Forming a Corporation

• Pages: 21-71
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

21

Chapter 2

FORMING A CORPORATION

2.01 Introduction

If a taxpayer exchanges property for other property, the

taxpayer generally must recognize any realized gain or loss on the

exchange. § 1001(c). For example, if T exchanges undeveloped real

estate with a $5,000 basis for a fishing boat with a $20,000 fair

market value, T recognizes his $15,000 realized gain ($20,000

amount realized minus $5,000 basis). T’s result is no different than

if he had sold the land for $20,000 and used the cash to purchase the

boat.

The case for recognition is weakened if the exchange does not

substantially alter the nature of T’s investment. For instance,

suppose that T continues as an owner of undeveloped real estate by

exchanging the real estate for other undeveloped real estate worth

$20,000. While T has a $15,000 realized gain, § 1001(c) and § 1031

may provide that T does not recognize the realized gain, since the

properties surrendered and received in exchange are like-kind.

1

If T’s

gain is not recognized, § 1031(d) provides that T takes a $5,000 basis

in the property received, preserving the realized but not recognized

gain for any later disposition.

2

Section 1031 reflects a congressional policy that taxing an

exchange is inappropriate where a taxpayer maintains a sufficient

continuity of inv estment after the exchange, but § 1031 does not

apply to every exchange that preserves that continuity. For example,

it does not apply to T’s transfer of the land to a newly created X Corp

in exchange for all of the stock of X Corp,

3

even though T’s continuity

of investment is stronger than if he received other real estate in

exchange: T continues to own exactly the same real estate, albeit

indirectly through his 100-percent ownership of the X stock.

Since 1921, however, Congress has generally provided that this

kind of property-for-stock exchange is not a taxable event.

Nevertheless, not all transfers of property to a corporation are tax-

free. For example, a taxpayer who transfers appreciated property to

a corporation in which she owns no stock in exchange for cash, rather

1

Among other requirements under § 1031, the property exchanged and

received must be held for use in a trade or business or for investment.

2

It is as if T has continued an investment in the same property, and under

our tax system, the mere appreciation in value of property is not a taxable event.

3

See also § 1031(a)(1) (providing that § 1031 applies only to exchanges of real

property).

22

FORMING A CORPORATION

Ch. 2

than stock, no longer has even an indirect continuity of investment

in the property transferred and will recognize any realized gain.

The essence of § 351 and related provisions is to ascertain

whether a transferor has a continuing relationship with the property

transferred to a corporation sufficient to justify non-recognition

treatment or whether the transferor has severed such a relationship

with the transferred property, justifying recognition.

2.02 An Overview of § 351

(a) Qualification

Section 351 is not elective. If it applies, a taxpayer defers

recognition of gain or loss. Section 351 applies only if the taxpayer-

transferor: (1) transfers property to a corporation; (2) receives stock

in exchange; and (3) along with other transferors, if any, controls the

corporation immediately after the exchange. Note that § 351 can

apply both to the formation of a new corporation and to a transfer to

an existing corporation (with the latter sometimes referred to as a

“midstream” transfer).

Each of the three major requirements of § 351 is intended to

ensure a continuity of investment. First, § 351 requires the transfer

of property and not the provision of services. If a person provides

services to a corporation for its stock, the person has compensation

income. See § 351(d)(1). Congress is unwilling to allow non-

recognition when a taxpayer converts human capital into corporate

capital—the change in form of investment is too great.

Second, the transferor must receive stock of the transferee-

corporation, a requirement intended to ensure that the transferor

maintains a sufficient connection to the property transferred.

Suppose T and three other joint owners of appreciated real estate

transfer the property to newly formed X Corp. T receives cash while

the other transferors receive X stock. The source of the cash to pay T

is borrowing by X Corp. from an unrelated party. For T, non-

recognition is unavailable since T merely sold the property. If T had

instead received stock, § 351 would have provided non-recognition for

T and the others, each of whom would continue to own the property

indirectly through ownership of X stock, benefitting from any

appreciation in value of the property (or suffering from any decline

in value).

What happens if T transfers the property in exchange for an X

Corp. financial instrument, like a debt instrument, rather than

stock? Some debt instruments, such as long-term debt, arguably

provide continuity similar to stock. For example, a forty-year bond

may link the transferor to the property transferred in much the same

Sec. 2.02

AN OVERVIEW OF § 351

23

way as stock. Indeed, for financially troubled corporations, debt

ownership may provide greater ownership rights in the corporation’s

assets than stock. On the other hand, if T were to receive a three-

year debt instrument bearing appropriate interest in ex change for

the transfer of property, it is as if T sold the property on the

installment method, almost like a sale for cash.

Section 351 adopts a bright-line rule: stock is qualified property

while debt is not. The section used to distinguish between long-term

debts (securities) and short-term debts (notes), providing non-

recognition treatment for receipt of the former and sales treatment

for receipt of the latter. This distinction proved troublesome as the

line between securities and notes was not easily drawn, and Congress

adopted the bright-line rule.

4

Finally, the transferors must control the corporation

immediately after the exchange, a requirement that also implements

the continuity concept. Just because a person exchanges property for

stock, the exchange does not guarantee that the person will possess

a sufficient continuity in the property transferred. For instance, if T

and the other transferors transfer their jointly owned real estate to

Microsoft in exchange for a small amount of Microsoft stock, the

transferors’ relationship to the real estate is far more attenuated

than if they had transferred the property to a newly formed, closely

held corporation. The gain realized on the transfers to Microsoft will

be recognized at the time of the exchange, because the transferors

will not control Microsoft immediately after the exchange.

Transferors control a corporation only if they own at least 80

percent of the total combined voting power of all classes of the

corporation’s voting stock and at least 80 percent of the total number

of each class of the corporation’s non-voting stock. § 368(c); Rev. Rul.

59–259.

5

These 80-percent tests offer some certainty, avoiding a

painstaking factual analysis of what constitutes control in many

situations, but they still offer less than complete certainty. Section

351 may apply by considering the property transferred by several

persons, and it may not be clear when various property transfers

should be considered together as part of the same “transaction.” For

example, if two transfers are made to X Corp. within six months, are

the 80-percent tests applied after each transfer or are the two

transfers combined and the 80-percent tests applied only once?

4

Unfortunately, astute tax planners blurred even this line by creating

financial instruments that were nominally equity but with critical features much like

debt, often lacking any significant long-term relationship to the corporation. Congress

responded in § 351(g) by defining a class of “nonqualified preferred stock” that is for

some purposes treated as stock and for others as akin to debt.

5

1959–2 C.B. 115.