Sample Answers to Question 2
Corporate & Partnership Tax (Short Course)
Spring 2006
Exam No. 1202
We don’t know what OPQ is classified as for tax purposes. Reg. § 301.7701-3(b) states that such entities, which are not otherwise classified as corporations under Reg. § 301-7701-2(b), are presumed to be taxed as partnerships. So first, we will explore what would happen if OPQ were taxed as a partnership.
1. Formation: Olivia. Normally, when a partner contributes money or property to a partnership in exchange for an interest in it, there is no gain or loss to either party under § 721(a). But Olivia is contributing services, which are not property. Under § 83(a), Olivia will therefore be taxed as if she had received property in connection with performance of services. The amount of her tax will be the FMV of the property she receives. In this case, the “property” is the partnership interest, so Olivia will be taxed on its FMV of $36,000; this will be taxed as ordinary income. Her basis in OPQ will be determined by its “tax cost,” i.e. the gain she paid tax on, under Reg. § 1.61-2(d)(2)(i); in other words, her basis in OPQ will be $36K.
Meanwhile, OPQ will be entitled to a deduction under § 83(h) for its contribution of property as, basically, wages. Under § 702(a), this deduction, rather than being attributed to the partnership, will pass through to Olivia (O), Peter (P), and Qwara (Q) based on their “distributive share.” Under § 704(a), distributive share is determined by the partnership agreement, unless the agreement does not have “substantial economic effect” under § 704(b)(2). Here, the partnership provides that all profits and losses are to be shared equally. Accordingly, OPQ’s expenditure of $36K of property will result in a $12K deduction each for O, P and Q, likely also of ordinary income (it’s property paid out, basically, as wages).
§ 705(a)(2) requires that each partner reduce his basis by the amount of pass-through deductions which he receives under § 702. O, P, and Q will each take that $12K deduction out of their basis in OPQ and be left with a basis of $24K.
2. Formation: Peter. § 721(a) provides, again, that normally when a partner contributes property for an interest in a partnership, neither recognizes gain or loss. §§ 722 & 723 provide, respectively, that the partner and the partnership receive a basis in the stock and property they receive which is carried over from the original property’s basis in the hands of the partner. Here, Blackacre’s adjusted basis was $25K, so P’s adjusted basis in OPQ is $25K, and OPQ’s basis in Blackacre is $25K.
However, OPQ also assumed a recourse liability of $30K when it took Blackacre. Reg. § 1.752-1(a)(1) provides that liabilities assumed by the partnership are recourse liabilities to the extent that any partner bears the economic risk of loss for it. Reg. § 1.752-2(b)(1) clarifies what is meant by “economic risk of loss”; meaning, if the partnership was constructively liquidated, the partner would be obligated to pay someone and would not be entitled to reimbursement for it. Here, as the sole general partner, only Olivia is on the hook for liabilities which the partnership assumes. Therefore, she bears the entire economic risk of loss for the mortgage.
§ 752(a) provides that when a partnership assumes a liability, the partners increase their partnership basis by their individual shares of the liability. (The assumption of liability is treated as a contribution of money to the partnership, which increases basis under § 722.) Normally under § 704(a), the partnership agreement would require the resulting increase in basis to be split evenly. But § 704(b) overrides this when the partnership agreement does not have substantial economic effect. Here, O is on the hook for the whole of the mortgage; the partnership agreement does not reflect this. Accordingly, O will increase her basis by the entire value of the mortgage, for $30K, to a total of $54K.
Meanwhile, § 752(b) provides that when a partnership assumes an individual partner’s liability, that is treated as a distribution of money to the partner; under § 731(a)(1), a partner does not recognize gain on such a distribution until the money distributed exceeds his partnership basis. Because OPQ assumed P’s $30K mortgage, P is treated as receiving a cash distribution of $30K. Unfortunately, his basis in OPQ, under § 722, is only $25K. As a result, under § 733(1) his basis in OPQ will be reduced to zero by the “money” distributed to him, and he will be taxed on $5K of gain, likely capital.
