Formation of a Corporation

1. 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.

2. 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

351 (a) non-recognition eligibility requirements

3. 13-2

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

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

5. 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”

6. 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.

7. 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.

8. 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...

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