Learn about Forming a corporation that involves a transfer of money
Forming a corporation involves a transfer of money, property, or both by prospective shareholders in exchange for capital stock in the corporation. However, §351 provides that transferors (i.e., potential shareholders) don’t have to realize any gain or loss in such a transaction.
For §351 to apply, the transferors of property to a corporation must, as a group, have control of the corporation immediately after the exchange 1. No gain or loss is recognized when the transferors receive solely stock. Profit, but not a loss, is recognized when the transferors receive other property in addition to capital.
Note: If the transferor receives property, including securities of the corporation, or money in addition to stock in exchange for the property transferred, gain (if any) is taxable to the extent of the capital, or fair market value of property received (§351(b)(1)).
A corporation recognizes no gain or loss on the transfer of property and money to the corporation in exchange for corporation stock (including treasury stock). A corporation does not recognize profit or loss on the acquisition or lapse of an option to buy or sell its stock (§1032).
Precisely what constitutes “property” for purposes of §351 is vague. No clear definition exists within the Code for the term “property” in this context. However,
the Code and regulations defined several items that will not constitute property.
Stock Solely For Services
Stock or securities issued for services (past,
a present or future) is not published in exchange
for a property (§351(a)). Transfer of services
to a corporation in return for stock results
in taxable compensation to the transferor
(§351(d); William S. James, 53 T.C. 63 (1959) acq.).
Hence, if a new shareholder receives stock
from a corporation in exchange for his future services to the corporation, he will realize income to the extent of the value of the capital, so received.
2. Impact on Recipient
The person who gets the sharestock for services as ordinary income on the exchange (§61 and §83).
A solution to this problem might be to have the new shareholder obtain stock from the corporation in exchange for his notes payable over the next several years or to buy stock from existing shareholders’ in exchange for cash and notes.
Impact on Other Shareholders
When some recipients of stock transfer services and others transfer property, the property transferors may not as a group receive the required control. Thus, they would recognize gain or loss on the exchange.
Stock for Debt
If a corporation issues stock in the discharge of its outstanding debt, both the corporation and the shareholder can have income. The corporation will
have debt cancellation income if the value of the new stock is less than the amount of the debt (§108(e)(10)(A)) 3. When §351 doesn’t apply, the shareholder recognizes gain or loss on the exchange.
Another definitive problem is what constitutes stock. There are few problems as
far as “stock” is concerned; however, where debt instruments are used, new issues arise.
As a general rule, notes with due dates of less
than five years are not considered stock.
Another major problem with debt financing is
the doctrine of the “thin corporation.” The
result of this doctrine would be that the IRS
would reclassify the debt instruments as
stock, thereby disallowing the interest deduction to the corporation, and making the repayment of principal taxable as dividends to the newly created “shareholder.” This doctrine is contained in §385; however, the regulations in this area continue nebulous.
The transferors must be in control of the corporation immediately after the exchange. To be in control, the transferors must, as a group, own:
(1) At least 80% of the total combined voting power of all classes of stock entitled to vote, and If the shareholder contributed the debt to capital by forgiving the debt and receiving no stock,
the corporation’s income is the difference between the amount of the debt and the shareholder’s basis for the debt (§108(e)(8)).
At least 80% of the total number of shares of all other classes of stock
When a transferor receives stock for both property and services, he is counted in
full as a transferor of property for purposes of the 80% control requirement.
However, the value of the stock received for services is ordinary income
The basis of the property a corporation receives in exchange for its stock in an 80%
control transaction, or as paid-in surplus, or as a contribution to capital is the same basis the transferor had in the property increased by any gain the transferor recognized in the exchange (§362).
If a corporation receives property by issuing stock for it, other than in an 80% control transaction, the basis of the property to the corporation is usually the fair market value of the stock at the time of the exchange. If the stock has no established value, evidence of the fair market value of the transferred property may be used to set the value of the stock if all outstanding stock is issued in exchange for that property (§1012).
