Forming a Farming/Ranching Corporation Tax-Free

Overview

Incorporation of an existing farming or ranching operation can be accomplished tax-free.  A tax-free incorporation is usually desirable because farm and ranch property typically has a fair market value substantially in excess of basis.  But, how is it done?  What are the basics?  What if liabilities are transferred to a corporation when it is formed?  Are there special rules concerning debt assumption?  What’s the IRS assignment of income theory all about? 

Tax-free incorporation – that’s our topic today.

Basic Principles

Three conditions – no election needed.  For property conveyed to the corporation, neither gain nor loss is recognized to the transferor(s) on the exchange (I.R.C. §357(a)) if three conditions are met.  I.R.C. §351.  First, the transfer must be solely in exchange for corporate stock.  Second, the transferor (or transferors as a group) must be “in control” of the corporation immediately after the exchange.  This requires that the transferors of property end up with at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of the total number of shares of all classes of stock.  Third, the transfer must be for a “business purpose.”

Because of the 80 percent control test, if it is desirable to have a tax-free incorporation, there can be no substantial stock gifting occurring simultaneously with, or near the time of, incorporation. Also, care should be taken to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation.  See, e.g., Priv. Ltr. Rul. 9405007 (Oct. 19, 1993).

Income tax basis and holding period.  The income tax basis of stock received by the transferors is the basis of the property transferred to the corporation, less boot received, plus gain recognized, if any.  I.R.C. §362.  If the corporation takes over a liability of the transferor, such as a mortgage, the amount of the liability reduces the basis of the stock or securities received.  I.R.C. §358.  The basis reduction can’t go below zero in the event the corporation assumes liabilities that exceed the basis of the assets transferred to the corporation.  See, e.g., Wiebusch v. Comr., 59 T.C. 777 (1973), aff’d., 487 F.2d 515 (1973). 

But, there is no basis reduction for a liability that generates a deduction when it is paid.  Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash.  The holding period of the transferor’s stock is pegged to the holding period of the assets that were transferred to the corporation.  I.R.C. §1223(1).  However, inventory and other non-capital assets do not qualify for “tacking-on” of the holding period.  Thus, to get long-term gain treatment when the stock that is received on incorporation is sold, the stock seller will have to have held the stock for at least 12 months.  See Rev. Rul. 62-140, 1962-2 C.B. 181.

The corporation's income tax basis for property received in the exchange is the transferor's basis plus the amount of gain, if any, recognized to the transferor.  Also, the holding period of the transferred property carries over from the transferor to the corporation.  I.R.C. §1223(2).  Depreciable property received by the corporation at the time of incorporation is not eligible for “fast” methods of depreciation (for non-recovery property), expense method depreciation or a shift in ACRS or MACRS status.  In other words, ACRS or MACRS property continues to be ACRS or MACRS property.

Transferring liabilities.  If the sum of the liabilities assumed or taken subject to by the corporation exceeds the aggregate basis of assets transferred, a taxable gain is incurred as to the excess. I.R.C. §357(c). The test is applied to each transferor individually, with the computation accomplished by aggregating the adjusted tax basis of all assets and measuring that result against all of the liabilities of that particular transferor.  The gain is capital gain if the asset is a capital asset or ordinary gain if the asset is not a capital asset.  I.R.C. §357(c)(1). 

But, some liabilities don’t count for purposes of the computation – specifically, those that give rise to a deduction when they are paid.  So, for example, accrued expenses of a transferor that is on the cash method of accounting would not be considered to be “liabilities” for purposes of the computation.  I.R.C. §357(c)(3).

Can taxable gain that would otherwise be incurred upon incorporating (when liabilities exceed basis) be avoided by giving the corporation a personal promissory note for the difference and claiming a basis in the note equivalent to the note's face value?  The IRS has said “no,” determining that this technique will not work because the note has a zero basis.  Rev. Rul. 68-629, 1968-2 C.B. 154.   The Tax Court agrees.  Alderman v. Comr., 55 T.C. 662 (1971); Christopher v. Comr., T.C. Memo. 1984-394.

