Tax-free formation of a corporation
A corporation’s initial shareholders often wish to transfer property to the corporation upon its formation.
General Rule-No Gain
This transfer may qualify for an exception to the general rule that a taxpayer must recognize gain or loss on the disposition of property.
A taxpayer recognizes no gain or loss on the transfer of property to a corporation solely in exchange for common stock of the corporation (and certain types of preferred stock) if the taxpayer (and other transferors of property, if any) is in control of the corporation immediately after the exchange.
Exceptions to Gain Recognition
The taxpayer-transferor may, however, be required to recognize gain if, in addition to receiving qualifying stock, he also receives other property (called “boot”), such as cash, a promissory note, or nonqualified preferred stock.
The transferor may also recognize gain if the transferee corporation assumes liabilities of the transferor. In that case, the transferor recognizes gain if the total amount of liabilities assumed exceeds the transferor’s total adjusted basis in transferred assets. This situation may arise if, for example, property was depreciated (for tax purposes) at a rate faster than the rate of repayment of the debt that the property secured.
Tax Free Incorporation Requirements
To qualify for nonrecognition treatment, a transferor must transfer “property.” Thus, if a transferor provides services for the stock received, he must recognize compensation income. If both property and services are transferred, a reasonable allocation must be made between the stock received in exchange for property and the stock received for services.
The stock received in the exchange may generally be either common or preferred, and either voting or nonvoting. However, “nonqualified preferred stock” is treated as boot and triggers gain recognition. In certain cases, the stock received may be either contingent stock or escrowed stock.
To qualify for nonrecognition treatment, the transferors must also have “control” of the transferee corporation “immediately after the exchange.” “Control” generally means ownership of stock having at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of each other class of stock outstanding.
Furthermore, the transferors must have a valid business purpose for the exchange of property for stock — otherwise, the transaction may be treated as a taxable exchange.
Deferred Gain Recognition even in ‘Non Taxable’ Corporate Formations
Nonrecognition treatment does not mean that the transferor’s gain escapes taxation.
Rather, it means only that the taxation of the gain is deferred until the stock received in the exchange is disposed of in a recognition transaction (e.g., sold). The transferor takes a substituted basis in the qualifying stock received (decreased by the amount of boot received and increased by any gain recognized).
Corporate Tax Effect
The transferee-corporation does not recognize gain or loss on its issuance of stock. The corporation takes a “carryover basis” in the property received in the exchange, meaning that its tax basis in the property is the same as that of the property’s transferor (increased by the gain, if any, that the transferor recognized on the exchange).
Investment Company Exception
Nonrecognition treatment is not applicable to the transfer of property to an “investment company,” which include, for example, a corporation more than 80% of the value of whose assets are held for investment. Nonrecognition may be similarly unavailable in other exceptional cases (e.g., if the corporation is bankrupt).