Tax Tips
| Publication year | 1980 |
| Pages | 938 |
| Citation | Vol. 9 No. 5 Pg. 938 |
1980, May, Pg. 938. Tax Tips
The rage continues, notably in Denver, over the issuance and trading of "penny stocks." Many, if not most, of these new public companies are not operating in the corporate form before the public offering is made. The decision to transfer the business' (partnership's) assets to a corporation prior to the public offering is dependent on resolution of the question of whether the gain inherent in the transferred asset will be recognized. The answer to this question is far from clear. This column examines the problems of determining and complying with I.R.C. § 351's control requirement when a subsequent offer of the stock to the public is contemplated.
Section 351 of the Internal Revenue Code of 1954, as amended (the "Code"), permits the transfer of property to a corporation by one or more persons free of federal income tax liability within certain guidelines.(fn1) Among other requirements of § 351, the transferors must be in control of the corporation "immediately after the exchange. "(fn2) In our situation, the issue facing the initial owners of the business is whether they are in control "immediately after the exchange" and can utilize the benefits of § 351, where a public issue has been contemplated from the inception of the corporation and is consummated sometime thereafter.
A typical example might be a company worth $500,000, issuing $1.5 million worth of stock to the public. Following the public offer, the original owners surely have lost control, despite a substantial amount of dilution. The failure to qualify for § 351 treatment can be disastrous to the original owners and would dictate a different course of events if such failure could be predicted, since a substantial portion of the fair market value of the business generally represents unrealized gain. This gain is subject to recognition upon transfer, absent § 351 qualification, and without concomitant cash flow. This gain exists in even a recently initiated business as a result of current deduction elections available to energy-related companies(fn3) and companies involved in research and development,(fn4) among other business endeavors.
In addition, certain properties, such as mineral leases, can appreciate in value almost instantaneously, given the happening of events such as discoveries adjacent to the company's property, changes in government policy and changes in recovery techniques. Often, these same events are what triggers the need for additional capital. A tax recognition event at this time in a company's development often would prevent the public offering and slow needed expansion in various business areas.
The concept or rule generally used in determining whether or not the original transferors have lost control for purposes of § 351 is called the "step transaction doctrine." Historically, application of the step transaction doctrine involves the following elements: intent of the parties, the time period over which transfers are made, the inter-dependency of the various transactions and the ultimate result. Realistically, inter-dependency is the determining factor. The problem is that the application of inter-dependency, unless it is defined as requiring a binding obligation, is difficult to predict, especially if control is lost through a subsequent stock issuance by the corporation.
The seminal case of American Bantam Car Co. v. Commissioner,(fn5) which is most often quoted for its mutual interdependence language, distinguished the facts involved there from prior cases and held for the taxpayer based on three grounds: (1) although there was a plan, no written contract existed prior to the § 351 transfer binding the transferors to transfer the stock received; (2) the persons receiving the transferors' new stock had no absolute right to ownership and (3) the existence of an escrow as further evidence of retained ownership of the stock by the original transferors.(fn6)
The binding obligation/contract test has been used in case after case as a basis for finding that the original transferors did not maintain control for purposes of § 351. The type of obligation which frustrates control is well defined; the agreement must deprive the original owners of their ownership rights in the stock.(fn7) The lack of a binding obligation, however, does not preclude a finding that control has been divested; the more general rules of the step transaction doctrine always can be, and have been, applied.(fn8)
Two recent cases have adopted a broader test urged by the IRS: the "integral part of a plan" test.(fn9) If several steps are integral parts of a single plan, all the steps will be combined.(fn10) In D'Angelo Associates, Inc. v. Commissioner, the court held that the boundaries of the transaction are "defined by including events contemplated for the success of the business plans from which they eminate."(fn11) The existence of a "plan" to dispose of control was held sufficient to disqualify the original transaction from the benefits of § 351 in Culligan Water Conditioning of Tri-Cities, Inc. v. United States.(fn12)
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