Most income tax planning involves questions about income, deductions or credits, character, or timing, or some combination of these questions. When viewed from these categories, even simple transactions can present tax planning opportunities.
The contribution of property to a corporation by its shareholder is an example. A contribution triggers taxable income to the shareholder. Our tax laws provide an exception that says that contributions of property in exchange for stock are not taxable. Our courts have extended this provision to say that contributions of property are not taxable even if stock is not issued by the corporation in exchange for the property.
The IRS issued AM 2020-05 to address this in the context of “meaningless gesture transaction.” This simple fact pattern can raise questions about income, deductions or credits, character, and timing. The IRS guidance only addresses one aspect of the timing but opens a whole host of other questions and tax planning opportunities.
Meaningless Gesture Transaction
The general rule for contributions by shareholders to corporations is found in Section 351. Section 351 says:
No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control
As noted above, the courts have extended this rule to situations where a corporation does not issue new stock to the shareholder for the contributed property.
The use of the word “meaningless” does not mean the transfer is actually meaningless. Indeed, the transfer may include a transfer of property that has significant value. The “meaningless” terminology refers to the absence of new stock being issued. There is no practical need to issue new stock if the corporation is wholly owned by one shareholder. Issuing stock in this situation would be “meaningless.”
The Timing Issue in the IRS’s Guidance
In AM 2020-005, the transaction involved the transfer of money or property to the corporation by its shareholder and then a subsequent sale of the corporation’s stock by the shareholder. Assume that there is more than a year that passes from the time of the initial contribution to the sale of the corporate stock.
Separate from the corporation, let’s assume the shareholder purchases a capital asset or investment that rapidly increases in value. If he was to sell the property, he would trigger a short-term capital gain as he did not hold the capital asset for at least a year. The taxpayer would have to hold the capital asset for more than a year to have a long-term capital gain. Thus, the shareholder would be taxed at the higher ordinary tax rates that apply to short-term capital gains.
What if the taxpayer combines the two transactions? Taxpayers are generally able to combine busienss and other transactions. They can even do so to try to minimize their business taxes. The shareholder forms a corporation and makes a contribution and a year or more passes from that date. The shareholder then contributes the recently purchased capital or investment asset to the corporation rather than selling it. Then the shareholder sells the corporation stock that he has owned for more than one year. Does he get long-term capital gain treatment on the sale of the stock? This is the question presented in the IRS’s AM 2020-005.
Split Basis and Holding Period
Let’s just jump to the conclusion. The IRS’s guidance concludes that a shareholder has to split his basis and holding period in his corporate shares based on the contributions it made:
After the subsequent transfer in each Situation, Shareholder’s stock in Corporation has a split basis and a split holding period to reflect the initial transfer and the subsequent transfer. Cf. Rev. Rul. 85-164, 1985-2 C.B. 117 (shares of stock received in an exchange to which section 351 applies, for property with different bases
and holding periods, have split bases and split holding periods for purposes of determining long-term or short-term capital gain or loss); Rev. Rul. 62-140, 1962-2 C.B. 181 (shareholder has split basis and split holding period after transferring money to exercise conversion right in convertible debenture, with the portion attributable to the money having holding period dating from the transfer).
With this conclusion, part of the shareholder’s gain on the sale of his corporation stock would be short-term capital gain while the other portion may be long-term capital gain. This is the result of the corporation taking a carryover or tacked holding period from the shareholder for the contributed property.
While the IRS’s ruling helps address situations where a shareholder is trying to extend their holding period for short-term capital assets, it does not address the transaction from the corporate level.
The corporation does not get to apply the lower tax rates for capital gains. Thus, the long-term vs. short-term distinction does not necessarily impact the tax rate. The corporation still has to track and report these two categories of gain on its tax returns and the distinction can impact other tax attributes, the timing of losses, etc. In addition to those issues, the holding period for assets can also be important for the corporation. There are a number of tax rules that look to the corporations holding period in its assets. To the extent the corporation is able to look to its contributing shareholder’s holding period, the corporation may be able to take advantage of that longer holding period.
The meaningless gesture transaction only arises when there is a contribution of cash or property, but the corporation does not issue new shares.
To the extent the corporation issues new shares, the basis in the shares will generally be equal to the basis of the property contributed. The shareholder computes his gain for each share or group of shares. Unlike the meaningless gesture transaction, this splits the holding period and basis in the corporate shares without having to do further analysis.
When a shareholder has contributed property to a wholly-owned corporation and isn’t issued additional shares and subsequently sells the corporation, care should be taken to determine the exact nature of the sale. The gain should be computed by splitting the basis and holding period.
The corporation should also consider the impact on the property it acquired. There may be significant tax savings opportunities available for the corporation. An experienced tax attorney can help advise on these options.