chapter review questions

CHAPTER 18

CORPORATIONS: ORGANIZATION AND CAPITAL STRUCTURE

TRUE/FALSE

1. The reason for § 351 (which permits transfers to controlled corporations to be tax free) can be justified under the wherewithal to pay concept.

ANS: T REF: p. 18-3

2. Similar to like-kind exchanges, the receipt of “boot” under § 351 can cause gain to be recognized.

ANS: TRealized gain is recognized to the extent of the boot received.

PTS: 1 REF: p. 18-4

3. Tina incorporates her sole proprietorship with assets having a fair market value of $100,000 and an adjusted basis of $110,000. Even though § 351 applies, Tina may recognize her realized loss of $10,000.

ANS: FSection 351 does not permit the recognition of realized losses.

PTS: 1 REF: p. 18-4

4. In a § 351 transfer, a shareholder receives boot of $10,000 but ends up with a realized loss of $3,000. Only $7,000 of the boot will be taxed to the shareholder.

ANS: FIf a shareholder ends up with a realized loss, the receipt of the boot will not cause that loss to be recognized. The receipt of boot will only trigger a realized gain.

PTS: 1 REF: p. 18-4

5. In a § 351 transfer, a shareholder who receives boot has a realized loss. None of the boot is taxed.

ANS: TIf a shareholder ends up with a realized loss, boot does not trigger gain or loss recognition.

PTS: 1 REF: p. 18-4

18-1

18-2 2008 Comprehensive Volume/Test Bank

6. In a § 351 transfer, gain will be recognized to the extent of the greater of realized gain or the boot received.

ANS: FIt is the lesser of and not the greater of.

PTS: 1 REF: p. 18-4

7. Adam transfers inventory with an adjusted basis of $120,000, fair market value of $300,000, for 85% of the stock of Heron Corporation. In addition, he receives cash of $30,000. Adam recognizes a capital gain of $30,000 on the transfer.

ANS: FAdam recognizes $30,000 of ordinary income. The gain on the transfer is limited to the boot received of $30,000; further, the gain is characterized by reference to the asset transferred.

PTS: 1 REF: p. 18-4

8. The definition of property for purposes of § 351 includes unrealized receivables transferred by a cash basis taxpayer.

ANS: T REF: p. 18-4

9. A secret process and patentable inventory both constitute “property” under § 351. Consequently, neither gain nor loss is recognized on the transfer of such “property” to a controlled corporation.

ANS: T REF: p. 18-4

10. The transfer of an installment obligation in a transaction qualifying under § 351 is a disposition of the obligation that causes gain to be recognized by the transferor.

ANS: FGain would not be recognized. An installment obligation is property under § 351.

PTS: 1 REF: p. 18-4

11. Since services are not considered property under § 351, a taxpayer must report as income the fair market value of stock received for such services.

ANS: T REF: p. 18-4

12. The receipt of securities (i.e., long-term debt) in exchange for the transfer of appreciated property to a controlled corporation results in recognition of gain to the transferor.

ANS: TSecurities (i.e., long-term debt), as well as other debt, constitute boot under § 351. As a result, the receipt of securities can trigger the recognition of realized gain.

PTS: 1 REF: p. 18-5

Corporations: Organization and Capital Structure 18-3

13. The receipt of nonqualified preferred stock in exchange for the transfer of appreciated property to a controlled corporation results in recognition of gain to the transferor.

ANS: TNonqualified preferred stock, as well as securities (i.e., long-term debt), constitute boot under § 351. Nonqualified preferred stock possesses many of the attributes of debt.

PTS: 1 REF: p. 18-5

14. Eileen transfers property worth $200,000, basis of $60,000, to Goldfinch Corporation. In return, she receives 80% of the stock in Goldfinch Corporation worth $180,000, and a long-term note, executed by Goldfinch and made payable to Eileen, worth $20,000. Eileen will recognize no gain on the transfer.

ANS: FThe long-term obligation of Goldfinch Corporation constitutes boot. Thus, Eileen has boot in the amount of $20,000 and will recognize gain to that extent.

PTS: 1 REF: p. 18-5

15. Three individuals form Skylark Corporation with the following contributions: Cliff, cash of $50,000 for 50 shares; Brad, land worth $20,000 for 20 shares; and Ron, cattle worth $9,000 for 9 shares and services worth $21,000 for 21 shares. Section 351 will not apply in this situation because the control requirement has not been satisfied.

ANS: FUnless the property contributed is relatively insignificant in value compared to the services performed by the transferor who contributes both, the entire contribution will be counted as being for property for purposes of the control requirement.

PTS: 1 REF: p. 18-7 | p. 18-8 | Example 9

16. The control requirement under § 351 requires that the person or persons transferring property to the corporation, immediately after the transfer, own stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

ANS: T REF: p. 18-5

17. In order to retain the services of Eve, a key employee in Ted’s sole proprietorship, Ted contracts with Eve to make her a 30% owner. Ted incorporates the business receiving in return 100% of the stock. Three days later, Ted transfers 30% of the stock to Eve. Under these circumstances, § 351 will not apply to the incorporation of Ted’s business.

ANS: TIn spite of Ted’s momentary control, it will not suffice if such control is lost by a contractually binding prearranged agreement.

PTS: 1 REF: p. 18-6


18. One month after Sally incorporates her sole proprietorship, she gives 25% of the stock to her children. Section 351 cannot apply to Sally because she has not satisfied the 80% control requirement.

