiving property in §351 exchange, §1223(2). 
a.      §1032 says that a corporation does not recognize gain or loss when it issues stock in exchange for money or property, and a corporation that receives property in exchange for stock in a §351 exchange steps into the shoes of the transferor. §362(a) generally prescribes a transferred basis, and §1223(2) says that if property has a transferred basis to the corporation, the transferor’s holding period likewise will carry over.
b.     Three Major Requirements For § 351 Non-Recognition:
                                                            i.      PROPERTY TRANSFER: One or more persons (including individuals, corporations, partnerships, and other entities) must transfer “property” to the corporation;
1.     “Property”
a.    Includes: cash, capital assets, inventory, accounts receivable, patents, a transferor company’s own stock, corporate or individual transferor’s notes, and, in certain circumstances, other intangible assets such as nonexclusive licenses and industrial know-how.
                                                                                                                                     i.      Nonexclusive License to Use Certain Patents:contribution was held to qualify as a 351. See p. 57 E&E.
                                                                                                                                  ii.      Corporate Debt (Principal Only): In the case of an existing corporation, the holder of a corporation’s debt may exchange the debt obligation in return for stock—debt will be considered property as long as it is evidenced by a security.
1.    Principal: Thus, a bond or debenture holder who exchanges the debt interest for equity (stock) will not recognize any gain or loss on the exchange attributable to the principal amount of the debt. 
                                                                                                                               iii.      Intellectual Property & Know-How: Despite some logical difficulty, courts generally hold that stock issued in return for: patents, copyrights, trademarks, and trade secrets is stock issued for property rather than for services.
1.    The Service Agrees: that where a “transferor agrees to perform services in connection with a transfer of property, tax-free treatment will be accorded if the services are merely ancillary and subsidiary to the property transfer.” Thus, receipt of stock in return for property and ancillary know-how will receive nonrecognition treatment under §351. 
2.    Excluded Services Still Deductible:BUTif compensation for services are excluded from §351, the corporation gets to deduct the payment as an ordinary business expense!!
b.    Doesn’t Include: stock issued for services shall not be considered as issued in return for “property.” §351(d)(1)
                                                                                                                                     i.      Services:don’t forget, that even when services are excluded for §351 purposes, the corporation still gets to deduct those expenses as ordinary and necessary business expenses!
1.    POLICY: Payment for services, regardless of the form of payment, is compensation and should be taxed to the recipient shareholder as ordinary income—horizontal equity.
2.    Transferring Services: Can get away with transferring services if you also transfer property BUT the accommodation transfer gambit fails if the value of the property transferred is de minimis relative to the stock received for services. 
a.    “De Minimis” 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 (anti-abuse rule) Rev. Proc. 77-37.
b.    EXAMPLE: E, an individual, owns property with a basis of $10K and an FMV of $18K. E also rendered services valued at $2K to Corporation F. Corporation F had outstanding 100 shares of common stock all of which are held by G. Corporation F issues 400 shares of its common stock (having a FMV of $20K) to E in exchange for his property worth $18K and in compensation for the services he has rendered worth $2K. Since immediately after the transaction, E owns 80% of the outstanding stock of Corporation F, no gain is recognized upon the exchange of the property for the stock. However, E realized $2K of ordinary income as compensation for services rendered to Corp. F,  Reg. §1.351-1(a)(2)(3)(Example 3).
                                                                                                                                  ii.      Interest: gain or loss will be recognized with regard to interest accrued while the transferor held the debt. 
                                                                                                                               iii.      Transferee Corp. Debts Not Evidenced by Security: are explicitly excluded from the de

                                  i.      Do the following transactions qualify under §351?
(a) A and B are unrelated individuals. A forms Newco, Inc. on January
[1] Four Main Code Provisions When Dealing With Corporate Formations:
351: nonrecognition to Corporation and SH
362: Corporation gets carryover B from SH
358: SHs get transferred B in their shares
1223: HP tacks—A considered to have owned stock received for as long as he held the land
[2] We call it a nonrecognition transaction but it’s really a deferred recognition transaction—the gain doesn’t go away, it just isn’t going to be recognized until later; no one gets away without paying tax UNLESS a SH dies because then he gets stepped-up basis on death. 
[3]Example: (E&E p. 66) Mother and daughter contributed $90K and $10K respectively in return for 50% and 50% of the stock in C Corporation. The disproportionate nature of the contributions will not disqualify mother and daughter from §351 treatment, but the transaction will be given tax effect in accordance with its true nature. Hence, we need to look at the facts and circumstances to determine the reason why the “losing” party in the transaction decided to agree to take less than her fair share. In the mother/daughter context, the most likely explanation is that mom was trying to make a gift. Mother will be viewed as first contributing 90% of the total contributions in return for 90% of the stock. The daughter is viewed as first contributing 10% of the total contributions for 10% of the stock and then receiving an additional 40% ($40,000 in stock) from mom as a tax-free gift and her basis for the gift will be governed by the gift-basis rules. Mother may be required to pay a gift tax on this transfer. 
Twist on Example: Likewise, if daughter had rendered services to mother then daughter would recognize ordinary income accordingly and mother would recognize gain or loss upon the difference between the basis to her of the shares and their FMV at the time of the exchange. Reg. §1.351-1(b)(2)(Example 2). 
[4] Treasury regulations take the position that “for purposes of §351, stock rights or stock warrants are not included in the term ‘stock.’” BUT, the Tax Court has held that a contract right to receive additional shares of stock upon the corporation’s achieving a specified net earnings goal was “stock” under §351. See p. 60 E&E.
[5] In some limited circumstances a long-term corporate security or debt may have so many equity characteristics that it will be reclassified as an equity interest for tax purposes.
[6] In that case, Shook had 100% of the stock, and was thus in control, but he had a pre-existing agreement with Wilson that the Corporation would transfer 50% of its stock to Wilson in return for his co-securing a needed loan.   This arrangement meant that Shook’s control was broken and that this wasn’t a 351 transaction for either Shook or Wilson—case weird because they didn’t want 351 treatment because assets had FMV and low basis and the statutory period of review was over so they wanted the high basis to get deductions.  
[7]American Bantam Car Co. v. Comm’r, 11 TC 397 (1948) aff’d per curiam, 177 F.2d 513 (3d Cir. 1949), cert denied, 339 US 920 (1950): In that case, some of the incorporator’s stock were placed in escrow at the time of incorporation with the understanding that the underwriter, upon successfully marketing preferred shares to the general public, would receive enough common shares to reduce the control group’s ownership percentage below 80%. One year after the incorporation, the underwriter met its quota and took the shares. Yet, the Court concluded that the control requirements were not violated because the arrangement was not a “sine qua non in the general plan, without which no other step would been taken.” In other words, the deal was fine under an application of the “mutual interdependence” test. The underwriter’s right to the shares was contingent and ownership of them remained with the incorporators until the underwriter satisfied the best efforts contract conditions.