Corporate Tax Bird-Pollan Spring 2017
Formation of a Corporation
Shareholder Nonrecognition General Rule for Transfer of Property in Exchange for Stock: No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation. (§351(a))
Application: Applies both to transfers to newly formed and preexisting corporations provided that the transferors of property have “control” immediately after the exchange.
Policy of §351: the transfer of appreciated or depreciated property to a corporation controlled by the transferor is viewed as a mere change in the form of a shareholder’s investment.
Policy Foundation: the incorporation of a business should generally be tax free both to the shareholders and to the corporation
Requirements for Nonrecognition under §351:
1) one or more persons (transferors) transfer property to a corporations (transferee);
Property: property is not specifically defined; however, it is construed broadly to include cash, tangible property, accounts receivable, nonexclusive licenses and industrial know-how.
Services Rule: Stock issued for services shall not be considered as issued in return for property (§351(d)(1))
Stock issued for services shall not be considered as issued in return for property. (§351(d)(1))
Transfer of Stock Rule: The stock will not be treated as having been issued for property is 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 stock already owned or to be received for services by the transferor (§1.351–1(a)(1)(ii), –1(a)(2) Example (3))
i.e., the accommodation transfer gambit fails if the value of the property transferred is de minimis relative to the stock received for services
Property transferred “will not be considered to be of relatively small value if the fair market value of the property transferred is equal to, or in excess of, 10 percent of the fair market value of the stock already owned (or to be received for services) by the transferor.” (Rev. Rul. 77–37)
General Boot Rule: If an exchange otherwise would have qualified under §351(a) but for the fact that the transferor received “other property or money” in addition to stock, then the transferor’s realized gain (if any) must be recognized to the extent of the cash plus the fair market value of the other property received (§351(b))
i.e., any gain realized by a transferor on an otherwise qualified §351(a) exchange must be recognized only to the extent of the boot received
Loss: no loss may be recognized (§351(b)(2))
Allocation: If a transferor transfers several different assets and receives some boot (in addition to stock), it is necessary to allocate the consideration received separately to each asset for purposes of determining the amount and character of gain recognized. (Rev. Rul. 68-55)
Assumption of Liabilities General Rule: The assumption of a liability by a transferee corporation in a §351 exchange will neither constitute boot nor prevent the exchange from qualifying under §351. (§357(a))
Postponement of Recognition: the recognition of any gain attributable to the transferred liability is postponed
Deferral by §358(d): reduces the basis in the stock received in the exchange by treating the relieved liabilities as “money Received” by the transferor for purposes of determining the shareholder’s basis.
Tax Avoidance Exception: the assumption of a liability is treated as boot if the taxpayer’s “principal purpose” in transferring the liability was the avoidance of federal income taxes or was not a bona fide business purpose (§357(b))
i.e., if an improper purpose exists, all the relieved liabilities are treated as boot (§1.357–1(c))
Purpose: to prevent taxpayers from transferring personal obligations to a newly formed corporations or from achieving a “bail out with boot” by borrowing against property on the eve of incorporation and then transferring the encumbered asset to the corporation
Burden of Proof: In “any suit” where the taxpayer has the burden of proving the absence of an improper purpose, that burden shall not be met unless the taxpayer “sustains such burden by the clear preponderance of the evidence” (§357(b)(2))
Prevention of Negative Basis: if the sum of the liabilities assumed by the corporation exceeds the aggregate adjusted basis of the properties transferred by a particular transferor, the excess shall be considered as gain from the sale or exchange of the property (§357(c))
Exception to §357(c): Under general tax principles, a taxpayer who is relieved of a liability that would be deductible if paid directly by the taxpayer does not recognize gain if the debt is discharged because any potential income would be offset by a corresponding deduction upon payment (§108(e)(2))
Note Face Value Rule: Personal notes to the corporation are taken at their face value when determining the amount received (Peracchi v. Commissioner) a shareholder’s basis in his own note equals its face amount because, necessarily, the note’s basis to the corporation was face value
Determination of Amount of Liability: (§357(d))
Recourse liability: is treated as having been “assumed” if, based on all the facts and circumstances, the transferee has agreed to and is expected to satisfy the liability, whether or not the transferor has been relieved of it. (§357(d)(1)(A))
Nonrecourse Liability: treated as having been assumed by a transferee who takes an asset subject to the liability, except that amount is reduced by the lesser of:
1) the amount of such liability which an owner of other assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is expected to, satisfy, or
2) the fair market value of those other assets
Purpose: to prevent double counting the same liability for basis adjustment purpose
§357(d) was enacted to eliminate a corporate tax shelter that exploited ambiguities in the interpretation of the phrase “transferred subject to a liability”
2) transfer must be solely in exchange for stock of the corporation; and
Stock Generally: means an equity investment in the company
Debt securities received in a §351 transaction, along with all forms of nonsecurity debt, do not qualify as nonrecognition property
Preferred stock with debt-like characteristics, known as “nonqualified preferred stock,” is treated as boot (“other property) rather than stock for purposes §351 and §356
Nonqualified Preferred Stock: preferred stock with any of the following characteristics: (§351(g)(2))
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 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
(1) thru (3) apply only if: the right or obligation with respect to the redemption or purchase of the stock may be exercised within the 20-year period beginning on the issue date of the stock, and such right or obligation is not subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase (§351(g)(2)(B))
Nonqualified preferred stock is treated as boot
Effect of §351(g): 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 (§351(g)(1)(B))
3) The transferor(s), as a group, must be in control of the corporation immediately after the exchange.
