Category: Nontaxable Exchanges; Corporations
Subject: Net Operating Loss
Title: Contribution of Profitable Proprietorship to Loss Corporation
IRC Sections: 351, 382, 269
Filename: 1101.html
Date Produced: 3/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer (TP) owns 100% of OLDCO, a dormant C corporation with unexpired net operating losses. TP also owns a profitable Schedule C business. TP wishes to contribute the Schedule C business tax-free to OLDCO under Section 351 such that the future profits generated by the Schedule C business can be offset by the net operating loss carryforwards of OLDCO.

Issue
Does any tax rule prohibit utilization of OLDCO's net operating loss against the income generated after the contribution by the former Schedule C business?

Answer
I see no rule to prohibit utilization of OLDCO's net operating losses; however, I am concerned that IRS might attempt to attack the transaction by attacking the tax-free status of the transfer of the Schedule C business into OLDCO.

Discussion
The principal statutory vehicles through which net operating losses are denied seem to be inapplicable to this set of facts.

Section 382 limits the amount of income which can be offset by net operating losses. This statutory limitation requires a change of corporate ownership. Since TP owns 100% of the stock of OLDCO both before and after the contribution of the Schedule C business, the rules of Section 382 cannot apply.

Section 269 allows the IRS to disallow the tax benefits, including net operating loss carryforwards, in acquisitions entered into to avoid or evade tax. In order for Section 269 to apply, control of either A) a corporation; or B) the assets of another corporation must be acquired. Neither of these events has occurred in this case. Accordingly, Section 269 does not apply.

Absent a direct, statutory means of attacking utilization of OLDCO's net operating losses, the Service could indirectly attack the transaction by contending that the transfer of the Schedule C business to OLDCO is taxable event and not protected by Section 351. This may or may not be a problem depending on the circumstances of the Schedule C business.

The IRS takes the position that a valid transaction under Section 351 must be supported by a valid business purpose other than tax avoidance. See Revenue Ruling 60-331, 1960-2 CB 189, Revenue Ruling 77-321, 1977-2 CB 98, Revenue Ruling 55-36, 1955-1 CB 340, Revenue Ruling 70-140, 1970-1 CB 73, and Revenue Procedure 83-59, 1983-2 CB 575.

The IRS has not been consistently successful with this position, however, it is clear that the courts will support the IRS in this matter to some extent particularly when the corporation in question is not operated before and after the transaction. See West Coast Marketing Corp. v. Comr, 46 TC 32 (1966), and Hempt Bros., Inc. v. U.S., 490 F.2d 1172 (3d Cir. 1973), and Weikel v. Comr., T.C. Memo 1986-58. In this case, the corporation in question was not operated immediately before the transaction but will be operated afterwards.

It seems to me that business purpose concept poses a risk under these circumstances. If the taxpayer simply desired to operate the Schedule C business as a corporation, why not contribute the business to a newly-formed corporation rather than expose the profitable business to the contingent liabilities of OLDCO? Absent the obvious tax motivation to transfer the profitable business into OLDCO, what business reason exists? Clearly administrative and legal costs are reduced by using an existing corporation versus a new one, but that seems rather thin to me. Can you and your client come up with something better to support this transaction?

It seems to me that the IRS could take the position that no matter what the taxpayer claims as a business purpose in this transaction, the overriding motivation is tax avoidance. It is not possible to predict the ultimate outcome if that issue were raised.