Category: Nontaxable Exchanges; Corporate
Subject: S Corporation Contribution
Title: S Corporation Contribution/Distribution of Appreciated Property
IRC Sections: 351
Filename: 1250.html
Date Produced: 07/95

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Background
Taxpayer is sole shareholder of a corporation which elected S corporation status at inception. Taxpayer owns highly appreciated property which he wishes (for personal reasons) to contribute to capital. Liabilities associated with the property to be assumed by the corporation do not exceed the taxpayer's basis in the property. These liabilities were not placed on the property in anticipation of this transaction.

Contribution: In General
Section 351 allows tax-free contribution of property to a corporation solely in exchange for stock if the transferor is in control of the corporation (owns at least 80% of the value and the voting power of the corporation's stock) immediately after the transfer. Taxpayer owns 100% of the stock both before and after the contribution. Issuance of additional shares in exchange for the property contribution is meaningless and is not required. The basis of the property in the hands of the transferee corporation is the same as the basis of the property in the hands of the taxpayer prior to the contribution.

Contribution: Risk Factor
There is a risk that the protection offered by Section 351 could be denied because there is no corporate business purpose in connection with the transfer of property. The IRS maintains that Section 351 requires a business purpose. Rev. Rul. 60-331, 1960-2 C.B. 189, 191, and Rev. Proc. 83-59, 1983-2 C.B. 575. There is some, although not unanimous, judicial support for the IRS's position. Ultimately, there is a risk that if the transaction described above were scrutinized, the IRS could successfully challenge the availability of Section 351.

Distribution
If the property is sold at some point in the future, the gain from the sale would flow through to the taxpayer, assuming the S election is still in place, and the taxpayer would be taxed on that gain. As a result, the taxpayer's stock basis would be increased by the gain pass-through thus allowing the taxpayer to withdraw the cash from the sale without further tax consequences.

On the other hand, if the taxpayer simply wants to withdraw the property in kind from the corporation at some point in the future, such withdrawal would trigger corporation level gain on the difference between the fair market value of the property at the time of withdrawal and its basis in the hands of the corporation. Sections 311(b) and 1371(a)(1).

Alternatives
Has the taxpayer considered a partnership or an LLC to hold this asset?

Using a partnership or an LLC taxed as a partnership eliminates the potential gain if the taxpayer ultimately wants to withdraw the property in kind: non-cash property can be distributed from a partnership without triggering gain.

In addition, the business purpose requirement for tax free transfers to a partnership or LLC under Section 721 APPEARS to be far less stringent. (Section 721 is the partnership equivalent of Section 351 in the corporation area.) The IRS can always attack a transaction that has no business purpose, but unlike Section 351 transfers, there is no published ruling in the partnership area to the effect that a business purpose is required for Section 721 to be operable.