ANS: FUnless Sally is legally obligated to give the stock to her children, the fact that she had initial control is enough.

PTS: 1 REF: p. 18-6 | Example 7

19. A person who performs services for a corporation in exchange for stock cannot be treated as a member of the transferring group even if that person also transfers some property to the corporation.

ANS: FA person who performs services and also transfers some property can be treated as a member of the transferring group if the property value is not relatively small compared to the value of the stock to be received for services rendered. Although the person will be taxed on the value of the stock issued for services, he or she is not taxed on the value of the stock issued for the property. Further, by being a member of the control group, § 351 treatment will not be lost for other persons who contribute property for stock.

PTS: 1 REF: p. 18-7 | p. 18-8

20. The use of § 351 is not limited to the initial formation of a corporation, and it can apply to later transfers as well.

ANS: TAs long as the 80% control requirement is met, there is no limit on the use of § 351.


21. The bona fide business requirement of § 357(b) is easily satisfied as long as the liability arose in the normal course of conducting the business that is incorporated.

ANS: T REF: p. 18-9

22. When incorporating her sole proprietorship, Samantha transfers all of its assets and liabilities. Included in the $30,000 of liabilities assumed by the corporation is $500 that relates to a personal expenditure (not business related). Under these circumstances, the entire $30,000 will be treated as boot.

ANS: TOne dollar of tainted liabilities causes all liabilities to be treated as boot under § 357(b).

PTS: 1 REF: Example 15

23. In determining whether § 357(c) applies, assess whether the liabilities involved exceed the bases of all assets a shareholder transfers to the corporation.

ANS: T REF: p. 18-10


24. A taxpayer transfers assets and liabilities to a corporation in return for its stock. If the liabilities exceed the basis of the assets transferred, the taxpayer will have a negative basis in the stock.

ANS: FThe result is precluded by compelling the transferor to recognize gain on the excess of the liabilities over basis.


25. If both §§ 357(b) and (c) apply to the same transfer (i.e., the liability is not supported by a bona fide business purpose and also exceeds the basis of the properties transferred), § 357(b) predominates.


26. When a taxpayer transfers property subject to a mortgage to a controlled corporation in an exchange qualifying under § 351, the transferor shareholder’s basis in stock received in the transferee corporation is increased by the amount of the mortgage on the property.

ANS: FThe shareholder’s basis in the stock received is reduced by the amount of the liabilities on the property.

PTS: 1 REF: p. 18-9

27. In a § 351 transaction, Gerald transfers equipment worth $85,000 (basis of $120,000) in exchange for all of the Rust Corporation stock. Gerald’s stock basis is $120,000 and Rust’s basis in the equipment is $120,000.

ANS: FWhen property contributed to a corporation in a § 351 transaction has an aggregate basis in excess of its fair market value, the basis in the property is stepped down to its fair market value. Therefore, Gerald’s stock basis is $120,000 and Rust’s basis in the equipment is $85,000. However, if Gerald and Rust both elect, Gerald could reduce his stock basis to its fair market value ($85,000), which will would allow Rust to take a carryover basis in the property ($120,000).

PTS: 1 REF: Example 21 | Example 22

28. Carl and Ben form Condor Corporation. Carl transfers cash of $50,000 for 50 shares of stock of Condor. Ben transfers a secret process with a tax basis of zero and a fair market value of $50,000 for the remaining 50 shares in Condor. Both Carl and Ben will have a tax basis of $50,000 in their stock in Condor Corporation.

ANS: FCarl will have a tax basis of $50,000 in his 50 shares in Condor Corporation, but Ben will have a zero basis in his 50 shares.

PTS: 1 REF: p. 18-11


29. Isabella and Marta form Pine Corporation. Isabella transfers land (basis of $40,000 and fair market value of $180,000) for 50 shares plus $20,000 cash, while Marta transfers $160,000 cash for the other 50 shares in Pine Corporation. Pine Corporation has a basis of $40,000 in the land it receives from Isabella.

ANS: FPine Corporation has a basis of $60,000 in the land it receives from Isabella. Isabella recognizes a gain of $20,000 on the transfer. Under § 362, Pine Corporation’s basis in the land is equal to Isabella’s basis of $40,000 plus the $20,000 gain Isabella recognizes on the transfer.

PTS: 1 REF: p. 18-12

30. Carmen and Carlos form White Corporation. Carmen transfers cash of $100,000 for 100 shares in White. Carlos transfers property (basis of $20,000 and fair market value of $80,000) and agrees to serve as manager of White Corporation for one year; in return, Carlos receives 100 shares in White. The value of Carlos’s services is $20,000. White Corporation can deduct $20,000 as compensation expense for the value of the services Carlos will render.

ANS: T REF: Example 23

31. Kim, a real estate dealer, and others form Eagle Corporation under § 351. Kim contributes inventory (land held for resale) in return for Eagle stock. The holding period for the stock includes the holding period of the inventory.

ANS: FTacking on of the old holding period is allowed only when the asset transferred is a capital or § 1231 asset.

PTS: 1 REF: p. 18-15

32. A corporation’s holding period for property received under § 351 includes the holding period of the transferor shareholder.


33. A shareholder’s holding period for stock received under § 351 includes the holding period of the property transferred to the corporation.


34. When depreciable property is transferred to a controlled corporation under § 351, any recapture potential disappears and does not carry over to the corporation.

ANS: FThe recapture potential carries over to the corporation.


