II. Corporate Formation – §351
A. §351 Generally
1. Defers tax on corporate formation and additional capital contributions. No gain or loss on the transaction, but the A/B of the prop. Carries over to the stock.
2. It is based on the notion that the s/h still have an indirect interest in their transferred property through the corp. – continuity of interest. (policy: only change in form of s/h investment)
3. It is a mandatory provision if it applies – is not elective.
4. Sales of assets from s/h to corp. may have to be reclassified as a §351 exchange
B. Requirements for §351 to Apply: (§351(a))
1. Property – One of more persons (including entities) transfer property to the corp.,
a. Property does not include – §351(d)
– A person who contributes services is not considered part of the control group for the
80% test, but if the other people pass, §351 will apply for them, but not for the person contributing services… must recognize G.
(2) Debt not evidenced by a security, and
– A security is long-term debt… short-term debt does not qualify as prop.
(3) Unpaid interest of debt owed by the corp.
b. Prop & Services together: De minimis prop. – If prop. Is relatively small in
comparison to the value of the stock already owned by the transferor, the prop. Will not be considered prop. For purposes of §351 (§1.351-1(a)(ii)). The IRS defines “relatively small” as < 10% of the stock or securities already owned by the transferor (Rev. Proc. 77-37)
Ex: A wants to transfer prop. To corp. for 10% of its stock and avoid tax. To meet 80% test, A gets B, a 75% s/h, to contribute $1 to the corp, so that the two contributors now own 80%… doesn’t qualify under this rule.
c. Stock given for prop. and services – recognize G for services, but the stock received for services counts towards 80% control test. (§1.351-1(a)(2)). De minimis prop. Rules apply for this as well. The FMV of the prop. Should be at least 10% of the FMV of the services. (Rev. Proc. 77-37)
d. S/h can contribute shares back to the corp. to increase the % of stock held by other s/h. The contributing s/h can’t take a loss… can only allocate the basis of the contributed shares to his remaining shares. (Fink)
e. A/R is prop. If cash basis s/h contributes A/R to corp. that s/h has not recognized income on yet, the corp. must recognize income when it receives payment for the A/R. (Hempt Bros.).
– If A/P is contributed to corp. by cash basis s/h, the corp. recognizes expense when paid. (Rev. Rul. 80-198)
2. The transfer is solely in exchange for the stock of the corp., and
a. Stock rights and warrants are not stock
a. If the stock distribution to the s/h is unequal to the FMV of the prop. each contributed, §351 applies, but disproportionate amount may be considered a gift or payment for an unrelated service or liability and treated as a separate taxable transaction. (§1.351-1(b))
b. NON-qualified preferred stk doesn’t qualify §351g
3. The transferors are in “control” of the corp. “immediately after the exchange”
a. Control – §368(c) – ownership of stock w/ >= 80% of the total combined voting power of all classes of voting stock and >= 80% of the total number of shares of all other classes of stock
– §318 attribution rules for constructive ownership do not apply for control test (Rev. Rul. 56-613)
b. It doesn’t matter how much stock the transfer group owned before the transfer, only after the exchange.
c. Immediately after the exchange:
(1) All transactions are considered together. If part of the same plan, it qualifies. (look to single integrated plan)
(2) If s/h gives away some shares to fall below 80% rule, §351 will still apply and the shares given away will be considered a separate gift transaction.
(3) A prior commitment by a contributor of prop. to sell the corp. stock at the time of the transaction will ruin §351.
– Exception for underwriters, who are treated as agents (§1.351-1(a)(3))
-A ptnrshp can distribute stk to its ptnrs w/o violating the immediately after requirement.
C. Results of §351 Transaction
1. The Corporation
(1) §1032 – A corp. does not recognize G/L on transfer of its own stock (including treasury stock) for prop. Rule applies whether or not §351 applies.
(a) Services are considered prop. for these purposes (Reg. §1.1032-1(a))
(b) §1032 doesn’t apply to a corp. reacquiring its own stock unless it is issuing its own stock in return.
(2) §118 – Contributions of money or prop. to corp. is not income to the corp.
(a) The corp. does not have to issue new stock to existing s/h for this to apply
(i) excludes amounts given as part of the ordinary course of business from customers and amounts used to aid construction.
(ii) does include non-quid pro quo grants of prop. from unrelated parties… e.g., gov’t or civic group grants land to corp. as inducement to relocate – falls under §118.
(c) Exception – §108(e)(6) – if a s/h forgives debt owed
atio and that amount is taxable as a G to the s/h.
(D) For each payment that creates a G to the s/h, the corp. must increase it’s A/B in the prop. by the amount of that G.
(4) If multiple assets are transferred in exchange for stock that comes with boot, the boot is allocated to each of the assets based upon FMV and the G on each asset is determined separately. (Rev. Rul. 68-55). EXAM; add up fv of assets transferred this becomes the denominator then put each asset fv over separately to get % then take % X gain on get recognizing gain separately.
(5) The character of the G depends on the type of prop. given up.
(1) If no boot, the A/B of the stock is the same as prop. exchanged (§358)
(2) If boot
(a) A/B of stock =A/B in prop. – FMV of boot + G recognized – L recognized + amount treated as a dividend
(b) A/B of boot is FMV (§358(a)(2))
(c) A/B is allocated among non-recognition prop. (§358(b)(1))
– If the transferor receives non-recognition property of stock and securities or stock of different classes, basis is allocated to each based upon the FMV of each security/stock (§1.358-2(b)).
(d) Assumption of liab. is treated as boot for purposes of A/B. (§358(d)(1))
– If liab. would produce a deduction in the hands of the corp., it is not considered a liab. for these purposes (§357(c)(3)). This includes contingent liabilities, such as possible environmental suits (Rev. Rul. 95-74)…. however, payment of mtg. doesn’t produce an expense.
c. Holding period – holding period carries over to the stock for §1221 capital asset and §1231 business asset property. However, the holding period of assets used in the ordinary course of business do not carry over.
3. Transactions involving §1231 depreciable prop. – §1245 depreciation recapture
a. Any boot recognized as G is automatically considered ordinary income up to the amount of depreciation taken on the prop. (§1245(b)(3))
b. Depreciation recapture that isn’t recognized is transferred to the corp., and