CHAPTER 3 CORPORATIONS: ORGANIZATION AND CAPITAL STRUCTURE LECTURE NOTES 4.1 ORGANIZATION OF AND TRANSFERS TO CONTROLLED CORPORATIONS

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1 CHAPTER 3 CORPORATIONS: ORGANIZATION AND CAPITAL STRUCTURE LECTURE NOTES 4.1 ORGANIZATION OF AND TRANSFERS TO CONTROLLED CORPORATIONS In General 1. Under 351, neither gain nor loss is recognized on the transfer by one or more persons of property to a corporation solely in exchange for stock in that corporation if, immediately after the exchange, such person or persons are in control of the corporation to which the property was transferred. a. Justification for this nonrecognition provision is similar to the justification supporting other tax-deferral sections (e.g., 1031 like-kind exchange). (1) There has been a lack of substantive change in the taxpayer s investment. (2) Taxpayer transferring property to the corporation lacks the wherewithal to pay a tax on any gain realized. (3) There is the concept that tax rules should not impede sound business judgments. b. Receiving cash or property (other than corporate stock) from the corporation causes gain recognition to the extent of the lesser of the gain realized or boot received. (1) Boot is equal to fair market value of other property and money received. (2) Type of gain recognized (capital, ordinary) is based on the nature of the assets transferred, not boot received. (3) Long-term debt securities (bonds) received in a 351 transaction are boot and may trigger gain recognition. c. Loss is never recognized by a property transferor in a 351 transaction. 2. Nonrecognition is accompanied by a substituted basis. Section 358 provides that the basis of stock received in a 351 transfer is the same as the basis the taxpayer had in the property transferred, increased by any gain recognized on the exchange and decreased by boot received.

2 3. Section 351 is mandatory if all of the requirements of the provision are met. Property Defined 4. Definition of property is comprehensive. a. Property includes items such as cash, unrealized receivables, installment obligations, and secret processes and formulas. b. Definition of property under 351 specifically excludes services rendered. Therefore, the value of any stock the shareholder receives in exchange for services rendered must be reported as income (i.e., compensation for services rendered). Stock Transferred 5. Stock under 351 includes common and most preferred stock. It does not include the following items. Nonqualified preferred stock. This preferred stock possesses many attributes of debt. Note that loss may be recognized when the transferor receives only nonqualified preferred stock. See 351(g). Stock rights and warrants. See Reg (a)(1)(ii). Securities such as long-term debt (i.e., bonds). Nonqualified Preferred Stock and Tracking Stock are not considered stock for 351 purposes. Nonqualified Preferred Stock is defined in 351(g). This stock is treated as boot for purposes of recognizing gain when received in exchange for property. Nonqualified preferred stock generally resembles debt and causes gain to be recognized up to the value of the nonqualified preferred stock received. However, nonqualified preferred stock continues to be treated as stock for purposes of determining whether the 80% control test is met (see discussion of the control test in Outline # 6 below). Congress apparently felt that receipt of nonqualified preferred stock should trigger gain because it is often a more secure form of investment than other stock. Nonqualified preferred stock, which is stock that is limited and preferred as to dividends, does not participate in corporate growth to any significant extent. In addition, such stock s redemption must be more likely than not to occur within a 20-year period. Further, preferred stock is nonqualified if the dividend rate varies, in whole or in part, with reference to interest rates, commodity prices, or other indices. Tracking Stock. This stock, also known as alphabet stock, is popular with investors because it is a vehicle to track economic performance of less than all of the assets of the issuing corporation. It can be used to track the performance of a branch, a division, or even a subsidiary corporation. This means of monetizing a position within a larger corporation allows corporations to fund the rapid expansion of hot business lines. Because tracking stock is both relatively new and unique, the tax ramifications of its ownership are unclear. In fact, the Code does not contain any provision that specifically covers this type of financial instrument. Furthermore, in Rev. Proc ( I.R.B. 108), the IRS indicates that it will not