35. In order to encourage the development of an industrial park, a county donates land to Ecru Corporation. The donation does not result in gross income to Ecru.



36. Silver Corporation receives $1 million in cash from Madison County as an inducement to expand its operations. Within one year, Silver spends $1.5 million to enlarge its existing plant. Silver Corporation’s basis in the expansion is $500,000.


37. To ease a liquidity problem, all of the shareholders of Osprey Corporation contribute additional cash to its capital. Osprey has no tax consequences from the contribution.

ANS: TThis is a classic capital contribution which has no tax consequences to the transferee corporation.

PTS: 1 REF: p. 18-15

38. Rosa, the sole shareholder of Robin Corporation, contributes land (basis of $40,000 and fair market value of $100,000) to the corporation but does not receive additional stock. Neither Rosa nor Robin Corporation will have to recognize gain as a result of this transfer.

ANS: TA contribution to the capital of a corporation produces neither gain nor loss to either the shareholder or the corporation.

PTS: 1 REF: p. 18-15

39. To help avoid the thin capitalization problem, it is advisable to make the repayment of the debt contingent upon the corporation’s earnings.

ANS: FThis makes the debt look like equity.

PTS: 1 REF: p. 18-18

40. If a corporation is thinly capitalized, all debt is reclassified as equity.

ANS: FNot all debt need be so reclassified.

PTS: 1 REF: p. 18-19

41. A shareholder lends money to his corporation in his capacity as an investor. If the loans become worthless, a business bad debt results.

ANS: FSince being an investor is not regarded as a trade or business for this purpose, a nonbusiness bad debt is the result.

PTS: 1 REF: p. 18-20


42. Amy owns 20% of the stock of Wren Corporation, which she acquired several years ago at a cost of $10,000. Amy is Vice-President of Wren and earns a salary of $80,000 annually. Last year, Wren Corporation was experiencing financial problems, and Amy loaned the corporation $25,000. In the current year, Wren becomes bankrupt, and both her stock investment and the loan become worthless. Amy has a nonbusiness bad debt deduction this year of $25,000.

ANS: FAmy has a business bad debt deduction. She is a minority shareholder and, thus, under more compulsion to loan the corporation money to protect her job. In addition, her stock investment is low in comparison to her annual salary.

PTS: 1 REF: p. 18-19 | p. 18-20

43. If a shareholder owns stock received as a gift from her mother, it cannot be § 1244 stock.

ANS: TA transfer of the stock causes the loss of the § 1244 trait. Only the original holder of the stock can take advantage of § 1244.


MULTIPLE CHOICE

1. Jane and Walt form Yellow Corporation. Jane transfers equipment worth $950,000 (basis of $200,000) and cash of $50,000 to Yellow Corporation for 50% of its stock. Walt transfers a building and land worth $1,050,000 (basis of $400,000) for 50% of Yellow’s stock and $50,000 in cash.a. Jane recognizes no gain; Walt recognizes gain of $50,000.b. Jane recognizes a gain of $50,000; Walt has no gain.c. Neither Jane nor Walt recognizes gain.d. Jane recognizes a gain of $750,000; Walt recognizes gain of $650,000.e. None of the above.

ANS: AWalt recognizes gain to the extent of the $50,000 of “boot” received.

PTS: 1 REF: p. 18-4

2. Eve transfers property (basis of $120,000 and fair market value of $400,000) to Green Corporation for 80% of its stock (worth $350,000) and a long-term note (worth $50,000), executed by Green Corporation and made payable to Eve. As a result of the transfer:a. Eve recognizes no gain.b. Eve recognizes a gain of $230,000.c. Eve recognizes a gain of $280,000.d. Eve recognizes a gain of $50,000.e. None of the above.

ANS: DA long-term note is treated as “boot.” Thus, Eve is taxed on the value of the note received.

PTS: 1 REF: p. 18-4 | p. 18-5


3. Ann, Irene, and Bob incorporate their respective businesses and form Dove Corporation. Ann exchanges her property (basis of $100,000 and fair market value of $400,000) for 200 shares in Dove Corporation on March 1, 2005. Irene exchanges her property (basis of $140,000 and fair market value of $600,000) for 300 shares in Dove Corporation on April 11, 2005. Bob transfers his property (basis of $250,000 and fair market value of $1,000,000) for 500 shares in Dove Corporation on May 15, 2007. Bob’s transfer is not part of a prearranged plan with Ann and Irene to incorporate their businesses. What gain, if any, will Bob recognize on the transfer?a. $1,000,000.b. $750,000.c. $250,000.d. $0.e. None of the above.

ANS: BThe exchange is taxable because Bob did not hold 80% control in Dove after the transfer.


4. Tom and George form Swan Corporation with the following investments: Tom transfers machinery worth $100,000 (basis of $40,000), while George transfers land worth $90,000 (basis of $20,000) and services rendered in organizing the corporation worth $10,000. Each is issued 25 shares in Swan Corporation. With respect to the transfers:a. Tom has no recognized gain; George recognizes gain of $80,000.b. Neither Tom nor George recognizes gain.c. Swan Corporation has a basis of $30,000 in the land.d. George has a basis of $30,000 in the shares of Swan Corporation.e. None of the above.

ANS: DTom has no recognized gain; George has a recognized gain of $10,000 representing the stock received for services rendered. Swan Corporation has a basis of $40,000 in the machinery and $20,000 in the land. George has a basis of $30,000 in the stock [$20,000 (basis of machinery) + $10,000 (value of services rendered)].

