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Let's now consider the existence of boot, or something extra besides stock,

in the transfer.

Nicholas, Michael and Emily form Sunchase Shakery Corporation by transferring

the following assets for all of the outstanding stock of the corporation.

Nicholas is going to contribute machinery with an adjusted basis of $10,000 and

a fair market value of $12,500 in exchange for 25% of the shares outstanding.

Michael's going to contribute land with an adjusted basis of $18,000 and

a fair market value of $25,000 in exchange for 40% of the shares,

as well as a $5,000 note.

Emily's going to contribute cash of $17,500 in exchange for

35% of the shares and we want to know what are the tax effects of the transaction for

each party to the transaction.

So where do we begin?

Well, let's start by first examining whether Section 351 applies.

And we can go through by examining each of the three components that we

always look at.

So do we have one or more person's transferring property?

And this one is an easy yes, because we just talked about how we do, in fact,

have each individual transferring items of property, right, machinery, land and cash.

Was the exchange solely an exchange for stock?

Well, here for the first time we have sort of a yes and a no.

So we have Nicolas receiving shares, Emily receiving shares,

Michael received shares plus a $5,000 note.

So we have some boot received.

And as you learned from the concepts video,

the receipt of boot does not prevent Section 351 from applying.

However, it can trigger gain recognition.

So this is something of concern, but it does not prevent 351 from applying.

And then immediately after the exchange, do the parties have control?

And, again, control is defined at that 80% threshold.

When we go through, we see that each of the three individuals receives 25%,

40% and 35% of all of the shares.

So we add that up, after the exchange they have 100%.

So control is present.

So Section 351 will apply, but

we know that we have this boot situation to think about.

So what does boot do?

Well, if other property or money, anything else in receipt beside stock, is received

by a shareholder, then any gain realized by the recipient can be recognized, right?

But only to the extent of the boot receive.

That is only to the extent they have this additional wherewithal to pay tax to

the government.

So let's go through each individual person.

Figure out how this works and then we'll look at the corporation at the end.

So let's start where we always start with each individual transferor by looking at

the amount realized.

In other words, what are they going to receive?

So Nicholas transfers machinery with a fair market value of 12,500 and

then receives 25% of the shares outstanding.

And, again, as we've done before in a closely-held corporation,

we have to presume that the shares are worth the amount of property that he

contributed because there's no open market to value the shares on.

What's the adjusted basis of the property that he gave up to get those shares?

And we're told from the problem, $10,000.

So he has a $2,500 realized gain.

And how much of this gain will he recognize?

Well, normally, we recognize all realized gains unless there's a code

section that tells us we don't have to.

And we just determined that Section 351 applies so there's no gain or

loss to recognize.

What's his basis in the shares that he just received?

Well, it should be our basis formula as we've used before.

So we would start with our exchange carryover basis of $10,000 plus any gain

recognized.

Now for the first time, we can use this particular element of the basis formula.

However, we just determined that there was no recognized gain,

minus the fair market value of any boot received.

Again, this is the first time that we can actually use this.

But, again, there's no boot in this particular person, minus any liabilities

assumed by the corporation, which we haven't used just yet.

So $10,000 is his basis, and let's look at the holding period.

And that would be tacked if he contributes a Section 1231 asset or a capital asset.

And here we're told that he's contributing machinery.

So we don't know if he's used this machinery in a business, so

it's hard to say whether it's a capital asset or a 1231 asset.

So what we'll do is we'll write tacked,

If the machinery was a Section 1231 or capital asset.

In other words, we're not entirely sure based on the facts in the problem.

So that's it for him.

Let's now look at Michael.

So let's start where we always start.

What is the amount realized?

And now we can be real careful, because he's going to receive a few things here.

So he's receiving 40% of the shares as well as a $5,000 note in exchange for

the property, the land that he's giving, which has fair market value of $25,000.

So the total amount of realized, in other words,

the total amount of the shared value that he's receiving as well as everything else

should equate to $25,000, the amount that he's giving up.

So in other words, what we can do is we can say,

the shares that he receiving must be worth $20,000.

So this would be the fair market value of the shares, such that when

we factor in this additional, the note, the boot that he's receiving,

that's something extra besides the shares of stock,

which we're told is 5,000, sums to 25,000.

The total amount realized,

which equates to the fair market value of the property that he gave up to get this.

Makes it an arms-length transaction.

What's his adjusted basis?

Well, it says that his adjusted basis in the property contributed was 18,000,

the land.

So he has a realized gain, Of $7,000.

And now here's the new part.

Given all this, how much of this gain does he recognize?

Normally, Section 351 says we do not recognize any gain or

loss, unless there's boot.

And then we recognize, so

we'll write it down since it's the first time we dealt with this.

We recognized gain to the extent, Of boot received.

So he has a $7,000 gain, how much boot did he receive?

