#11709 - Formation Of A Corporation - Corporate Tax (Duke Zelenak)

When a corporation issues stock for cash, shareholders simply has made a cash-purchase and takes a cost basis in the share, not a realization event.

Stock for property

1. For shareholders, section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for its stock if the transferors of the property are in control of the corporation immediately after the exchange. (see details below)

   1. However, the portion of shares in exchange for services will still be taxed as ordinary income

2. For corporation, section 1032(a) provides that a corporation shall not recognize gain or loss on the receipt of money or other property in exchange for its stock (including treasury stock).

3. Basis for shareholder

   1. Section 358(a)(1): Basis in stock= old basis in transferred property. That is, the basis of the stock received in section 351 exchange shall be the same as the basis of the property transferred by the shareholder to the corporation.

4. Basis for corporation

   1. Section 362(a) transferred basis:

      1. Corporation’s basis in property= old basis of the property

      2. the corporation’s basis in any property received in a section 351 exchange is the same as the transferor’s basis

5. Could end up with double taxable gains (shareholder sells shares, and corporation sells property)

   1. But you cannot get double losses

13-2

One or more persons (including individuals, corporations, partnerships and other entities)

1. Can look at a group of persons together as a controller group

The transferor must be in control of the corporation immediately after the exchange

1. Section 368(c) defines control as “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation”

Property defined

1. Property usually includes cash, capital assets, inventory, accounts receivable, patents, etc. Regulations 1.351-1(a)(1),(2)

2. Section 351(d)(1) specifically provides that stock issued for services shall not be considered as issued in return for property.

   1. E.g. A (50 FMV and 1 basis patent, for 50 shares); B (50 cash, for 50 shares); C (services, for 50 shares)

   2. C’s services does not count as property

   3. A and B’s group interest = 100/150=67% < 80%

   4. A has to recognize gain

   5. B does not care, B purchases stock with cash, not a realization event.

3. But if a person receives stock in exchange for both property and services, all that shareholder’s stock is counted toward the 80 percent control requirement

   1. In the previous example, if C contributes 1 dollar in exchange for 1 share, and contributes services for 49 shares, C would be contributing property, all 50 of C’s shares would count.

      1. Then A would qualify for nonrecognition.

      2. But still, C still needs to recognize as income the 49 shares.

      3. This is prohibited by regulations below:

   2. Regulation 1.351-1(a)(1)(ii): To prevent maneuvering around the control requirement, the regulations provide that the stock will not be treated as having been issued for property if (1) the primary purpose of the transfer is to qualify the exchange of the other property transferors for nonrecognition, (can argue that the primary purpose is to retain majority control) and (2) if the stock issued to the nominal transferor is of relatively small value in comparison to the value of the stock already owned or to be received for services by the transferor

      1. Revenue Procedure 77-37: if the cash is more than 10% of service (or shares already owned), then it is allowed

      2. In the previous example, if C transfers 5 dollars of cash for 5 shares, and 45 dollars for 45 shares, then property/service=5/45>10%, this is allowed.

      3. On the other hand: it is not clear that anything less than 10% is necessarily of relatively small value

4. Strategies for C in the previous example to avoid tax

   1. Section 83, if you receive property as compensation for property, and the property bears risks of forfeiture, then the taxpayer does not need to include in gross income until the risks are eliminated

   2. Could give A and B preferred stock, and give C common stock, and structure dividends in such a way that C cannot really get dividends. And if the corporation liquidates, C also practically cannot get anything. Then C’s common stock is practically worthless, of very little value, therefore little income.

Old and cold shares

1. If A already has 100 shares, A transfers property (5v, 1b) to get 5 additional shares, then A qualifies non-recognition

   1. 105/105=100%

2. In the previous example, if B also transfers property (100v, 20b) to get 100 additional shares

   1. Regulation 1.351-1(a)(1)(ii) kicks in and since A transferred only a relatively small value, does not count, cannot get B nonrecognition

   2. Revenue Ruling 77-37 kicks in, if A transfers a 10v, 1b for 10 shares, then 10/100=10%, then A and B as a group controls 205/205>80%, B qualifies for nonrecognition

   3. Or A can argue that the primary purpose of the 5v, 1b transfer is not to qualify B for non-recognition (the first prong of Regulation 1.351-1(a)(1)(ii)), then B can still qualify for non-recognition.