3 Chapter 4 Solutions to Research Problems 4-3 rule on whether tracking stock is considered stock of the issuer. Congress has considered proposals to provide clarity, but until legislation is enacted, the treatment of tracking stock is unclear. Control of the Corporation 6. Transferors must be in control immediately after the exchange. a. Control means at least 80% of total combined voting power for all stock classes entitled to vote and at least 80% of total number of shares of all other stock classes. Nonqualified preferred stock is treated as stock, and not boot, for purposes of this control test. b. Control may apply to a single person or to several taxpayers if they are all parties to an integrated transaction. c. The exchange does not necessarily require simultaneous exchanges by two or more persons but it does require that the rights of the parties have been previously defined and that the execution of the agreement proceeds with an expedition consistent with orderly procedure. d. Stock need not be issued to the property transferors in the same proportion as the relative value of the property transferred by each. e. Control is not lost if stock received by shareholders is sold or given to persons who were not parties of the 351 exchange. ETHICS & EQUITY A Professional-Free Incorporation Allen learns after the incorporation of Jay Corporation that he has made a terrible blunder that could cost him a significant amount of income taxes. By failing to own at least 80% of the stock immediately after the transfer, he is required to recognize the gain on the exchange. To overcome the mistake, he proposes a bartering transaction to the other shareholder, Beth, that would enable him to qualify for 351. Allen s solution to this quandary is questionable for several reasons: Allen did not discover the problem until after Jay Corporation had been formed. In order for Allen s plan to work, the actual exchanges by Allen and Beth would have to be disregarded. Based on the facts, the transactions resulting in the incorporation are old and cold and cannot be wished away. Allen s tax advice to Beth is incorrect. Beth should report the fair market value of 25% of Jay s stock as compensation income. Allen is suggesting that she report income of only 20% of the stock and to ignore the value of the antiques. Allen is exerting pressure on Beth to accept a plan that she otherwise would not even consider if she fully understood the tax consequences.

4 7. Individuals receiving stock only for services rendered cannot be counted as part of the control group. However, individuals who receive stock for services and also transfer property for stock may be treated as a part of the control group. a. However, individuals will be taxed on the value of the stock issued for services but not on the stock issued for property. b. To count a person transferring services and property in the control group, the property cannot be relatively small in value in relation to the services. For advance ruling purposes, the value of the property transferred must be at least 10 percent of the value of the services provided. 8. Section 351 applies to later transfers to an existing corporation by either new or existing shareholders. a. Either the new or existing shareholders involved in the transfer must have the requisite 80% control immediately after the transfer to receive 351 benefits. b. Because of this rule, it is difficult for a transfer by a new shareholder to an existing corporation to qualify for nonrecognition of gain under 351. The stock attribution rules of 318 do not apply to 351 transfers for purposes of the control test. Thus, stock of a family member is not counted in determining whether a transferor of property to a corporation has control of the corporation after the transfer. Example. Paul and Vicki (father and daughter) each hold 100 shares in Blue Corporation. Paul transfers real estate (basis of $50,000 and worth $250,000) to Blue Corporation for 20 additional shares. Paul has a taxable gain of $200,000 on the transfer. Since the stock attribution rules do not apply, Paul is not deemed to own Vicki s stock. As the sole property transferor, he would not have the required 80% ownership after the transfer (i.e., he owns 120 of 220 shares, or 54.5%). Example. Assume Paul, in the preceding example, transfers the real estate to Blue Corporation but receives no additional stock. Paul has made a tax-free capital contribution. Since no stock is received, 351 does not apply. Paul will increase his basis in his 100 shares. There may be other tax consequences, such as Paul may have made a gift to Vicki with respect to one-half the value of the transferred property. Assumption of Liabilities Section 357(a) provides that the assumption of a liability by the acquiring corporation will not produce boot to the transferor-shareholder in a 351 transaction. a. However, liabilities assumed by the corporation are treated as other property or money for purposes of calculating the basis of stock received in the exchange.