3. Formation: Qwara. A straightforward application of § 721(a): no gain is recognized to Q or to OPQ. Q’s basis in OPQ, under § 722, equals the money she received, for a grand total of $36K.
4.
In a partnership, § 704(c)(1)(B) provides that when a partner contributes property with a difference between its basis and fair market value, and that property is later sold, that individual partner will recognize gain up to the gain he would have recognized if he had sold the property for its fair market value on the date of distribution. Any remaining gain will pass through to all the partners, based on their distributive share, under § 702(a). Here, when P contributed Blackacre to OPQ, the difference between its FMV of $66K and basis of $25K was $41K. Therefore, P will recognize the entire $41K of gain on his individual tax return; Blackacre is probably a capital asset, but since it spent such a short time in the hands of OPQ, I don’t know whether its sale would result in ordinary income or capital gain for P.
Meanwhile, under § 752(b), the resulting decrease in O’s share of partnership lliabilities – she is now off the hook for the mortgage – will reduce her basis by $30K, back down to $24K.
In conclusion: O ends up paying tax on $36K of ordinary income, receives a deduction of $12K ordinary income, and has a basis in OPQ of $24K. P pays capital gains on $5K and what might be capital gains or ordinary income tax on $41K of gain, and his basis in OPQ is $0. Q receives a deduction of $12K and has a basis in OPQ of $24K.
What if OPQ elected to be taxed as a C corp?
Again, when O received stock in exchange for services she would be taxed on $36K of ordinary income under § 83(a), OPQ would be entitled to a deduction of $36K under § 83(h), and O’s basis in the stock would be its tax cost under Reg. § 1.61-2(d)(2)(i). However, the § 83(h) deduction would stay within OPQ, instead of passing to the shareholders.
P would not be eligible for a § 351 exchange because, as part of the formation transaction, O did not transfer property as is required by § 351(a); she transferred services. Accordingly, P’s exchange of Blackacre for stock would be treated as a § 1001 exchange, with P recognizing gain equal to the FMV of the property received (the partnership interest) minus the adjusted basis of the property given. Here, under Crane, the price paid includes the liability which OPQ assumes; P recognizes a gain of ($36K FMV of stock + $30K liability) - $25K basis = $41K. As the exchange of one capital asset for another, this may be taxed entirely as capital gain. P’s basis in his stock will be a cost basis of the FMV of the property he gave in exchange for it, or $66K.
Q would be treated as acquiring stock for cash; her basis, under § 1012, would be $36K.
On the sale of Blackacre, OPQ would recognize $41K of gain, none of which would pass through to the shareholders.
All told, the C corp would be a better deal for P, but worse for O and Q
Exam No. 1061
Available Elections:
Under federal tax law, state law labels are not necessarily controlling. Here, OPQ is a limited partnership, the question is whether it qualifies for partnership taxation under federal tax law. Under IRC 7701(a)(3) “corporation” includes associations, but associations is not defined in the code. In Treas. Reg. 301.7701-2(b), corporation means if the state labels it as a corporation, which was not done here. In Treas. Reg. 301.7701-3(a), OPQ may “check the box” to be a corporation under the tax code. The default is for it to be a partnership. So, for tax purposes, OPQ can be a partnership or a corporation.
Further, if OPQ qualifies, it may also elect to be an S corporation. To qualify as a small business corporation under IRC 1361(b), the business must not (A) have more than 100 shareholders, (B) have a shareholder other than a person, (C) have a nonresident alien shareholder, or (D) have more than one class of stock. Here, (A) is met, (B) is met, there are not enough facts to know if (C) is met (will assume so for this essay), and facts are limited as to whether (D) is met (this will also be assumed, however, the partnership arrangement—GP and 2 LPs—may have some effect on whether the stocks would be the same “class). Therefore, it is likely that if OPQ elects to be a corporation, it may also elect to be an S corporation
Therefore, all 3 tax entities are available and each will be treated in turn.
