Forming, reorganizing and liquidating corporations

When Leah moved her sole proprietorship into a corporation, she transferred appreciated property, equipment and goodwill, in exchange for stock. A sale of the same property would be taxable, but section 351 lets owners incorporate a business without recognizing gain, on the theory that they have merely changed the form of their investment. Similar non-recognition rules apply to tax-free reorganizations under section 368 and to the liquidation of a subsidiary into its parent. This lesson covers forming a corporation under section 351, the capital structure choice between debt and equity, the taxation of complete liquidations, the main types of reorganization and the choice between selling stock and selling assets when a business is sold.

Section 351: forming a corporation

Section 351 provides that no gain or loss is recognized when one or more persons transfer property to a corporation solely in exchange for its stock if, immediately after the exchange, the transferors are in control of the corporation. Control, defined in section 368(c), means owning at least 80 percent of the total combined voting power and at least 80 percent of the shares of each other class. Property includes cash, equipment, real estate, inventory, receivables and intangibles such as goodwill, but not services: a person who receives stock for services is taxed on its value as compensation, and is not counted as a transferor of property unless he also transfers property of more than nominal value. When an LLC that has been disregarded elects to be taxed as a corporation, as Brandt Aerial LLC did, the regulations treat the owner as contributing the LLC's assets and liabilities to a new corporation in exchange for its stock, and section 351 applies to that deemed exchange.

Boot, liabilities and basis

A transferor who receives money or other property besides stock, called boot, recognizes gain (but not loss) up to the amount of boot received, under section 351(b); the character of the gain depends on the assets transferred, so boot allocated to equipment produces section 1245 recapture. The corporation's assumption of the transferor's liabilities is generally not boot (section 357(a)), with two exceptions: if the principal purpose of the assumption was tax avoidance or lacked a business purpose, all of the liabilities are boot (357(b)); and if the liabilities assumed exceed the total adjusted basis of the property transferred, the excess is gain (357(c)). The transferor's basis in the stock is the basis of the property transferred, decreased by boot and liabilities assumed and increased by gain recognized (section 358). The corporation's basis in the property is the transferor's basis plus any gain recognized (section 362), and both parties tack the transferor's holding period for capital and section 1231 assets.

Debt or equity?

A corporation's owners can finance it with stock or with loans. Interest on debt is deductible by the corporation (subject to section 163(j) for larger businesses) and repayment of principal is tax-free to the lender, while dividends are not deductible and are taxable to the extent of E&P. Owners of closely held corporations are therefore tempted to lend rather than invest, but if the 'debt' looks like equity (no fixed maturity, interest payable only from profits, subordination to all other creditors, a high debt-to-equity ratio, or advances in proportion to stockholdings), the IRS can reclassify it, denying the interest deduction and treating repayments as distributions. Equity also has an advantage for small businesses: under section 1244, an individual who is an original holder of small business corporation stock can deduct a loss on it as an ordinary loss up to $50,000 a year ($100,000 on a joint return), rather than as a capital loss limited to $3,000 a year against ordinary income.

Leah's section 351 exchange

The program applies section 351 to the deemed contribution of Leah's sole proprietorship assets: drone equipment worth $14,000 with an adjusted basis of $9,000, goodwill worth $40,000 with no basis, and $1,000 of cash. The corporation assumes a $6,000 equipment loan and gives Leah a $9,000 note as well as all of its stock. The last lines look ten years ahead and compare selling the business, by having the corporation sell its assets and liquidate, as a C corporation and as an S corporation.

# Leah's assets move into a corporation: section 351 (illustrative figures)
assets = {"Drone equipment": (14_000, 9_000), "Goodwill": (40_000, 0), "Cash": (1_000, 1_000)}
liability_assumed = 6_000          # equipment loan taken over by the corporation
boot_note = 9_000                  # corporate note Leah receives besides 100% of the stock
fmv = sum(v for v, b in assets.values())
basis = sum(b for v, b in assets.values())
realized = fmv - basis
recognized = min(realized, boot_note)          # boot triggers gain up to the realized gain
excess_liab = max(0, liability_assumed - basis)   # s. 357(c)
stock_basis = basis - liability_assumed - boot_note + recognized + excess_liab
corp_basis = basis + recognized + excess_liab
print(f"FMV of property {fmv:,}; Leah's basis {basis:,}; realized gain {realized:,}")
print(f"Gain recognized because of the note (boot): {recognized:,}")
print(f"Liabilities in excess of basis (s. 357(c)): {excess_liab:,}")
print(f"Leah's basis in her stock:                   {stock_basis:,}")
print(f"Corporation's basis in the assets:           {corp_basis:,}")
print(f"Gain deferred in Leah's stock: {fmv - liability_assumed - boot_note - stock_basis:,}")
print()
# Ten years later: selling the business by liquidating a C corporation vs an S corporation
asset_fmv, asset_basis, sh_basis = 600_000, 250_000, 4_000
corp_gain = asset_fmv - asset_basis
c_tax = 0.21 * corp_gain
c_cash = asset_fmv - c_tax
c_sh_tax = 0.238 * (c_cash - sh_basis)         # 20% plus 3.8% NIIT on the liquidation gain
s_sh_tax = 0.20 * corp_gain                    # passes through once; no NIIT for an active owner (simplified)
print(f"C corporation: corporate tax {c_tax:,.0f} + shareholder tax {c_sh_tax:,.0f} = {c_tax + c_sh_tax:,.0f}")
print(f"S corporation: gain taxed once to Leah, about {s_sh_tax:,.0f}")

