2.4 Possible Tax Consequences of Transfers to Corporations

• Library: Corporations and Partnerships in Virginia (Virginia CLE) (2016 Ed.)

2.4 POSSIBLE TAX CONSEQUENCES OF TRANSFERS TO CORPORATIONS

2.401 In General. The transfer of property to corporations is generally tax free, as discussed in paragraph 2.301 of this chapter, but there may be tax consequences from the transfer of "recapture" property, as well as tax consequences from the incorporation of a going business. Some of the tax matters to be considered in such cases are discussed below.

2.402 Recapture Property.

A. Depreciation and Cost Recovery Recapture. The statutory provisions relating to depreciation recapture and cost recovery recapture override all other provisions of the tax laws. These recapture provisions contain limited exceptions, however, one of which is available in connection with the transfer of tangible personal property and real property to a corporation in a transaction that qualifies under I.R.C. § 351. ⁶⁵ Furthermore, where boot is received as a part of the transfer, the gain attributable to any recapture property that is required to be recognized under the boot provisions ⁶⁶ will be treated as ordinary income in accordance with the depreciation recapture rules. ⁶⁷

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Example: Smith owns section 1245 property that has a fair market value of $10,000, a recomputed basis (as defined in I.R.C. § 1245(a)(2)(A)) of $8,000, and an adjusted basis of $4,000. Smith transfers the property to a corporation in exchange for stock worth $9,000 plus $1,000 in cash in a transaction qualifying under I.R.C. § 351. Without regard to the depreciation recapture rules, Smith would recognize $1,000 gain under I.R.C. § 351(b). Since the recomputed basis of the property ($8,000) is lower than the amount realized ($10,000), the excess of the recomputed basis over adjusted basis ($4,000), would be treated as ordinary income under I.R.C. § 1245(a)(1). However, I.R.C. § 1245(b)(3) limits the gain taken into account by Smith to $1,000. ⁶⁸

B. Investment Credit Recapture. Investment credit (now repealed) previously taken on property that was transferred to a corporation in an I.R.C. § 351 exchange will be recaptured even though no boot is received, unless the transaction represents "a mere change in the form of conducting business . . . and the taxpayer retains a substantial interest in the business." ⁶⁹ A subsequent disposition of the property by the corporation will be treated as a disposition by the transferor for recapture. ⁷⁰ The property will not qualify as new property to the corporation, since the original use did not commence with the corporation, and it will not qualify as used property since the exchange does not qualify as a "purchase." ⁷¹

The essential question in determining if investment credit will be recaptured is whether the transfer is a mere change in the form in which the taxpayer conducts the trade or business. The regulations provide four conditions that must exist if the mere change in form exemption is to apply:

1.	The investment credit property must be retained as such in the same trade or business;
2.	The transferor must retain a substantial interest in the trade or business;

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3.	Substantially all of the assets necessary to operate the trade or business must be transferred by the transferor along with the investment credit property; and
4.	The basis of the investment credit property in the hands of the transferee-corporation must be determined, in whole or in part, by reference to the transferor's basis in the property. 72

Whether the transferor is considered to have retained a substantial interest in the trade or business depends on whether the transferor's interest, after the change of form, is either substantial in relation to the total interest of all persons or equal to or greater than the transferor's interest before the change in form. ⁷³ The other requirements are relatively self-explanatory. ⁷⁴

C. Other Properties. The disposition of an installment obligation usually results in the recognition of gain to the transferor. But the regulations provide that the nonrecognition provisions of I.R.C. § 351 will generally override the normal disposition provisions, with the result that the transferor of an installment obligation to a corporation in an I.R.C. § 351 exchange does not recognize any gain or loss, and the installment obligation will have the same character in the hands of the corporation. ⁷⁵

Where land clearance and farm soil and water conservation expenditures have been deducted, the farm land recapture rules will be applicable to the extent of boot, in a fashion similar to the depreciation recapture rules. ⁷⁶

2.403 Swap Funds. The tax-free provisions of I.R.C. § 351 are not available to transfers to investment companies, which are frequently called "swap funds." If the tax-free provisions were available for swap funds, it would be possible for a number of investors, each of whom owned highly appreciated stock, to diversify their investment portfolios on a tax-free basis under I.R.C. § 351 by transferring their appreciated stock to a newly organized swap fund. The result would be that the investors could diversify

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their ownership of stock...