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Exam 4: Corporations Organization and Capital Structure

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Question 1

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How is the transfer of liabilities in a property transaction generally treated for tax purposes? How is a transfer of liabilities generally treated in a § 351 transaction? What exceptions could arise to this usual treatment in a § 351 setting?

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Generally when another party assumes a liability in a property transaction, the party no longer responsible for the debt is treated as having received cash or boot. This is consistent with the rule dealing with like-kind exchanges under § 1031. However, when the acquiring corporation assumes a liability in a § 351 transaction, § 357(a) provides that the transfer does not result in boot to the transferor-shareholder for gain recognition purposes. To do so could trigger gain to the property transferor if the corporation assumed a mortgage on the transfer of encumbered property, which could, in turn, discourage the use of the corporate form of business.The general rule of § 357(a) has two exceptions: (1) § 357(b) provides that if the principal purpose of the assumption of the liabilities is to avoid tax or if there is no bona fide business purpose behind the exchange, the liabilities are treated as boot; and (2) § 357(c) provides that if the sum of the liabilities exceeds the adjusted basis of the properties transferred, the excess is taxable gain.

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Because boot is generated under § 357(b) (i.e., the liability is not supported by a bona fide business purpose), the transferor shareholder will always have to recognize gain.

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B) False

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Question 3

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Stock in Merlin Corporation is held equally by Jane, Eve, and Fred. Merlin seeks additional capital to buy a valuable tract of land that will cost $6,000,000. Jane, Eve, and Fred propose to loan Merlin $2,000,000 each, taking from Merlin a $2,000,000 ten-year note with interest payable annually at five points above the prime rate. Merlin Corporation has current taxable income of $7,000,000. How are the payments on the notes treated for tax purposes?

Carl and Ben form Eagle Corporation. Carl transfers cash of $50,000 for 50 shares of stock of Eagle. Ben transfers proprietary information with a tax basis of zero and a fair market value of $50,000 for the remaining 50 shares in Eagle. Carl will have a tax basis of $50,000 in his stock in Eagle Corporation and Ben's basis in his stock will be zero.

To ease a liquidity problem, all of the shareholders of Osprey Corporation contribute additional cash to its capital. Osprey has no tax consequences from the contribution.

Nick exchanges property (basis of $100,000; fair market value of $3 million), for 65% of the stock of Yellow Corporation. The other 35% of the stock is owned by Gloria who acquired it several years ago. What are the tax consequences to Nick?

Because services are not considered property under § 351, a taxpayer must report as income the fair market value of stock received for such services.

The use of § 351 is not limited to the initial formation of a corporation, and it can apply to later transfers as well.

Dick, a cash basis taxpayer, incorporates his sole proprietorship. He transfers the following items to newly created Orange Corporation. $\begin{array}{l}\begin{array}{lll}&&\text { Fair Market }\\&\text { Adjusted Basis }&\text {Value }\\\text { Cash } & \$ 10,000 & \$ 10,000 \\\text { Buil ding } & 120,000 & 175,000 \\\text { Mortgage payable (secured by the building and held } & 135,000 & 135,000\end{array}\\\text { for } 15 \text { vears) }\end{array}$ ? With respect to this transaction:

Kim, a real estate dealer, and others form Eagle Corporation under § 351. Kim contributes inventory (land held for resale) in return for Eagle stock. The holding period for the stock includes the holding period of the inventory.

In order to retain the services of Eve, a key employee in Ted's sole proprietorship, Ted contracts with Eve to make her a 30% owner. Ted incorporates the business receiving in return 100% of the stock. Three days later, Ted transfers 30% of the stock to Eve. Under these circumstances, § 351 will not apply to the incorporation of Ted's business.

Leah transfers equipment (basis of $400,000 and fair market value of $500,000) for additional stock in Crow Corporation. After the transfer, Leah owns 80% of Crow's stock. Associated with the equipment is § 1245 depreciation recapture potential of $70,000. As a result of the transfer:

When a taxpayer transfers property subject to a mortgage to a controlled corporation in an exchange qualifying under § 351, the transferor shareholder's basis in stock received in the transferee corporation is increased by the amount of the mortgage on the property.

When forming a corporation, a transferor-shareholder may choose to receive some corporate debt along with stock. Identify some of the issues the transferor must consider when deciding whether debt should be a part of the transaction.

What is the rationale underlying the tax deferral treatment available under § 351?

Similar to like-kind exchanges, the receipt of "boot" under § 351 can cause loss to be recognized.

A taxpayer transfers assets and liabilities to a corporation in return for its stock. If the liabilities exceed the basis of the assets transferred, the taxpayer will have a negative basis in the stock.

In return for legal services worth $60,000 rendered incident to its formation, Crimson Corporation issues stock to Greta, an attorney. Crimson cannot immediately deduct the value of any of this stock but instead must capitalize it as an organizational expenditure.

In order to induce Yellow Corporation to build a new manufacturing facility in Knoxville, Tennessee, the city donates land (fair market value of $400,000) and cash of $100,000 to the corporation. Several months after the donation, Yellow Corporation spends $450,000 (which includes the $100,000 received from Knoxville) on the construction of a new plant located on the donated land.

A shareholder transfers a capital asset to Red Corporation for its stock. If the transfer qualifies under § 351, Red's holding period for the asset begins on the day of the exchange.