5 Chapter 4 Solutions to Research Problems 4-5 b. The basis of stock received must be reduced by the amount of the liabilities assumed by the corporation. 10. Exceptions to 357(a) a. Tax Avoidance or No Bona Fide Business Purpose Exception. Under 357(b), if the principal purpose of the assumption of the liabilities is to avoid tax or if there is no bona fide business purpose behind the exchange, the liabilities, in total, will be treated as money received and have the affect of boot. b. Liabilities in Excess of Basis Exception. Under 357(c), if the sum of liabilities exceeds the adjusted bases of the properties transferred, the excess is taxable gain. (1) This gain recognition is necessary in order to avoid a negative basis in the shareholder s stock. As to whether such gain is capital or ordinary, look to the nature of the asset transferred. (2) Accounts payable that give rise to a deduction when paid are not considered liabilities for purposes of 357(c) (i.e., in the case of a cash basis taxpayer) and are not considered in the computation of stock basis. c. If both 357(b) and (c) apply, then 357(b) prevails. This is important because 357(b) merely produces boot and the realized gain limitations still apply, while 357(c) produces recognized gain regardless of the gain limitation. Basis Determination and Related Issues 11. The postponement of gain or loss has a corollary effect on the shareholder s stock basis and on the property received by the corporation. a. Basis of Stock to Shareholder. Section 358(a) determines the basis of the stock to the transferor-shareholder. (1) See Figure 4.1 in the text. A substituted basis results. An alternative stock basis calculation formula is: fair market value of the stock received less gain not recognized or plus loss not recognized. Also see Concept Summary 7.1 in Chapter 7 of the text. (2) Liabilities are treated as boot received for basis calculation purposes. b. Basis of property to corporation. Section 362(a) determines the corporation s basis in property received from the shareholder under 351. (1) See Figure 4.2 in the text. A carryover basis results (shareholder s basis in the property plus gain recognized on the transfer by the transferorshareholder). (2) Note that the corporation s basis in the property could be different than the transferor-shareholder s basis in the stock received. c. Basis Adjustment for Loss Property. Section 362(e)(2) requires the corporation s carryover basis to be reduced when the aggregate basis of the property transferred by a shareholder exceeds the fair market value.

6 (1) This adjustment is necessary to prevent both the shareholder and the corporation from benefiting from the losses involved. (2) Downward basis adjustments (potential loss associated with the property transferred) are allocated proportionately among assets with a built-in loss. (3) If the shareholder and corporation both elect, the basis reduction can, as an alternative, be applied against the shareholder s stock basis. 12. Stock Issued for Services Rendered. The corporation can deduct the value of the stock it issues for services rendered unless the payment is characterized as a capital expenditure (e.g., an organizational expenditure). 13. Holding Period for Shareholders and Transferee Corporation. a. Shareholder s holding period for stock received in exchange for a capital asset or 1231 property includes the holding period of the property transferred. Stock received for other property (ordinary income property) begins the day after the exchange. b. Transferee corporation s holding period for property acquired in a 351 exchange is the holding period of the transferor-shareholder regardless of the character of the property in the transferor s hands. 14. Recapture Considerations. Depreciation recapture potential carries over to the corporation and does not trigger gain to the shareholder making the transfer. 4.2 CAPITAL STRUCTURE OF A CORPORATION Capital Contributions 15. Corporations recognize neither gain nor loss on the receipt of money or other property in exchange for its capital stock (including treasury stock) ( 1032). a. Contribution to corporate capital by a shareholder (not in exchange for stock). (1) No income is recognized by the corporation [ 118(a)]. (2) Corporation generally has a basis in the property equal to the shareholder s basis. However, the basis adjustment for loss property (described above) also applies to contributions to capital [ 362(a)(2) and (e)(2)]. (3) Shareholder recognizes no gain or loss on the transfer and the basis in the original shares must be adjusted accordingly [ 358(a)]. b. Contribution by nonshareholders. (1) Corporation recognizes no income and the basis in the property transferred to the corporation is zero. (2) If money is contributed by a nonshareholder, the basis of property acquired is reduced by the amount of money contributed. Special rules apply if the money contributed exceeds the cost of the property acquired.

