Corporate Taxation

5. Bill Jones and Mary Smith agree to go into business together. He transfers appreciated property worth $100,000. She transfers cash of the same amount. They each receive half of the only class of stock in the company. Have the transferor’s of “property” received “control”? See Treas. Reg. §1.351-1(a)(1) and text p. 56

6. X, an individual owns eighty percent of Corporation O's only class of stock. X is an officer of O. Corporation O is short of cash and issues additional shares to X in lieu of salary. What tax consequences to X? Does Section 351 apply? See Code Section 351(d)(1), Treas. Reg. Section 1.351-1(a)(i) and text, p. 60-61.

7. X and Y are partners. X has a talent or an idea. Y has $100,000. They want to do business in the corporate form, so they incorporate. Y puts in $100,000 for half of the stock of the new corporation. X signs an employment agreement with the new corporation, and gets half of the stock for $1,000.

(a) How will the Revenue Service seek to tax X? Treas. Reg. Sections 1.351-1(a)(i) and 1.351-1(b), statutory cross-references §§351(f)(3) and (f)(4) text, p. 61.

(b) Now for the hard part. How could this fiasco have been avoided? Hint: Is there some way for X and Y to reduce the value of the corporation's stock, so that X's half is worth only $1,000?

(c) If your plan involves the new corporation to issue debt instruments to Y for his money, does §351 permit that? Suppose Y transferred not cash but appreciated property in return for the corporation's debt instruments? Reread sec. 351(a) and text, p. 61.

C. "Stock in such Corporation"

8. (a) What if X transfers property to a corporation which X controls, (as the word is used in Section 351) but receives cash, not stock? See Code sections 1001(a) & (c) and 351(b).

(b) What if X receives cash and stock? See section 351(b). We will return to the computation of gain recognized under Section 351(b) later.

(c) What if X received common stock and also preferred stock? The preferred stock has an unusual feature: X can require the corporation to purchase it back from him for the amount he paid plus 10% of that amount for each year he has held the stock. See new §351(g), enacted in 1987, and text, pp. 61-62.

D. Gain recognized when boot is received

Assignment: Casebook, pp. 64-69

9. Now for the computation of gain recognized and basis when there is "boot" present; that is, when Section 351(b) applies.

(a) X, an individual, transfers to O Corporation an asset with a basis of 10 and fair market value of 100, receiving back 90% of O Corporation's only class of stock and $20 in cash. How much gain, if any, does X realize? See Section 1001(a), IRC. How much does he recognize? See Sections 1001(c) and 351(b), IRC and text, pp. 64-66. Notice that in computing "gain" under Section 1001(a), "amount realized" includes all property and money received, without regard to its status as "boot" under Section 351.

(b) Suppose the same facts as in example (a) above, except that the basis of the property transferred had been $95?

10. Anne bought land for $100,000, but it is now worth only $50,000 She transfers it to her wholly owned corporation for new shares in the corporation worth $10,000, and cash of $40,000. What loss can she deduct? See Code Section 351(b)(2). Why so harsh a rule? See Code Sections 267(a)(1) and (b). What do you suppose is the point of Sections 267(a)(1) and (b)?

11. (a) This time X transfers to O Corporation two assets, one with a FMV of $50 and a basis of $10, and another with a basis of $50 and FMV of $10. X receives from O Corporation 90% of its only class of stock plus cash of $20. How much gain, if any, does X realize? How much does he recognize? What is the bearing of §351(b)(2)? See Rev. Rul. 68-55, text p. 67.

(b) Suppose in problem (a), above, gain of $40 is realized under §1001(a). How much gain is recognized under §351(b)?

E. "Control"

12. Many of the problems that arise under Section 351 have to do with whose stock counts toward "control", and with whether a series of steps are to be treated as one transaction, or as several separate transactions. See text, p. 55-56 and Intermountain case, p. 56..

Individuals X and Y agree with each other that each will transfer property whose value exceeds its basis to newly formed O Corporation, each receiving half of O Corporation's only class of stock. Does either X or Y have "control" of O Corporation within the meaning of Section 351(a)? Do X and Y recognize gain on their transfer? Why or why not? See Code Section 351(a)(1), Treas. Regs. Section 1.351-1(a)(1) and (2), Example (1)

13. X and Y, individuals, are partners. They transfer their partnership to Corporation O, newly formed for this purpose. Each receives in exchange half of O's only class of stock. Y then sells half of his stock to Z, an unrelated person, realizing and recognizing gain on the sale.

