Let’s say a man and his wife owned a sole proprietorship. They formed a corporation and transferred all of their assets to the corporation.
The US Tax Court has already ruled on this scenario by saying this type of transaction would be a Code Section 351 transfer. In this case, the IRS appealed it, and when the appellate court heard the case, apparently the appeal was so nonsensical that the court didn’t even write an opinion.
To explain a Section 351 transfer, you can transfer assets from one wholly owned business to a corporation tax free, provided that you own the majority of shares in the corporation. If you think about it, we do these 351 Transfers all the time.
Mr. Bell operated Realty World MBA, a real estate brokerage, as a sole proprietorship. His wife also worked in the business. A significant part of the business dealt with “real estate owned properties” (REO’s), which were foreclosed properties that the Bells' assisted in repossessing, fixing up for sale, and listing to sell for the lender.
In 2008, the Bells incorporated the business under the name MBA Real Estate, Inc. (MBA), holding all of the MBA stock. Shortly thereafter, MBA renewed Mr. Bell's franchise license agreement with Realty World-Northern California, Inc., for a renewal fee of $250.
MBA, Inc. and Mr. Bell then entered into a purchase agreement under which Bell agreed to sell to MBA, for $225,000, all of the proprietorship's “work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets.” The purchase price was determined solely by the Bells; no appraisal was performed.
The Bells allocated $25,000 of the purchase price to the 5-year franchise license agreement Mr. Bell entered into with Realty World-Northern California, Inc. in 2004 for $3,200. $200,000 of the purchase price was allocated to 40 contracts between Mr. Bell and various lenders to assist during the REO process.
The purchase agreement stated that the price was payable in monthly installments of $10,000 or more on the first of each month and that the unpaid principal amount was subject to 10% interest each year. MBA provided no security for the purchase price, and no promissory note was executed. The purchase price was eventually paid in full.
On their returns for the years at issue, 2008-2010, the Bells reported long-term capital gain from the sale transaction, using Form 6252, Installment Sale Income. They also reported interest income. MBA reported substantially the same amounts as interest payments on its returns for the years at issue. It amortized the $225,000 purchase price over five years.
The IRS found deficiencies based on its determination that the transfer of the sole proprietorship's assets to MBA was a capital contribution subject to Code Sect. 351, not a sale. It argued that payments made to the Bells were actually dividends and that the assets transferred to MBA could not be amortized or depreciated.
The Tax Court concluded that the transfer of assets was a capital contribution governed by Code Sect 351 and not a sale to MBA. It noted that when a series of closely related steps that are taken under a plan to achieve an intended result, the transaction must be viewed as an integrated whole for tax purposes.
The sole purpose of MBA's organization was to incorporate the sole proprietorship. The inseparable relationship between MBA's organization and the transfer of the sole proprietorship's assets weighed in favor of finding that the transfer was a capital contribution, particularly in light of the lack of evidence of a business reason for dividing the transaction.
The Court then considered each of the Ninth Circuit's Hardman factors (since the case was appealable to that circuit), including the following, in reaching its conclusion the issuance of a note evidences debt and the issuance of stock indicates an equity contribution. The purchase agreement provided that the purchase price was to be paid in installments of $10,000 or more on the first of each month.
The unpaid principal amount was subject to interest at the annual rate of 10%. The wording in the purchase agreement was typical of a promissory note and did not contain wording commonly included in a stock certificate. This factor weighed in favor of finding that the transaction was a sale.
Payments that depend on earnings or come from a restricted source indicate an equity interest. The purchase agreement had no caveats regarding payment of the purchase price. On its face, the payments were due even if MBA was not profitable.
This interpretation was supported by evidence presented by the Bells indicating that one of the benefits of structuring the transfer of Realty World MBA's assets to MBA as a sale, was that they would receive a steady stream of income each month “for several years until the purchase price was paid off, without concern for the ups and downs of the business world.”
However, the Tax Court said it could not ignore the fact that MBA acquired essentially all of its assets, which had very little, if any, liquidation value, in exchange for its promise of repayment. Without income, it would be impossible for MBA to make any payments due under the purchase agreement, and repayment was completely contingent on MBA's earnings. Consequently, this factor weighed on the side of determining a capital contribution.
An increase in a shareholder's interest in a corporation as the result of a transaction indicates an equity interest. MBA had no shareholders when the purchase agreement was signed, and the Bells subsequently became its sole shareholders. The transaction did not affect Mr. Bell's ownership interest - this factor was neutral.
Advances made by shareholders in proportion to their stock ownership indicate a capital contribution. “A sole shareholder's advance is more likely committed to the risk of the business than an advance from a creditor who is not a shareholder” (NA General Partnership, TC Memo 2012-172). The transaction took place between MBA and Mr. Bell. The fact that Mr. and Mrs. Bell became MBA's sole shareholders indicated a capital contribution.
The corporation's ability to borrow funds from a third party indicates a debt. “If no reasonable creditor would have sold property to the corporation with payments to be made in the future, an inference arises that a reasonable shareholder would not do so either” (Hardman). The record contained no evidence as to whether MBA, a newly organized and thinly capitalized business, could have obtained a loan from a third party.
The Tax Court believed that an arm's-length creditor would not have been willing to lend MBA $225,000 on terms and conditions similar to those in the purchase agreement. This factor weighed in favor of a finding of capital contribution.
Usually changing from a proprietorship to a corporation is done basically for tax reasons, and someone must have given them that advice. My question is: “Did this same person also prepare the returns in question?”
If they did, was it their idea to sell the assets on the installment instead of having it be a simple 351 transfer? If so, I hope they were fired.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice for almost 23 years. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.