Client Memorandum
DATE
______________________________________________________________________________
Client:
Issue:
Tax Consequences of Corporate Contributions and
Distributions
Introduction
The purpose of this Client Memorandum is to provide guidance with respect
to the tax consequences of corporate contributions and distributions for
corporate shareholders and the possibility of the assignment of depreciation
deductions from one taxpayer to another.
Corporate
Distributions
The first proposed course of action is the distribution of depreciated property
to a shareholder (“Shareholder”). In order to determine the amount
distributed, Section 301(b) of the Internal Revenue Code (the “Code”)
instructs us to look at the fair market value of the distributed property,
reduced by any liability(ies) assumed by the shareholder. Under §301(c)(1),
distributions that are dividends within the meaning of §316 must be included
in gross income. In testing for dividend status, the regulations under §316
first look to current and accumulated earnings and profits. Any distributions
that are not dividends under §316 are then treated as a recovery of the
shareholder’s basis and any excess over basis is generally treated as a gain
from the sale or exchange of stock.
However, under 311(a)(2) of Code, the general rule is that no gain or loss
shall be recognized to a corporation on the distribution, not in complete
liquidation, with respect to its stock, of property. Although there is an
exception to the general rule of non-recognition, it deals with distribution of
appreciated property and is therefore irrelevant here. Therefore, upon the
distribution of fully depreciated property to the Shareholder of Oldco, there
will not be any gain or loss to Shareholder. Since we do not have all the
information regarding the company’s earnings and profits, nor the basis of
the shareholder, or the fair market value of the property, we will be unable to
estimate or approximate the portion, if any, which would be taxable to the
shareholder as a result of this transaction.
Finally, Shareholder will have a holding period in the property equal to that
which the corporation had in the property under §1223(2).
Depreciation
Deduction
Assignments
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The next proposed course of action is for Shareholder who received the
Corporate
Contributions distribution from the original company (“Oldco”) to combine the property
& Formation which he received from Oldco with similar property he individually owned
prior to the distribution and contribute all of the property to a newly formed
Company (“Newco”) in exchange for stock, followed by a sale of the stock
to a third party (“Buyer”).
Initial
Contribution
On the initial contribution of the property to Newco, the general rule is that a
shareholder does not recognize gain or loss on the transaction. Specifically,
§351(a) of the Code provides that no gain or loss shall be recognized if
property is transferred to a corporation (1) by one or more persons (2) solely
in exchange for stock (3) if the transferors of property are in control of the
corporation immediately after the exchange. Control is defined in §368(c) as
the ownership of stock possessing at least 80% of the total combined voting
power of all classes of stock entitled to vote and at least 80% of the total
number of shares of all other classes of stock of the corporation. The
problem here is that Shareholder plans to immediately sell his shares in
Newco to Buyer. Such a plan could lead him open to a challenge by the
Internal Revenue Service (the “Service”) because under current law the
control requirement of §351 is not satisfied if the transferor (Shareholder
here) agrees beforehand to transfer enough of his stock in the corporation to
lose control or if such a transfer is an integral part of the plan of
incorporation. 1
The Step
Transaction
Doctrine
The Service’s argument that the control requirement of §351 is not satisfied
is based upon the Step Transaction Doctrine. The Step Transaction Doctrine
is a doctrine utilized by the Service to determine if one transaction is
complete in itself or if it is just one of a series of transactions and should be
viewed as a whole. If the Service feels like the Doctrine should apply, they
can and will re-order and re-characterize entire taxpayer transactions. From
looking at case law, it appears that courts and the Service have intermittently
and interchangeably used three (3) tests in determining whether to apply the
Step Transaction Doctrine – the Binding Commitment test, the End Result
test and the Interdependence test – and have held that the finding of the
satisfaction of only one of these tests is sufficient to apply the Step
Transaction Doctrine to a so-called series of related taxpayer transactions. 2
Binding
Commitment
Test
In 1976, in Intermountain Lumber Co., the U.S. Tax Court seemed to
adequately sum up the Binding Commitment test by saying:
If the transferee, as part of the transaction by which the shares were
acquired, has irrevocably foregone or relinquished at that time the
legal right to determine whether to keep the shares, ownership in such
