The Tax Court held that a taxpayer’s taxable gain from
boot on a Section 351 transaction with a related party was an
ordinary gain under Section 1239.
In Gary Fish et ux. v. Commissioner, T.C. Memo 2013-270,
No. 3768-11 (Nov. 25, 2013), the taxpayer recognized taxable gain
on boot in a Section 351 transaction. The sole issue before the
court was whether the taxpayer and the deemed newly created
corporation (a former qualified subchapter S subsidiary of the
taxpayer’s S corporation that was deemed to be created when
the transaction was completed) were related for purposes of Section
1239.
Section 1239 generally provides that gain on a transaction between
related taxpayers must be recharacterized as ordinary income. The
taxpayer and the newly created corporation are treated as related
under Section 1239 if the taxpayer owned (i) more than 50% of total
combined voting power of all classes of stock entitled to vote, or
(ii) more than 50% of the total value of shares of all classes of
stock.
Even though the taxpayer owned approximately two-thirds of the
voting stock of the newly created corporation, the court considered
the possibility that the taxpayer’s voting power may have
been reduced below 50% because of restrictions on the
taxpayer’s (i) ability to approve or disapprove of
fundamental changes in the corporate structure, and (ii) ability to
elect the corporation’s board of directors.
The terms of the corporation’s stock provided that the
taxpayer could elect three of the five directors in the newly
created corporation. One of these appointed directors had to be
“independent” and approved by the other shareholders,
but the other shareholders could not unreasonably withhold their
approval. The court ruled that this independence requirement is
“not the type that would reduce the voting power to below
50%” and noted that the requirement is not unlike the
independence requirements under the Sarbanes-Oxley Act.
In addition, the newly created corporation could not engage in
certain transactions without consent from the other shareholders of
the corporation. The court noted that the taxpayer would serve as
president and CEO and, as such, had a significant role in the
management of the newly created corporation. As a result, the court
held that the taxpayer was related to the deemed newly created
corporation because he had more than 50% of the voting power of the
newly created corporation, notwithstanding the restrictions
mentioned, and that the taxable gain was ordinary income under
Section 1239.
Although the court’s voting analysis concluded that the
taxpayer and the newly created corporation were related under
Section 1239, the court also conducted a value analysis to address
whether the taxpayer owned more than 50% of the value of the newly
created corporation. The taxpayer argued that the value of the
corporation’s shares should be based on a deemed liquidation
of the newly created corporation. Under the taxpayer’s
proposed approach, in liquidation, the other shareholders would
receive a preferred return, which would be more than 50% of the
value of the newly created corporation.
The court rejected the taxpayer’s approach, noting it did not
account for the immediate cash distribution made to the taxpayer.
The court followed the government’s recommended approach
whereby the shares in the newly created corporation were valued
based on their redemption value. In redemption the other
shareholders would receive the greater of the fair market value of
their shares or the issue price plus any accrued dividends. Thus,
the taxpayer’s shares constituted more than 50% of the value
of the newly created corporation.
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