Business Memo Example: Taxation

To: Tiger Associates
From: xxxxx
Date: 1st Nov. 2016

MR. B
Re: Section 351 of control requirement in relation to Mr. B’s exchange

FACTS

Mr. B initially transferred some real and tangible personal property to a company by the name Notorious Corporation in exchange for 90% of the corporation’s stock. At the same time, Mr. S also transferred machinery and equipment to Notorious Corporation in exchange for the remaining 10% of the corporation’s stock. Pursuant to the binding agreement that had been concluded before the above transfers, Mr. B sells half of his stock to Mr. S, which leaves him with 45% of the stock while the buyer gets 55%. The issue of control is, however, not just about the percentage of stock owned after the transfer.

ISSUE(S)

The client has asked us whether or not the exchange with Mr. S meets the Section 351 of control requirement.

DISCUSSION

According to Internal Revenue Code (IRC) Section 351, after property is transferred to a corporation by one or more persons in exchange for stock in that corporation, the person or persons who have transferred the property in exchange for stock are in control (Cornell University Law School). This means that after transferring the property and machinery in exchange for the stock at Notorious Corporation, Mr. B and Mr. S gained control over the corporation. As such, any actions that they partake in after the exchange of the stock is up to them. At that point of taking control, it can be noted that Mr. B has 90% of stock while Mr. S has 10%. With regards to the definitions used in Section 351, the stock that Mr. B transfers to Mr. S is that of a corporation that is under the control of Mr. B. This means that the transaction qualifies under special rules where distribution to shareholders is not taken into account when determining the control possession. The transaction between Mr. B and Mr. S was pursuant to a binding agreement that had been concluded before Mr. B acquired the 90% of stock. In other words, potentially, Mr. B may not have acquired the stock if he had not intended to distribute it to Mr. S who would by then already be a shareholder with 10% stock in the corporation. It, however, remains inconclusive as of whether the transaction qualifies under Section 351 of control requirement.

To clarify further, according to I.R.C. Section 368, the party in control must possess at least 80% of the stock of the corporation in question (Cornell University Law School). Considering that prior to the exchange between Mr. B and Mr. S it was Mr. B who had more than 80% of the stock, it can be asserted that he still continues to control the corporation even after selling half of his stock to Mr. S. In this case, it would be stated that the transaction between Mr. B and Mr. S does not qualify for the Section 368 of the requirements. Admittedly, the control cannot be transferred to Mr. S under this regulation. Thus, according to this rule, the control remains with Mr. B. This Code thus also limits the exchange between Mr. B and Mr. S from qualifying under the Section 351 of control requirement.

Treas. Reg. Sections 1.351-1 states that the transfer to a corporation that is controlled by transferor demands a non-recognition of gain and loss on the part of those transferring. When Mr. S transferred the property to Notorious Corporation in exchange for 10% stock while Mr. B got 90% stock, the law will not recognize either gain or loss in any case. The transaction between Mr. B and Mr. S after the transfer is thus considered as one that takes place on fair grounds, with the fair market value of the stock being considered. However, the codes applied in the sections above indicate that since Mr. S receives less than 80% of the stock after the final transfer, they cannot be presumed as in control of the company. This regulation thus limits the ability of the shareholder to claim control over the firm.

In the Revenue Ruling 79-194, it is argued that even if the sales of stock between the two transferors is conducted pursuant to the binding agreements and entered into before the exchange, the shift in ownership of the stock does not affect the application of Section 351(a) (Cornell University Law School). The shift of ownership that occurs subsequent to the stock transfers is not considered as an application in the control requirements mainly because those transfers simply do not meet the purpose of the legal definitions in relation to the stock exchanges and control. For Mr. S to qualify for control, Mr. B would have to sell a bigger amount of stock to him and to provide more than 80% of the stock in possession m. Hence, the exchange between Mr. B and Mr. S still does not qualify under Section 351 of control requirements.

Revenue Procedure 77-37 argues for continuity of interest stating that if the acquiring corporation shows a continued interest in the company that they have acquired, they are likely to retain control unless the other party has over 80% of the stock. In the case of Mr. S and Mr. B, not only is Mr. S rather short on controlling stock, but he is also limited by the fact that Mr. B has showed some continuing interest in the Notorious Corporation. Mr. B may no longer have more than 80% in stock but there has been no point during the exchange in which Mr. S had more than 80% of the stock to gain control. This means that the exchange does not qualify under the Section 351 of control requirement, and Mr. B continues to take a full responsibility and control of the corporation in question.

CONCLUSION

In order to qualify for the Section 351 of control requirement, a number of conditions must be met. First, the transferor must own at least 80% of the stock from the company in question. In this case, Mr. B did have 90% of the stock prior to the exchange with Mr. S. The second requirement, however, is that Mr. B shows no continuing interest in the corporation. It can be noted that in this case Mr. B does not sell all of his stock but rather only a half. This means that prior to the exchange Mr. B possessed 90% of the stock and after it he has 45% against Mr. Small’s 55%. Mr. S can still not claim control of the organization since he is below the 80% mark for control. This is based on I.R.C. Section 351, I.R.C. Section 368, Treas. Reg. Sections 1.351-1, Revenue Ruling 79-194 and Revenue Procedure 77-37. The scenario between the two investors, that is Mr. B and Mr. Small can be ameliorated in a number of ways. The first option could be that Mr. B agrees without coercion or intimidate to relinquish a part of his 45% stake to Mr. S to allow the latter assume the controlling status in the business. The second option could be that the two parties agree to apportion management responsibilities among themselves in observance of the relevant sections of the law. However, as it is stated currently, none of the two investors hold the key to controlling stake in the business as defined by the sections mentioned above.