PTS: 1 REF: Example 3 | Example 9 | Example 21

5. Ann transferred land worth $200,000, with a tax basis of $40,000, to Brown Corporation, an existing entity, for 100 shares of its stock. Brown Corporation has two other shareholders, Bill and Bob, each of whom holds 100 shares. With respect to the transfer:a. Ann has no recognized gain.b. Brown Corporation has a basis of $160,000 in the land.c. Ann has a basis of $200,000 in her 100 shares in Brown Corporation.d. Ann has a basis of $40,000 in her 100 shares in Brown Corporation.e. None of the above.

ANS: CThe transfer does not qualify under § 351 as Ann has only a 1/3 interest in Brown Corporation. The requirements of § 351 apply to transfers to an existing corporation, as well as to a newly formed corporation.



6. Tara incorporates her sole proprietorship, transferring it to newly formed Black Corporation. The assets transferred have an adjusted basis of $240,000 and a fair market value of $300,000. Also transferred was $10,000 in liabilities, $1,000 of which was personal and the balance of $9,000 being business related. In return for these transfers, Tara receives all of the stock in Black Corporation.a. Black Corporation has a basis of $241,000 in the property.b. Black Corporation has a basis of $240,000 in the property.c. Tara’s basis in the Black Corporation stock is $241,000.d. Tara’s basis in the Black Corporation stock is $249,000.e. None of the above.

ANS: ETara has a recognized gain of $10,000 that is the amount of the boot she is treated as having received. Thus, her basis in the Black Corporation stock is $240,000 [$240,000 (basis of the property given up) – $10,000 (boot received) + $10,000 (gain recognized)]. Black Corporation’s basis in the property is $250,000 [$240,000 (Tara’s basis in the property) + $10,000 (gain recognized by Tara)]. In terms of the $10,000 boot, § 357(b) taints all liabilities even though some are supported by a bona fide business purpose.

PTS: 1 REF: p. 18-9 | p. 18-10

7. Tim, a cash basis taxpayer, incorporates his sole proprietorship. He transfers the following items to newly created Wren Corporation.

Adjusted Fair MarketBasis Value

Cash $ 20,000 $ 20,000Building 110,000 160,000Mortgage payable (secured by the building and held for 15 years) 135,000 135,000

With respect to this transaction:a. Wren Corporation’s basis in the building is $110,000.b. Tim has no recognized gain.c. Tim has a recognized gain of $25,000.d. Tim has a recognized gain of $5,000.e. None of the above.

ANS: DUnder § 357(c) Tim recognizes gain to the extent liabilities (mortgage payable of $135,000) exceed the basis of all assets transferred [$110,000 (building) + $20,000 (cash)]. Wren Corporation’s basis in the building is $115,000 [$110,000 (Tim’s basis) + $5,000 (gain recognized by Tim)].

PTS: 1 REF: p. 18-8 to 18-11


8. Mary transfers a building (adjusted basis of $15,000 and fair market value of $90,000) to White Corporation. In return, Mary receives 80% of White Corporation’s stock (worth $65,000) and an automobile (fair market value of $5,000). In addition, there is an outstanding mortgage of $20,000 (taken out 15 years ago) on the building, which White Corporation assumes. With respect to this transaction:a. Mary’s recognized gain is $10,000.b. Mary’s recognized gain is $5,000.c. Mary has no recognized gain.d. White Corporation’s basis in the building is $15,000.e. None of the above.

ANS: AAs a result of the transfer, Mary receives boot of $5,000 (fair market value of the automobile) and has additional gain of $5,000 (excess of the mortgage over the basis of the building). Since the sum of these amounts is less than the realized gain of $75,000, $10,000 is recognized under § 351(b). White Corporation’s basis in the building is $25,000 [$15,000 (Mary’s basis in the building) + $10,000 (Mary’s recognized gain)].

PTS: 1 REF: p. 18-4 | p. 18-9 to 18-12

9. Kim owns 100% of the stock of Cardinal Corporation. In the current year Kim transfers an installment obligation, tax basis of $30,000 and fair market value of $200,000, for additional stock in Cardinal worth $200,000.a. Kim recognizes no taxable gain on the transfer.b. Kim has a taxable gain of $170,000.c. Kim has a taxable gain of $180,000.d. Kim has a basis of $200,000 in the additional stock she received in Cardinal Corporation.e. None of the above.

ANS: AAn installment obligation qualifies as “property” under § 351. Thus, Kim recognizes no gain on the transfer. Cardinal has a basis of $30,000 in the installment obligation.

PTS: 1 REF: p. 18-4 | p. 18-11


10. Rob and Sharon form Swallow Corporation with the following investments.


From Rob— Cash $400,000 $400,000From Sharon— Land 500,000 440,000

Each receives 50% of Swallow’s stock. In addition, Sharon receives cash of $40,000. One result of these transfers is that Sharon has a:a. Recognized loss of $60,000.b. Recognized loss of $20,000.c. Basis of $460,000 in the Swallow stock (assuming Swallow reduces its basis in the land to

$440,000).d. Basis of $400,000 in the Swallow stock (assuming Swallow reduces its basis in the land to

$440,000).e. None of the above.

ANS: CSince § 351 applies, no loss can be recognized (choices a. and b.). Sharon’s basis in the stock is $460,000, determined as follows: $500,000 (basis in the land) – $40,000 (boot received).

