“Which do you prefer: a taxable or a non-taxable transaction?”
Most taxpayers would probably respond that they prefer a non-taxable transaction. After all, who wants to pay tax if they don’t have to?
Closer analysis, however, may reveal that given a particular taxpayer’s situation, a taxable transaction may yield a better result. For example, the taxpayer may have loss carry-forwards that a taxable transaction would enable the taxpayer to utilize, or the taxpayer may want to recognize the loss inherent in the property.
In most cases, a taxpayer that desires a taxable transaction should not have much difficulty in effecting that result. However, there have been a number of instances in which such a taxpayer has inadvertently stumbled into a non-taxable exchange.
Tax-Free By Mistake
Easy: by satisfying the requirements for such treatment. For example, The Code provides that “no gain shall be recognized if property is transferred to a corporation” solely in exchange for stock in such corporation,” and “immediately after the exchange,” the transferor is in control of the corporation.
This provision is not elective – it is mandatory. It applies regardless of the taxpayer’s intent, so long as its requirements are satisfied. One taxpayer realized too late that this was the case.
Sale or Contribution?
A recent decision examined whether the Taxpayer’s transfer of assets to Corp was a sale or a capital contribution. Taxpayer operated a real estate business (selling foreclosed properties on behalf of lenders) as a sole proprietorship for many years. In 2008, Taxpayer created Corp and, shortly thereafter, Corp’s board of directors authorized Corp to purchase Taxpayer’s sole proprietorship.
Corp and Taxpayer entered into a purchase agreement pursuant to which Taxpayer agreed to sell to Corp “[a]ll the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of” the sole proprietorship.
When the purchase agreement was signed, Corp had no capital, no assets, and no shareholders. Weeks after the purchase agreement was signed, Corp’s board of directors resolved to issue shares to Taxpayer in exchange for $X.
No appraisal was performed, so there was no way to establish the reasonableness of the $X. The purchase price was determined exclusively by the Taxpayer. The Taxpayer allocated a portion of the purchase price to a franchise license agreement to which Taxpayer was a party and the balance of the purchase price was allocated to contracts between Taxpayer and various lenders.
The purchase agreement stated that the purchase price was payable in monthly installments and that the unpaid principal amount was subject to 10% interest each year. Corp did not provide any security for the purchase price, and a promissory note was not executed. The purchase price was eventually paid in full, but Corp did not make all payments timely.
Tax Return and the IRS
On his returns for the years at issue, the Taxpayer reported long-term capital gain from the transaction using the installment method. The Taxpayer also reported interest income. Corp reported substantially the same amounts as deductible interest payments on its returns for the years at issue. Corp also amortized the purchase price.
The IRS issued notices of deficiency for the years at issue to both Taxpayer and Corp, arguing that the transfer of the sole proprietorship’s assets to Corp was a capital contribution subject to section 351, not a sale. The IRS also argued that the payments made to Taxpayer were, in fact, taxable dividends and that the assets transferred to Corp may not be amortized.
The issue to be decided, the Court said, was whether the transfer was a capital contribution or a sale creating a debtor-creditor relationship.
The Court began its analysis by stating that the substance of a transaction, not its form, is controlling for tax purposes. Transfers between related parties, such as Taxpayer and Corp, are subject to close scrutiny but do not necessarily lack economic substance.
According to the Court, when an overall plan is accomplished through a series of steps, it is the overall plan that must be evaluated for tax purposes, not each step.
“Where a series of closely related steps are taken pursuant to a plan to achieve an intended result, the transaction must be viewed as an integrated whole for tax purposes.” The sole purpose of Corp’s organization was to incorporate Taxpayer’s sole proprietorship. The inseparable relationship between Corp’s organization and the transfer of the sole proprietorship’s assets weighed in favor of finding that the transfer was a capital contribution, particularly in the light of the lack of evidence of a business reason for dividing the transaction.
Factors to Consider
The Court then applied a multi-factor test to determine whether Taxpayer’s transfer to Corp was a sale or a capital contribution. No single factor was controlling, it said, and the facts and circumstances of each case must be taken into consideration. The primary purpose of the factors is to help the Court determine the parties’ intent “through their objective and subjective expressions.”
The following factors were considered:
The issuance of a note evidences debt, and the issuance of stock indicates an equity contribution;
- The lack of a fixed maturity date indicates that payment is linked to the success of the business and is evidence of an equity interest;
- Payments that depend on earnings or come from a restricted source indicate an equity interest;
- The right to enforce payment of principal and interest (as through a secured interest) is evidence of a debt;
- An increase in a shareholder’s interest in a corporation as the result of a transaction indicates an equity interest;
- Subordinating the right to repayment to rights of the corporation’s other creditors generally indicates an equity interest;
- Thin capitalization tends to indicate that a transaction is a capital contribution;
- Advances made by shareholders in proportion to their stock ownership indicate a capital contribution; and
- The corporation’s ability to borrow funds from a third party indicates a debt.
The Court found that some of these factors were neutral, that others weighed in favor of finding that the transaction created a debtor-creditor relationship, and that others favored finding that it created an equity interest. Considering all of the factors together, the Court concluded that they weighed in favor of finding that the transaction was in substance a capital contribution.
Contribution and Dividends
Section 351(a) provides: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Person(s) have control if they own stock possessing at least 80% of: (1) the total combined voting power of all of the corporation’s voting stock and (2) the total number of shares of all of the corporation’s other classes of stock. The application of section 351 is mandatory when all of the requirements are met.
In substance, in order to incorporate Taxpayer’s existing business, the Taxpayer transferred a nominal amount of cash and all of the sole proprietorship’s assets to Corp solely in exchange for Corp’s stock. Taxpayer was in control of Corp immediately after the transfer of cash because taxpayer became Corp’s sole shareholder. Thus, section 351 governed the tax consequences of the transaction.
The Court then turned to the payments made by Corp to the Taxpayer pursuant to the “exchange agreement.” Money distributed to a shareholder out of a corporation’s E&P is considered a dividend and shall be included in gross income. To the extent that a corporation has E&P, they are generally considered the source of corporate distributions.
Since the Court determined that the Taxpayer’s transfer of the sole proprietorship’s assets to Corp was a capital contribution, Corp’s payments to the Taxpayer in the years at issue must be treated as distributions, not installment payments. Because Corp’s E&P in each of these years exceeded the amount distributed to the Taxpayer, the distributions should have been treated as dividends for tax purposes.
Generally speaking, it will usually be more advantageous for a transaction to be treated as a non-taxable event. However, if the taxpayer’s overall tax consequences will be more favorable if the transaction were taxable, then the taxpayer must plan carefully—especially where the transaction involves a transfer to a closely-held business entity.
If a sale is to be respected as such, the taxpayer must be mindful of the factors set forth above to avoid recharacterization of the sale as a capital contribution and dividends. (Of course, even a “successful” sale must be careful to avoid the related party sale rules.) Alternatively, a taxpayer may consider failing the “control” requirement referred to above though this may be unattractive from a business perspective.
The bottom line, as always, is: plan in advance. It is often the case that the business goals sought may be accomplished and reconciled, at least in part, with the desired tax consequences.