Avoiding Gain When a Shareholder Receives Corporate Debt

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 19th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Kellie J. Bushwar and Lisa A. Lachmann, published by Practitioners Publishing Company, Fort Worth, TX, 2006 ((800) 323-8724; www.ppcthomson.com).

A shareholder’s receipt of debt issued by a corporation in exchange for contributed property will ruin an intended tax-free Sec. 351 exchange, because the debt will be treated as taxable boot to the extent of its fair market value (FMV).

Generally, this is not a problem when the FMV of the property contributed to the corporation equals its basis in the transferor’s hands. For instance, if only cash and depreciated personal property with a FMV equal to or less than basis is contributed in a Sec. 351 exchange, the shareholder would recognize no gain, even if the transaction failed to qualify under Sec. 351. However, if property with (1) no basis in the shareholder’s hands (such as cash-basis receivables) or (2) a FMV in excess of its basis is transferred, the shareholder will recognize gain to the extent of the lesser of any boot received or the FMV in excess of basis.

Example 1

Bill forms a corporation, Billco, to operate a new business that will be acquired by direct purchase from a third party. Bill transfers $300,000 cash and appreciated real property (with a $200,000 basis and $800,000 FMV) to Billco in exchange for all of its stock. At the same time, he loans Billco $700,000 that he borrowed from a bank. Billco will make the loan payments to Bill, as he is required to repay the bank. Billco uses most of the cash contributed and loaned by Bill to purchase new business assets.

 Because Bill has contributed real property with a FMV in excess of basis, he recognizes gain on the transfer to the corporation if the transaction does not qualify as a Sec. 351 exchange. Bill failed the solely-for-stock requirement, because he has also received a debt instrument from Billco in the same transaction; thus, he recognizes $600,000 gain($800,000 FMV – $200,000 basis in the appreciated real estate). However, with careful tax planning, Bill should be able to avoid this situation.

Example 2

The facts are the same as in Example 1, except that Bill guarantees a loan made directly from the bank to Billco, rather than borrowing $700,000 from the bank and then loaning it to Billco. The transaction should now qualify as a tax-free Sec. 351 exchange. Bill receives only stock in exchange for the cash and appreciated property he transferred to the corporation; thus, he recognizes no gain on the transfer.

What if Bill makes the $700,000 loan to Billco three months after the cash and appreciated property are exchanged for Billco’s stock? While there is a problem with contributing cash and appreciated property in exchange for stock and debt in a single Sec. 351 transaction, separating the transfers should alleviate the problem. If it is clear from the corporate documentation that certain assets were transferred in exchange for the stock, and a certain amount of cash was loaned to the corporation, tax-free treatment should still be available.

If there is concern about adversely affecting the Sec. 351 transfer, the cash loan could be made a few months (or even longer) after the transfer of the property in exchange for the stock. This should make it clear that the transfers are separate transactions, and the taxpayer received only stock in exchange for the contributed property.