Control Test: (§368(c))
1) the ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote and
2) at least 80 percent of the total number of share of all classes of stock of the corporation
Requisite Control: the requisite control must be obtained by one or more transferor of “property” who act in concert under a single integrated plan.
Integrated Plan Rule: Sufficient if the rights of the parties are “previously defined” and the agreement proceeds with an “expedition consistent with orderly procedure.” (§1.351–1(a)(1))
The transfers need not be simultaneous
Momentary Control Rule: Momentary control will not suffice if the holdings of the transferor group fall below the required 80 percent as a r
excessive
Meanwhile, ratio of 50:1 and higher has been held to be acceptable
Whether or not a ratio is excessive may depend on norms for the particular business in which the corporation is engaged.
(3) Intent
Some cases turn on whether the parties “intended” to create a debtor-creditor relationship.
Intent may be measured by objective criteria such as a lender’s reasonable expectation, evaluated in light of the financial condition of the corporation and its ability to pay principal and interest.
Often the inquiry is whether an outside lender would have loaned money to the corporation under the same terms.
(4) Proportionality
i.e., the relationship between the holdings of stock in the corporation and the holdings of the debt under scrutiny
Rationale: if debt is held in roughly the same proportion as stock, the “creditors” have no economic incentive to act like creditors by setting or enforcing the terms of the so-called liability
Debt held by shareholders in the same proportion as their stock is subject to special scrutiny. The rationale is that if debt is held in the same proportion as stock, the shareholders have no economic incentive to act like creditors by setting or enforcing the terms of the purported debt.
(5) Subordination
i.e., whether the debt under scrutiny is subordinated to or has preference over any other indebtedness of the corporation
Subordination of shareholder debt to claims of outside lenders and trade creditors is sometimes regarded as evidence that the shareholder debt should be reclassified as equity.
But because many lenders typically require shareholder loans to be subordinated, this factor is not controlling.
(6) Convertibility
i.e., whether the interest is convertible into stock
Ex: A, B, and C are equal shareholders of NEWCO. They each contribute $10,000 cash in exchange for 100 shares of common stock and each loan Newco $50,000 in exchange for 5-year Newco notes. The nominal debt may be reclassified as equity.
(7) Source of Repayment
An expectation of repayment solely from corporate earning is not indicative of bona fide debt regardless of its reasonableness because it implies that an advance is really an equity contribution.
To be classified as debt, the source of repayment generally is viewed as coming from four possible sources:
(1) liquidation of assets,
(2) corporate profits,
(3) cash flow, and
(4) refinancing with another lender.
(Indmar Products Co., Inc. v. Commissioner)
Basic Issue: whether the advances made to the company by the stockholders were loans or equity contributions.
Deduction Rule for Debt: A taxpayer may take a tax deduction for “all interest paid or accrued…on indebtedness.” (26 USC §163(a))
In this case:
If the advances were loans, the 10% payments made by Indmar to the Rowes were “interest” payments, and Indmard could deduct these payments.
If, however, the advances were equity contributions, the 10% payments were constructive dividends, and thus were not deductible.
Objective Facts Rule: To determine whether an advance to a company is debt or equity, courts consider “whether the objective facts establish an intention to create an unconditional obligation to repay the advances.”
Economic Substance Rule: In doing so, courts look not only to the form of the transaction, but, more importantly, to its economic substance. (Fin Hay Realty Co. v. United States)
Standard of Review Rule: Tax Court’s factual findings are reviewed for “clear error” and its application of law de novo.