Well, at $5,000.

So he's going to recognize a gain all the way up until the amount of the boot

received.

In other words, $5,000.

Okay, so what's his basis now in these new shares?

Well, this is where we use our basis formula.

So we start with the exchange basis or the carryover basis.

Which is the basis of the property that he contributed, or $18,000.

Plus, we'll add any gain recognized by the shareholder,

which we just determined he will recognize $5,000.

We'll subtract the fair market value of any boot received,

which in this case was also $5,000,

minus any liabilities assumed by the corporation which is 0 in the situation.

We haven't gotten to that just yet.

And so we see that the basis in the shares of stock is $18,000.

So it's important to note that in this problem, these two numbers, the gain and

the fair market value of the boot,

were actually the same such that they netted out.

But that is not always the case, so

you still always have to use the basis formula.

Because there are situations where those numbers will not be the same.

But they just were for this problem, okay?

So the basis is 18,000, and what is his holding period in the stock?

Well, the holding period here would be tacked, Likely.

And the reason would be that land is a section 1231 asset if it's

used in a trade or business.

Or in other words, if he holds this as an investment,

then it would be a capital asset.

So based on the information we have, it would likely be tacked.

Now let's look at Emily's situation.

So she is contributing cash of 17,500.

So she's going to receive stock of 17,500.

Her adjusted basis is the cash she gave up, 17,500.

So in other words, she has no realized gain or loss.

And then, of course, nothing to recognize.

Her basis in the shares would be the basis of the property she gave up.

Increased by any gain minus fair market value of any boot received.

And then minus the amount of any liabilities assumed by the corporation.

All of which are 0 in this situation, so she would receive the $17,500 basis.

And then her holding period, because it's not a capital or

1231 asset, would be not tacked.

She used cash, so it's just like she purchased it.

So the holding period would begin at the time of the purchase, okay?

So that's our three transfer, or our shareholders.

Now let's consider the corporation.

Section 1032 says,

for the case of a corporation dealing in its own stock, no gain or loss.

So we don't have to figure out anything there.

But we do have to pay close attention to the basis, right?

So if you recall, the basis formula for the corporation,

Is exchange/carryover basis,

Plus any gain recognized by the shareholder, so

that's the important part here.

We have to know the shareholders' tax effects before we can figure out the basis

for the corporation, so let's look at each asset.

So then we have the machinery, the carryover basis from Nicholas.

So his basis at the time of the transfer was $10,000 plus any gain

recognized by Nicholas, which we determined was 0.

So the corporation's basis would be $10,000 and the machinery.

Then we have the land from Micheal.

His basis at the time of the transfer was $18,000, Plus any gain

recognized by the shareholder, which we determined was $5,000.

So the corporation's basis would be $23,000.

So why do we do this? Well,

this is important because now if the corporation turns around and

sells this asset.

The basis is $5,000 higher to represent the $5,000 gain that Michael recognized.

Which means it won't be double counted in the future.

So this is an important adjustment that we have to make.

And it's very favorable to the taxpayer and the corporation in that sense.

And then Emily's contributing cash, so the basis with cash is cash.

Kind of an irrelevant concept because you're not going to sell cash as

an investment.

Okay, then we can think about the holding period for each of these assets for

the corporation.

And the rule for the corporation is that the holding period is tacked if

they received exchanged or carryover basis.

Which applies in all three of these situations.

Even though it's, again, an irrelevant concept when it comes to cash.

But we can still write tacked, tacked, and tacked for the holding periods for

each of the three assets.

Okay, so hopefully this is a really good problem for you to practice on your own.

It involves boot as well as all the major concepts of section 351 that we've

learned so far.

With the exception of built-in loss property in one problem.

Nicholas transferred a building with a fair market value of $130,000 and

an adjusted basis of $75,000 to Sunchaser Shakery Corporation.

In exchange for 95% of its only class of stock and

a vehicle with a fair market value of $30,000 and an adjusted basis of $25,000.

And the question asks,

what is Sunchaser's basis in the building received from Nicholas?

So before we even start,

it's important to point out that this problem sort of is kind of tricky, right?

Because it's asking about what is the corporation, that is Sunchaser's,

basis in the assets.

We can't solve that problem until we know the effects on the shareholder first.

Because the corporation's basis formula includes any gain

recognized by the shareholder.

So keep that in mind as you do this problem, as well as look for

this trick in the future.

Okay, so let's start where we always start, right, does section 351 apply?

And we can just kind of look at the problem and see we have one or

more persons.

We have Nicholas transferring property, solely in exchange for stock.

But he's getting something else extra, in this case, a vehicle, which is boot.

Boot does not prevent section 351 from applying.

It just means we have some special treatment,

particularly with respect to gain recognition.

And afterwards, it says that he has 95% of the only class of stock.

