Corporate Formation and Capitalization

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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 a liability in connection with corporate organizations and reorganizations. Under the new law, the rule that a liability automatically is treated as assumed where a property is taken subject to it is repealed for §351 transfer and various reorganization transfer purposes.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) Liabilities Assumed in Certain Corporate Transactions

Recourse Liability

A recourse liability (or a portion of it) will be treated as assumed if, on the basis of 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.

Nonrecourse 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. This could trigger gain recognition by the transferor, but the transferee’s basis increase could be limited by the rules described below.

Basis

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 a liability. For this purpose, a 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 determined on the basis of the relative fair market values of all assets subject to it.

Incorporation of a Partnership

There are basically three methods that can be employed to incorporate a partnership, and they are as follows: LLC Filing as a Corporation or Partnership

Alternative #1

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.

Alternative #2

The partnership will distribute all of its assets and liabilities to it partners in proportion to their partnership interests in 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.

Alternative #3

The partners will transfer their partnership interests to a newly formed corporation 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.

The Service formerly ruled in R.R. 70-239 that the tax consequences of all three alternatives are the same. Thus, the Service regarded the incorporation of a partnership as essentially the transfer under §351 by the partnership of all of its assets, subject to its liabilities, to the corporation in exchange for all of the outstanding stock of the corporation. In R.R. 84-111, the Service corrected its prior position and described the tax consequences of the three variations as indicated:

 Example

Assume partnership assets worth $4,000,000 (no cash assets) and two partners, each partner has a basis of $1,000,000 in their partnership interest, a partnership has $3,000,000 basis in assets, and the liabilities of a partnership are $1,000,000.

Tax Consequences – Alternative #1

1. Under §351, the partnership does not recognize gain or loss on the transfer of all of its assets to the corporation in exchange for the corporation’s stock and the assumption by the corporation of the partnership’s liabilities. THE NUTS AND BOLTS OF THE TAXATION OF MERGERS AND ACQUISITIONS

2. Under §362(a), the corporation’s basis in the assets received from the partnership equals the basis to the partnership immediately before the transfer (i.e., $3,000,000).

3. Under §358(a), the basis of the partnership in the stock received is the same as the basis of the assets transferred to the corporation, minus the liabilities assumed by the corporation ($3,000,000 minus $1,000,000 =$2,000,000).

4. The assumption of liabilities by the corporation is treated as a payment of money to the partnership (§358(d)).

5. Under §752 and §733, the assumption by the corporation of the partnership’s liabilities decreases each partner’s share of the partnership liabilities, thus decreasing the basis of each partner’s partnership interest (for each partner $1,000,000 minus $500,000 = $500,000).

6. The partnership terminates on the distribution of the corporation’s stock (§708(b)(1)(A)).

7. Under §732(b), each partner’s basis in the stock distributed equals their adjusted basis in their partnership interest ($500,000).

Tax Consequences – Alternative #2

1. On the transfer of all of the partnership’s assets to its partners, the partnership is terminated under §708(b)(1)(A).

2. Under §732(b), each partner’s basis in the assets distributed equals the adjusted basis of each partner’s partnership interest reduced by the money distributed (for each partner, $1,000,000 minus 0 = $1,000,000).

3. The decrease in the partnership’s liabilities resulting from the transfer to the partners is offset by the partner’s assumption of such liabilities so that the net effect on the basis of each partner’s interest in the partnership is zero(§752).

4. Gain or loss is not recognized by the partners on the transfer to the corporation of the partnership’s assets and liabilities (§351).

5. Under §358(a), the basis to the partners of the stock received from the corporation is the same as their individual basis (under §732(b)) in the partnership assets received, reduced by the liabilities assumed by the corporation (for each partner, $1,000,000 minus $500,000 = $500,000).

6. The assumption of the liabilities by the corporation is treated as a payment of money to the partners under §358(d).

7. Under §362(a), the corporation’s basis in the assets received equals the basis of the assets to the former partners (as determined under §732(c)) immediately before the transfer ($1,000,0 $1,000,000 =$2,000,000).   What Is Adequate Capitalization in an LLC?