7 Chapter 4 Solutions to Research Problems 4-7 Debt in the Capital Structure 16. Advantages of receiving long-term debt by a transferor shareholder include the following. a. Interest is deductible by the corporation, whereas dividend payments are not. b. Shareholders are not taxed on loan payments unless they exceed basis, whereas withdrawing a stock investment can only rarely be tax-free. c. Beginning in 2003, the general advantages of debt over equity from the investor s perspective have been softened. This is the case because dividend income on equity holdings is taxed to individual investors using the low capital gains rates while interest income on debt is taxed at the higher ordinary income rates. d. The tax advantages of financing a corporation with some debt are clear and beyond question. In fact, debt is so advantageous from a tax perspective that some corporations overdo it. Nonetheless, some well-known, successful corporations choose to operate without significant amounts of long-term debt. Microsoft, Walgreen, and Cisco Systems apparently have decided that the nontax advantages of minimizing debt (e.g., not having to contend with debt service costs) outweigh the tax advantages of using debt. Such debt-free companies may be the envy of corporations that have relied on debt, perhaps excessively, as a means of growth. In some cases, corporate debt does little to enhance a shareholder s investment and may even destroy it. 17. In certain instances, the IRS will contend that debt is really an equity interest and will deny the shareholders the tax advantages of debt financing. a. If the debt instrument has too many features of stock it may be treated as a form of stock. In such a case, principal and interest payments on debt reclassified as stock are treated as dividends. b. In the current environment (i.e., where dividend income is taxed at capital gains rates and interest income is taxed at ordinary income rates), the IRS may be less inclined to raise the thin capitalization issue because the conversion of interest income to dividend income would produce a tax benefit to individual investors. 18. Section 385 authorizes the Treasury Department to issue Regulations to clarify when debt should be reclassified as equity but to date, Treasury has not done so. Thus, taxpayers must rely on judicial decisions to determine whether a true debtor-creditor relationship exists between the corporation and the debt holders. 19. Together, Congress and the courts have identified the following factors that should be considered in resolving thin capitalization issues. Debt is in proper form. Open account advance easily characterized as contribution to capital. Debt instrument bears a reasonable rate of interest. Debt is paid on a timely basis.

8 Payments on the debt are not contingent on earnings. Debt is not subordinated to other liabilities. Holdings of debt and stock are not proportionate. Funds were not loaned to the corporation to finance initial operations or capital asset acquisitions. Corporation ratio of shareholder debt to shareholder equity is not high. 4.3 INVESTOR LOSSES Stock and Security Losses 20. Generally, losses from worthless stock and bond investments fall under 165(g)(1). a. This treatment is normally not an advantageous result for the investor. Section 165(g)(1) usually leads to a long-term capital loss. No deduction for the loss will be allowed unless the investor can prove that the stock is entirely worthless. b. Ordinary (rather than capital) loss treatment on stocks and bonds is permitted in the following circumstances: When the shareholder is a dealer in securities. When the affiliated corporation rules of 165(g)(3) apply. When 1244 applies as to stock in a small business corporation. For individual investors, a loss incurred on the sale or worthlessness of a stock investment results in capital loss treatment. For these taxpayers, the deduction for net capital losses is limited to a $3,000 per year offset to ordinary income. In contrast, qualifying investors who meet the requirements of 1244 may deduct a loss of as much as $100,000 per year. Further, a loss from the sale or disposition of 1244 stock is accorded ordinary rather than capital treatment. There has been discussion to increase the $3,000 loss limitation to provide greater tax incentives for small investors. Given that some individuals portfolios may reflect significant stock market losses, such a change would prove highly popular among investors. In addition, it would bring the tax treatment of ordinary investors losses more in line with that of Furthermore, the $3,000 limitation is not indexed for inflation. This threshold has not changed since the 1970s. Nonetheless, any efforts to enact such a change face a significant roadblock. Opponents point out that a more generous loss limitation would reduce revenue at a time when the Federal budget deficit is projected to continue at high levels. Hence, the need for fiscal discipline precludes any change that would further aggravate the deficit.