PTS: 1 REF: p. 18-3 | p. 18-4 | p. 18-11 | Example 21 | Example 22


11. Rick transferred the following assets and liabilities to Warbler Corporation.


Building $210,000 $225,000Equipment 45,000 75,000Automobile 15,000 30,000Mortgage (held for four years) on building 30,000 30,000

In return Rick received $75,000 in cash plus 90% of Warbler Corporation’s only class of stock outstanding (fair market value of $225,000).a. Rick has a recognized gain of $60,000.b. Rick has a recognized gain of $75,000.c. Rick’s basis in the stock of Warbler Corporation is $270,000.d. Warbler Corporation has the same basis in the assets received as Rick does in the stock.e. None of the above.

ANS: ARick has a realized gain of $60,000 determined as follows.

Amount realized— Fair market value of the stock in Warbler Corporation $225,000 Cash received 75,000 Liability transferred 30,000 $330,000 Less: Basis of property transferred (270,000)Realized gain $ 60,000

Because recognized gain cannot exceed the lesser of the realized gain ($60,000) or the boot received ($75,000), the recognized gain is $60,000.

Rick’s basis in the Warbler Corporation stock is $225,000 [$270,000 (basis of property transferred) – $75,000 (boot received) – $30,000 (liability transferred) + $60,000 (gain recognized)].

Warbler Corporation’s basis in the property transferred is $330,000 [$270,000 (basis in the property transferred) + $60,000 (gain recognized)].

PTS: 1 REF: p. 18-4 | p. 18-11


12. Sarah and Tony (mother and son) form Dove Corporation with the following investments: cash by Sarah of $55,000; land by Tony (basis of $35,000 and fair market value of $45,000). Dove Corporation issues 200 shares of stock, 100 each to Sarah and Tony. Thus, each receives stock in Dove worth $50,000.a. Section 351 cannot apply since Sarah should have received 110 shares instead of only 100.b. As a result of the transfer, Tony recognizes a gain of $10,000.c. Tony’s basis in the stock of Dove Corporation is $50,000.d. Section 351 may apply because stock need not be issued to Sarah and Tony in proportion

to the value of the property transferred.e. None of the above.

ANS: DThe fact that the stock was not in proportion to the value of the property transferred (choice a.) does not prevent § 351 from applying. Since § 351 applies and no boot was received, Tony does not recognize a gain (choice b.). His basis in the stock is $35,000 plus $5,000, the basis of the stock implicitly gifted by Sarah to Tony (not $50,000 as in choice c.).

PTS: 1 REF: p. 18-4 | p. 18-11 | Example 6

13. Hunter and Warren form Tan Corporation. Hunter transfers equipment (basis of $210,000 and fair market value of $180,000) while Warren transfers land (basis of $15,000 and fair market value of $150,000) and $30,000 of cash. Each receives 50% of Tan’s stock. As a result of these transfers:a. Hunter has a recognized loss of $30,000, and Warren has a recognized gain of $135,000.b. Neither Hunter nor Warren has any recognized gain or loss.c. Hunter has no recognized loss, but Warren has a recognized gain of $30,000.d. Tan Corporation will have a basis in the land of $45,000.e. None of the above.

ANS: BThis fact pattern clearly comes within the scope of § 351. As such, Hunter may not recognize the realized loss of $30,000 (choice a.). Although cash was involved, it was given and not received by Warren (choice c.). It is not, therefore, boot within the meaning of the § 351. Tan Corporation will have a basis of $180,000 in the equipment transferred by Hunter ($210,000 carryover basis reduced by the $30,000 built-in loss) and $15,000 in the land (not $45,000 as in choice d.).

PTS: 1 REF: p. 18-3 | p. 18-4 | p. 18-12 | Example 21

14. Erica transfers land worth $500,000, basis of $100,000, to a newly formed corporation, Robin Corporation, for all of Robin’s stock, worth $300,000, and a 10-year note. The note was executed by Robin and made payable to Erica in the amount of $200,000. As a result of the transfer:a. Erica does not recognize gain.b. Erica recognizes gain of $400,000.c. Robin Corporation has a basis of $100,000 in the land.d. Robin Corporation has a basis of $300,000 in the land.e. None of the above.

ANS: DErica has a recognized gain of $200,000 which is the amount of the boot she is treated as having received through her receipt of the securities in Robin Corporation. The basis of the land to Robin would be equal to the basis Erica had in the land, $100,000, plus the gain recognized by Erica, $200,000, or $300,000.

PTS: 1 REF: p. 18-5 | p. 18-12


15. Hazel transferred the following assets to Starling Corporation.


Cash $120,000 $120,000Machinery 48,000 36,000Land 108,000 144,000

In exchange, Hazel received 50% of Starling Corporation’s only class of stock outstanding. The stock has no established value. However, all parties sincerely believe that the value of the stock Hazel received is the equivalent of the value of the assets she transferred. The only other shareholder, Rick, formed Starling Corporation five years ago.a. Hazel has no gain or loss on the transfer.b. Starling Corporation has a basis of $48,000 in the machinery and $108,000 in the land.c. Starling Corporation has a basis of $36,000 in the machinery and $144,000 in the land.d. Hazel has a basis of $276,000 in the stock of Starling Corporation.e. None of the above.

ANS: CThis is a taxable exchange because Hazel did not meet the 80% control requirement of § 351. Thus, Starling Corporation will have a basis of $180,000 in the machinery and land; Hazel has a recognized loss of $12,000 on the machinery and a recognized gain of $36,000 on the land; and she has a basis of $300,000 in the Starling Corporation stock she receives.

