Tax Free Exchange / Basis Step Up - § 351 and § 357

[bbrownatl]

Just need a reality check on the proper treatment of a transaction. My client is majority owner in four entities (C-Corps) that agreed to contributed assets and liabilities to a new C-Corp (NewCo). Some of the entities had liabilities in excess of assets. Though, in accordance with § 351 and § 357, we treated this as tax free exchange and did not report any gain as the four entities received no cash proceeds and retained both control and retained primary liability on the transferred liabilities. I just got a call from the NewCo CPA saying they were going to report a step up in basis to FMV on the NewCo tax return and was questioning why we did not report a gain. It is my understanding that NewCo would file their return and indicate in a disclosure that they are taking a contrary position to the predecessor entities. As the CPA for the four predecessor entities, I don’t have visibility into the new entity as that work is done via another firm plus I deem that we recorded it correctly. Am I mistaken in this regard or is it ok for the NewCo to report the step up when no gain was reported. Just a bit out of my realm of recent experience. Any insight much appreciated.

[BHoffman]

It is my understanding that the transferor/shareholder will recognize a gain when property is transferred to a corporation & the liabilities assumed by the corporation are in excess of basis of the property.

This is to prevent a "negative" stock basis.

[bbrownatl]

Sec. 351/357 - Cash Basis - Transfer of Accounts Receivable

Ok, so it looks like a gain should be recognized. Now, one further question. The Corporations transferring all of their assets and liabilities were on the cash basis of accounting. In theory, I'd just figure all liabilities in excess of all assets and there is the gain. However, are accounts receivable and accounts payable handled differently?

[BHoffman]

Ok, so it looks like a gain should be recognized. Now, one further question. The Corporations transferring all of their assets and liabilities were on the cash basis of accounting. In theory, I'd just figure all liabilities in excess of all assets and there is the gain. However, are accounts receivable and accounts payable handled differently?

The gain we were discussing would be only on that particular fixed asset with a basis lower than the liability that was incurred to finance the purchase of that particular fixed asset. This is per asset/per note payable so you can't just lump everything together.

Perhaps you might want to discuss this with the current CPA so you are on the same page? The numbers do have to coordinate and I would consult with him or her.

There might be other issues regarding A/R and A/P, but those would depend on how the deal was structured.

Good Luck!

[Roland Slugg]

NewCo's CPA is probably correct. See Code §357(c)(1).

The gain we were discussing would be only on that particular fixed asset with a basis lower than the liability that was incurred to finance the purchase of that particular fixed asset. This is per asset/per note payable so you can't just lump everything together.

That is not correct. Code §357(c)(1) reads as follows: "If the sum of the amount of the liabilities assumed exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be." I believe this concept would apply to each of the four transferor corps, not to the combined amounts for all four transferor corps taken as a whole.

In the OP it says the transferors ... i.e. the four C Corps ... maintained "control" of NewCo, but it doesn't say how much control. In order to qualify as a tax-free transfer (not a tax-free exchange) under Code §351, control is defined as owning at least 80% of the transferee's voting stock and at least 80% of all other classes of stock immediately after the transfer. For this control measurement the combined holding of NewCo stock by all four transferors taken as a whole does apply.

When corporate transferors are involved in transactions like this, as opposed to individuals, care must be taken. It is possible that instead of a tax-free transfer to a controlled corporation, covered by Code §351, that what actually occurred was a corporate reorganization ... probably a Type A or Type C ... to which Code §368(a)(1)(a) or §368(a)(1)(c) applies.

[bbrownatl]

PP&E - OK, but what about other debt - Report Gain??

Thanks for all the feedback. This is quite helpful. I'm clear on the treatment for the fixed assets, associated debt, and gain thereof. My question now is on the remaining items on a tax basis balance sheet. For simplicity, say the entity has Cash of $100, Bank Note Payable of $250, and Retained Earnings of ($150). Again, everything is being contributed to the new entity. This is now my confusion. So it would appear that the contribution of the Cash and N/P would generate a $150 gain as the liabilities exceed the assets.

If the answer, is report a gain, that is easy. The gain is reported, retained earnings nets to $0, the balance sheet is clear and the entity has a $0 basis in the NewCo entity.

If the answer is not to report a gain, then we you take the cash and N/P off the books, what is the other side of the entry - I assume retained earnings. So then on your Sch. M-2, do you put this amount on line 3, Other increases and reference your § 351 statement that you attach to the return? Basis is $0 in this scenario as well.

So report gain or no gain?? Again, much thanks for your insight. Very helpful!!

[JON]

351 has to do with incorporation tax free and 357 liabilites involved. ???

If you have four corporations combining are you not looking towards IRC sections that reference mergers, consolidations and acquisitions. If it involves the liquidation of entities and assets/liabilities transferred to shareholders (gain/loss required) then a 351 incorporation would be used for the new entity. 357 problems can exist in all forms of formation.

[BHoffman]

Roland and bbrown - I stand corrected, however- won't the gain be the same and won't the new CPA need the per asset/per note payable information? Sorry for the confusion and glad you and Jon are offering comments on this thread.

[bbrownatl]

Apply via individual company or in aggregate

I think the answer here is by company but please correct me if I'm wrong. For purposes of the Sec. 357 gain calc, I believe that is done on an individual company basis, right. As an update, the four companies (three C-Corps and one S-Corp) transferred everything into one new C-Corp.

On an individual basis, I've calculated out that two of the entities must recognize a gain. However, on an aggregate basis, it looks like no gain is necessary.

Any further insight appreciated.

Much thanks and hope everyone is having a great weekend.