The basis of the stock received in exchange for the transfer of property to a corporation is the same as the basis of property transferred decreased by:
(1) The fair market value of any other property (except money) received,
(2) The amount of any funds received, and
(3) Any loss you recognize on the exchange;
and increased by:
(1) Any amount treated as a dividend, and
(2) Any gain realized on the transaction.
The basis of property received, other than money or stock, is its fair market value (§358(a)).
Occasionally, a new corporation will assume the responsibilities of the previous business or take the property subject to liability. That does not affect §351. The amount of the obligation will reduce the contributor’s basis in the stock, and the
corporation’s basis in the property will be the basis of the contributor immediately before the exchange. The gain will be taxed, however, to the extent that the liabilities assumed exceed the contributor’s adjusted basis (§357(c)).
Real property with a basis of $65,000 and the present value of $120,000 has a mortgage against it for $85,000
is transferred to a newly formed corporation in exchange for stock. $20,000 would be taxed as gain to the contributor ($85,000 liability – $65,000 basis = $20,000 gain).
Miscellaneous Trade & Technical Corrections Act – §351
On June 25, 1999, the President signed the Miscellaneous Trade and Technical Corrections Act into law, thereby changing the tax impact of property
taken subject to liability in connection with corporate organizations and reorganizations.
Under the new law, the rule that a liability automatically is treated as assumed where the property is taken subject to it is repealed for §351 transfer and various reorganization transfer purposes. Only liabilities specifically treated as assumed under the new rules will result in a basis step-up for the transferee corporation (H.R. 435, P.L. 106-36,6/25/99).
A recourse liability (or a portion of it) will be treated as assumed if, based on all facts and circumstances, the transferee has agreed to, and
is expected to, satisfy the liability (or portion of it), whether or not the transferor has been relieved of the liability.
A nonrecourse liability will be treated as assumed by the transferee of any asset subject to the liability, except that the amount of a nonrecourse liability treated as assumed would be reduced by the lesser of:
(a) the amount of the liability that the owner of other assets not transferred to the transferee which are also subject to that liability has agreed with the transferee to, and is expected to, satisfy, or
(b) the fair market value of those other assets subject to the liability. If the owner of untransferred assets also securing a nonrecourse debt
does not agree to pay any of it, the amount of the liability treated as assumed by the transferee would not be reduced at all. That could trigger
gain recognition by the transferor, but the transferee’s basis increase could be limited by the rules described below.
Under the new law, the transferee’s basis couldn’t be increased in a Section 351 transfer to a controlled corporation nor by Section 362(b) (in reorganization) above the property’s fair market value by the gain recognized by the transferor as a result of the assumption of liability. For this purpose, fair market value is determined without the Section 7701(g) rule
treating property subject to nonrecourse debt as worth at least as much as the debt.
Also, if a property transferor recognizes gain as a result of an assumption of a nonrecourse liability that is also secured by assets not transferred to
the transferee and no person is subject to tax on the gain, the transferee’s basis can be increased only by the ratable portion of the liability deter-
mined based on the relative fair market values of all assets subject to it.
Incorporation of a Partnership
Three methods can be employed to incorporate a
partnership and they are as follows:
The partnership will transfer all of its assets to a newly formed corporation in
exchange for all the outstanding stock of the corporation and the assumption
by the corporation of the partnership’s liabilities (§351). The partnership is then terminated by distributing all the corporation stock to the partners in proportion to their partnership interests.
The partnership will distribute all of its assets and liabilities to its partners in proportion to their partnership interests in the termination of the partnership under §708(b)(1)(A). The partners, then transfer all the assets received from the partnership to the newly formed corporation, in exchange for all its outstanding stock and the assumption by the corporation of the partnership’s liabilities that were assumed by the partners in the earlier distribution.
The partners will transfer their partnership interests to a newly formed cor-
poration in exchange for all its outstanding stock. This exchange will terminate the partnership, and all of its assets and liabilities will become the assets and liabilities of the corporation.
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