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Federal Income Tax II
University of Oregon School of Law
Mann, Roberta F.

Mann, Fed Tax II, Spring 2015

Choosing a Business Entity: State law considerations (liability, asset protection, form of governance, formality vs. informality, flexibility), tax law considerations (tax or accounting entity, flexibility, simplicity, double taxation concerns)


Corporate Formation

w/o nonrecognition, TPs who transfer property to a newly formed corporation in exchange for stock would recognize gain or loss measured by the difference between FMV of stock received and the TP’s adjusted basis in transferred property (1001(a), (c))

· 351 Nonrecognition (really deferred recognition, will recognize gain when stock is sold)

o Requirements:

§ One or more persons must transfer property to a corporation

· “Property”: cash, inventory, accounts receivable, patents and other intangibles such as goodwill and industrial know-how (351(d)(1), Reg 1.351-1(a)(1)(i))

o Services are not property – a service provider recognizes ordinary income under 61 on the value of any stock received for past, present, or future stock

§ The property must be transferred solely in exchange for stock of the transferee corporation

· “Transfer”: all substantial rights in the property must be transferred

· “Solely in exchange for stock”: stock represents an equity ownership interest in a corporation

o Nonqualified preferred stock is treated as “other property” aka boot rather than stock. Nonqualified preferred stock is preferred stock with any of the following debt-like characteristics:

§ Shareholder has right to require the issuing corporation or a related person to redeem or purchase the stock

§ Corporate issuer is required to redeem or purchase the stock

§ Issuer 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

§ Stock’s dividend rate is variable

§ The transferors, as a group, must be in control of the corporation immediately after the exchange (transferors need substantial skin in the game, not just acting to accommodate other transferors)

· “Control”: transferors of property collectively must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of each class of nonvoting stock (368(c))

· “Immediately after the exchange”:

o Binding agreements to dispose of stock – if a shareholder disposes of stock received in exchange for property pursuant to a prearranged binding agreement entered into prior to an incorporation exchange, the control test is applied after the stock disposition

o In a nontaxable transaction – a transfer of assets to a newly formed corporation in exchange for all of its stock satisfies this requirement even though, if a prearranged binding commitment, transferor loses control by immediately transferring the new stock; the two transactions, viewed independently, both qualify for nonrecognition

o Basis and holding period

§ Shareholder’s basis: transferor’s basis is the same as basis in the transferred property immediately prior to the exchange (exchanged/substituted basis, 358(a)(1))

§ Shareholder’s holding period: includes the holding period of transferred property (tacking)

§ Corporation’s basis/holding period: the new company’s basis in the assets transferred is the same as the transferor’s basis (transferred/carryover basis); holding period includes the transferor’s holding period

o Limitation on transfer of built-in losses – if property with net built-in loss is transferred, the transferee corporation’s aggregate adjusted basis of such property is limited to its FMV immediately after the transfer (362(e)(2)(A))

o Assignment of Income

§ Income is taxed to the party who earned it, cannot contractually sign away right to income

· Cash method accounting recognizes income only when it is actually or constructively received (businesses who have inventory can’t be cash basis)

· Accrual method accounting allows taxpayers to take amounts into income when they have the right to receive it; when you actually get paid, don’t take into income again

o Boot

§ Generally: if transferor receives property other than stock (cash, corporate debt securities, NQPS, etc) in a 351 transaction, there are really two transactions – 351(b)

· Gain recognized is limited to amount of boot received (cash of FMV or other property), no loss recognized!

o Was boot received?

o Determine realized gain: FMV property received (value of stock + value of boot) – A/B property

o Gain recognized is lesser of gain realized OR amt of boot

· Character of any gain recognized is determined by the character of the transferred asset to which the gain is attributable (how the corporation uses it)

§ Allocation: when several assets are transferred in exchange for a combo of stock and boot, boot is allocated among the transferred assets in proportion to their relative FMVs; realized gain on a transferred asset is recognized to the extent of the boot allocable to that asset, but no realized losses may be recognized

§ Basis and holding period

· Shareholder’s basis: (1) transferor’s basis in property transferred, minus (2) amount of cash and FMV of boot received, plus (3) gain recognized by transferor (358(a)(1))

· Corporation’s basis: generally is the transferor’s basis plus any gain recognized (362(a))

§ Assumption of liabilities: if the new corporation assumes a liability of the transferor shareholder, the assumption generally is not treated as boot received (357(a)); to preserve that gain that otherwise would have been recognized, the liability is treated as boot for determining the transferor’s basis in the new stock (358(d))

· Recourse liability – treated as having been assumed to the extent that the transferee has agreed and is expected to satisfy the liability, whether or not the transferor-shareholder

premium payments deductible

§ §104 exclusion allowed to corporation in Castner Garage (p 33 in textbook) – no deduction for premium payments if corporation is beneficiary (consistent with overall policy of IRC, can’t deduct payments that get you tax exempt investments, 165)

· 261 (life) also restricts interest deductions 264(f)

· Rev Rul 66-262 (disability)

§ COLI or “dead peasant” policies

· 101(j) gross income includes excess insurance proceeds over amount of premiums paid

· n/a if notice and consent of employees

· family members sued Walmart (employees had no notice, covered all the employees with an average of $300k, family members got nothing, weren’t even sued for tax reasons)

· Dividends received deduction §243 – corporate shareholders generally may deduct 70% of dividends received from other domestic corporations

o Levels

§ 70%: dividends other than qualifying

§ 80%: 243(c), if they own 20% or more (up to 80%) of the corporation paying dividends

§ 100%: qualifying dividends, recipient has to be eligible to be a member of an affiliate group, and insurance companies

o Abuses: dividend stripping = stripping out earnings and profits before you sell it, in the form of dividend so you don’t pay taxes, upon sale your gain will be less

§ §246(c) – exclusion of certain dividends

· Denies deduction if the stock has not been held by the corporate owner for the requisite amount of time (45 days or less during the 91 day period beginning on the date which is 45 days before the date on which the taxpayer becomes entitled to receive the dividend [ex-dividend day]), relatively short-term

· Want to prevent corps from buying stock, getting dividend, not paying tax on it and immediately selling the stock

§ §1059 – extraordinary dividends (corporate shareholder’s basis in stock reduced by non-taxed portion of extraordinary dividends)

· Extraordinary = if it exceeds 5% of the shareholder’s adjusted basis in preferred stock or 10% of its adjusted basis in the case of any other stock

· A corporate shareholder that receives an extraordinary dividend must reduce its basis in the underlying stock by the “nontaxed portion” of the dividend if the shareholder hasn’t held the stock for more than 2 years before the earliest of the date at which the distributing corporation declares, announces, or agrees to pay the dividend