shares is lacking for purposes of section 351. By contrast, if there are
no restrictions upon freedom of action at the time he acquired the
shares, it is immaterial how soon thereafter the transferee elects to
dispose of his stock or whether such disposition is in accord with a
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preconceived plan not amounting to a binding obligation. 3
Under the Binding Commitment test, “a determination must be made
whether, after the first step occurs, the parties were under a binding
commitment to take the later steps.” 4 In a case decided in 1978, a
corporation who bought the assets of another corporation (hereinafter
“Buying Corporation” and “Original Corporation”) and then liquidated
Original Corporation was forced to recapture depreciation deductions under
§1245 of the Code and therefore tried to argue that the incorporator of
Original Corporation should not have received §351 treatment, but instead
should have recognized a gain on the sale of his assets to Original
Corporation; thereby, relieving Buying Corporation from any
recapture/ordinary income liability on the liquidation of Original
Corporation. 5 Buying Corporation tried to assert that the incorporator was
not entitled to §351 treatment because he failed the control requirement by
having a “plan to part with control” at the time Original Corporation was
formed. 6
The 9th Circuit Court of Appeals reviewed the facts of the case, mainly
focusing on the following facts: (1) Original Corporation was incorporated in
October of 1965; (2) the agreement by incorporator and a third party to sell
stock was reached sometime after January of 1965; (3) incorporator followed
the formal incorporation requirements in Washington; and (4) Buying
Corporation had not established by a preponderance of the evidence that a
pre-existing obligation or plan was in existence for incorporator to sell his
interests in Original Corporation at the time of the formation of Original
Corporation. 7
Therefore, the Curt held “the transfer of assets [by
incorporator] to Kennewick (Original Corporation) is governed by Section
351. Therefore, the “old and cold” defense seemed to work in this particular
case.
10th Circuit
Precedent
Application to
Shareholder
End Result Test
Under the End Result test, “purportedly separate transactions will be
amalgamated into a single transaction when it appears that they were really
component parts of a single transaction intended from the outset to be taken
for the purpose of reaching the ultimate result.” 8 Although Revenue Ruling
70-140 provides only limited facts, it appears that the Service applied the
End Result Test to a transaction whereby a shareholder of X corporation
contributed assets which he owned individually to X corporation in return for
X corporation stock and then transferred that stock to Y corporation for Y
stock. The Revenue Ruling’s holding provided “the two steps were part of a
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prearranged integrated plan and may not be considered independently of
each other for federal income tax purposes.”
Application to
Shareholder
Interdependence
Test
The Interdependence test “requires an inquiry as to whether on a reasonable
interpretation of objective facts the steps were so interdependent that the
legal relations created by one transaction would have been fruitless without a
completion of the series.” 9 An illustration of the Interdependence test is
found in Manhattan Building Co., a 1922 case which was based on §351’s
predecessor, in Manhattan Building Co., the court said “[t]he test is, were the
steps taken so interdependent that the legal relations created by one
transaction would have seen fruitless without a completion of the series.” 10
Application to
Shareholder
Conclusion
The 10th Circuit made it clear that if a taxpayer and his or her series of
transactions did not pass even one of the three tests underlying the Step
Transaction Doctrine, then the Step Transaction Doctrine would be applied
to defeat a taxpayer’s claim of the application of §351 for non-recognition of
gain. Based on the above analysis …..
Tax
Consequences
of the Step
Transaction
Doctrine
If the Service successfully argues that the Step Transaction Doctrine should
apply in shareholder’s case, then the transaction would be termed a “busted
§351 transaction.” The tax consequences of a busted §351 transaction would
be to turn the transaction into a taxable asset-for-Newco stock exchange, and
more specifically as follows:
•
•
•
•
The contribution of the assets of shareholder to Newco would be
treated as a sale under §1001.
Shareholder would likely realize a gain on the “sale” of the assets –
which would be determined by subtracting his adjusted basis in the
assets from his amount realized (which would be equal to the fair
market value of the assets).
o Gain would likely result because the facts indicate that the
property has been fully depreciated.
o Since the property sold consists of fully depreciated property,
then part of the gain would be ordinary income to Shareholder
due to §1245 and its depreciation recapture provisions.
