ACCOUNTING 306 CHAPTER 18

Example 1 Nonqualified preferred stock, defined in 351(g), is treated as boot for purposes of recognizing gain when it is received in exchange for property. In general, nonqualified preferred stock resembles debt and will cause gain to be recognized up to the value of the nonqualified preferred stock received. However, nonqualified preferred stock continues to be treated as stock for purposes of determining whether the 80% control test is met. Example 2 A Professional-Free Incorporation (page 18-7). Allen learns after the incorporation of Jay Corporation that he has made a terrible blunder that could cost him a significant amount of income taxes. By failing to own at least 80% of the stock immediately after the transfer, he is required to recognize the gain on the exchange. To overcome the mistake, he proposes a bartering transaction to the other shareholder, Beth, that would enable him to qualify for 351. Allens solution to this quandary is questionable for several reasons: Allen did not discover the problem until after Jay Corporation had been formed. In order for Allens plan to work, the actual exchanges by Allen and Beth would have to be disregarded. Based on the facts, the transactions resulting in the incorporation are old and cold and cannot be wished away. Allens tax advice to Beth is incorrect. Beth should report the fair market value of 25% of Jays stock as compensation income. Allen is suggesting that she report income of only 20% of the stock and to ignore the value of the antiques.

Allen is exerting pressure on Beth to accept a plan that she otherwise would not even consider if she fully understood the tax consequences.

Example 3 Example. Paul and Vicki (father and daughter) each hold 100 shares in Blue Corporation. Paul transfers real estate (basis of $50,000 and worth $250,000) to Blue Corporation for 20 additional shares. Paul has a taxable gain of $200,000 on the transfer. Since the stock attribution rules do not apply, Paul is not deemed to own Vickis stock. As the sole property transferor, he would not have the required 80% ownership after the transfer (i.e., he owns 120 of 220 shares, or 54.5%). Example 4 Example. Assume Paul, in the preceding example, transfers the real estate to Blue Corporation but receives no additional stock. Paul has made a tax-free capital contribution. Since no stock is received, 351 does not apply. Paul will increase his basis in his 100 shares. There may be other tax consequences, such as Paul may have made a gift to Vicki with respect to one-half the value of the transferred property. Example 5 The tax advantages of financing a corporation with some debt are clear and beyond question. In fact, debt is so advantageous from a tax perspective that some corporations overdo it. Nonetheless, some well-known, successful corporations choose to operate without long-term debt. Microsoft, Walgreen, and Cisco Systems apparently have decided that the nontax advan-tages of avoiding debt (e.g., not having to contend with debt service costs) outweigh the tax advantages of using debt. Such debt-free companies may be the envy of corporations that have relied on debt, perhaps excessively, as a means of growth. In some cases, corporate debt does little to enhance a shareholders investment and may even destroy it. Example 6 Example. Rita and Quinn are partners in the RQ Partnership. RQ Partnership acquires 100 shares of 1244 stock in White Corporation at a cost of $100,000. A few months later RQ Partnership distributes 25 shares to Rita and 25 shares to Quinn. White Corporation suffers financial difficulties and files for bankruptcy two years later. White Corporation stock is worthless. RQ Partnership can claim an ordinary loss of $50,000 (the cost of the remaining 50 shares in White Corporation), which is then passed to Rita and Quinn as ordinary loss. However, Rita and Quinn have a capital loss of $25,000 each on the shares distributed to them by RQ Partnership. The 50 shares RQ Partnership distributed to Rita and Quinn lose their 1244 status. Rita and Quinn were not the original holders of the stock (see Reg. 1.1244(a)-1(b)(2) and Jerome Prizant, 30 TCM 817, T.C. Memo. 1971-196). If RQ Partnership had not distributed the stock to Rita and Quinn, it would have claimed an ordinary loss of $100,000, which would have passed to Rita and Quinn as ordinary loss. Thus, Rita and Quinn could each have claimed ordinary loss of $50,000 on their individual returns. 2

Example 7 Will the Sale Be Recognized (page 18-23)? Lane is apparently trying to avoid the application of 351 since he wants to recognize his realized loss. He has accomplished his goal if the separate sale is recognized and the transfer is not tied to the original incorporation. In this regard, Lane seems to have the advantage since he did not receive stock for the cranes but installment notes receivable. END OF CHAPTER QUESTIONS COVERED IN LECTURE NOT COLLECTED : 7, 8, 9, 10, 11, 14, 15, 16, 17, 25, 26, 27, AND 29