Partnership
Formation
For Q, who gave cash, there is no tax consequence to Q (not sales tax) and Q has a basis of $36k as a cost basis under IRC 1012. For the partnership, there is no tax consequence for Q buying the partnership interest (IRC 721).
For O, who gave past and future services, the tax consequences are a tax under IRC 83 (since O did not give property). Therefore, O has income of $36k (FMV of the partnership interest) at the formation of the partnership, when O receives the partnership interest. The basis in O’s partnership interest is $36k under the regulations of IRC 84 & 61. The tax consequences for OPQ depend on the facts of the transaction. OPQ may have an immediate deduction as an expense or a basis in the employment contract. There are not facts given to make this determination, but an immediate deduction will be presumed.
For P, who gave Blackacre, giving Blackacre was a realizing event. For there to be a tax there must also be a recognition event. Here, there is a nonrecognition provision under IRC 721 such that no gain or loss is recognized to the partnership or the partner on exchange of interest for property. Therefore, neither P nor OPQ has a gain on this transaction. P’s initial basis in the partnership interest is a carryover basis of $25k, which was the basis of Blackacre. For OPQ, the basis in Blackacre is also a carryover basis of $25k under IRC 723.
Further, in this transaction, OPQ assumed a mortgage of $30k. Under IRC 752(a), some partner gets basis for that as if it were a contribution. The question is which partner. Under Reg. 1.752-1, this loan is a recourse loan because partners bear the economic risk of loss. Going to Reg. 1.752-2 for a recourse loan, a doomsday scenario is run to determine who gets the basis. For a limited partnership, the GP is the partner who takes on all the risk of the mortgage. Therefore, O’s basis increases by the entire amount of the mortgage to $66k.
Now is a good time to recap current basis before going to the elimination of the mortgage as a liability for P. Basis, O: $66k, P: $25k, Q: $36k.
Back to the transaction for P, the hammer falls. Under 752(b), any decrease in liabilities is treated as a distribution to the partner. So, we act like the partnership distributed $30k cash (the value of the mortgage) and as if it was received by P, who got the economic benefit. Under 731(a)(1) a distribution is not recognized except to the extent it exceeds basis. Here, the $30k exceeds the basis of P $25k, so P has a recognized gain of $25k at the formation of the partnership, which maintains its character as a gain on the sale of property (capital). Under IRC 733, T’s basis in the partnership is reduced for his tax free distribution. So, his basis goes to -0-.
So, to summarize basis: O: $66k, P: $0, Q: $36k.
Blackacre is sold for $36k cash and $30k assumption of mortgage, for a total sale of $66k. The basis in Blackacre at the partnership level was $25k. Therefore, at the partnership level, there is a gain of $41k. When P joined, this $41k gain was built into Blackacre. Under IRC 704, we follow the true economics (substantial economic effect) of the transaction. P has already paid for the mortgage portion of the gain ($30k above). The remainder of the gain, the $11k is then P’s at the time of the sale. The timing is when sold and the character passes through—capital gain on the sale of property. P’s basis remains -0- because it can’t be reduced below zero. The remainder of the gain (the assumption of the mortgage) reduces the economic debt of the partnership.
For the assumption of the mortgage, under IRC 752(b), the partnership’s liabilities decrease and so does their basis. Here, all of the basis reduction is O’s because O was the GP and carried all the economic risk that was alleviated when the mortgage was assumed. Therefore, O’s basis drops to $36k.
Wages to O
As discussed, the wages to O may be a deductible loss or an asset with a basis. If presumed it is a loss at the partnership level, that loss passes through to the partners equally ($12k loss each to O and Q). The loss maintains character and is lost when the partnership loses it. The basis of each O and Q then decreases (O to $24k, and Q to $36k). P cannot take the loss because P does not have basis to take the loss. P’s loss will carryforward.
