'Fish': Ordinary Income From Incorporation Transaction

, New York Law Journal

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Elliot Pisem

Under §351 of the Internal Revenue Code, a business may be transferred to a corporation in exchange for its stock without the recognition of income or gain, so long as the transferors are "in control" of the corporation (under an 80 percent ownership standard) immediately after the transfer and certain other requirements are met. Conversely, if an appreciated business is sold to an unrelated person, the sale will generally result in income treated as capital gain, except to the extent attributable to such assets as inventory, receivables, or "recapture" with respect to depreciable property.

Starting from these rules of thumb, it may come as a surprise that the transfer of a business to a corporation for a combination of stock and cash (purportedly qualifying for nonrecognition treatment under §351, except to the extent of the cash received) may lead to a worse result in terms of character of income—more specifically, to ordinary income rather than capital gain—than would a sale to the same assets to an unrelated third party. A recent Tax Court memorandum decision, Fish v. Commissioner,1 illustrates how this might occur.

Facts in 'Fish'

FishNet Consulting (Consulting), an S corporation of which Gary Fish (Fish) was the sole shareholder, was incorporated in 1998 to conduct a growing network security business. In September 2004, after Consulting had retained a financial adviser to evaluate potential financial partners and a possible sale of the company, a private equity fund offered to purchase newly created convertible preferred stock in Consulting, to represent 43 percent of the company's equity on a fully diluted basis, for $12 million. This amount was to be distributed to Fish in partial redemption of his shares.

Because a corporation, in order to maintain its tax status as an S corporation, is required to have only one class of stock,2 the issuance of preferred stock would have prevented Consulting from continuing to qualify for this favorable tax status. For this and (no doubt) other reasons, a more complicated transaction was implemented.

First, in November 2004, Fish incorporated Fish Holdings (Holdings), for which an S corporation election was made. Fish then contributed the stock of Consulting to Holdings, and Holdings made a "QSSS election" to treat Consulting as a "qualified subchapter S subsidiary" under IRC §1361(b)(3)(B). As a result of that election, Consulting would be considered, for federal tax purposes, to be liquidated into Holdings in a nontaxable liquidation (even though Consulting retained its separate corporate existence for state law purposes) and thereafter to be disregarded as a separate entity for federal tax purposes.3 This sequence of steps was treated for tax purposes as a tax-free reorganization in the nature of a reincorporation.

Consulting, Fish, and several investor partnerships entered into a stock purchase agreement, under which the partnerships purchased convertible preferred stock of Consulting for $10.5 million on Jan. 3, 2005, and agreed to purchase an additional $1.5 million of preferred stock within three years thereafter. The sale proceeds from the initial sale of preferred stock were paid to Fish as the owner of Holdings, the sole common stockholder of Consulting, and Consulting was renamed FishNet Security (Security).

The issuance of the preferred stock caused Security to cease to qualify as a QSSS. Security was therefore treated for tax purposes as a new corporation acquiring assets (and assuming liabilities) immediately before such cessation from Holdings, in exchange for Security stock.4 This transaction was considered to have occurred immediately before the preferred stock was issued and just two months after Security (formerly Consulting) was considered to have made a "liquidating distribution" of the same assets, subject to the same liabilities, to Holdings.5

Security's tax return for 2005 showed intangible assets with an amortizable basis of $9,462,700 at the beginning of the year, and claimed an amortization deduction of $630,847 for 2005, consistent with the 15-year amortization period generally applicable to amortizable intangibles under IRC §197. Although the tax return did not specify what intangible assets had been acquired by Security, a footnote in the opinion indicates that the court understood the intangibles to consist primarily of goodwill that had received a basis step-up by reason of the "transfer" that was considered for tax purposes to have been made from Holdings to Security and the associated "receipt" by Holdings of cash (ultimately paid to Fish) that gave rise to recognition of gain.

Holdings's tax return for 2005 reported $9,687,699 of distributions from Security, consisting of $9,463,227 received on the date of closing in January 2005 and an additional distribution in December 2005 made as an adjustment under the stock purchase agreement. Substantially all of those distributions were treated as long-term capital gain and passed through by Holdings to its shareholder, Fish.

The IRS issued a notice of deficiency to Fish determining that additional tax was due on the ground that the amount reported by Holdings as long-term capital gain should have been characterized as ordinary income (i) under IRC §1239 (discussed below) and (ii) to a much lesser extent under IRC §1245 (relating to depreciation recapture). Fish conceded that $175,570 of gain should have been reported as ordinary income under §1245, and the only issue before the Tax Court was whether the balance of the capital gain should instead have been treated as ordinary income under §1239.

Discussion

Where property is sold or exchanged between certain related persons and the property is, in the hands of the transferee, of a character subject to depreciation for tax purposes (including amortization under §197), any gain recognized to the transferor must be treated as ordinary income under §1239. The purpose of §1239 is to prevent a taxpayer's sale of low-basis depreciable property from giving rise to long-term capital gain, taxed at preferential rates, while the related purchaser is computing its depreciation deductions, that may be offset against ordinary income, on a stepped-up basis. One relationship covered by §1239 is that between two corporations more than 50 percent of the stock of one of which, as determined by voting power or by value, is owned by the other.

There was no dispute that there had been a sale or exchange upon which gain was required to be recognized. The court characterized the cash received by Fish under the stock purchase agreement as money, often referred to as "boot," originally received by Holdings in a deemed exchange of assets for Security stock, resulting from the termination of the QSSS election, in a transaction governed by IRC §351. Section 351(b) provides that, where such boot is received, gain must be recognized to the transferor (in this case, Holdings), but not in excess of the amount of cash received.

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