Sample Answers to Question 3
Corporate Tax
Spring 2015
Part A
Exam No. 1046
From the outset, the transfer of property by Laila and Malik is a § 351 exchange because it appears to be done pursuant to an integrated plan such that they are both transferors of property (not services) in control of the corporation after the transaction (they own 100% of the stock). Because § 351 is not elective (if the conditions are met, you are stuck with it -for better (usually) or worse), all of the ensuing tax consequences to Laila and Malik are discussed as occurring under § 351.
Tax Consequences to Laila (L)
L's basis in the company (via all of the assets transferred) is initially $45K (carryover Blackacre $10K plus stock $35K) and the liabilities assumed are $40K. It is fair to assume that the liability (mortgage principal payments) are not immediately deductible to L, so they will reduce L's basis in the stock. Because L has more basis in the company ($45K carryover) than the liability assumed, she does not immediately recognize any gain on the assumption of liabilities, but does drop her basis in the stock from $45K to $5K. Furthermore, because the aggregate basis of the property L transfers is not less than the FMV of the property she transfers, there will be no "basis haircut" resulting from the built-in loss property (stock). Accordingly, an election for the shareholder to take the basis reduction is inapplicable. The end result is that L realizes $220K (stock plus liability assumption) and recognizes $0, but has a reduced basis in her stock of $5K. The Corp (C) gets a carryover basis in the stock of $35K and carryover basis in the land of $10K (no upwards adjustment because no gain recognized by L). The Corp. has no gain or loss on the issuance of its stock.
Tax Consequences to Malik (M)
M receives boot (promissory note) in addition to stock. Thus, although § 351 is preserved (transaction meets every other 351 test), § 351(b) applies. There are two potential ways for this to play out: one with M electing the installment method on the note via § 453 (usually the better choice), and one where he does not. In this occasion there isn't going to be as big a difference because he will have no basis to allocate to the promissory note (see below).
M realizes $30K on the transaction ($20K FMV stock, $10K FMV note). He will only recognize a portion of this gain via the note on the installment method. He has $4K of basis from the property to allocate among the stock and the note. The basis must be allocated to the nonrecognition property first (i.e. the stock) to the extent of its FMV, so all $4K of basis goes to the stock. This means that M will eventually be fully taxed on the note for $10K. The basis in his stock is thus $4K carryover + amount recognized ($10K) minus boot FMV ($10K), for a not surprising final amount of $4K. Even though under the installment method, M recognizes gain on the note only as it is paid (i.e. next year) he gets the full $10K "amount recognized" towards determining his stock basis all at once. However, he will recognize and realize $5K upon each payment. Furthermore, the Corp. will only get to add that recognized $5K to its basis in the underlying property (i.e. the vacant lot) as it is actually paid out. Thus C will have a basis in the property of $4K until the first payment next year (2016), when it will go to $9K (and then $14K in the year after).
When the dust settles, M therefore has a basis in his stock of $4K without any present tax (in 2015), and can anxiously await being taxed in 2016 and 2017 on the installments. If he did not elect under the installment method he would be fully taxed on the value of the Note ($10K) all at once. While his basis in the stock would remain the same, the Corp's would actually go up to $14K (quicker) than it does under the installment method. Nonetheless, it is not a smart move to pay more now for the comfort of basis, so electing the installment method would be the smarter move.
Ancillary Issues
It should be mentioned that the Promissory Note is definitely debt and not subject to recharacterization as equity. For one, it is non-convertible (i.e. has basically no chance of sharing in the growth of the company as an equity instrument); it is also paid over a short period of time with a market interest rate (in other words, it has a specific term with a reasonable rate of interest). As a promissory note it is also presumptively an unconditional promise to pay. The biggest threat to recharacterization as equity would be the ensuing behavior of the parties (i.e. if the Corp routinely did not make payments, M made no demands, and was instead paid large lump sums of "interest" at later random dates). Assuming that won't happen, the consequences of the note as true debt mean that the Corporation can deduct the interest payments to M, which M also recognizes as ordinary income.
One other issue that may arise is whether the Corporation will be considered an "investment company" such that § 351 does not apply under §351(e). This is doubtful since it does not appear to hold +80% of its value for investments as readily marketable securities/stocks (per Treas. Reg. § 1.351-1(c)). This wrinkle only really arises because the assets do seem to be investments (i.e. unimproved land) and the intents of the parties (i.e. as a business) are not clear from the facts.