So control would be present, so overall, section 351 will apply.

We just have boot present that we have to take care of.

But our ultimate question, again, is about the corporation's basis in the building.

But we can't answer that until we figure out what are the effects for Nicholas.

So section 351 will apply, yes, and now let's look at the effects for Nicholas.

Where do we start?

Where we always start, amount realized.

So what is Nicholas going to receive in this transaction?

Well, he's going to get $100,000 worth of stock.

And then he's going to receive a vehicle that has a fair market value of

$30,000, right?

So we have the vehicle, and then we have the stock.

So his total amount realized is $130,000.

What is the adjusted basis of the property that he is contributing?

And we're told he is going to contribute a building with an adjusted basis of 75,000.

So that means he has a realized gain of $55,000.

How much of this gain does he recognize?

Well, we said that we have this vehicle that's something extra other than stock

that he's receiving.

So we're going to recognize gain, in this case, to the extent of boot received.

So we have a vehicle of $30,000.

He has a $55,000 gain, so we'll recognize our $55,000 gain to the extent of

the boot that he receives, in other words, $30,000.

So what is Nicholas's basis in his shares?

It didn't ask this specifically, but we know how to answer this now, so

we can do it anyway, right?

We start with exchanged or carryover basis,

which would be the basis of the property that he contributed, $75,000.

Plus any gain recognized by the shareholder,

which we just determined was 30,000.

Minus the fair market value of any boot received, Which is the $30,000 vehicle.

So again, these two numbers are the same in this problem, and oftentimes they are.

But they do not have to be, so we always have to check.

Minus any liabilities assumed by the corporation,

which there were none, so $75,000 basis in his shares.

Okay, so now that we know what happens to Nicholas,

we can answer the actual question.

Which is, what is the basis for the corporation, Sunchaser, in this situation?

So starting off, though, we know that there's no gain or loss recognized.

And the reason would be section 1032,

because the corporation's dealing with its own stock.

And now we want to know what's the basis in the building,

which is the point of this entire problem.

All right, so we use the basis formula, which says start with the exchange, or

carry over, basis.

In other words,

what was the basis in the building when it was contributed by Nicholas?

In this case, $75,000, plus any gain recognized by the shareholder.

So this is why we had to figure out the effects for

Nicholas before we could answer the question.

So gain by the shareholder, and we said he's going to recognize a $30,000, here,

I'll put this one in parentheses too, $30,000 gain.

So the basis for the corporation, and the answer to the question, is $105,000.

To form Sunchaser Shakery Corporation,

Nicholas transfers business assets in exchange of $40,000 of cash and

all of the stock, which has a fair market value of $460,000.

Specifically, he's going to contribute accounts receivable,

fair market value of $50,000 and adjusted basis of $10,000.

Equipment with a fair market value of $150,000, adjusted basis of $90,000.

And land with a fair market value of $300,000 and

an adjusted basis of $175,000.

And we want to know, what amount, if any, does Nicholas recognize on the transfer?

So where do we begin?

Right where we always begin, does Section 351 apply to this transaction?

So let's just quickly run through the three elements of Section 351 to ensure

that they're present.

So we have one or more persons, in this case, Nicholas, transferring property.

Solely in exchange for stock?

Well, not necessarily, the case, I mean, he is receiving stock,

but he's also receiving boot.

Receipt of boot does not prevent Section 351 from applying.

But it does potentially trigger gain recognition,

which is what we have to be on the lookout for.

And then finally, does Nicholas have control immediately after the exchange?

And here, we're told that he receives all of the stock, which means he has 100%

control immediately after the exchange, so control is present.

So overall, Section 351 will apply to the transaction.

The only issue is that we have boot, and we know how to handle that now, so

we'll do that with this problem.

All right, so

let's first look at everything from Nicholas's perspective in general.

And then we'll figure out kind of what to do as we go.

So let's start with the overall amount realized for Nicholas, Which is $460,000,

because we're told he's going to receive exactly $460,000 worth of stock.

He's also going to receive something else in the exchange, and that is boot,

in this case, it's cash, of $40,000.

So his total amount realized, Is the sum of the two, or $500,000.

Now we need to factor in the adjusted basis of all the property

he's contributing.

And so he's contributing property with basis of $10,000 in the accounts

receivable, 90,000 in the equipment, and $175,000 in the land.

So the 10,000 plus the 90 plus the 175, or

the $275,000 in total, which means he has a realized gain,

Of $225,000.

So how much of this gain does he recognize?

Well, normally, none, because Section 351 applies.

However, we know we have boot present,

because he's receiving something other than the shares of stock.

That is, he's receiving the cash of $40,000.

So he's going to recognize gain to the extent of boot received, so

to the extent of boot.

And he has $40,000 worth of boot.

So he's going to recognize $40,000 of his $225,000 gain.

