Wednesday, February 28, 2018
Monday’s post on whether the new tax law indicates that a C corporation should be the entity form of choice generated a lot of interest. Some of the questions that came in surrounded what the tax consequences are when a C corporation is formed. That’s a good question. The tax Code does have special rules that apply when forming a C corporation. If those rules are followed, forming a C corporation can be accomplished without tax consequences.
The tax rules surrounding C corporation formation, that’s the topic of today’s post.
Tax-Free Incorporation Rules
Incorporation of an existing business, such as a sole-proprietorship farming or ranching operation, can be accomplished tax-free. A tax-free incorporation is usually desirable. That’s particularly the case for farming and ranching businesses because farm and ranch property typically has a fair market value substantially in excess of basis. That’s usually the result of substantial amounts of depreciation having been taken on farm assets.
For property conveyed to the corporation, neither gain nor loss is recognized on the exchange 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.”
Be careful of stock transfers. 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. For example, parents who transfer all of their property to a corporation can destroy tax-free exchange status by gifting more than 20 percent of the corporate stock to children and other family members simultaneously with incorporation or shortly thereafter.
How long is the waiting period before gifts of stock can be made? There is no bright line rule. Certainly, a month is better than a week, and six weeks are better than a month. In addition, care should also be given to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation. See, e.g., Ltr. Rul. 9405007 (Oct. 19, 1993).
Income Tax Basis Upon Incorporation
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. 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. Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash. 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.
When Is Incorporation A Taxable Event?
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). Bonus depreciation and I.R.C. §179 may have been taken on equipment resulting in little-to-no remaining tax basis. This, combined with an operating line, prepaid expenses and deferred income result in taxable income recognition upon the incorporation of a farm. Thus, for those individuals who have refinanced and have increased their debt level to a level that exceeds the income tax basis of the property, a later disposition of the property by installment sale or transfer to a partnership or corporation, will trigger taxable gain as to the excess.
Technique to avoid tax? The liability in excess of basis problem has led to creative planning techniques in an attempt to avoid the taxable gain incurred upon incorporation. One of those strategies involves the transferor 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 ruled that this technique will not work because the note has a zero basis. Rev. Rul. 68-629, 1968-2 C.B. 154.
While one court, in 1989, 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)), that is not a view held by the other courts that have addressed the issue. For example, in Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191, 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 Peracchi 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 did acknowledge 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. That seems to be a key point that the court overlooked. If the taxpayer was creditworthy, then a legitimate question exists concerning why the taxpayer failed to make payments on the note before being audited. Clearly, the taxpayer never had any intention of paying off the note. Thus, a good argument could have seemingly been made that the note did not represent genuine indebtedness. The court also appears to have overlooked the different basis rules under I.R.C. § 1012 and I.R.C. § 351. An exchanged basis is obtained in accordance with an I.R.C. § 351 transaction which precludes application of the basis rules of I.R.C. § 1012.
Note: After Lessinger and Peracchi were decided, I.R.C. §357 was amended to include subsection (d). That subsection specifies that a recourse liability is to be treated as having been assumed if the facts and circumstances indicate that the transferee has agreed to, and is expected to, satisfy the liability (or a portion thereof) regardless of whether the transferor has been relieved of the liability. Non-recourse liabilities are to be treated as having been assumed by the transferee of any asset subject to the liability.
What about other entities? The Peracchi 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. However, Rev. Rul. 80-235, 1980-2 C.B. 229, specifies that a partner in a partnership cannot create basis in a partnership interest by contributing a note. This all means that the IRS is likely to continue challenging “basis creation” cases on the ground that the contribution of a note is not a bona fide transfer.
Different strategy? 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.
As the above discussion indicates, a good rule of thumb is that property should never be transferred to a new entity without first determining whether there is enough basis to absorb the debt. If it is discovered that the debt exceeds the aggregate basis of the property being transferred to the entity, several options should be considered for their potential availability. These include not transferring some of the low basis assets to the new entity or consulting with the lender and leaving some of the debt out of the entity, permitting it instead to run against the individual shareholders, or having the shareholders later pledge their stock to secure the debt. Alternatively, cash can be contributed to the entity in lieu of some of the low basis assets or in addition to the assets. Cash is all basis.