9 Chapter 4 Solutions to Research Problems 4-9 Business versus Nonbusiness Bad Debts 21. Business bad debts are ordinary losses while nonbusiness bad debts are short-term capital losses. a. Businesses may write-off debts as they become uncollectible while nonbusiness debts can be written off only when the amount remaining on the debt becomes entirely uncollectible. b. Nonbusiness bad debt treatment is limited to noncorporate taxpayers; however, all bad debts of corporations qualify as business bad debts. Section 1244 Stock 22. Losses on 1244 stock (small business corporation stock) are treated as ordinary losses up to a maximum of $50,000 (single) or $100,000 (joint return) per year. 23. Total amount of 1244 stock that can be issued cannot exceed $1,000,000. The $1,000,000 limitation is determined on the date the stock is issued. a. For these purposes, property received in exchange for stock is valued at its adjusted basis, reduced by any liabilities assumed by the corporation or to which the property is subject. b. Losses above the $50,000/$100,000 limitations are capital. To qualify as a small business corporation under 1244, a corporation must derive more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales and exchanges of stock or securities (only the gains are considered). This gross receipts requirement applies only if the corporation s receipts equal or exceed its deductions other than a net operating loss deduction or the dividends received deduction. The test is applied for the corporation s most recent five years. Only the original 1244 stockholder qualifies for ordinary loss treatment. If stock is sold or donated, it loses its 1244 status as to the new owner. If a partnership is involved, the partnership must not distribute stock to its partners. The individual using 1244 must have been a partner at the time the partnership acquired the stock. Each partner s share of partnership tax attributes includes the share of the loss the partnership sustains on the stock. Example. Rita and Quinn are partners in the RQ Partnership. The RQ Partnership acquires 100 shares of 1244 stock in White Corporation at a cost of $100,000. A few months later RQ Partnership distributes 25 shares to Rita and 25 shares to Quinn. White Corporation suffers financial difficulties and files for bankruptcy two years later. White Corporation stock is worthless. RQ Partnership can claim an ordinary loss of $50,000 (the cost of the remaining 50 shares in White Corporation), which is then passed to Rita and Quinn as ordinary loss. However, Rita and Quinn have a capital loss of $25,000 each on the shares distributed to them by RQ Partnership. The 50 shares RQ Partnership distributed to Rita and Quinn lose their 1244 status. Rita and Quinn were not original stockholders (see Reg (a)-1(b)(2) and Jerome Prizant, 30 TCM 817; TC Memo ). If RQ Partnership had not distributed the stock to Rita and Quinn, it would have claimed an ordinary loss of

10 $100,000, which would have passed to Rita and Quinn as ordinary loss. Thus, Rita and Quinn could each have claimed ordinary loss of $50,000 on their individual returns. 24. If 1244 stock is issued for property that has a basis in excess of its fair market value on the date of the exchange, the basis for purposes of 1244 is reduced to the fair market value of the property on the date of the exchange. a. Only the decrease in the stock after the date of the exchange is ordinary loss. b. The difference between the basis and the fair market value on the date of the exchange is capital loss. To qualify as 1244 stock, the corporation must derive at least 50% of its aggregate gross receipts from sources other than passive income, portfolio income and stock or securities sales. What if the corporation never emerges from the startup phase before its stock becomes worthless? Is it an operating corporation for purposes of 1244 so its shareholders qualify for the ordinary loss treatment? In Robert Schwartz, 70 TCM 526, TC Memo , the IRS contended that stock in a corporation organized to acquire another corporation and which had never began operations, did not qualify as a small business corporation. The IRS disallowed the shareholder an ordinary loss deduction for his investment loss. However, the Tax Court looked to the corporate director s intent, which was to have the corporation sell and operate video-lottery machines. It concluded that the corporation would have been an operating corporation had it emerged from the startup phase. Thus, it ruled that the shareholder s stock qualified as 1244 stock. GAIN FROM QUALIFIED SMALL BUSINESS STOCK 25. Up to 50% of gain recognized on the sale or exchange of qualified small business corporation stock may be excluded under The exclusion is increased to 75% for stock acquired after February 17, 2009; the exclusion is 100% for stock acquired after September 27, 2010 and before a. The 0% and 15% capital gains rates do not apply. Rather, the highest marginal rate applicable to sale of qualified small business stock is 28%. Therefore, after the exclusion, the maximum effective tax rate is 14% (28% X 50%) or 7% (28% X 25%). b. To qualify, taxpayers must have acquired the stock as part of the original issue and must hold the stock for more than 5 years. The exclusion is only available to noncorporate shareholders. c. A qualified small business corporation is a C corporation whose aggregate gross assets did not exceed $50 million on the date the stock was issued.

11 Chapter 4 Solutions to Research Problems 4-11 d. Exclusion is applied to the greater of $10 million or 10 times the shareholder s aggregated adjusted basis in the stock.