PTS: 1 REF: p. 18-8 | p. 18-12

16. Dawn, a sole proprietor, was engaged in a service business and reported her income on a cash basis. Later, she incorporates her business and transfers the assets of the business to the corporation in return for all the stock in the corporation plus the corporation’s assumption of the liabilities of her proprietorship. All the receivables and the unpaid trade payables are transferred to the newly formed corporation. The assets of the proprietorship had a basis of $105,000 and fair market value of $300,000. The trade accounts payable totaled $25,000. There was a note payable to the bank in the amount of $95,000 that the corporation assumes. The note was issued for the purchase of computers and other business equipment.a. Dawn has a gain on the transfer of $15,000.b. The basis of the assets to the corporation is $300,000.c. Dawn has a basis of $10,000 in the stock she receives.d. Dawn has a zero basis in the stock she receives.e. None of the above.

ANS: CDawn has a basis of $10,000 in the stock in the newly formed corporation [$105,000 (basis in the assets transferred to the corporation) – $95,000 (liabilities assumed by the corporation)]. Because the trade accounts payable give rise to a deduction, they are not considered to be liabilities for purposes of § 357(c); thus, liabilities do not exceed basis. In addition, the cash basis payables are not considered in the computation of Dawn’s stock basis. Dawn has no gain on the transfer, and the basis of the assets to the corporation is $105,000.

PTS: 1 REF: p. 18-10 | p. 18-11


17. Carl transfers land to Cardinal Corporation for 90% of the stock in Cardinal Corporation worth $20,000 plus a note payable to Carl in the amount of $40,000 and the assumption by Cardinal Corporation of a mortgage on the land in the amount of $100,000. The land, which has a basis to Carl of $70,000, is worth $160,000.a. Carl will have a gain on the transfer of $70,000.b. Carl will have a gain on the transfer of $30,000.c. Cardinal Corporation will have a basis in the land transferred by Carl of $70,000.d. Cardinal Corporation will have a basis in the land transferred by Carl of $160,000.e. None of the above.

ANS: AThe mortgage on the land exceeds Carl’s basis in the land by $30,000. This amount would be gain under § 357(c). In addition, the note payable to Carl does not qualify for nonrecognition under § 351; thus, Carl would have additional gain of $40,000.

Amount realized: Stock $ 20,000 Note 40,000 Release of mortgage 100,000

$160,000 Less: Basis of land (70,000)Realized gain $ 90,000Recognized gain ($30,000 + $40,000) $ 70,000

Cardinal Corporation will have a basis of $140,000 in the land [$70,000 (Carl’s basis in the land) + $70,000 (gain recognized by Carl with respect to the transfer of the land)].

PTS: 1 REF: p. 18-4 | p. 18-10

18. Kirby and Helen form Red Corporation. Kirby transfers property, basis of $20,000 and value of $300,000, for 100 shares in Red Corporation. Helen transfers property, basis of $40,000 and value of $280,000, and provides legal services in organizing the corporation. The value of her services is $20,000. In return Helen receives 100 shares in Red Corporation. With respect to the transfers:a. Kirby will recognize gain.b. Helen will not recognize gain.c. Red Corporation will have a basis of $280,000 in the property it acquired from Helen.d. Red will have a business deduction of $20,000.e. None of the above.

ANS: EKirby will not recognize gain on the transfer. Helen will have income of $20,000, the value of the services she rendered to the corporation. Red Corporation will have a basis of $40,000 in the property it acquired from Helen. Red Corporation will not have a business deduction of $20,000. Instead, it must capitalize the $20,000 as an organizational expense.



19. Joe and Kay form Gull Corporation. Joe transfers cash of $250,000 for 200 shares in Gull Corporation. Kay transfers property with a basis of $50,000 and fair market value of $240,000. She agrees to accept 200 shares in Gull Corporation for the property and for providing bookkeeping services to the corporation in its first year of operation. The value of Kay’s services is $10,000. With respect to the transfer:a. Gull Corporation has a basis of $240,000 in the property transferred by Kay.b. Neither Joe nor Kay recognize gain on the exchanges.c. Gull Corporation has a business deduction under § 162 of $10,000.d. Gull capitalizes $10,000 as organizational costs.e. None of the above.

ANS: CGull Corporation has a basis of $50,000 in the property it received from Kay. Kay has income of $10,000 on the exchange. Gull Corporation deducts the $10,000 as a business expense.


20. Earl and Mary form Crow Corporation. Earl transfers property, basis of $200,000 and value of $1,600,000, for 50 shares in Crow Corporation. Mary transfers property, basis of $80,000 and value of $1,480,000, and agrees to serve as manager of Crow for one year; in return Mary receives 50 shares of Crow. The value of Mary’s services is $120,000. With respect to the transfers:a. Mary will not recognize gain.b. Earl will recognize a gain of $1,400,000.c. Crow Corporation has a basis of $1,480,000 in the property it received from Mary.d. Crow will have a business deduction of $120,000 for the value of the services Mary will

render.e. None of the above.

ANS: DEarl will not recognize gain on the transfer. Mary will have income of $120,000, the value of the services she will render to Crow. Crow will have a business deduction of $120,000.