Exam No. 1608
Code §§ 351 and 1032 provide for the nonrecognition of certain transfers of property to a corporation. In order to qualify for complete nonrecognition, one or more persons must transfer "property" to the corporation, the property must be transferred "solely" in exchange for stock of the transferee corporation, and the transferors, as a group, must be in "control" of the corporation "immediately after the exchange."
Control: In this case, the transferor group (L and M) satisfy the control requirement. To be in control of the corporation, the transferors of the property must collectively own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of each class of nonvoting stock. 368(c). Some transferors may receive voting stock while others receive nonvoting stock, so long as all the transferors as a group own at least 80% of each class of stock immediately after the exchange. Here A owns all of the Class A stock, and M owns all of the class B stock, so collectively, they own 100% of all classes of stock immediately after the exchange. Even if the transactions between L and M and Corp were did not occur simultaneously, they will be treated as occurring at the same time if, as the facts of the problem indicate, they were part of a single integrated plan.
Property: Both L and M transfer property to the corporation, because real estate, publicly traded stock, and undeveloped land all qualify as property.
Solely in Exchange for Stock: Whether L and M satisfy the "solely in exchange for stock" requirement depends on whether or not Corp's Class B stock is nonqualified preferred stock. Nonqualified preferred stock is stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent that has debt-like characteristics. Nonqualified preferred stock is treated as "other property" for 351 purposes, and in this case, it would ruin the viability of 351 nonrecognition. if it is nonqualified preferred stock, then as long as the M and L's transfers were part of a single integrated plan, M's transfer of property to Corp would ruin the "control" requirement, and neither M's nor L's transfers would qualify for nonrecognition. If L's transfer of property in exchange for Class A stock occurred first, and M's transfer was not part of a plan, then L might still qualify. The rest of this analysis assumes that the Class B stock is not nonqualified preferred, and thus does not ruin 351 nonrecognition. Corp's transfer of its IOU to M does not cause problems for nonrecognition, and it will be treated as boot.
Tax Consequences of Laila's Transfer
To Laila
L's basis in Corp's stock will equal the basis of the transferred property immediately prior to the exchange. 358(a)(1). L transferred two different properties here: Blackacre (FMV 200K, Basis 10K, 40K mortgage) and ABC stock (20K FMV, 35K basis).
If, as part of the consideration in an otherwise valid 351 exchange, a transferee corp assumes a liability of the transferor SH, the assumption is generally not treated as boot received by the transferor. 337(a). However, to preserve any gain that would otherwise have been recognized, the liability is treated as boot for the purposes of determining the transferor's basis in the stock. 358(d). There is an exception to the general rule of 358(d), for liabilities in excess of basis. In such a case, the excess is treated as gain from the sale or exchange of property. That exception does not come into play in this case even though the mortgage on Blackacre is greater than its basis, because the exception considers the aggregate bases of all the property transferred, not just the one that is subject to the liability.
In this case, Corp takes Blackacre subject to a 40K mortgage. That liability is treated as money received for the purposes of determining L's basis in the property under 358. Thus, L's basis in the Corp stock will be the combined bases of the transferred property ($45K) less the amount of the liability (40). So, her basis in the stock will be $5K.
L's holding period in the stock received will include the Corp's holding period if the transferred property is a capital asset or 1231 property. As long as Laila is not a real estate dealer, both the real estate and the stock are probably capital assets, so her holding period for the stock will be tacked.
To Corp
Corp's holding period will include Laila's holding period for each asset.
A corporation's basis in the assets transferred in a 351 transaction is generally the same as the transferor's basis, increased by the amount of gain recognized to the transferor on such a transfer. However, if property with a "net built in loss" is transferred in a 351 transaction, the transferee corporation's aggregate adjusted basis of such property is limited to it's FMV immediately after the transfer. Although ABC stock has a built in los because its basis exceeds its FMV, when multiple properties are transferred in the same transaction, the 362(e)(2) basis limitation only applies where there is a net built in loss. Here there is no net built in loss, so Corp will take L's bases in each property.