Shareholder’s basis in the stock would be equal to the fair market
value of the assets – calculated by utilizing his substituted basis in the
assets and adding to that his recognized gain.
Newco’s basis in the assets is determined under §362(a)(2) and will
be equal to the fair market value of the assets (transferred basis in the
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asset + recognized gain to transferor).
When Shareholder sells the assets to Buyer, Buyer would take a cost
basis in the stock under §1012 and it is unlikely that Shareholder
would recognize a gain or loss.
In conclusion, while Shareholder would have to recognize gain on the “sale”
of the property to Newco (a tax burden), both he and Newco would receive a
step-up in basis of their property to fair market value (a tax benefit). Since
the assets in Newco would be stepped up to fair market value they could be
depreciated, thereby giving Newco a tax benefit. Also, on the future sale of
the stock of Newco to Buyer, there would be no adverse tax consequences to
any party and Buyer would receive a cost basis in the Newco stock.
Tax
Consequences if
§ 351 is Found
to Apply
If the Service and/or the courts determine that §351 does apply, the following
tax consequences will occur:
Shareholder’s
Basis in Newco
Stock
Shareholder’s basis in Newco stock will be determined in reference to §358
of the Code. Section 358 provides “where §351 applies, the basis of the
property received under §351 without the recognition of gain or loss shall be
(in formulaic form):
•
•
•
Shareholder’s
Sale of Newco
Stock to Buyer
Basis of property transferred (“transferred basis”)
Less:
o Fair market value of any other property, besides money,
received by the taxpayer
o The amount of any money received by the taxpayer
Includes Assumption of liability – see §358d
o Recognized loss
Plus:
o Amount which was treated as a dividend
o Recognized gain by taxpayer on exchange
As to the question of whether gain or loss would be recognized on the
subsequent sale of the stock, Section 1001 of the Code would govern.
Section 1001 provides that a gain is realized when the amount realized on a
sale or exchanged is greater than the adjusted basis that the seller had in the
asset. If this is the case, under §1001(d), unless otherwise provided all
realized gains must be recognized. Therefore, depending on the numbers
involved, there may or may not be gain involved on the contemplated sale.
To determine the character of the gain, assuming there would be one on the
contemplated sale, we must first recognize that the corporate stock would be
a capital asset under §1221 of the Code, therefore any gain would be a
capital one. However, whether the capital gain was a short-term or a longterm capital gain would depend upon the holding period, or how long the
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shareholder had held the stock. A short-term capital gain is a gain on
property in which the seller owned the property for less than a year, and a
long-term capital gain is just the opposite (i.e. where the seller owned the
property for greater than a year).
In our situation, §1223(1) provides in a §351 exchange, as we have here, the
holding period of the contributed property is determined by including the
period which the shareholder held the transferred property, if the transferred
property is a capital asset or a §1231 asset. Therefore, we could tack onto
the original shareholder’s holding period in the distributed property and his
own personal property as long as they were considered capital assets or
§1231 assets. After the information was gathered to answer this question,
the tax preparer would then net the shareholder’s net short-term capital gains
versus his net short-term capital losses, and vice versa (long-term gains
versus long-term gains), to help determine the individual’s taxable income
for the year.
ENDNOTES
1
Bittker & Eustice: Federal Income Taxation of Corporations and Shareholders, Paragraph 3.09.
Associated Wholesale Grocers, Inc. v. U.S.C.A.10, 927 F.2d 1517 (10th Cir. 1991).
3
Intermountain Lumber Co. & Subsidiaries, et al. v. C.I.R., 65 T.C. 1025 (1976).
4
TAM 8735009, 1987 WL 421355 citing C.I.R. v. Gordon, 391 U.S. 83, 96 (1968).
5
Culligan Water Conditioning of Tri-Cities, Inc. v. U.S.C.A. Wash., 567 F.2d 867 (9th Cir. 1978).
6
Id. at 870.
7
Id.
8
Id. citing King Enters., 418 F.2d at 516 (1966).
9
Id. citing Paul & Zimet, “Step Transactions,” Selected Studies in Federal Taxation 200, 254 (2d Series 1938).
10
Manhattan Building Co., 27 TC 1032, 1042 (1957).
2
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attachment