C Corp
Formation
For Q, putting in cash, there is no consequence to either Q or the Corp. Q gets a cost basis of $36k in their stock.
For O, putting in service, that is income to O $36k ordinary income under IRC 83 (ordinary). O gets a basis in O’s stock of $36k, IRC 1012. The C corporation gets a basis in a work contract or a loss depending on the facts of the transaction.
For P, putting in Blackacre, there is no IRC 351 nonrecognition event because the three shareholders do not have control (more than 80% needed, O’s service ruins that). P therefore has a recognized gain on Blackacre of $41k ($66k FMV – $25k basis). This is not a good situation for P, P would not want to elect to be a corporation. The gain is capital at the time of formation of the C corporation. P’s basis in P’s stock is a cost basis of $66k.
The consequences for the C corporation are that it has a basis in Blackacre of $66k (stepped up) Also, since it is a C corporation, the assumption of the mortgage has no effect on the basis available for taking losses.
When the C corporation sells Blackacre for $66k, there is no gain because the sale price equals the basis. Therefore, under IRC 11, the C corporation has no tax to pay. For Xavier, the buyer, X has a basis in Blackacre as a cost basis of $66k.
Wages to O
Wages to O may be deductible to the C corporation as expenses under IRC 162. Therefore, the corporation may have a loss of $36k. There are no gains to assert this loss against in the current year, but the loss can be carried forward to future years.
S Corporation
Formation
For an S corporation, the formation is the same as the C corporation. Therefore, Q has a basis of $36k and no tax consequences, P has a $41k capital gain and a basis of $66k in P’s stock, and O has $36k income from wages and a $36k basis in O’s stock. S corporation OPQ has a basis of $66k in Blackacre.
The mortgage has no effect on the S corporations availability to take loses
.
When the S corporation sells Blackacre, there is no gain because the sale price equals the basis.
Wages to O
Wages to O may be deductible and a loss as discussed. Therefore, the S corporation may have a pass through loss of $36k, split pro rata for a loss of $12k to each at the formation of the partnership. The character would be ordinary.
The basis of O, P, and Q’s stock would decrease under IRC 1367 to O: $24k, P: $54k, and Q: $24k.
Exam No. 1345
Question Two:
Formation
Olivia and Qwara
Olivia must pay tax on the fair market value (fmv) of her past and future services under §83. Since the fmv of these services is $36,000, she will be taxed on this amount, and this will become her basis in the partnership interest because of §1012. Under §83(h), the partnership gets an immediate deduction, or will set up a basis in the employment contract (depending on whether it is treated as a capital expenditure). Qwara will not have to pay any tax when she contributes cash to the partnership because cash counts as property and §721(a) provides that there is no gain or loss recognized to the partnership or any partners when property is contributed in exchange for an interest in the partnership. Her basis in her partnership interest will be $36,000 because of §1012.
Peter
Peter’s situation is much more complicated. §721(a) provides that no gain or loss will be recognized to a partnership or any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. Blackacre certainly counts as property, so he qualifies. However, Blackacre is encumbered by a mortgage, which changes the situation. When Peter contributes Blackacre to OPQ subject to the mortgage, the debt gets allocated to the partners under §752(a).
To determine which partner gets to increase his or her basis, we have to look at the regulations. First, we have to decide whether this is a recourse liability. Reg. 1.752-1 provides that a recourse liability is one where any partner bears the risk of loss. To determine whether anyone bears the economic risk of loss, we have to look at 1.752-2(b). This tells us that we have to pretend that there is a constructive liquidation and look to see who would be obligated to make a payment to anyone because a liability becomes due and wouldn’t be reimbursed by another partner. Since we have a limited partnership and Olivia is the general partner, she bears the economic risk of loss because in constructive liquidation she would be the only one who would actually have to pay. This means we have a recourse loan and that Olivia’s share of this equals the portion of that liability for which the partner bears the economic risk of loss (Reg. 1.752-2(a)). Since Olivia is the only one who bears the economic risk of loss, she will get to add the entire amount to her basis, increasing it from $36,000 to $66,000. This is not the end of the story.