However, an appellate court, in reversing the Tax Court in a different case eighteen years later, held that a shareholder's personal note, while having a zero basis in the shareholder's hands, had a basis equivalent to its face amount in the corporation's hands.  Lessinger v. United States, 872 F.2d 519 (2d Cir. 1989), rev'g, 85 T.C. 824 (1985).  The Tax Court was reversed again in a 1998 case. Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191. In this case, the taxpayer contributed two parcels of real estate to the taxpayer's closely-held corporation.  The transferred properties were encumbered with liabilities that together exceeded the taxpayer's total basis of the properties by more than $500,000.  In order to avoid immediate gain recognition as to the amount of excess liabilities over basis, the taxpayer also executed a promissory note, promising to pay the corporation $1,060,000 over a term of ten years at eleven percent interest.  The taxpayer remained personally liable on the encumbrances even though the corporation took the properties subject to the debt.  The taxpayer did not make any payments on the note until after being audited, which was approximately three years after the note was executed.  The IRS argued that the note was not genuine indebtedness and should be treated as an enforceable gift.  In the alternative, the IRS argued that even if the note were genuine, its basis was zero because the taxpayer incurred no cost in issuing the note to the corporation.  As such, the IRS argued, the note did not increase the taxpayer's basis in the contributed property.

The court held that the taxpayer had a basis of $1,060,000 (face value) in the note.  As such, the aggregate liabilities of the property contributed to the corporation did not exceed aggregate basis, and no gain was triggered.  The court reasoned that the IRS's position ignored the possibility that the corporation could go bankrupt, an event that would suddenly make the note highly significant.  The court also noted that the taxpayer and the corporation were separated by the corporate form, which was significant in the matter of C corporate organization and reorganization. Contributing the note placed a million dollar “nut” within the corporate “shell,” according to the court, thereby exposing the taxpayer to the “nutcracker” of corporate creditors in the event the corporation went bankrupt.  Without the note, the court reasoned, no matter how deeply the corporation went into debt, creditors could not reach the taxpayer's personal assets.  With the note on the books, however, creditors could reach into the taxpayer's pocket by enforcing the note as an unliquidated asset of the corporation.  The court noted that, by increasing the taxpayer's personal exposure, the contribution of a valid, unconditional promissory note had substantial economic effect reflecting true economic investment in the enterprise.  The court also noted that, under the IRS's theory, if the corporation sold the note to a third party for its fair market value, the corporation would have a carryover basis of zero and would have to recognize $1,060,000 in phantom gain on the exchange even if the note did not appreciate in value at all.  The court reasoned that this simply could not be the correct result.  In addition, the court noted that the taxpayer was creditworthy and likely to have funds to pay the note.  The note bore a market rate of interest related to the taxpayer's credit worthiness and had a fixed term.  In addition, nothing suggested that the corporation could not borrow against the note to raise cash.  The court also pointed out that the note was fully transferable and enforceable by third parties.  The court also acknowledged that its assumptions would fall apart if the shareholder was not creditworthy, but the IRS stipulated that the shareholder's net worth far exceeded the value of the note. 

The court was careful to state that the court's rationale was limited to C corporations.  Thus, the opinion will not apply in the S corporation setting for shareholders attempting to create basis to permit loss passthrough.  Likewise, a partner in a partnership cannot create basis in a partnership interest by contributing a note.  Rev. Rul. 80-235, 1980-2 C.B. 229. 

