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How to Get Assets and Money into a Corporation Tax-Free

Forming a corporation is similar to getting married. It is easy to get into but much harder to get out of.

—Sandy Botkin

Many times people want to start their corporate business by transferring personal assets to their corporation. Let’s face it—it’s certainly a lot cheaper and easier to use assets that you already own than to purchase new assets.

You can transfer property to a corporation easily and tax-free if you know what you’re doing. Generally, no gain or loss is recognized on the transfer of property to a corporation solely in exchange for stock in that corporation.¹

Author’s note: As noted, you can’t take any loss on the transfer. Thus you generally should not transfer property that would result in a tax loss to you if you sold it. You’re better off selling the property and taking the loss. You then can transfer the net cash received to the corporation.

To have no gain or loss apply, you must meet certain easy conditions:

1. You must transfer assets. It can be almost any property, such as other stock, real estate, cash, patents, copyrights, etc.² In fact, there’s a lot of flexibility. However, and this is a big however, you cannot transfer services for stock tax-free. It doesn’t matter if the services have been rendered in the past or will be rendered in the future.³ If you do, you will be taxed as ordinary income on the fair market value of what you receive.⁴ If you both transfer property and render services for the stock, you will be taxed as compensation (ordinary income) on the portion of the stock received that applies only to the services.

Example: Ted and Carol form a corporation, and each receives 50 percent of the stock. Ted transfers $100,000 cash and Carol performs some legal services and incorporation services and transfers $50,000 cash. Since some of the stock that Carol received was for services, she would be taxed on the portion that relates to the services.

2. You must receive stock for your property.⁵ This sounds very clear-cut, but there are a few issues that you should know about. First, stock means stock and not warrants, calls, puts, or any other options.⁶ Second, it doesn’t have to be solely for voting stock. It can even be preferred stock if you want some investors to get preferences as to dividends.

For those who don’t know what preferred stock is, here’s a great definition: Preferred stock is “stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent.”⁷ Thus preferred stockholders would get a flat, fixed dividend, similar to a bond. They don’t get to vote and don’t benefit significantly from the growth or equity of the company. In addition, if the company makes a lot of money, the preferred stockholders don’t get larger dividends. The use of preferred stock is normally to fix the value for estate planning and to bring in investors who want greater security in their dividends.

3. After the transfer, you must control at least 80 percent of the voting stock and at least 80 percent of all other shares of any other class of stock.⁸ This simply means that you can have some stockholders getting voting stock and some getting other types of stock, such as nonvoting or preferred stock, as long as everyone together owns at least 80 percent of the voting stock and 80 percent of all the shares of the other stock.⁹

Author’s note: If you and some others are organizing a newly formed corporation, you will, in all probability, receive over 80 percent control of all stock. Thus this third requirement is not normally a problem for new corporations. Also, and this is important, if you want to give away your stock (such as to your children or grandchildren) after the transfer, you may do so as long as you’re not obligated to retransfer the stock. All stock should be issued to you first; then you can do with it as you please, as far as the Internal Revenue Service (IRS) is concerned.¹⁰

Traps in Transferring Property to a New Corporation

The bad news is that Congress created several traps that would result in tax to you on incorporating. The good news is that I’ll show you how to avoid them easily.

Trap 1: Don’t Place a Debt on Transferred Property Right before Forming the Corporation

As I said earlier, when you transfer property for stock in a corporation, you avoid all gains and losses. The corporation can even assume your indebtedness on the transferred property without any gain recognized by you or any other person who transfers property.¹¹ However, if it appears that the principal purpose of the assumption of debt was to avoid federal income tax on the exchange, then the debt will be treated as money received and taxed to you.¹² Yuck!

Author’s note: Generally, if a debt has been on the property for a while, at least one year, you won’t have a problem. If you place the debt on the property just within the last four to six months,¹³ you’d better have a great reason for doing this. An example of a good reason actually given by the IRS would be to replace an existing debt on property.¹⁴ Another good reason, in my opinion, would be to refinance an existing debt at a lower interest rate.

Example: Sue transfers for stock property worth $200,000, but with a debt of $50,000; the corporation assumes Sue’s debt on the property. This would be a tax-free transfer.

Example: Assuming that Sue placed the debt on the property two months before transferring the property to the corporation, she probably would be taxed on the liability assumed by the corporation because the transfer was to avoid taxes.

Trap 2: Don’t Receive Cash or Other Property Back from the Corporation

You must transfer property for stock. If you receive anything else besides stock, such as cash or other property, you will be taxed on the receipt of the cash or property received.¹⁵

Example: Mike and Gloria transfer property to form their corporation. Mike transfers $100,000 in cash, and Gloria transfers real estate worth $120,000 but gets the same amount of stock as Mike. If Gloria receives back $20,000 in order to equalize the transfer, she will be taxed on the $20,000 that she receives.

Trap 3: Don’t Transfer Any Property That Has Debt Greater than Your Basis¹⁶

What does this mean? This is where you transfer property whose adjusted basis to you (cost plus improvements less depreciation taken) is less than the debt on the property. This can happen in a number of ways.

Example: You pay only $100,000 for some real estate that skyrockets to $600,000 in value. You then go to a bank and refinance the property and get a loan for 80 percent of the value, or $480,000. Your basis was $100,000, which is what you paid,¹⁷ but your loan on the property is now $480,000, which is $380,000 more than your basis. If you transfer this property with this debt, you will pay tax on the $380,000! How’s that for a congressional “gotcha”?

This also can happen if you take a lot of depreciation but your debt gets paid off over a longer period than the depreciation. Your property could be completely written off, but you still have some debt.

Author’s note: There’s a great way around this problem. In fact, if you ever have this problem, this book will pay for itself many times over.

Here’s the IRS rule: You pay tax on the excess of your liabilities over your basis of the property transferred, but it’s the sum of all the liabilities for each transferor over the sum of all the adjusted bases of the properties transferred by each transferor.¹⁸ What this means to you is this: Transfer more property to the corporation so that the total basis of what you transfer exceeds the total debt on the transferred property.

Example: Calvin transfers some real estate to a corporation for stock. His real estate has a basis of $50,000, but there’s a mortgage of $100,000 on the property. If Calvin transfers this property alone for stock, he would pay tax on $50,000. Thus he should either not transfer this property or add some other property so that the total basis equals or exceeds the total debt. Thus, if he also adds $50,000 in cash as part of the transfer, his total basis in the real estate and cash is $100,000, which equals the debt. Thus no tax! Pretty slick, isn’t it?

If Possible, Don’t Transfer Real Estate to a Regular Corporation

As my opening quote notes, it’s hard to get property out of a corporation, especially a regular corporation. If you have real estate in the corporation that appreciates in value, which real estate tends to do, you may have to pay tax at the corporate level on the appreciation whenever you sell the property or liquidate the corporation¹⁹ and probably pay tax at your individual level, too. That’s double taxation! There are ways around it with reorganizations, etc., but it takes some knowledgeable tax planning.

The rich have known this for years. Thus what many top tax experts are recommending is to form an LLC or a limited partnership that would own the real estate and then lease it to the corporation. In this way, you don’t have to worry about the real estate appreciation being “trapped” in the corporation, and you or your family members can receive the lease payments. Thus you can shift income to your family at lower tax brackets. Even better, you don’t need to worry about the liability being over the basis because the property wasn’t transferred to the corporation. Finally, you can take a deduction for the depreciation of the real estate on your individual tax return or the tax return of your family members if they’re part owners. The real estate losses and depreciation won’t be locked into the corporation because a flowthrough entity owns the real estate, so all losses flow through to you and your family or the owners of the flowthrough entity. What a great country this is!

Don’t Forget to Attach the Required Schedules to Your Tax Return

There’s a price for all these nice tax-free goodies: You get to somewhat enrich your accountant. The IRS requires a statement to your tax return noting a complete description of the property transferred, a complete description of what you received in exchange (including other property received), a complete description of the stock received, and a description of any liabilities that were assumed.²⁰ In addition, if this isn’t bad enough, you need to attach a similar description to the corporate tax return.²¹

Summary

•   To transfer property to a corporation tax-free, transfer it for the stock in the corporation.

•   Do not receive warrants or options. This isn’t deemed stock.

•   The stock can be preferred stock as long as there’s no mandatory buyback.

•   Don’t transfer property that would result in a loss if sold. You will lose the loss. It’s better to sell the property and transfer the cash instead.

•   Don’t transfer services for stock, or you’ll be taxed on the fair market value of the stock attributable for those services.

•   All the transferors in total should own at least 80 percent of the voting stock and 80 percent of all shares of other stock issued.

•   You can have the corporation assume any liabilities on the transferred property. Just don’t place any liabilities on the property within one year (to be safe) before the transfer, unless you have one heck of a good corporate reason.

•   Don’t transfer property whose liabilities exceed your basis. If this is a problem, transfer other property so that the total basis of the properties transferred equals or exceeds the total of the liabilities assumed.

•   Don’t forget that if you receive anything other than stock from the transfer, you may pay tax on what you receive.

•   Don’t have a regular corporation own real estate. Do what the rich do: Form either an LLC or a limited partnership to own the real estate, and lease it to the corporation.

Notes

1.   Section 351(a) of the IRC.

2.   George Holstein, 23 T.C. 923 (1955); DuPont de Nemours and Co. v. United States, 471 F.2d 1211 (Ct. Cl.1973).

3.   Section 1.351-1(a)(1)(i) of the ITR.

4.   Section 351(d)(1) of the IRC and Section 1.351-1(a)(1) of the ITR.

5.   Section 351(a) of the IRC.

6.   Section 1.351-1(a)(1) of the ITR.

7.   Section 351(g)(3)(A) of the IRC. I should note that when the preferred stock is sold, it could result in ordinary income and not capital gain under Section 306 of the IRC.

8.   Sections 351 and 368(c) of the IRC.

9.   Marsan Realty Corp., T.C. Memo 1963-297; see also IRS Letter Ruling 8230028.

10.   Wilgard Realty Co., Inc. v. Commissioner, 127 F.2d 514 (2nd Cir. 1942).

11.   Section 357(a) of the IRC.

12.   Section 357(b)(1)(A).

13.   W. H. B. Simpson v. Commissioner, 43 T.C. 900 (1965); W. H. Weaver v. Commissioner, 32 T.C. 411 (1959); Drybrough v. Commissioner, 376 F.2d 350 (6th Cir. 1967).

14.   Revenue Ruling 79-258 1979-2 CB 143.

15.   Section 351(b)(1) of the IRC.

16.   Section 357(c)(1) of the IRC.

17.   For purposes of simplicity, I’ve ignored any depreciation that you may have taken. This would reduce your basis.

18.   Revenue Ruling 66-142, 1966-1 CB 66.

19.   Section 336(a) of the IRC.

20.   Section 1.351-3(a) of the ITR.

21.   Section 1.351-3(b) of the ITR.