Accounting 6073
Fall 2011

Lesson 3B:  Boot, Basis, Debt, "Midstream Issues"

I.	"Solely In Exchange":  The receipt of Boot

	A.  Basic Rule:

		1.  Section 351 b requires gain (not loss) to be recognized
			a. to the extent of the fair market value of boot received
			b. limited by gain realized

		2.  See example p. 3-20

	B.  Multiple Properties transferred
	 
		1.  Consider each asset separately--allocate proceeds based on relative
			fair market value ( see p. 3-21).
		2.  Parties may agree on a different allocation of proceeds if business purpose 
			and arms-length.

	C.  Timing/Character of Boot Gain Recognition

		1.  Character of asset transferred determines (using asset by asset
			 approach above) 
		2.  Consider recapture if depreciated prop is transferred (may
			have to recognize gain)

	D.  Certain "debt like" preferred stock may be considered boot

		1.  Limited and preferred as to dividends
		2.  No significant participation in corp.'s growth
		3.  Such stock considered equity for all other purposes

II. Transferor's Basis for Stock Received

	A.  In general--

		1.  In simplest case, basis of stock rec'd = basis of prop transferred
		2.  If several classes of stock rec'd--allocate basis IAW relative fair market 
			value of each class.

		3.  If boot rec'd, 
			a. Basis of boot = its fair market value
			b. Basis of non-recognition property (i.e. stock rec'd in 
				the exchange) = 
			
			Basis of prop transferred-boot rec'd + gain recognized.

	B.  Estoppel--If taxpayer later claims higher stock basis because he should have 
		recognized gain on 351 exchange,
		
		1.  Some authority for allowing stepped up basis absent fraud.
		2.  But ordinarily will reopen the statute of limitations for year of 
			351 exchange.

	C.  Holding Period

		1.  Ordinarily "tacks" if transferred prop was a capital asset or
			 1231 asset
		2.  Holding period tacks even if boot was rec'd (basis determined by				 reference to basis of prop given up) 				
		3.  If no gain deferred, basis of stock rec'd = its fair market value.

	D.  Boot received in installments:  stock basis increased only as gain recognized. 

III. Contributions to a Corporation's Capital

	A.  In general--capital contributions excluded from gross income of corporation 

		1.  Contributions of shareholders (voluntary)
			a. normally pro rata transfers are capital contributions.
			b. non pro rata transfers by shareholders acting in that capacity

		2.  Non-shareholder contributions if meets these criteria:
			a. permanent part of working capital
			b. not compensation
			c. contribution must be bargained for 
			d. foreseeable benefit commensurate with its value.
			e. must be employed to generate additional income.

		3.  Doesn't include contributions by persons in capacity as customers
			or potential customers.

	B.  If debt forgiven as capital contribution, 

		1.  Corp has COD income as if satisfied debt with cash = to 					shareholder adjusted basis in debt.
		2.  If adj. basis of debt = its face amount, corp. has no income.
		3.  Corp's accounting method is relevant in determining basis.		
		4.  If corp. insolvent, rule is superseded. 

	C.  Corp's basis in property contributed as capital

		1.  Same as transferor’s basis plus any gain recognized
		2.  If not contrib. by shareholder, basis is zero
		3.  If non s/h contributes money, reduce basis of other assets

	D. Shareholders generally increase basis of their stock for capital contributions.

IV. Assumption of Liabilities 

	A.  History--
		1.  U.S. v. Hendler (1938):  assumption/payment of liabilities by corporation 
			treated as receipt of boot by transferor.
		2.  But this meant that transferors who did 351 transactions in earlier
			years could step up basis even though statute of limitations closed.
		3.  Congress responded by legislatively overruling Hendler.

	B.  General Rule:  IRC 357(a)
		1.  Assumption of liabilities by corporation is not boot but
		2.  Transferor reduces basis in stock received by amount of debt assumed
		3.  See e.g. p 3-26
		4.  Applies to recourse and non-recourse liabilities, whether or not 
			transferor is released from obligation.
		5.  Transferor in such case has no COD income.

	C.  Exception for "tax-avoidance" transactions (357(b) IRC)
		1.  Assumption of liabilities is treated as boot if, from the nature
			 of the liability and circumstances, it appears the
			 principal purpose was :			
			a. avoidance of federal income taxes or 
			b. otherwise not a bona fide business purpose
		2.  Purpose of rule:  avoid cash bail out where taxpayer borrows
			 against appreciated property  just prior to transfer (maybe for personal
			 purposes).
3.  If 357(b) applies, all liabilities in transaction treated as boot, not just those related to alleged non business purpose.
4.  357(b) probably also applies to assumption of personal liabilities of transferor, unless business purpose.