            What if the transferor remains personally liable?  A similar technique designed to avoid gain recognition upon incorporation of a farming or ranching operation (where liabilities exceed basis) is for the transferors to remain personally liable on the debt assumed by the corporation, with no loan proceeds disbursed directly to the transferors. However, gain recognition is not avoided unless the corporation does not assume the indebtedness.  Seggerman Farms, Inc. v. Comm’r, 308 F.3d 803 (7th Cir. 2002), aff’g, T.C. Memo. 2001-99.  But, nonrecourse debts of a transferor, under I.R.C. §357(d), are presumed to be transferred to the corporation unless the transferor holds other assets subject to the debt that are not transferred to the corporation and the transferor remains subject to the debt.  The same rule applies to recourse liabilities. 

            What if gain is triggered?  If liabilities exceed basis, the gain is “phantom” income.  That’s because the taxpayer hasn’t generated any cash to pay the tax on the gain that is triggered by transferring assets to the corporation with less basis than debt.  In addition, for farm/ranch incorporations, the gain is likely to be ordinary in nature (determined as if the transferred assets were sold – I.R.C. §357(c)(1)).  The one favorable factor if gain is recognized upon incorporation is that the basis of the transferred assets is increased by the amount of the gain.  I.R.C. §358(a)(1(B)(ii)).  

Business purpose.  As noted above, one of the three requirements that must be satisfied to accomplish a tax-free incorporation is that the transfer must be for a business purpose.  If the corporate assumption of liabilities has as a purpose the avoidance of federal income tax or lacks a bona fide business purpose, the assumed liabilities are treated as boot paid to the transferor.  I.R.C. §357(b); 351(b).  If the liabilities are created shortly before incorporation and are then transferred to the corporation, the IRS will raise questions.  See, e.g., Weaver v. Comr., 32 T.C. 411 (1959); Thompson v. Campbell, 353 F.2d 787 (5th Cir. 1965); Harrison v. Comr., T.C. Memo. 1981-211.

Assignment of Income

In general, formation of a farm or ranch corporation in the regular course of business not involving substantial tax avoidance motives or a manifest desire to artificially shift income tax liability should not result in income recognition.  However, the IRS has several theories available to challenge transfers carried out in the presence of obvious tax avoidance motives or a manifest desire to shift income tax liability artificially.  See, e.g., I.R.C. §482.  For instance, the “assignment of income” doctrine may override an otherwise tax-free exchange and cause the proceeds from the sale of transferred assets to be taxed to the transferor.  See, e.g., Weinberg v. Comr., 44 T.C. 233 (1965); Slota v. Comr., T.C. Sum. Op. 2010-152.  The IRS utilization of this theory should be watched in situations where the transferor has, via incorporation, shifted income to the corporation but claimed associated deductions on the transferor’s personal return.  However, the theory does not apply to the transfer of cash method accounts receivable.  See, e.g., Hempt Bros., Inc. v. United States, 354 F. Supp. 1172 (M.D. Pa. 1973), aff’d, 490 F.2d 1172 (3d Cir. 1974); Rev. Rul. 80-198, 1980-2 C.B. 113. 

Distortion of Income

The IRS also has, under I.R.C. §482, broad powers to reallocate income, deductions, credits or allowances as necessary “in order to prevent the evasion of taxes or clearly to reflect...income.”  See, e.g., Rooney v. United States, 305 F.2d 681 (9th Cir. 1962).  However, if all of the farm income and expense that is incurred before incorporation stays with the transferor and is reported on the transferor’s return accordingly, an IRS challenge to a tax-free incorporation is not likely.  See, e.g., Heaton v. United States, 573 F. Supp. 12 (E.D. Wash. 1983).  One thing to avoid is the incurring of a substantial net operating loss shortly before incorporation.

Conclusion

A corporation can be formed tax-free.  But, certain requirements must be satisfied and the transferred assets must have more basis than liabilities.  In addition, stock should not be issued for basis, unless there is only one transferor or, for all transferors, the income tax basis of transferred assets bears a uniform relationship to the fair market value of the transferred property. 

Carefully following the rules can lead to a happy tax result.  Unfortunately, the opposite is also true.