CHAPTER 2 TAXATION OF C CORPORAT FORMATION OF A CORPORATION gave B $310,000 of Y common stock, 810,000 cash and will take the building subject to the $80,000 first mortgage? (c) Is the difference in results between (a) and (b), above, justified? (d) When might there be legitimate business reasons for a corporation assuming a transferor's debt or taking property obligation subject to debt? to the corporation in the amount of the potential Section 357(c) gain. which generally is treated as "assumed" unless a third party has pledged existed. A similar factual inquiry may be required with nonrecourse debt, other assets as collateral and "has agreed to, and is expected to, satisfy the As for planning, it has been suggested that Section 357(c) problems transfers encumbered property to a controlled corporation enters into an could be avoided, at least with respect to recourse debt, if a shareholder who agreement with the corporation providing that the shareholder will satisfy Section 357(d), and neither Section 357(a) nor Section 357(c) would apply to the debt. In that event, the debt would not be treated as "assumed" under the transfer. This strategy would be an alternative to contributing a note Inc, v. Commissioner, 81 T.CM. 1543 (2001), afrd 308 F.3d 803 court in illiinted that 98 PROBLEMS 1. A organized X Corporation by transferring the following: inventory with a basis of $20,000 and a fair market value of $10,000 and unimproved lana held for several years with a basis of $20,000, a fair market value of $40.000 and subject to a recourse debt of $30,000. In return, A received 20 shares of X stock (fair market value, $20,000) and X took the land subject to the debt (a) Assuming no application of Section 357(b), how much gain, if any, does A recognize and what is A's basis and holding period in the stock? (b) What result in (a), above, if the basis of the land were only $5,000? () In (b), above, what is the character of A's recognized gain under Reg. $ 1.357-2(b)? Does this result make sense? How else might the character of A's gain be determined? (d) In (b), above, what is X Corporation's basis in the properties received from A? (e) What might A have done to avoid the recognition of gain in (b), above? 2. B organized Y Corporation and transferred a building with a basis of $100,000 and a fair market value of $400,000. The building was subject to a first mortgage of $80,000 which was incurred two years ago for valid business reasons. Two weeks before the incorporation of Y, B borrowed $10,000 for personal purposes and secured the loan with a second mortgage on the building. In exchange for the building, Y Corporation will issue $310,000 of Y common stock to B and will take the building subject to the mortgages. (a) What are the tax consequences to B on the transfer of the building to Y Corporation? (b) What result if B did not borrow the additional $10,000 and, instead, Y Corporation borrowed $10,000 from a bank and Farms. remaining personally liable for the E. INCORPORATION OF A GOING BUSINESS The preceding sections were designed to illustrate the basic requirements and exceptions for qualifying as a tax-free incorporation, For pedagogical reasons, the problems have involved relatively isolated fact patterns, and it has been assumed that the Code and regulations will provide an answer to virtually every question. When a going business is incorporated, however, matters may become more complex. The mix of ordinary income propertie proprietorship or partnership may include and the corporation may assume accounts payable, contingent liabilities, and supplies the cost of which was deducted by the transferor prior to the Questions arise as to the proper taxpayer to report the receivables and to deduct the payables. In addition, these items potentially raise a broad issue that will recur throughout our study of Subchapter C: to what extent must a nonrecognition provision yield to judicially created "common law" principles of taxation or to more general provisions of the Code? This section examines the special problems raised by midstream transfers and, in so doing, provides an opportunity to review some concepts introduced earlier in the chapter. incorporation. Hempt Brothers, Inc. v. United States United States Court of Appeals, Third Circuit, 1974. 490 F.2d 1172, cert. denied 419 U.S. 826,95 S.Ct. 44 (1974). ALDISERT, CIRCUIT JUDGE. [A cash method partnership transferred all its assets, including $662,820 in zero basis accounts receivable, to a newly formed corporation in exchange for all the corporation's stock. Because the exchange qualified under Section 351, the Service contended that the partnership's zero basis in the receivables carried over to the corporation under Section 362, causing the corporation to realize income upon their collection. In an odd reversal of roles, because the statute of limitations had run on earlier years, the corporation contended that the receivables were not "property" within the meaning of Section 351 and that their transfer to the corporation was an assignment of income by the partnership, subjecting the partners to tax when the receivables were transferred or cost ie fair market * See Bogdanski, supra note 89 at 26-28. In dicta, the Tax