	D.  Exception for Liabilities in Excess of Basis:  (357(c) IRC)
		1.  In general
			a. More objective than 357b, and applies by self-assessment.
			b. Applies where aggregate debt assumed exceeds aggregate  				basis of property transferred.
			c. purpose:
				--recapture benefit of faster depreciation than debt repayment
				--tax part of w/d of borrowed cash secured by assets
			d. see e.g. p 3-32:  note this applies even if no gain realized.
			e. 357b supersedes 357c if both apply.

		2.  Can reduce this problem by
			a. paying off liabilities before entering 351 exchange
			b. getting creditors to look solely to transferor or 
				un-transferred property.
	c. possibility:  give note to corporation to reduce net liabilities to less than basis.
				--IRS disagrees:  such note has 0 basis to transferor
				--but see Lessinger (2nd circuit)...transferee has basis
					in note = to face amount.
			The jury is out on this tactic.

3.  If liabilities transferred are cash basis (deductible when paid) 357c N/A, unless liabilities result in basis increase in any property.

		4.  Character of gain recognized under 357c depends on asset(s)
			 transferred.  If capital and ordinary income assets, allocate 
				recognized gain IAW relative fair market value.

		5.  Amount of gain recognized
			a. compare aggregate liabilities with aggregate adjusted basis
			b. apply on a person by person basis

		6.  Effect of new 357d
			a. recourse liabilities considered transferred only if transferee agrees to
				 satisfy them
			b. non-recourse liabilities considered transferred if any asset
				 subject thereto is transferred.
			c. The amount of non-recourse liabilities considered transferred
				 is reduced by liabilities attributable to assets not transferred				 that owner has agreed to satisfy.

	E.  Effect of default by transferee corporation if transferor pays
		1.  Bad debt deduction for transferor or
		2.  Contribution to capital (would increase basis of stock)
		3.  If stock sold, probably a capital loss, if stock was capital asset.

	F.  Contingent liabilities
		1.  Probably not taken into account for purposes of 357/351.
		2.  But if contingent liabilities later ripen...possible delayed effect of 357
			under "open transaction doctrine"

	G.  Basis of non-recognition property (i.e. stock) received by the transferor
		 when 357 applies is reduced (since liabilities given up are considered 
		like money received by transferor), whether or not gain recognized
	 by transferor under 357.  The formula is similar to the one used above when boot is received:

	Basis of prop transferred-liabilities transferred + gain recognized

	H.  Transferee may deduct payments related to assumed liabilities if transferor was 
		able to.
	
V. Transfer under 351 vs. Dividend

	Regulations mention the possibility, which might arise in the following cases:
		
		1.  An existing corporation transfers stock to a controlling shareholder with
			fair market value exceeding fair market value of  property transferred 
			to corporation by shareholder, and the existing corporation has 
			earnings and profits.
		2.  Receipt of debt securities, property or money in otherwise tax free
			recapitalization, or 351 transaction where there are earnings & profits.

VI. Midstream transfers of Potential Income

	A.  In general
		1.  Some possibility that "hot assets" may not qualify as property for
			 351 when going business is incorporated e.g.
			a. accounts receivable
			b. inventory
			c. some installment obligations 
			d. contract rights
			e. other "ordinary income" property

		Issue:  cannot defer recognition of ordinary business income.

		2.  Other doctrines may supersede 351 in some cases:
			a. assignment of income doctrine
			b. tax benefit rule
			c. IRS authority under 446 and 482 (clear reflection of income)

	B.  Examples:
		1.  Assignment of income:  transfer of accounts receivable satisfies 351 if 
			business purpose (Rev Rul. 80-198).
		2.  Section 482--IRS can make sure dealings between related parties
			are at arms-length (e.g. asset selection for 351 transfer)
		3.  Section 446--accounting method must clearly reflect income
			(e.g. completed K vs. percentage of completion method)
		4.  Tax benefit rule--may be invoked to approximate result based on a 
			transactional (vs. annual) accounting system.

VII. Collateral Considerations when Incorporating a Going Business
	
	A.  For transferors
	1.  Non arms-length lease of assets—If corporation pays rent to 
			shareholder in excess of fair market value, rent can be re-characterized 
			as dividend.

		2.  Incorporation of partnership--use caution
			a. different routes (e.g., partnership liquidates, partners transfer			 		their partnership interest, or partnership transfers its		 
				assets) all have different tax consequences.
			b. suspended passive losses could be suspended permanently.

	B.  For transferee corps
		1.  New corporations choose their own tax attributes w/o regard to tax			 	attributes of existing businesses.

		2.  Corp does succeed to basis and holding period of property					transferred in 351 exchange.