Peter gets a carryover basis from Blackacre of $25,000 per §722. However, §752(b) provides that a decrease in a partner’s individual liabilities by reason of assumption of the partnership of such individual liabilities is considered as a distribution of money to the partner by the partnership. §752(c) goes further to provide that a liability to which property is subject (like this mortgage) is considered as a liability of the owner of the property to the extent of the fmv of the property. Since the fmv is more than the balance of the mortgage, the entire mortgage is a liability of Peter’s that is assumed by the partnership. We have to pretend that Peter got a distribution of $30,000.
§731(a) provides that gain isn’t recognized except to the extent that any money distributed exceeds the adjusted basis of the partners’ interest right before distribution. Immediately before distribution, Peter had a basis of $25,000. This means that he has to recognize $5,000 of gain because he received $30,000. Now, we have to determine Peter’s basis in the partnership interest by looking at §733. The adjusted basis to such a partner of his interest is reduced by the amount of any money distributed (but not below zero). Since his interest was only $25,000 and $30,000 was distributed, this means that Peter now has a basis of $0 in his partnership interest.
The basis of Blackacre to the partnership (the inside basis) is determined by §723 and will be the basis to the contributing partner increased by any gain recognized under §721(b). We don’t have any specialized gain under §721(b), so the basis to the partnership will be $25,000. However, §734 permits the partnership could make an election under §754 to increase the basis of Blackacre by the amount of gain recognized, which would mean that the basis could be $30,000 to the partnership. This is probably a bad idea because once this election is made, you have to do it this way every time.
Conclusion
In conclusion, Olivia has a basis in her partnership interest of $66,000. Peter has a basis of $0 and Qwara has a basis of $36,000. Blackacre has a basis to the partnership of $25,000 (unless the election is made, which is doubtful).
In general, when contributed property is sold, it is shared among partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. This means that Peter will have to recognize this amount of gain under §704(c) first. When Peter contributed the property, it had a fmv of $66,000 and he only had a basis of $25,000. So, this means that the first $41,000 of gain will have to be allocated to Peter.
To determine the amount of gain, we have to look at the total amount that Xavier paid, which just happens to be $66,000 (cash plus assumption of the mortgage) and subtract the adjusted basis to the partnership ($25,000) to get the amount realized. This leaves us with $41,000 of gain from the sale of property. This means that all of this gain will have to be recognized by Peter. Lucky for him, it will be capital gains because the character of the income is determined at the partnership level. Peter then gets to increase his basis in his partnership interest by this amount under §705, so he will now have a basis of $41,000.
Next, we have to worry about Olivia. §752(b) says that when a partner’s share of partnership liability decreases, it is treated as a distribution of money. When Xavier assumed the mortgage, Olivia was let off the hook. This means, we have to pretend that she was given a distribution of money of $30,000. §733 says that if there is a distribution of money, it must reduce the basis in the partnership interest by that amount. Olivia had a basis of $66,000, so that will now be reduced to only $36,000.
Since OPQ otherwise breaks even for the year, this means that Olivia and Qwara end up with basis of $36,000 and Peter ends up with a basis of $41,000 in their partnership interests.
