Gain Recognition in incorporation when liabilities exceeds basis
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Joel is a sole business owner who would like to incorporate his business so that the liabilities of the business do not extend to his personal assets. He wishes to startup a corporation in which he will be the only shareholder. During incorporation he realizes that he has liabilities in excess of the bias and according to the provisions of the internal revenue service code, he has to recognize a gain of $70,000. Joel does not want to recognize the gain because he would have to pay tax for it. To avoid recognition of gain for tax evasion, Joseph writes out a personal check to the corporation promising to pay up the amount at a later date. The note has a face value equivalent to the deficit between the liabilities and the bias. This paper will research on the case of Joel and find out if writing out a note will save him from recognizing gain. The paper will also seek to clarify how writing out a note can be interpreted by the internal revenue service.
The transfer of holdings to a corporation is not a taxable event (Fastrom, 1999). This fails to be the case when the basis of transfer is less than the liabilities of the transfer. To help clarify if Joel can evade recognition of gain for tax purposes, the paper will examine the proceedings of the case Perrachi v. Commissioner, court of appeal summary opinion 1998 – 1754, a case similar to the above mentioned case and it helps expound on when gain needs to be recognized and the arguments that can be made when a sole owner of a corporation writes a promissory note to the corporation. In this case Mr. Perrachi transferred assets to a corporation that he solely owned in order to aid two of its subsidiaries which it had full control of because the subsidiaries did not meet the legal requirement in the capital they held. Mr. Perrachi’s transferable assets were not enough basis that he required to transfer to the corporation and he therefore wrote an unsecured capita l note to the corporation promising to the pay the remaining money plus interest. He did not honor his note until the internal revenue service caught up to the business of the corporations that he owned. The following facts were submitted in the court during the case. Mr. Perrachi also failed to show that he intended to honor his promise to the corporation because his first payment was late. In this case the judge ruled that Mr. Perrachi’s note could be admitted as part of the basis but this was after the following arguments were presented by the IRS.
According to the regulations of the internal revenue service in section 357 (Perrachi Vs. Comm., 1998), the transferor of basis should acknowledge gain if his liabilities are more than basis of his transfers. Due to this section of the code, Joel would have a hard time convincing a court that a promissory note could be admitted as part of the basis. The internal revenue service argued that Mr. Perrachi gained stock out of a debt and thus the transaction should be treated as a sale of a product to the corporation. If this argument was to be applied in the case of Joel, he would have to pay tax on his gain (Perrachi Vs. Comm., 1998).
Mr. Perrachi’s note was unsecured and the corporations he owned would not demand payment until he said so. This was viewed as grafting by the IRS. In the case of Joel, he would have to write a secured note or prove beyond doubt that he intends to honor the promise he made to the corporation. He should also be able to show that he can draw a boundary between himself and the corporation despite owning it fully. This is because the corporation would need to ask him to honor the note as he promised without being compromised by the sole owner.
In the case of Perrachi, the judge agreed that in case of bankruptcy of the NAC Corporation which was fully owned by Perrachi, the creditors of the corporation could enforce the note by reaching for the personal assets of Mr. Perrachi. The judge was convinced that the note could be viewed as an unenforced asset of the corporation. He therefore ruled that the note could be admitted a part of the basis capital that Mr. Perrachi transferred to the corporation. In the case of Joel, this argument would favour him because if the note was to be admitted as part of the basis, then he would not have to recognize any gain because section 357(a) of the corporation does not require recognition of gain on the transferable assets. The note would be recognized as part of the basis with a value equivalent to its face value of $70,000.
Section 358(a) of the internal revenue service regulations allows the shareholder to make contribution to a corporation in form of letters of credit. Application of this section allows a note to be admitted as part of the contribution to an investment. Where an unsecured note is made the cost basis does not preserve the unrecognized gain (Perrachi Vs. Comm., 1998). The gain is incorporated into the shareholders stock and is recognized when the shareholder sells all or part of his stock. This action allows the gain to be deferred to a later date but not to make it disappear. The conclusion is that, a gain can be deferred until the stocks are sold instead of when the transfer happens (Fastrom, 1999). This would not be a favorable ruling to the case of Joel because he would not have avoided taxation.
Section 351 of the internal revenue service regulations provides for un-recognition of gain. It states that, a contribution can be made at any time of the corporation's existence and does not require recognition of gain by the transferor. This implies that a promissory note could be admitted as a contribution to be made at a later date when the corporation has already started (Perrachi Vs. Comm., 1998). This was an argument that presented itself during the proceedings of the Perrachi case. Joel can argue that the note is part of the bias that he wishes to contribute at a later date. This would require him not to recognize gain on his exchange.
Section 358(a) of the internal revenue service regulations allows the shareholder to make contribution to a corporation in any form including of letters of credit. Application of this section allows a note to be admitted as part of the contribution to an investment. (Perrachi v. Comm., 1998). The gain is incorporated into the shareholders stock and is recognized when the shareholder sells all or part of his stock. This action allows the gain to be deferred to a later date but not to make it disappear. The conclusion is that, a gain can be deferred until the stocks are sold instead of when the transfer happens (Fastrom, 1999). This would not be a favorable ruling in the case of Joel because his sale of the stock would require recognizing gain.
Section 357(a) of the regulations provides that a shareholder engaging in an exchange as provided for in section 351 of the regulations need not acknowledge gain if the corporation assumes his liabilities. 'This does not mean that á potential gain is eliminated. The section instead offers that the shareholder's stock should be decreased by the amount of the liability assumed by the corporation and the gain be transferred to the corporation. If this argument was to be employed, Joseph would have to recognize gain at the time of sale equivalent to the difference between the new lower basis and the sale price of his stock (Perrachi Vs. Comm., 1998)'. In the case of Joel, his stock holding based on this argument would go down by an amount equivalent to the face value of the note which is $70,000.
In conclusion, it should be appreciated that with the right argument based on the provisions of the internal revenue service code, Joel would avoid gain recognition at the time of incorporation. To avoid the confusion, Joel could write a secured note to the corporation during the transfer. Alternatively, he could write a personal promissory note to the corporation showing that he intends to pay the corporation its full face value and on time. He would also need to show that the corporation is an independent entity on its own that does not make its decision under his influence despite his being its sole shareholder. Any other alternative would require him to recognize gain either during the transfer or during the sale of his stock.