21. Four individuals form Chickadee Corporation under § 351. Two of these individuals, Jane and Walt, made the following contributions:


From Jane— Cash $360,000 $360,000 Patent -0- 40,000

From Walt— Equipment (depreciation claimed of $100,000) 240,000 370,000

Both Jane and Walt receive stock in Chickadee Corporation equal to the value of their investments.a. Jane must recognize income of $40,000; Walt has no income.b. Neither Jane nor Walt recognize income.c. Walt must recognize income of $130,000; Jane has no income.d. Walt must recognize income of $100,000; Jane has no income.e. None of the above.

ANS: BBoth Jane and Walt are protected by § 351 and have no income to recognize (choices a., c., and d.). The depreciation recapture rules do not apply to Walt because he does not recognize income from the transaction.

PTS: 1 REF: p. 18-15 | Example 2 | Example 3

22. Leonard transfers equipment (basis of $40,000 and fair market value of $100,000) for additional stock in Green Corporation. After the transfer, Leonard owns 90% of the stock. Leonard had claimed depreciation of $50,000 on the equipment prior to transferring it to Green Corporation. With respect to the transfer:a. Leonard has ordinary income of $50,000.b. Leonard has ordinary income of $50,000 and a § 1231 gain of $10,000.c. Green Corporation has ordinary income of $50,000.d. Green Corporation has a basis of $40,000 in the equipment and it will have no

depreciation recapture if it later disposes of the equipment in a taxable transaction.e. None of the above.

ANS: EThe transfer comes under § 351; thus, Leonard has no recognized gain and no depreciation to recapture. However, when Green Corporation later disposes of the equipment in a taxable transaction, it must take into account the § 1245 recapture potential originating with Leonard. The basis of the equipment to Green is $40,000.



23. In order to induce Yellow Corporation to build a new manufacturing facility in Knoxville, Tennessee, the city donates land (fair market value of $400,000) and cash of $100,000 to the corporation. Several months after the donation, Yellow Corporation spends $450,000 (which includes the $100,000 received from Knoxville) on the construction of a new plant located on the donated land.a. Yellow recognizes income of $100,000 as to the donation.b. Yellow has a zero basis in the land and a basis of $450,000 in the plant.c. Yellow recognizes income of $500,000 as to the donation.d. Yellow has a zero basis in the land and a basis of $350,000 in the plant.e. None of the above.

ANS: D REF: Example 27

24. George transfers cash of $150,000 to Grouse Corporation, a newly formed corporation, for 100% of the stock in Grouse worth $80,000 and debt in the amount of $70,000, payable in equal annual installments of $7,000 plus interest at the rate of 9% per annum. In the first year of operation, Grouse has net taxable income of $40,000. If Grouse pays George interest of $6,300 and $7,000 principal payment on the note:a. George has dividend income of $13,300.b. Grouse Corporation does not have a tax deduction with respect to the payment.c. George has dividend income of $7,000.d. Grouse Corporation has an interest expense deduction of $6,300.e. None of the above.

ANS: DThe payment will be treated as a payment on the debt. The interest will be ordinary income to George and produce a deduction to Grouse Corporation.


25. Adam transfers cash of $300,000 and land worth $200,000 to Camel Corporation for 100% of the stock in Camel. In the first year of operation, Camel has net taxable income of $70,000. If Camel distributes $50,000 to Adam:a. Adam has taxable income of $50,000.b. Camel Corporation has a tax deduction of $50,000.c. Adam has no taxable income from the distribution.d. Camel Corporation reduces its basis in the land to $150,000.e. None of the above.

ANS: AAdam will have a taxable dividend of $50,000. Camel will not be permitted a deduction for the $50,000 payment because dividends are not deductible by the distributing corporation.

PTS: 1 REF: p. 18-17

26. Wren Corporation (a minority shareholder in Lark Corporation) has made loans to Lark Corporation that become worthless in the current year.a. Wren Corporation is not permitted a deduction for the loans.b. The loans result in a nonbusiness bad debt deduction to Wren Corporation.c. The loans provide Wren Corporation with a business bad debt deduction.d. None of the above.

ANS: CCorporate shareholders can only have business bad debts.

PTS: 1 REF: p. 18-20


27. Pat, Maria, and Lynn are equal shareholders in Lime Corporation. Lime has assets with a basis of $150,000 and a fair market value of $1,200,000. In the current year, Pat lends Lime Corporation $200,000 and Maria lends it $150,000. Both notes bear interest at the rate of 8% per annum. Lime Corporation has no other debt outstanding. Lynn leases machinery to Lime Corporation for an annual rental of $16,000.a. The IRS will be successful in reclassifying both loans as equity.b. The IRS will be successful in reclassifying the $200,000 loan as equity.c. Lime Corporation cannot support its debt-equity ratio.d. Because the loans are not pro rata and Lime Corporation can support its debt-equity ratio,

the loans should not be reclassified as equity.e. None of the above.

ANS: DLime Corporation can support its debt-equity ratio by stressing the fair market value of its assets. The shareholders also have avoided pro rata holding of debt. Thus, the loans should not be reclassified as equity.

PTS: 1 REF: p. 18-24 | p. 18-25 | Example 35 | Example 36

28. When Pheasant Corporation was formed under § 351, Kristen transferred property (basis of $26,000 and fair market value of $22,500) for § 1244 stock. Kristen’s basis in the Pheasant stock is $26,000. Three years later, Pheasant Corporation goes bankrupt and its stock becomes worthless. Kristen, who is single, owned the stock as an investment. Kristen’s loss is:a. $26,000 capital.b. $22,500 ordinary and $3,500 capital.c. $3,500 ordinary and $22,500 capital.d. $26,000 ordinary.e. None of the above.