Problem p67

1. A and B are forming Newco. Jan 2, A transfers appreciated property 50v, 10b, for 50 shares of common stock. Mar 2, unrelated to A’s transfer, B transfer 10v, 1b for 10 shares of non-voting preferred stock (qualified preferred stock)

   1. A qualifies under 351, 50/50=100%

   2. B does not qualify under 351. Separate transaction, 0% of voting power.

2. If they are related transactions

   1. Immediately after= within a reasonable period of time, as part of the same plan

   2. A and B would be treated as a group owning 100% of both voting and non-voting shares.

3. If they are related transactions, but on Mar 6, A transferred 25 shares to A’s daughter, D.

   1. Concern: control test does not count D, because D does not transfer property

   2. No need to be concerned, gratuitous transfer does not count in the same transaction, A and B still count as non-recognition

   3. What if gift in January?

      1. Not clear, A might as well wait.

4. If A transferred 15 shares to E two months after B’s transfer, pursuant to a binding obligation.

   1. Contest 35/50<80%

Nonqualified preferred stock

1. Certain preferred stock with debt like characteristics: Section 351(g)(2), non-qualified preferred stock is treated as other property, or boot, rather than stock for purposes of section 351

2. Nonqualified preferred stock is generally defined as preferred stock with any of the following characteristics

   1. The stockholder has the right to require the issuing corporation or a related person to redeem or purchase the stock

   2. The issuer or a related person is required to redeem or purchase the stock

   3. The issuer or a related person has the right to redeem or purchase the stock, and, as of the issue date, it is more likely than not that such right will be exercised; or

   4. The dividend rate on such stock varies in whole or in part with reference to interest rates, commodity prices, or similar indices.

      1. The first three of these categories apply only if the right or obligation with respect to the redemption or purchase of the stock may be exercised within the 20-year period beginning on the issue date of the stock, and such right or obligation is not subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase.

3. Problem 69-70

   1. Newco corporation;

   2. Nate 200 property, basis 50, receives 200 shares

   3. Venture capitalist 150 cash, receives 150 shares

   4. Manager gets 150 shares, as compensation, and cash compensation reduced to 40 per year for 5 years.

      1. Nate has to recognize (fail the control test, not >80%)

      2. M cannot get nonrecognition because it’s in exchange for service, get 150 shares worth of compensation subject to tax

   5. Manager gets 150 shares, in exchange for 150 note, and cash compensation is 80

      1. 351(d) issue, stock in exchange for service or note?

      2. 351(a) issue, note counts as property? Probably, no legal precedent here. If it is property, then Nate could get non-recognition under the control test

   6. Manager transfers 1 cash, for 150 shares

      1. For manager, 1 cash for 1 share, 149 shares of compensation income

      2. For Nate

         1. Regulation 1.351-1(a)(1)(ii): small amount+purpose

         2. Revenue Ruling 77-37: 1/149<10% (not 1/150)

         3. Nate must recognize (350/500<80%)

   7. Manager transfers 20 cash, for 150 shares

      1. For manager, 20 shares for cash, 130 shares of compensation income

      2. For Nate

         1. Regulation 1.351-1(a)(1)(ii): small amount+purpose

         2. Revenue Ruling 77-37: 20/130>10% not a small amount

         3. Therefore Nate can get non-recognition (500/500>80%)

   8. Manager transfers 20 cash, for 20 shares, and another 130 shares subject to forfeiture in 5 years if manager ceases to be employed by Newco

      1. Section 83(a): generally, if you receive property in exchange for service, and the property is subject to forfeiture, then you don’t have to include it as income until the risk of forfeiture is eliminated.

         1. Therefore, manager will be taxed on the 130 shares when the risk of forfeiture lapses five years later. Taxed as ordinary income, and at the price of the stock five years later.

         2. Alternatively, manager can elect under 83(b) to be tax now (rather than when the risk lapses), to avoid being taxed five year later at ordinary income rate, and at the price five years later. Instead, if manager sells the stock five years later he will be taxed at...