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Transfer of Assets to Wholly Owned Corporation Not a Sale; Capital Gains Treatment Denied.

(Parker Tax Publishing June 18, 2015)

The transfer of a sole proprietorship’s assets to a corporation wholly owned by the taxpayer and his wife was a capital contribution rather than a sale of property and payments subsequently received by the taxpayers were ordinary income rather than capital gains. Bell v. Comm’r, T.C. Memo. 2015-111.


In 2008 through 2010, the years at issue, J. Michael Bell (Michael) and Sandra Bell lived in California. During this time, there were a number of defaults on loans secured by residential real estate. Lenders often acquired at foreclosure sales many of the residential properties securing their loans. These types of properties were known as “real estate owned properties” (REOs). During the years at issue, Michael was a licensed real estate broker and Sandra was a certified real estate appraiser and a licensed real estate sales agent. Michael also assisted lenders with their REO portfolios and his compensation for such work was principally commissions paid when the property was sold. Until September 1, 2008, Michael operated his real estate business as a sole proprietorship. As a result of the increase in his REO work, Michael incorporated his business under the name MBA Real Estate, Inc. (MBA).

On October 1, 2008, MBA and Michael entered into a purchase agreement. For $225,000, Michael agreed to sell MBA all the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of his sole proprietorship. When the purchase agreement was signed, MBA had no capital, no assets, and no shareholders. A couple weeks later, MBA issued 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 a five-year franchise license agreement Michael had entered into in 2004. 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 one of the 40 contracts was sold before September 1, 2008, and MBA booked a $10,800 account receivable for this contract. The other 39 contracts required additional services by Michael; 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 no promissory note was executed. The purchase price was eventually paid in full, but MBA did not make all payments timely.

On their returns for the years at issue, the Bells reported long-term capital gain from the sale of the assets on Form 6252, Installment Sale Income. The Bells also reported interest income for years 2008, 2009, and 2010, and MBA reported substantially the same amounts as interest expense on its returns for those years. MBA amortized the $225,000 purchase price over five years. At the end of 2008 and 2009, MBA had accumulated earnings and profits (E&P) of approximately $88,000 and $158,000, respectively. During 2008 and 2009, MBA distributed to Michael and Sandra approximately $45,000 and $109,000, respectively. MBA’s current E&P for 2010 and its accumulated E&P of $158,000 exceeded a $53,000 distribution to the Bells in 2010.

The Bells’ 2008 return was due by April 15, 2009, but was not filed until June 20, 2009. MBA’s 2008 tax return was due by March 15, 2009, and was filed on March 14, 2009. In 2012, the IRS sent notices of deficiency to the Bells and MBA, determining that the Bells’ entire gain from the 2008 sale was ordinary income.


According to the IRS, the transfer of Michael’s sole proprietorship’s assets to MBA was a capital contribution subject to Code Sec. 351 rather than a sale generating capital gains. The IRS further argued that the payments made to the Bells were in fact dividends and that the assets transferred to MBA could not be amortized or depreciated.

The Bells and MBA countered that the statute of limitations barred the IRS assessment for the 2008 tax returns. In addition, the Bells and MBA argued that the transfer of the sole proprietorship’s assets to MBA was a sale that created a debtor-creditor relationship and should be respected as such.

The Tax Court held that the deficiency notices issued to the Bells and MBA were timely and that the transfer of assets to MBA was a capital contribution governed by Code Sec. 351. With respect to the timeliness of the deficiency notices, the Tax Court noted that Code Sec. 6501 generally requires that taxes be assessed within three years after a return is filed. Since the deficiency notices were sent via certified mail on February 7, 2012, they were issued before the expiration of the three-year period and thus were timely.

With respect to the characterization of the transfer of assets to MBA, the court examined various factors, noting that an appeal in this case would go to the Ninth Circuit, which has applied an 11-factor test to determine whether a shareholder’s transfer to a corporation is a sale or capital contribution. The Tax Court noted that the sole purpose of MBA’s organization was to incorporate Michael’s sole proprietorship and that 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. This was particularly so, the court said, in the light of the lack of evidence of a business purpose for the transaction.

The court also observed that payments that depend on earnings or come from a restricted source indicate an equity interest. MBA acquired essentially all of its assets, which had very little, if any, liquidation value, in exchange for the promise of repayment in the purchase agreement, the court noted. 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, the court found that this factor weighed in favor of finding that the transfer was a capital contribution. The court also noted that because the transaction took place between MBA and Michael, and Michael and Sandra later became MBA’s sole shareholders, this factor was another indication that the transaction was a capital contribution.

While the court did find several factors that indicated the transaction was a sale – namely the parties’ intent, the fixed maturity date of payments, and the wording in the purchase agreement – the preponderance of evidence indicated to the court that the transaction was a capital contribution and not a sale.

Since the court concluded that the Bells’ transfer of the sole proprietorship’s assets to MBA was a capital contribution, MBA’s payments to the Bells in the years at issue had to be treated as distributions, not installment payments. Because MBA’s accumulated E&P in each of the years exceeded the amount distributed to the Bells, the distributions were dividend income for tax purposes.

Finally, the court held that, under Code Sec. 362(a), 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. With respect to the transferred contracts and goodwill, the court found that the Bells had no basis in those items and thus MBA had no basis. As a result, MBA was not entitled to any depreciation or amortization with respect to those items.

For a discussion the rules relating to the transfer of property to a corporation, see Parker Tax ¶45,105. (Staff Editor Parker Tax Publishing)

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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