Elections
A partnership can choose to be taxed like a corporation under the check-the-box rules in Reg. 301.7701-3. This would allow OPQ to be treated like a corporation. This would be bad for them. Upon formation, Qwara will not have any income because all she is doing is purchasing stock, and she will have a cost basis of $36,000 under §1012. Peter contributes property, which could be tax free to him under §351, but by investing services, Olivia messes this up by making them fail the control test (80% of stock owned by persons transferring property). Instead, Peter has to use §1001, which says that if you exchange property for other property that is different in kind, it is treated as a realizing event. This means that Peter has to realize a lot of gain. The amount realized will be the sum of any money received (which includes the mortgage) plus the fmv of the property received. The gain will them be the amount realized – adjusted basis. This means that his gain will be ($66,000 + $30,000) - $25,000 = $71,000. This is too bad for Peter. This gain will be capital, but that’s still a big huge problem. When Olivia invests her future services, it is not considered as in return for property under §351(d). This means she’ll have to pay tax on the fmv of the property received (which is $36,000). The basis of the property then has to be increased for OPQ under §358(a) by the amount of gain recognized and reduced by any money received (which includes assumption of the mortgage).
Since we now presumably have a corporation, when OPQ sells Blackacre, they have income. The adjusted basis for the corporation is as if Peter just sold the property to them, so it is $66,000. Since the value of the mortgage and the cash together equal this amount, there will be no gain to OPQ. Since OPQ otherwise breaks even for the year, there will be no corporate tax.
OPQ also could elect to be an S corporation which has pass-through taxation (because less than 100 shareholders, all individuals, etc.). This would not be as good of a deal for them as in a partnership though because they still would not be able to use 351. The results in an S corporation would be the same in this case due to §1371.
Exam No. 1663
OPQ can elect to be taxed as a partnership, or it can opt to Check the Box and be taxed as a corporation. Because it meets all the requirements of §1361, if O, P and Q each consent simultaneously, OPQ can also be an S Corp.
Partnership
As a P’ship, neither the P’ship nor Q will recognize any gain on her $36k contribution. She will get a basis of $36k in the P’ship under §1012.
O will have ordinary income equal to the value of the P’ship interest exchanged for her services under §83—in this case, $36k. She will have a basis in OPQ of $36k. The P’ship will get a deduction for her services, but will most likely have to amortize the deduction over the life of O’s employment contract. This is a bad deal for O because not only will she have $36k of ordinary income, but because she is not getting paid in cash for the value of her services, she will have to find other cash to pay the income taxes due on the $36k. Also, because O is the general partner, her wages will be treated as Net Earnings from Self Employment and she will have to pay both halves of the FICA taxes. This will be 12.4% for Social Security, and 2.9% for Medicare.
When P contributes Blackacre, the P’ship will be treated as having assumed a liability. Ordinarily, according to §752(a), when a P’ship assumes a liability, the partners will all get increased basis, allocated to them based on their economic risk of loss. In the case of a contribution of property encumbered by a mortgage, the P’ship is treated as assuming the liability of the contributing partner, and that assumption is treated as a distribution to the contributing partner, in this case P, per §752(b). P will recognize gain to the extent that the distribution—or the mortgage assumed—exceeds his basis in the P’ship.
When P contributes Blackacre he is given a carry over basis in OPQ worth $25k under §722. OPQ gets a carry over basis in Blackacre under §723 of $25k and assumes P’s debt of $30k. This assumption of liability is allocated to the partners based on their economic risk of loss. Because this is a limited partnership, only O as the general partner will bear the economic risk of loss according to Reg. §1.752-2, and therefore, she will get the entire $30k of basis. O’s basis will increase to $66k.
P will be treated as receiving a distribution equal to the liability that OPQ has assumed under §752(b). P therefore has a distribution of $30k. Distributions are tax free to the extent that they do not exceed a partner’s basis under §731(a), but because P only has $25k of basis, he also will have $5k of taxable gain.
Partners’ Basis at this point:
O: $66k
P: $0
Q: $36k
When OPQ sells Blackacre, the P’ship recognize gain equal to the difference between the property’s basis and sale price. OPB got a carryover basis in Blackacre of $25k, and sold Blackacre for $66k—the sum of the $36k cash, plus the assumption of the $30k mortgage.
