Question

3. Jack and Carter formed Sheriff Inc., a C-Corporation. Jack transfers land (FMV $450,000 and adjusted basis of $50,000) for 50% of the stock in the corporation. Carter transfers equipment (FMV 450,000 adjusted basis of $500,000) and will provide legal services worth $250,000 to Sheriff Inc. to draft corporate operating agreements for 50% of the stock in the corporation.

a. Will the transfer qualify under §351 as a tax free transfer? Explain.

b. What are the tax consequences to Jack and Carter including the basis in the stock they received?

c. What is Sheriff Inc.’s basis in the land and equipment?

d. How would your answers change if Carter’s property had a FMV of $21,500 and basis of $1,000 instead?

(I know it does qualify for 351, due to the fact they are part of an integrated plan)

Answer 1

a.) Yes the transfer qualify under §351 as a tax free transfer

Section 351.–Transfer to Corporation Controlled by Transferor

Whether a transfer of assets to a corporation (the “first corporation”) in exchange for an amount of stock in the first corporation constituting control satisfies the control requirement of § 351 of the Internal Revenue Code if, pursuant to a binding agreement entered into by the transferor with a third party prior to the exchange, the transferor transfers the stock of the first corporation to another corporation (the “second corporation”) simultaneously with the transfer of assets by the third party to the second corporation, and immediately thereafter, the transferor and the third party are in control of the second corporation.

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 stock in such corporation and immediately after the exchange such person or persons are in control (as defined in § 368(c)) of the corporation.

Section 368(c) defines control to mean 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. Section 1.351-1(a)(1) of the Income Tax Regulations provides that the phrase “immediately after the exchange” does not necessarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure.

b.)

Tax law has a number of important rules that apply when one contributes appreciated property to a corporation. In general, if one transfers property to a corporation in exchange solely for the corporation’s stock, and immediately after the transfer, the transferor, together with all other persons who also transferred property as part of the same transaction, are in "control" (defined below) of the corporation, the transferor will not recognize gain or loss. However, it is significant to note that persons who receive stock for services do not count towards the control requirement, even if they also transfer a nominal amount of property.

A transferor’s cost basis for the contributed property carries over to the corporation and also becomes the transferor’s basis for the stock received. However, if the corporation’s carryover basis for all the property one has transferred is more than the property’s fair market value immediately after the contribution, the corporation’s basis is reduced to the property’s fair market value under a carryover basis limit rule. If this rule applies, the transferor and the corporation can jointly elect to apply the basis reduction to the cost basis of the stock received by the transferor, instead of the corporation’s basis in the property. When property the transferor will be contributing has declined in value, these special rules are relevant.

"Control"

"Control" means the ownership of 80 percent of the voting power of the voting stock of the corporation’s voting stock and 80 percent of the number of shares in each class of non-voting stock. One important exception is that a transferor who has entered into a binding commitment to dispose of stock to be received for the transfer of property does not count towards the 80 percent "control" requirement.

If the persons transferring the property (together) do not "control" the corporation immediately after the transfer, each transferor recognizes gain or loss equal to the difference between his or her basis in the transferred property and the value of the stock received. Note, however, that even if loss is recognized, it will not necessarily be deductible.

"Boot"

Even if the "control" test is met, a transferor may still have to recognize gain if the transferor receives cash or property ("boot") other than stock of the transferee in exchange for the transferor’s property. Debt securities are treated as "boot" for this purpose, as are certain types of redeemable or adjustable-rate preferred stock.

If the transaction includes the receipt of "boot," the transferor will recognize the lesser of (a) the gain realized as to the property (i.e., the excess, if any, of the amount received (including the value of the stock received) over the transferor’s basis in the property transferred), or (b) the cash and other "boot" received. The transferor’s basis in the stock is the basis the transferor had in the property transferred, plus gain recognized, minus "boot" received.

c).

Relief of indebtedness is generally a taxable event. However, in most cases, when a transfer of assets qualifies as tax-free under Sec. 351, the transfer of debt (or the transfer of property subject to debt) is not a taxable event (Sec. 357(a)).

The transfer of debt to a corporation will create a taxable event in these three situations:

1. The transfer is made to avoid tax (Sec. 357(b)(1)(A)). In that instance, the full amount of the debt assumed by the corporation is treated as cash (boot) received by the shareholder, and the shareholder recognizes gain equal to the lesser of boot received (relieved debt) or realized gain.
2. If no bona fide business purpose exists for the transfer, the entire debt assumed by the corporation is treated as money received by the shareholder (Sec. 357(b)(1)(B)). In such cases, because money is considered boot under Sec. 351, gain is recognized by the shareholder, but only to the extent of the lesser of gain realized or boot received. For example, assume an individual transfers to a corporation, with no bona fide business purpose, property with an adjusted basis of $60,000 and a fair market value (FMV) of $170,000 along with the underlying mortgage on that property of $80,000. The realized gain will be $110,000 (FMV of $170,000 less adjusted basis of $60,000), and the recognized gain will be $80,000 (the amount of debt). The character of gain (capital or ordinary) to the shareholder usually corresponds to the character of the asset in the shareholder's hands before the transfer.
3. Even if a bona fide business reason exists for the transfer of debt and there is no tax avoidance, gain is recognized by the transferor/shareholder to the extent the aggregate amount of debt transferred to the corporation exceeds the shareholder's basis in the property transferred (Sec. 357(c)). The computation of gain in this situation is applied on a shareholder-by-shareholder basis.

d).if Carter’s property had a FMV of $21,500 and basis of $1,000 in this case Carter's looses the controling interest in Sheriff Inc.’s . Accordingly it is not eligible for  §351 tax benifit, the difference between (21,500 - 1000) = 20,500 $ recognised as gain