FMV of property 55,000; Leah's basis 10,000; realized gain 45,000
Gain recognized because of the note (boot): 9,000
Liabilities in excess of basis (s. 357(c)): 0
Leah's basis in her stock:                   4,000
Corporation's basis in the assets:           19,000
Gain deferred in Leah's stock: 36,000

C corporation: corporate tax 73,500 + shareholder tax 124,355 = 197,855
S corporation: gain taxed once to Leah, about 70,000

Leah realizes a $45,000 gain on the exchange but recognizes only $9,000, the boot. The $6,000 liability is not boot and does not exceed her $10,000 basis, so section 357(c) does not apply. Her stock basis is $10,000 − $6,000 − $9,000 + $9,000 = $4,000, and the corporation's basis in the assets is $10,000 + $9,000 = $19,000. The remaining $36,000 of gain is deferred in her stock. The second part shows why the entity matters at exit. If a C corporation sells assets worth $600,000 with a basis of $250,000 and liquidates, it pays $73,500 of corporate tax and Leah pays $124,355 on her liquidation gain, nearly $198,000 in total; through an S corporation, the gain passes through once and costs about $70,000 at the 20 percent rate (ignoring recapture taxed at ordinary rates).

Liquidations

In a complete liquidation, the corporation distributes all of its assets to its shareholders and dissolves. Under section 336, the corporation recognizes gain or loss as if it had sold each asset at fair market value (with limits on losses from property distributed to related persons or recently contributed with built-in losses). Under section 331, the shareholders treat the distribution as full payment for their stock and recognize capital gain or loss equal to the value received minus their stock basis. Assets received take a fair market value basis. A liquidation of a C corporation therefore produces two levels of tax. The exception is the liquidation of an 80 percent subsidiary into its parent corporation, which is tax-free to both under sections 332 and 337, with the parent taking the subsidiary's basis and tax attributes, such as NOLs, under sections 334(b) and 381.

Tax-free reorganizations

Section 368 lists the transactions that qualify as tax-free reorganizations: a statutory merger or consolidation (type A); an acquisition of a target's stock solely for voting stock of the acquirer (type B); an acquisition of substantially all of a target's assets for voting stock (type C); transfers of assets to a controlled corporation followed by distribution of its stock, which include spin-offs, split-offs and split-ups (type D, with section 355); a recapitalization (type E); a mere change in identity, form or place of organization (type F); and a bankruptcy reorganization (type G). Beyond the statutory definitions, judicial doctrines require continuity of interest (the target's shareholders must receive a substantial equity stake in the acquirer), continuity of business enterprise and a business purpose. Shareholders who exchange stock in a reorganization recognize gain only to the extent of boot (sections 354 and 356); the corporations recognize no gain (section 361); and bases carry over.

Selling a business: stock or assets

When a business is sold, the buyer and seller must decide whether to transfer stock or assets. Sellers of a C corporation usually prefer a stock sale, which produces a single level of tax at capital gain rates, possibly reduced by section 1202. Buyers usually prefer to buy assets, which gives them a cost basis for depreciation and amortization, including 15-year amortization of goodwill under section 197, and leaves the target's liabilities behind. For a C corporation, an asset sale followed by liquidation means double tax, so the price must compensate. For an S corporation, an asset sale is taxed once to the shareholders, though part of the gain may be ordinary recapture; and the parties can often get asset treatment for a stock sale by a joint election under section 338(h)(10) or section 336(e), which treats the S corporation as selling its assets and liquidating. Allocation of the price among asset classes, reported by both parties on Form 8594, determines how much is ordinary income and how much capital gain.