CHAPTER 2 TAXATION OF C CORPORAT FORMATION OF A CORPORATION gave B $310,000 of Y common stock, 810,000 cash and will take the building subject to the $80,000 first mortgage? (c) Is the difference in results between (a) and (b), above, justified? (d) When might there be legitimate business reasons for a corporation assuming a transferor's debt or taking property obligation subject to debt? to the corporation in the amount of the potential Section 357(c) gain. which generally is treated as "assumed" unless a third party has pledged existed. A similar factual inquiry may be required with nonrecourse debt, other assets as collateral and "has agreed to, and is expected to, satisfy the As for planning, it has been suggested that Section 357(c) problems transfers encumbered property to a controlled corporation enters into an could be avoided, at least with respect to recourse debt, if a shareholder who agreement with the corporation providing that the shareholder will satisfy Section 357(d), and neither Section 357(a) nor Section 357(c) would apply to the debt. In that event, the debt would not be treated as "assumed" under the transfer. This strategy would be an alternative to contributing a note Inc, v. Commissioner, 81 T.CM. 1543 (2001), afrd 308 F.3d 803 court in illiinted that 98 PROBLEMS 1. A organized X Corporation by transferring the following: inventory with a basis of $20,000 and a fair market value of $10,000 and unimproved lana held for several years with a basis of $20,000, a fair market value of $40.000 and subject to a recourse debt of $30,000. In return, A received 20 shares of X stock (fair market value, $20,000) and X took the land subject to the debt (a) Assuming no application of Section 357(b), how much gain, if any, does A recognize and what is A's basis and holding period in the stock? (b) What result in (a), above, if the basis of the land were only $5,000? () In (b), above, what is the character of A's recognized gain under Reg. $ 1.357-2(b)? Does this result make sense? How else might the character of A's gain be determined? (d) In (b), above, what is X Corporation's basis in the properties received from A? (e) What might A have done to avoid the recognition of gain in (b), above? 2. B organized Y Corporation and transferred a building with a basis of $100,000 and a fair market value of $400,000. The building was subject to a first mortgage of $80,000 which was incurred two years ago for valid business reasons. Two weeks before the incorporation of Y, B borrowed $10,000 for personal purposes and secured the loan with a second mortgage on the building. In exchange for the building, Y Corporation will issue $310,000 of Y common stock to B and will take the building subject to the mortgages. (a) What are the tax consequences to B on the transfer of the building to Y Corporation? (b) What result if B did not borrow the additional $10,000 and, instead, Y Corporation borrowed $10,000 from a bank and Farms. remaining personally liable for the E. INCORPORATION OF A GOING BUSINESS The preceding sections were designed to illustrate the basic requirements and exceptions for qualifying as a tax-free incorporation, For pedagogical reasons, the problems have involved relatively isolated fact patterns, and it has been assumed that the Code and regulations will provide an answer to virtually every question. When a going business is incorporated, however, matters may become more complex. The mix of ordinary income propertie proprietorship or partnership may include and the corporation may assume accounts payable, contingent liabilities, and supplies the cost of which was deducted by the transferor prior to the Questions arise as to the proper taxpayer to report the receivables and to deduct the payables. In addition, these items potentially raise a broad issue that will recur throughout our study of Subchapter C: to what extent must a nonrecognition provision yield to judicially created "common law" principles of taxation or to more general provisions of the Code? This section examines the special problems raised by midstream transfers and, in so doing, provides an opportunity to review some concepts introduced earlier in the chapter. incorporation. Hempt Brothers, Inc. v. United States United States Court of Appeals, Third Circuit, 1974. 490 F.2d 1172, cert. denied 419 U.S. 826,95 S.Ct. 44 (1974). ALDISERT, CIRCUIT JUDGE. [A cash method partnership transferred all its assets, including $662,820 in zero basis accounts receivable, to a newly formed corporation in exchange for all the corporation's stock. Because the exchange qualified under Section 351, the Service contended that the partnership's zero basis in the receivables carried over to the corporation under Section 362, causing the corporation to realize income upon their collection. In an odd reversal of roles, because the statute of limitations had run on earlier years, the corporation contended that the receivables were not "property" within the meaning of Section 351 and that their transfer to the corporation was an assignment of income by the partnership, subjecting the partners to tax when the receivables were transferred or cost ie fair market * See Bogdanski, supra note 89 at 26-28. In dicta, the Tax