(a) Did the group X and Y have control of O "immediately after the exchange?" See Intermountain, p. 56

(b) Since Y is taxed on his gain when he sells his stock, what difference does it make whether Sec. 351 applies?

(c) Does the question of the application of Section 351 to the incorporation of the partnership turn on whether the underwriting contract is signed before or after the incorporation? If it does, should it? This kind of tension between formalism and flexibility is another recurring theme in corporate taxation.

14. X, an individual, owns land which has appreciated in value. O Corporation has offered her half of its only class of stock for the land. Right now, individual Y owns all of O's stock; after the proposed deal, X and Y would each own half. Is there a way to arrange the transaction so that Section 351 protects X against recognition of gain? Note well the warning of Treas. Reg.1.351-1(a)(1)(ii). Here is a third recurring problem in corporate taxation: what to do about the taxpayer who arranges to come within the formal requirements of the statute, but whose compliance is not within the statute's spirit. What do you think of making the answer in this case turn on the taxpayer's purpose?

F. Basis to transferor of property of shares received.

15. If X transfers property worth 100 but with a basis of 20, to O Corporation for stock of O Corporation and Section 351(a) applies to the transaction, what is X's basis in the stock received? See Section 358(a) and text, p. 53

16. The computation of basis of shares received by the transferor shareholder is more complicated when there is gain recognized. Compute the basis to X of the shares in O she received in each of the cases in problem 9, above. See Section 358(a), again. Why does Section 358(a) step up basis in the amount of gain recognized? Why step it down in the amount of money received? Does all of this have a familiar sound? Think back to and re-read Code §1031(d).

G. Treatment of the Corporate Transferee

17. How about gain to the corporation? See Section 1032. Basis to the corporation? See Section 362(a) and text, p. 54. Why the latter rule? Notice that the corporation will be taxed on preincorporation appreciation or deduct preincorporation decline in the property's value. Why should that be?

18. Mary owns a business with two assets, inventory and goodwill. The inventory has a basis of 100 and a fair market value of 150. The goodwill has a value of 150 and a basis of zero.

(a) Why does goodwill often have a basis of zero?

(b) Mary incorporates her business, transferring the two assets to New Corporation for all of its stock. What is the aggregate basis to the corporation of all the assets received? See 362(a). How should that basis be allocated between the two assets?

(c) Suppose as part of the exchange Mary received from New Corporation boot of $50, and recognized gain in that amount. What is the aggregate basis to New Corporation of the assets received? What is the basis of each asset?

H. An Extra-Hard Exercise: Assumption of Liabilities

Assignment: Text pp. 73-90.

19. The text pp 73-76. , is good on the effect of a transferee corporation's assuming the liabilities of the transferor of an asset, or taking the asset subject to the liability. It may, however, help you to recall from your first course in income taxation that under the Crane and Tufts cases there is a general rule that any buyer's assumption of (or taking subject to) a liability is treated as a cash payment both to the seller in computing the seller's "amount realized" under §1001(a) and to the buyer in computing the buyer's basis. This is so both in nonrecognition transaction, (such as like-kind exchanges, for which see Code §1031(d), last sentence and Treas. Reg. §1.1031(d)) and in sales generally (for which see Treas. Reg. §1.1001-2.)

(a) Section 357(a) changes this rule for transfers of property to a controlled corporation. Why might Congress have done that? Text, p. 73.

(b) What is the effect on basis of an assumed liability? Suppose X owns land with a basis of 100, subject to a mortgage of 40. X transfers the land to O Corporation for stock of O, and O assumes the mortgage, or takes the land subject to it. X controls O corporation after the exchange.

(1) What would the taxation of the exchange be absent §357(a)? Text, p. 73

(2) What is the taxation of the exchange given §357(a)?

(3) What is the basis to X of the stock of O Corporation that X has received? See Code §§358(a) and (d)., What is the point of reducing X's basis by the amount of the liability which O Corporation assumed?

(4) Onward and upward: Suppose we change the facts of our problem so that X's basis in the land is 10, but the mortgage is still 40. X again transfers the land to O Corp, subject to the mortgage, for stock of O, and controls O. See Section 357(c). Why did Congress provide for this result? Text, p. 74.

20. Section 357(c)(3) (discussed at text, pp. 75-76, undoes a trap that made for some pathetic cases. It still makes for a good review of tax accounting and principles of basis. Suppose X owns a business as a sole proprietor and uses the cash method of accounting. Her balance sheet shows:

Assets Liabilities and Net Worth