Tax Notes

 

JULY 6, 1992

 

LENGTH: 1147 words 

 

DEPARTMENT: Letters to the Editor (LTE) 

 

CITE: 56 Tax Notes 115 

 

HEADLINE: 56 Tax Notes 115 - ISSUER'S FMV BASIS IS NOT CARRIED OVER. 

 

AUTHOR: Johnson, Calvin H.

 Arnold, White & Durkee 

 

TEXT:

 

 To the Editor: 

 

   A corporation's basis for property acquired with its own stock in a taxable transaction is the fair market value of the stock. In his Letter to the Editor of June 1, 1992, Jasper Cummings of the North Carolina bar attempts to justify that result on the ground of what he calls a 'basis cloning policy.' A seller receiving stock in a taxable sale must recognize gain or loss in the transaction and the seller would then have a basis in the stock received equal to the fair market value of the stock. Cummings argues that the seller- shareholder's fair market value basis is 'cloned' or replicated for the corporation, even when the new shareholder does not fit into section 351. /1/ 

 

   I doubt that current law supports a cloning-of-basis policy when the sale does not qualify under section 351. Since 1918 the Treasury Regulations have continuously provided that the corporation's basis, when section 351 nonrecognition does not apply, is the corporation's 'cost.' /2/ 'Cost' is not a carryover of shareholder basis. 

 

   For the corporation to clone or carryover basis in an arm's- length exchange of stock for property, the transaction must qualify as a reorganization or section 351 transaction. Section 362(a) of the code, which in fact allows a corporation to carry over shareholders' basis, was enacted as a logical corollary of the nonrecognition treatment given to the shareholders. Just as section 351 exchange is considered to be too little a change in substance to justify recognition of tax gain or loss to the transferring shareholders, the argument went, so under the same theory the transaction has too little substance to change tax basis in assets. /3/ 

 

   In accounting terminology, a section 351 transfer is like reporting the transaction under the 'pooling' method of accounting. The shareholders have no gain because they are just pooling their properties and not selling their properties. They have continued their proprietary interest in the transferred property in an altered form. Symmetrically, the corporation has not purchased the shareholder's property. It has simply received property that the shareholders in substance are considered to continue their interest in. In a section 351 transaction, the corporation steps into the shoes of the transferring shareholders and takes their basis as its own. It does not restate the depreciable basis of the transferred property. 

 

   Under current law, both carryover basis and nonrecognition are available only when the corporation is in essence the alter ego of the transferring shareholders. Section 351 applies only if the transferring sellers, in aggregate, own at least 80 percent of the corporation after the transfer. If the corporation is the alter ego of the shareholders, then both nonrecognition to the selling shareholders and a carryover basis to the corporation follow. A section 351 transaction is much like a transfer between different divisions of the same corporation or a transfer between different accounting pockets within the same taxpayer. 

 

   Where the transaction does not qualify under section 351, however, there is neither nonrecognition nor a carryover basis. The corporation is considered to be a purchaser rather than the continuing alter ego of the transferring shareholders and the corporation restates the tax basis of the property. 'Pooling' and 'purchase' are mutually exclusive ways to account for a transaction. There is no such thing as a transaction that is a purchase as to shareholders, but pooling as to the corporation. 

 

   There are carryover basis situations outside of section 351. Section 1015 allows a donee to carry over the basis of his donor. Section 362(a)(2) allows a corporation to carry over basis of a contribution to its capital. But these are gratuitous transfer cases, far afield from a corporation's acquiring property in an arm's-length commercial exchange. 

 

   I doubt, moreover, that section 362(a) should be extended to cover arm's-length nonsection 351 cases. There is no general right to claim basis because some other taxpayer has a tax cost. A corporation should not get basis from just any stranger. Section 362(c), for instance, refuses to give a corporation basis for transfers made by nonshareholders (or by shareholders not acting as such). The rationale is that the corporation should not get basis for an 'investment it has refused to make.' /4/ Refusing to replicate basis does mean that the corporation must pay tax on gain that the shareholders already have paid tax on. But the corporate tax is by nature a double tax. All corporation earnings are subject to both corporate and shareholder taxes. I doubt that tax doctrine can or should be manipulated to uninvent the double tax. 

 

   It is nonetheless legitimate for a corporation to get a fair market value basis in property acquired with its  own stock. The best rationale, I have argued before, /5/ is that the value of the stock is a fair proxy for the nondeductible, post-tax cash that the corporation will pay on its stock. By issuing stock, the corporation has committed itself to paying dividends and redemption or liquidation proceeds that have a present value equal to the value of the stock. The stock has value only because of the cash. In valuation of stock, the cash is discounted, at a quite-healthy risk-considering discount rate. The discounting process takes away any tax advantage the corporation might get from using stock instead of cash to buy the property. Using stock in fact is ordinarily a very expensive way to achieve basis. Looking at stock as a proxy for future nondeductible cash is the only rationale that fairly legitimates the corporation's fair market value basis.

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                                   Sincerely yours,

                                   Calvin H. Johnson

                                   Arnold, White & Durkee

                                   Centennial Professor of Law

                                   June 26, 1992

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                                   FOOTNOTES

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   /1/ See also Patricia Bryan, 'Cancellation of Indebtedness by Issuing Stock in Exchange,' 63 Texas L. Rev. 89, 126-127 (1984), for a similar suggestion. 

 

   /2/ Treas. Reg. section 1.1032-1(d) (1960); Treas. Reg. 33 (rev.), art. 101, para. 367, 20 Treas. Dec. Int. Rev. 127 182 (1918). 

 

   /3/ Statement of the Changes Made in the Revenue Act of 1921 by H.R. 6715 and the Reasons Therefor, 68th Cong., 1st Sess. 13 (Comm. Print March 6, 1924) explaining enactment of the predecessor of section 362. 

 

   /4/ Detroit Edison Co. v. Commissioner, 319 U.S. 98, 103 (1943). 

 

   /5/ 'Expenses Paid With Stock Are Legitimate Deductions,' 55 Tax Notes 1281 (June 1, 1992); 'The Legitimacy of Basis From a Corporation's Own Stock,' 9 Am. J. of Tax Policy 155 (1991).