Tax Consequences of Malik's Transfer
To Malik
If a transferor receives property other than stock--e.g. corporate debt--in a 351 transaction, 351(b) provides that the transferor's realized gain is recognized to the extent of the cash and the FMV of the boot. Thus, Malik must recognize 10K as a result of the IOU that he receives from Corp. A transferor who receives boot in the form of a debt instrument from the transferee corp may be allowed to defer any 315(b) gain under 453. To do this, you have to bifurcate the exchange into two parts: a 351 nonrecognition exchange to the extent of the stock received by the transferor and a taxable sale to the extent of the boot received. Here, all of M's basis will be allocated to the nonrecognition exchange because he received 20K worth of stock and his basis was 4K. Because the boot received here is less than the realized gain, the gross profit ratio will be 100%. Thus, M will recognize 10K worth of capital gain on the sale (as long as he's not a dealer in land), and he will report that gain as it comes in. The market interest will be treated as ordinary income. If M elects out of 453 treatment, he will recognize the 10K gain right away. Here it is unlikely that the debt will be reclassified as equity because it's form and other indicators suggest debt. In the event that it is recharacterized, it will be treated as preferred stock, and M will not recognize any gain on the exchange.
Malik's basis in the stock will be his carryover basis in the property (4K) - FMV of the boot he received (presumably 10K) plus any gain that he recognized (10K). So his basis will be 4K. It's notable here that for the purposes of calculating basis under 358(1), the SH is treated as if he elected out of 453, so he gets the full basis bump even though he does the installment reporting.
To Corp
Under 362, the corporation's basis in a transferred asset is the carryover basis plus the SH's recognized gain. Under proposed Regs, the corporation probably doesn't get the basis increase that results from installment boot until the SH reports the gain. Thus, Corps basis in the land immediately after the exchange will be 4K. That basis will go up as M recognizes installment gain.
Corp's holding period includes that of M.
NOTE: if Corp is classified as an investment company, then under 351(e), transfers of property to it will not qualify for nonrecognition under 351. In that case, L and M would be better served by selling their assets and then contributing cash to the corporation.
Exam No. 1441
The formation of Corp might qualify as a tax free 351 exchange. Requirements under 351 are 1) that property is transferred to the corporation 2) solely in exchange for stock and 3) immediately after the exchange those contributing property are in control of the corporation. Requirement 1 is met because both L and M contributed property. Requirement 2 is not met (M receives a note), but boot is allowed in a 351. The problem under these facts might be the classification of Class B stock (depending on its nature) as nonqualified preferred stock, which is also treated as boot. If the Class B stock is cast as NQP then M has NOT received “solely” stock and, in fact, has not received any stock, so M is not eligible for a 351, and since M controls all of the Class B shares, L would ALSO not qualify for a 351 since L would need to control at least 80% of those shares. Assuming that the Class B shares are bond fide stock then requirement 2 is satisfied. Requirement 3 is satisfied if both M and L are otherwise qualified under 351, because between the two of them they own 80% of the voting shares and 80% of all other classes of stock (under these facts it doesn’t really matter if either or both of the classes can vote for purposes of determining a 351 except inasmuch as it would impact the NQP analysis for M).
If this is a good 351, then L would not recognize gain on the receipt of the shares of Class A stock. L would not be able to recognize the loss on the ABC stock, but would be able to keep that basis in the Class A shares (to be recognized later when they are sold), and which would be transferred from the contributed property. So L’s basis in Class A shares would be 10 (basis in Blackacre) + 35 (basis in ABC) or 45k of basis. EXCEPT that under 358(d) the liability assumed by the Corp is deducted from the basis of the shares. So L ends up with 5k of basis in Class A shares. This type of liability assumption is not considered “boot” under 357 so there is no immediate recognition of gain.
With respect to L, the Corp will recognize no gain or loss under 1032 and will have a basis of 10k in Blackacre (under 362) and a basis of 35k in ABC. The Corp does not have to take a basis “haircut” under 362(e)(2) because there is not an aggregate built-in loss when combining Blackacre with ABC, otherwise the Corp would only get a basis of 20k (FMV) in ABC unless L and Corp elected to have L take the haircut.
