Question

Adam, Beth, Clayton and David are forming a bakery business, called ABCD Corp, and decided to organize as a corporation. Adam Beth and Clayton will each own 300 shares of the common stock and David will own 100 shares of the stock (there are 1000 shares total of the corporation). Adam is contributing cash of $200,000, Beth is contributing equipment from a prior business that was originally purchased for $300,000 and was depreciated for tax purposes by $120,000 (current FMV is $200,000). Clayton is contributing a store front that he purchased two years ago for $250,000, but is currently worth only $200,000. David is contributing his time and will work full time for the business as the manager for the first year to train all the staff and get the business running on its own (David’s services would cost $67,000).

A. Determine any gains/losses or income that may be recognized incident to the formation of ABCD Corp. (make sure you consider the tax consequences pursuant to IRC Section 351).

B. Determine Adam, Beth, Clayton and David’s basis in their newly issued ABCD Company stock and ABCD Corp’s basis and tax consequences of the contributed property/services, if any.

C. Do your answers change if ABCD Corp already existed as David’s 100% owned company for two years before Adam, Beth and Clayton make their property contributions?

            D. What would be the result if Beth’s property were worth $250,000 and so the Corporation gave her $50,000 cash in addition to her stock?

E. What would be the result if two years after formation, a capital call is made and each shareholder is required to contribute $100 of cash for each share owned? What if Beth wanted to meet the capital call with appreciated property?

Problem 2. Assume all of the same facts as Problem 1 above, except that each will receiving 25% of the common stock for their contributions of property and services.

What are the tax consequences of this deal (gains/losses/income recognized, basis of shareholders in stock, basis of corporation in property)?

How might the transaction be structured differently in such a case to provide for a more favorable tax result for the shareholders? What if David gave $25,000 cash as well as his services for his 25% interest?

Answer 1

A.Concern about the tax liability that could result from incorporating a currently unincorporated business and the barrier to incorporation it could present, prompted Congress to enact Section 351 to remove this barrier to incorporation of an unincorporated business.

The idea was to allow unincorporated businesses to develop, unimpeded by any immediate tax consequence resulting from the exchange of property for stock.

In other words, Congress thought that any gain on an exchange of property for stock should be deferred (put off) until a future time, such as when the stock received in the exchange was eventually disposed of by the shareholder.

Note that a loss on an exchange is not deductible if you own, directly or indirectly, more than 50% of the stock.