46 § 351.
If a business seeks to become incorporated, all of the business assets will be transferred to the corporation (in exchange for stock) at the time of incorporation. Often times this can lead to a realized loss or gain. Although this is a taxible event, § 351 allows this type of transaction to occur tax free if certain perameters are met. That is, there is no recognized gain or loss if:
- Property or cash (not services) is transferred to the corporation;
- Corporation provides stock for the property or cash received; and
- The transforors retain 80% control (shares and votes) of the corporation immediately after the transaction.
Must be Property Transferred
If there are services contributed with the property, then maybe 351 applies. For example, if the service provider is treated as part of a control group (see control below) by contributing more than a non-trivial amount of property (10% of the value of services), then 351 applies. In this situation, the stock received for service will be taxed but not the stock received for property.
Must Receive Stock
If the transforor receives anything other than stock, it results in boot. Boot is not subject to § 351 and is taxed. Boot is taxed at the lessor of (1) the value of the boot, (2) or the realized gain (no loss is recognized). Because no loss is recognized, some transactions are purposfully designed to fail so people can recognize the loss.
Assumption of Liabilities
A lot of the time property is contributed and there is debt, or a liability, attached to the property. The corporation will often times assume this liability. When the corporation assumes the liability, it might feel like the transforor is receiving debt forgiveness, which intuitively seems like boot. However, liability assumption does not count as boot unless: (1) the liabilities are greater than the total basis in the contributed assets. In this instance, only the excess (gain) would be counted as boot. (2) If there is no business purpose for assuming the liability, then the entire amount (not just the excess) is treated as boot.
Control
For the transaction to be successful, control must be obtained “immediately” after the transaction. This can include any prior ownership before the transaction occurred. An issue may arise if there is a sell of the stock received shortly after the transaction. For instance, a plan to sell stock before the transaction occurs may cause the sell to fail to qualify for § 351.
Additionally, if a group together can obtain 80%, then all group members can be counted as having control, even if they wouldn’t have had control on their own.
Basis
To calculate the shareholder’s basis in stock the following formula applies:
Start with the basis of the contributed assets. Add in any gain recognized on the exchange. Subtract the value of any boot received. Subtract non-boot liabilities. The result is the shareholder’s basis in the stock received.
Typically, for shareholders the basis of the stock is the basis of the assets that were contributed.
The corporations basis equals the basis of the transferred assets plus the gain (calculated by fair market value) received by the shareholder.
Losses
If the property contributed has a loss—the basis is higher than the value of the property—then there is a problem. Both the corporation and the shareholder is not permitted to claim a loss. So, there are a couple of solutions. The corporation’s basis could be reduced to elimate the loss. Another option is to reduce the shareholder’s basis in the stock by the net loss.
Capital Contributions
If a shareholder contributes to the corporation, the contribution does not result in a gain or loss (not taxible) and the corporation adopts the basis of the shareholder. For the shareholder, they can increase the basis in their stock by the basis contributed.
If a non-shareholder contributes to the corporation, this results in taxible income to the company with a fair market value of the corporation.
§1244 Stock
Shareholder’s stock is generally considered a capital asset. § 1244 provides some protections to shareholders if they sell stock at a loss, by classifying some of the loss as ordinary instead of capital (increasing deductibility of the loss). $50,000 (100,000 if filed jointly) of the loss can be classified as ordinary. This section only applies if: (1) the shareholder is an original shareholder (received the stock directly from the company), and (2) the shareholder contrubution was within the first 1 million dollars.
Debt v. Equity
For debt, interest payments are deductible and only has to pay back the value of the debt plus interest. For equity, dividends are not deductible (and may end up costing more than debt), and redemptions are taxible for both the corporation and shareholder.
Businesses would prefer debt and investors would prefer equity.