Okay, but now what's different in this problem is that we have multiple

items of property.

So we have to figure out how this boot impacts that gain recognition.

Because the gain was ultimately caused by multiple different types of property.

So let's write down a couple rules that we're going to use.

This is things that you learned in the concepts videos.

But we'll write them down again,

since this is the first time that we've used them here in a problem.

So we must allocate the gain recognized,

Pro rata to each property item,

Using the relative fair market value.

And we essentially did this in the prior problem.

It's just that the prior problem only had one item of property.

And then any remaining part of the gain would be deferred.

So remaining gains are deferred.

And then the character of any gain for each item of property, So the character

of the recognized gain, Is determined by the type of property involved.

So it's determined by the property, To which the boot is allocated.

So if it's allocated to an ordinary asset, it will trigger ordinary income.

So we've done everything in general and aggregate up to this point.

But now we need to allocate this boot or this $40,000 of gain across the three

properties that created the gain to figure out how each is treated.

So let's go through each property item, starting with the first one, or

the accounts receivable.

So we just kind of follow the same formula that we always do.

But now we're going to look at it property by property basis, so

that we can allocate it correctly.

So how much are they receiving in exchange for this accounts receivable?

Well, we can use the fair market value, because the sum of all the fair market

value equates to the sum of the total property received in the transaction.

So the amount realized for the accounts receivable would be $50,000,

which is the fair market value of the stock assigned or, I guess,

allocated to the accounts receivable.

Less the adjusted basis in the accounts receivable, which is 10,000.

So on this asset in isolation here, there's a realized gain of 40,000.

And now we want to allocate the boot that they received of 40,000 to

this particular asset.

So we'll put boot apportioned, or allocated, same thing.

And how are we going to do that?

Well, the rule said, the one that we wrote down, that we would allocate this boot pro

rata to each property item using the relative fair market value.

So the relative fair market value of all the property contributed is the sum of

the fair market value of all the property items.

So the 300 plus the 150 plus the 50,000, in other words, 500,000.

So the fair market value of this particular item is $50,000.

So we're going to take 50,000, the fair market value of the accounts receivable,

and allocate it pro rata over the sum of the fair market value of all the property

contributed, that is, the $500,000.

We're going to use this proportion,

multiply it by the $40,000 of boot that was received.

And that's how much we're going to allocate to this particular asset,

in other words, 4,000, or 10% of the 40,000.

So that means that we're going to recognize the gain.

In sum, we already determined that we're going to recognize 40,000.

But of that, $4,000 is going to be deemed to be from the accounts receivable.

Why would we do that, right?

Well, that's important because accounts receivable is an ordinary asset,

which means this $4,000 of gain is ordinary in character.

So now let's look at the equipment.

And so the fair market value of the equipment and

thus of what's received is $150,000.

Adjusted basis on equipment was 90,000.

So on this asset, There's a realized gain of 60,000.

And we're going to apportion or

allocate some of the boot to this asset because it also created the gain.

And so the fair market value of this asset was 150 out of the total $500,000

of property contributed at fair market value.

And we'll multiply that or allocate the boot of 40,000 based on that ratio,

which would give us $12,000 allocated to this asset.

So the gain that's recognized on this asset in particular would be $12,000.

And so its character here would likely be determined under Section 1231,

because these are business assets that were contributed.

And we're told this is equipment, so equipment used in a trade or business.

Depreciable real property used in a trade or business held for more than one year,

which this may be, would be 1231.

If it's a 1231 asset, then we would have a 1231

treatment to help determine the gain or loss.

So odds are this would be a long-term capital gain in character,

because the sale of Section 1231 assets for

a gain result in long-term capital gain treatment., okay?

And then, finally, the last asset is the land.

$300,000 fair market value, Adjusted basis of 175,000,

Such that we have a realized gain on this asset of 125,000.

And we'll allocate the remaining portion of the boot that's left,

which is the fair market value of this asset.

Out of the total 500 of all the assets transferred,

that ratio times the 40,000 of the boot,

or 24,000, which means we're going to recognize

a gain here on this asset in particular of 24,000.

It is land, thus, it is a Section 1231 asset because these are business assets.

So it would also receive long-term capital gain treatment.

So, overall,

we had a $40,000 gain that we determined in aggregate must be recognized.

And then by allocating it out by asset, by allocating the boot,

then we've looked at each individual piece.

So with respect to the accounts receivable,

we said, $4,000 was ordinary.

The equipment, $12,000, was long-term capital gain.

And then with the land, the remaining

24,000 is also long-term capital gain.

And if we sum all this up, we see that it equates to $40,000.

So we know that we have correctly identified all of the gain that must be

recognized and

put a character to each asset based on the allocation of the boot received.

Lesson 3.6.2 Treatment of “Boot”: Applications

Taxation of Business Entities I: Corporations

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