M would not have to recognize gain on receipt of the Class B shares (again, assuming they are not NQP shares), but would have to recognize gain on the note from Corp. M’s basis in the Class B shares would be 4k transferred from the Lot. M could use 453 reporting for the note and recognize gain as the payments are received. This forces Corp to only add basis in Lot as M reports gain. Corp basis in Lot would ultimately be 4k. When the first payment on the note is made in 2016, M would recognize $5k plus interest in capital gain and Corp would have $2k in basis in Lot. When the next and final payment is made on the note, M would again recognize $5k plus interest in capital gain and Lot would have $4k basis in Corp’s hands, assuming no other basis adjustments.
Electing (or attempting to elect) S corp status for a C corp is not a taxable event, so there is no tax impact to any party.
Part B
Exam No. 1996
S Corporation Election:
Although M and L consented for S election by Corp, consent is not the only factor necessary in becoming a S corp.
Here Corp has two classes of stock A and B. Unless A and B confer identical rights in distribution and liquidation, and are only characterized as different classes for voting purposes, Corp will not meet the 1 class of stock requirement. Reg. 1.1361-1(l). Another problem for Corp would be the promissory note that it distributed to M. Unless that promissory note satisfies the straight debt harbor of 1361(c)(5) - here it seems that the note would be straight debt because it is not contingent on profits or the like, it is not convertible, and the creditor is an individual.
Additionally, we would have to make sure that Corp meets the other eligibility requirements, assuming M and L are citizens or resident aliens, as the sole shareholders of Corp, they meet the 100 shareholder limit. Its also important to make sure that Corp is not an ineligible corporation.
If the above meets the requirements of 1361, then the corporation by electing to become an S corp on May 10, 2015, should have the S taxable year take effect for the 2015 year because it was made within 2.5 months of the corporations taxable year (beginning when the corporation was formed).
Exam No. 1682
Under IRC 1361(a), in order to be an S Corp an entity must be a small business corporation and it must make a proper election. The definition of small business corporation is in IRC 1361(b), and is as follows: it must be a corporation organized in the U.S. that is not an ineligible corporation (reserve accounting, insurance company, DISC, etc) that has 100 shareholders or less, with no non-individual shareholders (with some exceptions), have no non-resident alien shareholders and have no more than 1 class of stock, and no preferred stock. Some of these elements can be disposed of relatively easily. This entity is a corporation, and we know it is organized in the U.S. because it is filing with the IRS. We have no facts that say it is an ineligible corporation. Further, it only has two shareholders. If Malik and Laila were related, they would count as 1 shareholder, but even if they are not, we are way under the 100 shareholder cap. Further, we don't have an non-individual shareholders, but as I said, these rules are lenient. One of them could die and drop the shares into a trust, and the election, if valid, would still be valid. They could also give the shares away to charity. Further, there is nothing that says either of these shareholders is a non-resident alien. However, here IRC 1361(b), there can be only one class of stock. Every share must have the same economic rights, but differences in voting are fine were IRC 1364(c)(4). Further, under IRC 1361(c)(5), debt will only be treated as preferred stock if it is really egregious. If it has an interest rate, and is not convertible, it is probably allowed.
Thus, we're a little worried that we have more than 1 class of stock in this corporation. Technically, by the letter of the law, this is more than 1 class of stock and thus their S election should not be valid. However, they might be saved by the language that requires only that each shareholder have the same "economic rights" as the other shareholders. If the only difference between these shares is their name, they could argue that there is really no economic difference. However, it did not have to be this way. The corporation could have given each shareholder the same "named" class of shares, and simply given them different amounts of the shares to reflect the different amounts that each shareholder contributed. They would have to be careful though because if one of the shareholders is going to work for the company, they would have to make sure that they comply with the 10% services safe harbor in Reg. S. 1.351(a)(1)(ii), and also Rev. Proc. 77-37. They would have to make sure that each shareholder put in property equal to at least 10% of the value of the stock they are getting.
Another problem with the S election might if the note described above were reclassified as preferred stock. Unlike the other question, if this happened, they were plainly ineligible to be an S Corp. However, as I said above, per IRC 1361(c)(5), debt will only be treated as preferred stock if it is really egregious. Here, it has an interest rate, is not convertible, and the creditor is in an individual. Thus, it appears we are safe on this front as well. Note that it is a slightly different standard for preferred stock here than it would be in the distribution realm. It is more generous and deferential than the 5 factor judicial test, likely because the IRS really does not want to mess up S elections retroactively. It helps that the money will begin to be repaid within a year, this helps the analysis above and here. It is a little odd that the payments are coming in two lump sums. This might look a little bit more like equity, but because of all the other great things about this note, it is probably safe.