Any decrease in a P’ship’s liabilities is treated as a distribution to the partners under §752(b), which decreases the partners’ basis under §733. Because the entire liability was allocated to O, Xavier’s assumption of the $30k mortgage will be treated as a distribution to O and will decrease O’s basis by $30k. O’s basis is now $36k.
There is $5k of gain remaining from the sale of Blackacre, b/c OPQ had a carryover basis worth $25k in the property. Ordinarily, gain on the sale of property is passed through to the partners based on their distributive share, as set out in the P’ship Agreement according to §704(a). However, under §704(c)(1)(A), income with respect to property contributed to the P’ship shall be shared amongst the partners so as to take into account the difference between the basis of the property and its fair market value at the time of its contribution. Therefore, the amount of any appreciation on Blackacre prior to its contribution to OPQ will be taxed to P, any appreciation earned after its contribution is shared amongst the partners. In this case, P will have $5k of capital gain passed through to him. This raises his basis §705(a)(1)(A) to $5k. P is then treated as receiving a $5k distribution, which will decrease his basis back to $0.
C and S Corporation
For contributions, all transactions are the same whether OPQ elects to be taxed as a C Corp or an S Corp.
If OPQ had Checked the Box, they could opt to be taxed as a C Corp.
Q will have a $36k basis and the Corp will recognize no income under §1032.
O will have ordinary income of $36k. Under §351(d), stock issued for services shall not be considered as issued in return for property. This will screw up the §351(a) exchange for P, dealt with below. O’s salary will be deductible for OPQ as a normal business expense under §162, and will offset any E&P the Corp may have. O’s income will be §61 wages and taxed as ordinary income. One potential issue—§162 only permits the Corp to deduct a reasonable allowance for personal services actually rendered—so O must actually work for OPQ. Also, depending on the work O is doing, it may be treated as a Capital Expenditure under §263, and will not be immediately deductible to OPQ, even though O’s wages will be taxable to O. Both O and OPQ will be responsible for their half of the FICA taxes—6.2% each for Social Security and 1.45% each for Medicare. O will have a basis of $36k in her stock.
P will have taxable gain on the difference between Blackacre’s basis and the value of the stock he receives under §1001, taxed as Capital Gain. Because O was not contributing property in exchange for her stock, P will fail the §351(a) “Control” requirement—the group exchanging property for stock will not control 80% of the stock in the corporation immediately after the exchange. P had a basis in Blackacre of $25k, and received $36k in stock. Because this is treated as a direct swap of appreciated property for stock, the exchange is a recognition event and P gets a basis of $36k in his stock and OPQ gets a basis of $36k in Blackacre
Because Blackacre was encumbered by a mortgage, P would recognize gain, in the form of boot, to the extent that the value of the mortgage exceeds P’s basis in Blackacre under §357(c). However, these rules only apply in the case of §351 exchanges, and because the shareholders failed the Control requirement, §351 does not apply. Going back to Federal Income Tax—waaaaaaaaay back—I think that the mortgage assumed by Blackacre is all boot to P. Therefore, P has an additional $30k of ordinary income and OPQ’s basis in Blackacre is increased by any gain recognized by P. Therefore, OPQ’s basis in Blackacre is $66k.
When OPQ sells Blackacre, it will have no gain because it had a basis in Blackacre of $66k, which is equal to the sale price. The assumption by Xavier of Blackacre’s mortgage has no tax consequences for OPQ.
In the event that I messed up the basis analysis, and Blackacre only had a $36k basis, OPQ would have $30k of gain on the sale of Blackacre. This would be Capital Gains, but C Corps don’t get special rates for Capital Gains. This is only important to the extent that OPQ may have had Capital Losses that it could use to offset this gain. This would create $30k of E&P and OPQ would have to pay corporate tax under §11 on this.
As an S Corp, this gain would have passed through to O, P and Q per their pro rata share under §1366(a)(1).
Created by: bojack@lclark.edu
Update: 08 Aug 06
Expires: 31 Aug 07