Bob and Carl transfer property to Stone Corporation for 90% and 10% of Stone stock, respectively. Pursuant to a binding agreement concluded before the transfer, Bob sells half of his stock to Carl. Prepare a memorandum for your tax manager explaining why the exchange does or does not meet the Sec. 351 control requirement. Your manager has suggested that, at a minimum, you consult the following authorities:
- IRC Sec. 351
- Reg. Sec. 1.351-1
C:11-66
One of your wealthy clients, Cecile, invests $100,000 for sole ownership of an electing S corporation’s stock. The corporation is in the process of developing a new food product. Cecile anticipates that the new business will need approximately $200,000 in capital (other than trade payables) during the first two years of its operations before it starts to earn sufficient profits to pay a return on the shareholder’s investment. The first $100,000 of this total is to come from Cecile’s contributed capital. The remaining $100,000 of funds will come from one of the following three sources:
- Have the corporation borrow the $100,000 from a local bank. Cecile is required to act
as a guarantor for the loan.
- Have the corporation borrow $100,000 from the estate of Cecile’s late husband. Cecile
is the sole beneficiary of the estate.
- Have Cecile lend $100,000 to the corporation from her personal funds.
The S corporation will pay interest at a rate acceptable to the IRS. During the first two years of operations, the corporation anticipates losing $125,000 before it begins to earn a profit. Your tax manager has asked you to evaluate the tax ramifications of each of the three financing alternatives. Prepare a memorandum to the tax manager outlining the information you found in your research
Full Answer Section
- Combined Ownership: After the transfer, Bob and Carl will own a combined total of 100% (90% + 10%) of Stone's stock.
- Binding Agreement: The presence of a binding agreement between Bob and Carl for Bob to sell half his stock to Carl might be viewed as a pre-arranged plan to establish control.
However, there is a potential point of contention:
- Timing of Sale: Since the sale of half of Bob's stock to Carl occurs after the transfer to Stone Corporation, some interpretations might argue that control wasn't established immediately after the transfer.
Recommendations:
- To strengthen the case for control, consider citing relevant case law (e.g., C:11-66) that supports the "pre-arranged plan" concept for establishing control under Sec. 351.
- Consult with the tax manager to determine if any additional documentation or evidence regarding the binding agreement is necessary.
- Tax Ramifications of Financing Options for Cecile's S Corporation
Cecile has three financing options for her new S corporation:
Option 1: Loan from Local Bank
- Tax Ramifications for Cecile: As a guarantor, Cecile will be personally liable for the loan if the corporation defaults. Any payments made by Cecile on the defaulted loan may be deductible as a business bad debt if the corporation becomes worthless and the debt cannot be collected.
- Tax Ramifications for S Corporation: The corporation can deduct the interest paid on the loan as a business expense.
Option 2: Loan from Cecile's Husband's Estate
- Tax Ramifications for Cecile: This option offers similar tax implications to a bank loan. Interest payments are deductible by the corporation, and Cecile may deduct any bad debt payments if the estate becomes insolvent.
- Additional Considerations: There could be estate tax implications depending on the terms of the loan and the size of the estate. It's advisable to consult with an estate planning attorney.
Option 3: Loan from Cecile Personally
- Tax Ramifications for Cecile: There is no immediate tax deduction for Cecile unless the corporation defaults and the debt becomes worthless.
- Tax Ramifications for S Corporation: The corporation can deduct the interest paid to Cecile as long as the interest rate is considered "arm's length" by the IRS (comparable to what an unrelated lender would charge).
Additional Considerations for All Options:
- S Corporation Losses: Since the corporation anticipates losses in the first two years, these losses will pass through to Cecile on her tax return, potentially reducing her taxable income.
- Passive Activity Limitations: If Cecile is not materially participating in the S corporation's business, there may be limitations on her ability to deduct losses.
Recommendations:
- Further research on "arm's length" interest rates for S corporation shareholder loans is necessary.
- Discuss Cecile's level of involvement in the corporation's business to determine potential limitations on deducting losses.
Conclusion
This memorandum provides a preliminary analysis of the two issues you requested. It's highly recommended to consult with the tax manager and potentially a tax attorney to determine the best course of action for Bob, Carl, and Cecile based on their specific circumstances.
Sample Answer
MEMORANDUM
To: Tax Manager From: [Your Name] Date: May 3, 2024 Subject: Analysis of Sec. 351 Control Requirement and Tax Ramifications of Financing Options for Cecile's S Corporation
This memorandum addresses two separate issues:
1. Sec. 351 Control Requirement for Bob and Carl's Stock Transfer to Stone Corporation
Analysis:
Bob and Carl's transfer of property to Stone Corporation in exchange for stock likely meets the "control" requirement under Section 351 of the Internal Revenue Code (IRC) based on the following: