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Contractual Right to Receive $225,000 Is a Right to Stock; Section 351(a) Governs Incorporation

(Parker Tax Publishing August 2017)

The Ninth Circuit affirmed a Tax Court holding that a contractual right to $225,000 that a couple received after incorporating the husband's real estate business was properly treated as "stock" for tax purposes. As a result, since the couple received only "stock," Code Sec. 351(a), and not Code Sec. 351(b), governed the tax treatment of the transaction. Bell v. Comm'r, 2017 PTC 326 (9th Cir. 2017).


From 2008 - 2010, the number of defaults on loans secured by residential real estate in California increased dramatically because of the 2008 recession. During this time, a property's fair market value was often less than the amount owed to the lender. As a result, lenders acquired at foreclosure sales many of the residential properties securing their loans and attempted to resell the properties at higher prices. These types of properties are known as "real estate owned properties" (REO). Some lenders serviced their own REO portfolios while others relied on third parties for these services.

During the years at issue, 2008 - 2010, Michael Bell was a licensed real estate broker and his wife, Sandra, was a certified real estate appraiser and a licensed real estate sales agent. By 2007, Michael had completed training and had obtained the necessary certifications to join networks of brokers who assisted lenders with their REO portfolios. Before the years at issue and until September 1, 2008, Michael operated his real estate business as a sole proprietorship under the trade name Realty World MBA (MBA). The proprietorship was reported as Michael Bell & Associates on the Bells' 2008 federal income tax return. As a result of the increase in his REO business, Michael incorporated his business on August 4, 2008. On the same day, the Bells and MBA executed a lease for the business' office. Shortly thereafter, MBA renewed a franchise license agreement Michael had with Realty World-Northern California, Inc., for a renewal fee of $250. MBA's organization minutes were signed one month after the articles of incorporation were filed, appointing Michael as president and treasurer and Sandra as vice president and secretary. At approximately the same time, the board of directors authorized MBA to broker real estate under Michael's license and to purchase Michael's sole proprietorship.

MBA and Michael entered into a purchase agreement on October 1, 2008. For $225,000, Michael agreed to sell MBA "[a]ll the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of that business known as 'Realty World - MBA'". When the purchase agreement was signed, MBA had no capital, no assets, and no shareholders. Weeks after the purchase agreement was signed, MBA's board of directors resolved to issue 250 shares to Michael and 250 shares to Sandra in exchange for $500.

No appraisal was performed. The $225,000 purchase price was determined exclusively by the Bells. The Bells allocated $25,000 of the purchase price to the five-year franchise license agreement Michael had entered into with Realty World-Northern California, Inc., in 2004 for $3,200. The remaining $200,000 of the purchase price was allocated to 40 contracts between Michael and various lenders and entities to assist during the REO process. The property subject to 1 of the 40 contracts was sold before September 1, 2008, and the Bells received a payment of $10,800 for services rendered pursuant to the contract on September 3, 2008. On September 4, 2008, MBA booked a $10,800 account receivable for this contract. When the purchase agreement was entered into, the other 39 contracts required additional services by Michael; and there was no certainty that these contracts would produce income.

The purchase agreement stated that the purchase 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 percent interest each year. MBA did not provide any security for the purchase price, and a promissory note was not executed. The purchase price was eventually paid in full, but MBA did not make all payments timely.

Tax Return Treatment

On their returns for the years at issue the Bells reported a $5,000 cost basis in the Realty World franchise and reported long-term capital gain from the transaction using Form 6252, Installment Sale Income. The Bells also reported the following amounts as interest payments: $4,688 for 2008, $11,250 for 2009, and $4,500 for 2010. MBA reported substantially the same amounts as interest payments on its returns for the years at issue. MBA amortized the $225,000 purchase price over five years.

The IRS issued a deficiency notice after finding that the transfer of the sole proprietorship's assets to MBA was a capital contribution subject to Code Sec. 351(a) and was not a sale. Under Code Sec. 351(a), no gain or loss is 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 defined in Code Sec. 368(c)) of the corporation. The IRS argued that payments made to the Bells were in fact dividends and that the assets transferred to MBA could not be amortized or depreciated. The Bells took their case to the Tax Court.

Tax Court's Decision

The Tax Court held that the Bells' transfer of the sole proprietorship's assets to MBA was a capital contribution under Code Sec. 351. According to the court, in order to incorporate Michael's existing business, the Bells transferred $500 in cash and all of the sole proprietorship's assets to MBA solely in exchange for MBA's stock. The Bells were in control of MBA immediately after the transfer of cash because they became MBA's sole shareholders. Thus, the court said, Code Sec. 351 governed the tax consequences of the transaction. As a result, MBA's payments to the Bells in the years at issue were distributions, not installment payments. Further, because MBA's E&P in each of these years exceeded the amount distributed to the Bells, the distributions were dividends for tax purposes.

With respect to MBA, the Tax Court found that MBA's initial basis in all of the property it received in connection with the Code Sec. 351 transaction was the same as the Bells' basis in the property. In addition to the amount MBA paid to renew the franchise license agreement, the court said, MBA assumed Michael's basis in the franchise license agreement. On the basis of the evidence presented, it appeared to the Tax Court that the Bells had no basis in the transferred contracts or goodwill. The court thus concluded that, pursuant to Code Sec. 362(a), MBA had no basis in these items and thus could not depreciate or amortize them.

Appeal to the Ninth Circuit

The Bells appealed to the Ninth Circuit, arguing that the Tax Court erred because the Bells received a contractual right to $225,000, not "stock." Thus, the Bells contended, the transaction should be governed Code Sec. 351(b).

Code Sec. 351(b) provides that, if Code Sec. 351(a) would apply to an exchange but for the fact that there is received, in addition to stock, other property or money, then gain (if any) to such recipient is recognized, but not in excess of (1) the amount of money received, plus (2) the fair market value of such other property received. In addition, no loss is recognized to such recipient.

Ninth Circuit's Decision

The Ninth Circuit held that the Tax Court properly treated the contractual right to $225,000 as "stock" for tax purposes and, because the Bells received only "stock," Code Sec. 351(a), and not Code Sec. 351(b), governed the tax treatment of the transaction. The court began its analysis by looking at Code Sec. 385, which defines the treatment of certain interests in corporations as stock or debt. The court noted that although a corporation may characterize a transaction as creating debt, under Code Sec. 385, that characterization is not binding on the IRS. In other words, the court said, Code Sec. 385 dictates whether the Bells' interest in the corporation - the contractual right to collect $225,000 - is "stock" for tax purposes.

The Ninth Circuit observed that, for the years involved, the IRS had yet to issue regulations listing the factors that would determine whether an interest in a corporation was treated as stock or debt. As a result, the Ninth Circuit developed its own 11-factor test in Hardman v. U.S., 827 F.2d 1409 (9th Cir. 1987). After considering those factors, the Ninth Circuit concluded that the contractual right to the $225,000 was "stock" and not "debt." In reaching its conclusion, the court found the following factors persuasive in characterizing the right to the $225,000 as "stock": (1) MBA had no meaningful assets apart from the REO contracts and no history of doing business; (2) there was no security; (3) there was no promissory note; (4) MBA had very little capital; (5) MBA had no history of repayment; and (6) MBA's sole non-trivial assets - the REO contracts - were speculative.

For a discussion of Code Sec. 385, see Parker Tax ¶45,310.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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