To make a valid S election, under IRC 1362, all shareholders must elect to be an S Corp, and Shareholders must sign a consent form and mail to the IRS. Generally, the election is effective at the beginning of the next taxable year. However, if the form is filed on or before March 15, the election can take effect retroactively for that year. A new corporation's taxable year starts when the corporation starts (in this case, March 1, when the IRC 351 happened). Then, it is trying to make the S election 9 days later. They had about 2 and a half months, and they did so in 9 days. Thus, this election is timely. If for some reason the election is not timely, this corp would be a C corp for at least a little while, and some of the C corp horrors, particularly with the property inserted as part of the IRC 351, would stick around. But, as long as they can convince the IRC that the stock has the same economic rights, they should be find with this S election. However, they should not have done it this way--it will be a big headache for them. It appears each has the same economic rights because each is getting stock value of what they put in, and thus they have the same growth potential.
Note that if the IRC 351 is invalid above for any reason, the taxpayers would be recognizing gain or losses on their transactions respectively. Further, the mortgage on Blackacre would be boot to Leila, and the corporation would get a basis equal to the FMV of the property.
Exam No. 1759
Per section 1361 in order to qualify for S corp status the entity must be a "small business corporation" and must have made a valid election.
Eligibility for S Status:
Section 1361(b) sets out the requirements to be a "small business corporation": (1) the entity must be a corporation which is met here as facts expressly say they formed a "corporation"; (2) must be a domestic corporation, would appear to be the case, but facts do not expressly state, would need to confirm status as domestic corporation; (3) cannot be an "ineligible corporation," no problem here as no indication Corp. is an insurance company taxed under Subchapter L, a DISC, etc.; (4) there cannot be more than 100 SHs (although effectively allows up to 100 unrelated SHs), here no problem as only two SHs, Laila and Malik; (5) cannot have any ineligible SHs, no problem here on facts as nothing to indicate either Laila or Malik is a nonresident alien, etc.; and (6) there cannot be two classes of stock. Corp does have two classes of stock, Class A and Class B. On the off-chance that Laila and Malik just used an odd term for the stock and it is just voting and non-voting common stock, that would be fine, but it appears that there are in fact two classes of stock and thus Corp does not qualify as a small business corporation and therefore cannot qualify for S status. To solve this problem the SHs could get rid of the second class of stock, e.g. by having Corp redeem it. Potentially could even request forgiveness from IRS under 1362(f) arguing that it was inadvertent mistake to try and qualify as S corp from day one.
Effective Date:
Assuming that the election is valid (which I think means further assuming that Corp does validly qualify for S corp status, however if Corp doesn't qualify for S status the election can never be valid unless they fix the inadvertent mistake and get the IRS to forgive it), the election could be effective as of March 1, 2015. The default is that S corp status is effective as of the start of the corporation's next taxable year, however if the election is filed within the first 2.5 months of the corporation's taxable year, the election can be effective as of that year. Here Corp began its life on March 1, which for a brand new corporation is considered to be the start of its taxable year (the day it is created). The election was made on May 10, which is less than 2.5 months after the start of Corp's taxable year on March 1, so the election can be effective as of the start of this year. Note, the election must expressly request this, if they fail to make the request, the default is to start of next year which would be very bad as that would mean they default to being a C corp for year one. Many of the problems an S corp can encounter only crop up if they were a former C corp and have accumulated E & P. Finally, in order for the election to be valid as of the start of the current year, all people who were SHs from March 1 through the date of the election (1) must have been allowable SHs in an S corp; and (2) must provide their consent. On the facts does not appear any other SHs than Malik and Laila. As discussed above each are permissible SHs in an S corp and each turned in their consents so they met this additional requirement. Once an election has been made, do not need any further consents.
A final note, would need to worry about state law that may make a spouse a SH. Need their consent too.
Created by: bojack@lclark.edu
Update: 6 Feb 16
Expires: 31 Aug 17