Category: Corporations; Deductions &
Credits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) is 100% owner of an S corporation. TP wishes to retire from the business. TP plans to gift his shares in several stages to various individuals, one of whom is TP's brother. TP also wishes to have two parcels of appreciated real estate owned by the corporation. One parcel consists of vacant land with a fair market value of $184,000 and a tax basis of $25,400. The other parcel is a resort home with a fair market value of $100,000 and a tax basis of $50,000. Both parcels are debt free. The value of TP's stock is approximately $1 million. The corporation also has a receivable on the books at $225,000. TP also wishes to have this asset. The receivable is worth substantially less than face and perhaps has only nominal value. The full face value of the receivable is taken into account in TP's stock value. TP has no basis in his corporate stock. The corporation's S election was made before 1986. The corporation has significant C corporation earnings and profits. Issues: 1) Can TP withdraw the desired assets from the corporation in such a way that the withdrawal will be considered a redemption of his stock? 2) Will the distribution of assets create corporate-level taxation? 3) Can TP take advantage of the provisions which allow reinvestment of certain stock proceeds in a Small Business Investment Company? Based on my preliminary findings which I related to you by telephone on July 14, 1994, we changed the scope of the project. Following is a summary of my findings regarding the original issues as well as my thoughts on the new issues we discussed. 1. The transaction could be arranged as a redemption by completing the gifting program prior to redeeming the stock of the existing shareholder. The concept is to give away stock with a value equal to all the assets of the corporation except the three assets desired by the existing shareholder. Assume arguendo that the receivable is really only worth $10,000 instead of its face value of $225,000, the total value of the corporation is $785,000 of which the existing shareholder wishes to have assets valued at $294,000 ($184,000 vacant land plus $100,000 resort property plus $10,000 receivable). These assets represent about 37.5% of the total value of the corporation. Accordingly, it would be necessary to gift 62.5% of the existing shareholder's stock in order to make the value of his resulting holdings equal to the value of the desired assets inside the corporation. Once the gifting program is completed, the assets desired by the existing shareholder would be distributed in complete redemption of all his remaining stock. Under §302(b)(3), the redemption of a taxpayer's entire interest in a corporation is treated as sale or exchange of the taxpayer's shares thus making the transaction eligible for capital gain treatment assuming the taxpayer's stock is a capital asset. The pre-redemption transfer of stock to the taxpayer's brother does not affect the outcome in this case. While it is true that the constructive ownership provisions come into play in determining whether a shareholders entire interest has been redeemed, the constructive ownership rules of §318 are used. See §302(c)(1). Stock owned by the taxpayer's brother is not attributed back to the taxpayer under §318. The family attribution rules of §318 only take into account the taxpayer's spouse, children, grandchildren, and parents. §318(a)(1). 2A. §311(b) provides that gain shall be recognized if a corporation uses appreciated property to redeem its stock. That gain is measured as though the corporation had sold the property at its fair market value. Under the scenario set forth above, the corporation would recognize gain of $208,600 based on the values and adjusted bases of the properties distributed. This gain would be allocated to all the shareholders of the corporation. 2B. Given that the receivable desired by the existing shareholder
has a current tax basis equal to its face and the collectability
of that receivable is in doubt, a bad deduction could be available
in the amount of $215,000 ($225,000 minus $10,000). If the bad
debt deduction were triggered at the same time as the gain under
§311(b), the resulting deduction would offset the gain at
the corporate level and no net gain would be passed through to
the shareholders. On the other hand, if the receivable has some value now and continues to have some value through the year of the redemption, the taxpayer has total discretion regarding the timing of the bad debt deduction. §166(a)(2) and Regulation §1.166-3 provide that a deduction for partial worthlessness of a business bad debt can be claimed in the year in which the taxpayer takes a charge-off on his books for a portion of the debt. Thus, the taxpayer can control the timing of the deduction by controlling the year in which the debt is partially charged off on the books. Ultimately, it becomes a question of fact as to which treatment (total worthlessness or partial worthlessness) applies. If a bad debt deduction is claimed in the year of redemption based on the position that the debt is only partially worthless, there is exposure that the IRS would claim that the debt became totally worthless in a prior year. The taxpayer at that point would bear the burden of proving that the receivable had some value at the time of the charge-off. Otherwise, the deduction under §166(a)(2) would be disallowed thus exposing all the shareholders to the gain produced under 311(b). 2C. There is no corporate level tax as a result of the redemption. Since the S election was made prior to 1986, the built in gains tax of present-law §1374 is inapplicable. The corporate-level capital gains tax on pre-1986 §1374 is potentially applicable, but has no effect in this case since the assets were acquired more than three years prior to their disposition. 3. Finally, the reinvestment provision you mentioned is not applicable. This is §1044 and it applies only to the disposition of publicly traded stock. Having found some unfavorable news with respect to the original issues, we discussed the possibility of using other measures to achieve the taxpayer's goals. Specifically, we discussed the possibility of leaving the land, resort home, and the receivable in the existing corporate shell and spinning off the active business into a new corporation the stock of which would be gifted to the new shareholders over time. Unfortunately, more careful consideration has revealed that this plan is not viable. Separation of the assets of a corporation into two corporations one containing active business assets and the other containing inactive assets would present taxpayers with a means of bailing out corporation earnings at capital gains rates. Although bail out of earnings is not the goal of this transaction, the Code contains anti-abuse provisions which prohibit the treatment the taxpayer would like to have in this case. In order to have a valid tax-free spin-off under §355 and/or the D reorganization provisions of §368(a)(1)(D), both the transferor corporation (the existing company) as well as the transferee corporation (the newly-formed company to which the active business assets would be transferred) must each contain immediately after the transfer the assets of an active trade or business which has been conducted for at least five years. While it is possible to separate a single active business into two corporate shells by dividing the business along functional lines for example, it is not possible to divide a single business into an active component and a non-active component as in this case. Accordingly, the tax free spin-off provisions under §355 and 368(a)(1)(D) are not available in this case. |