ANS: B REF: Example 31

29. Shawn transfers property (basis of $40,000 and fair market value of $35,000) to Condor Corporation in exchange for § 1244 stock. The transfer qualifies as a nontaxable exchange under § 351; therefore, Shawn’s basis in the Condor stock is $40,000. Five years later, Shawn sells the Condor stock for $25,000. With respect to the sale, Shawn has:a. An ordinary loss of $15,000.b. An ordinary loss of $10,000 and a capital loss of $5,000.c. A capital loss of $15,000.d. A capital loss of $10,000 and an ordinary loss of $5,000.e. None of the above.

ANS: BFor purposes of § 1244 treatment, the basis in the stock is $35,000. When the stock is sold for $25,000, only $10,000 qualifies as an ordinary loss; the remaining $5,000 loss is a capital loss.



ESSAY

1. What is the rationale underlying the tax deferral treatment available under § 351?

ANS:Realized gain or loss is not recognized in a § 351 transaction when a taxpayer’s economic status has not changed. This provision reflects the principle that gain should not be recognized when a taxpayer’s investment has not substantively changed. When a business is incorporated, the owner’s economic status remains the same; only the form of the investment has changed.

The gain deferral is also justified under the wherewithal to pay concept discussed in Chapter 1. This notion recognizes the fact that if the shareholder receives solely stock in the exchange, that he or she is hardly in a position to pay a tax on any realized gain.

Finally, § 351 exists because Congress believes that a tax should not be triggered on the incorporation of a business because such a tax could tend to impede the exercise of sound business judgment (e.g., choice of corporate form of doing business).

PTS: 1 REF: p. 18-2 | p. 18-3

2. Issues relating to basis arise when a taxpayer is involved in a § 351 transaction. Describe the underlying basis rules, and the purpose they serve.

ANS:To the extent that § 351 causes a realized gain or loss to go unrecognized, the deferral continues until the shareholder disposes of the stock in a taxable transaction. To ensure that postponed gain or loss ultimately will be recognized, the basis rules are utilized.

Stock received in a § 351 transaction is given a substituted basis. The stock’s basis is the same as the basis the taxpayer had in the property transferred, increased by any gain recognized on the exchange and decreased by boot received.

The basis of property received by the corporation is determined under a carryover basis rule that provides a basis equal to the basis in the hands of the transferor increased by the amount of any gain recognized by the transferor-shareholder.

However, an adjustment to the corporation’s basis in property received or the shareholder’s stock basis may be required when loss property is contributed to a corporation in a § 351 transaction. In the event a shareholder transfers property with an aggregate adjusted basis in excess of its fair market value, § 362(e)(2) generally requires the corporation to step down the carryover basis amount for the property by the amount of the net built-in loss. However, if the shareholder and the corporation elect, the basis reduction can instead be taken against the shareholder’s stock basis.

PTS: 1 REF: p. 18-11 to 18-13


3. How is the transfer of liabilities in a property transaction generally treated for tax purposes? How is a transfer of liabilities generally treated in a § 351 transaction? What exceptions could arise to this usual treatment in a §351 setting?

ANS:Generally when another party assumes a liability in a property transaction, the party no longer responsible for the debt is treated as having received cash or boot. This is consistent with the rule dealing with like-kind exchanges under § 1031. However, when the acquiring corporation assumes a liability in a § 351 transaction, § 357(a) provides that the transfer does not result in boot to the transferor-shareholder for gain recognition purposes. To do so could trigger gain to the property transferor if the corporation assumed a mortgage on the transfer of encumbered property, which could, in turn, discourage the use of the corporate form of business.

The general rule of § 357(a) has two exceptions: (1) § 357(b) provides that if the principal purpose of the assumption of the liabilities is to avoid tax or if there is no bona fide business purpose behind the exchange, the liabilities are treated as boot; and (2) § 357(c) provides that if the sum of the liabilities exceeds the adjusted basis of the properties transferred, the excess is taxable gain.

PTS: 1 REF: p. 18-9

4. For transfers falling under § 351, what are the holding period rules for stock received by the shareholder and for the assets transferred to the corporation?

ANS:In a § 351 transaction, the shareholder’s holding period for stock received in exchange for a capital asset or § 1231 property includes the holding period of the property transferred to the corporation. That is, the holding period of the property is “tacked on” to the holding period of the stock. The holding period for stock received for any other property begins on the day after the exchange. The corporation’s holding period for property acquired in a § 351 transfer is the holding period of the transferor-shareholder, regardless of the character of the property in the transferor’s hands.

PTS: 1 REF: p. 18-15


5. When forming a corporation, a transferor-shareholder may choose to receive some corporate debt along with stock. Identify some of the issues the transferor must consider when deciding whether debt should be a part of the transaction.

ANS:Significant tax differences exist between debt and equity in the capital structure.

Interest payments on debt are deductible by the corporation while dividend payments on stock are not.

Loan repayments of debt are not taxable to investors unless the repayments exceed basis; however, a shareholder’s nonliquidating receipt of property from a corporation cannot be tax-free as long as the corporation has earnings and profits.

Dividend income on equity holdings is taxed to individual investors at the preferential capital gains rates while interest income on debt is taxed at the higher ordinary income tax rates.

PTS: 1 REF: p. 18-17 | p. 18-18

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