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Transferring Property to a Corporation With a Fair Market Value Lower Than its Adjusted Basis
After operating your consulting business for two years as a sole proprietorship you decide to incorporate. You plan on transferring your business property to the corporation in exchange for its stock.
Your business property is comprised of:
- One computer and a printer:
- Original cost for both items two years ago was $2,000.
- You did not claim the first-year expensing deduction.
- You claimed annual depreciation for these items totaling $1,040.
- Adjusted basis for the computer and printer is currently $960 ($2,000 minus $1,040).
- One desk and a chair:
- Original cost for both items two years ago was $800.
- You also claimed annual depreciation for these items totaling totaling $310.
- Adjusted basis for the desk and chair is $490 ($800 minus $310).
The fair market value for each piece of property at the time of incorporation is less than its adjusted basis:
- Fair market value:
- Computer and printer-$500.
- Desk and chair-$200.
- Adjusted basis:
- Computer and printer-$960
- Desk and chair-$490.
Two questions?
- What value does the corporation use for the property it receives from you?
- What value do you use for the stock you receive in exchange for your property?
To answer these questions you must be aware of two Internal Revenue Code (IRC) sections.
- Section 362(e)(2)(A)
- Section 362(e)(2)(C)
These two IRC sections apply to a situation where the fair market value of property being transferred to a corporation is lower than the property's adjusted basis at the time of the transfer. The IRS allows you and the corporation the option of choosing one of these IRC sections (not both) to determine which values to apply to the property and stock being exchanged. Both you and the corporation must use the same IRC section.
Option 1: Applying the rules of Section 362(e)(2)(A).
You use the higher adjusted basis as your stock basis. The corporation uses the lower fair market value for the property it receives. Under option-
The result under option 1:
- Your stock basis would be $1,450 ($960 plus $490).
- The corporation's basis for the property it receives would be $700 ($500 plus $200).
Option 2: Applying the rules of Section 362(e)(2)(C).
- You use the lower fair market value for the stock you receive.
- The corporation uses the higher adjusted basis for the property it receives.
The result under option 2:
- Your stock basis would be $700 ($500 plus $200).
- The corporation's basis for the property it receives would be $1,450 ($960 plus $490).
Notice that the rules under each Code section are the exact opposite of each other.
Note:
The reason for the tax rules regarding property transferred with a lower fair market value than its adjusted basis is to limit the amount of loss that can be deducted when such property is disposed of.
Section 362(e)(2)(A)
When the fair market value of property being transferred to a corporation is less than its adjusted basis, IRC Section 362(e)(2)(A) must be followed UNLESS both you and the corporation elect the rules under IRC Section 362(e)(2)(C).
In other words, you and the corporation may elect to apply the rules under 362(e)(2)(C) rather than Section 362(e)(2)(A) if you so choose.
Both you and the corporation must apply the same IRC section.
Under Section 362(e)(2)(A):
- You (the transferor, including those in the transferor group) use the higher adjusted basis as your stock basis, and
- the corporation (the transferee) must use the lower fair market value as the basis in the property it receives.
Remember, both you and the corporation must apply the rules under IRC Section 362(e)(2)(A) unless you and the corporation elect to apply the rules under Section 362(e)(2)(C).
Example: Applying the rules of Section 362(e)(2)(A):
Under Section 362(e)(2)(A) you use the higher adjust basis of the property transferred as your basis in the stock you receive in the exchange with the corporation.
The corporation uses the lower fair market value as its basis in the property it receives from you in the exchange.
Let's say you transfer property into the corporation with an adjusted basis of $5,000 and the property has a fair market value of $2,000. You receive all the stock of the corporation in exchange for your property. The value used for your basis in the stock is $5,000 (the higher adjusted basis in the property you transferred to the corporation).
The corporation's basis in the property it receives from you is $2,000 (the lower fair market value of the property at the time of the exchange). If you were to sell your stock for $2,000 (equal to the fair market value of the property you transferred) you would have a deductible loss of $3,000 (amount realized on the sale of $2,000 minus your adjusted basis in the stock of $5,000).
If the corporation was to immediately sell the property it received from you for $2,000 it would have no gain or loss (amount realized on the sale of $2,000 minus $2,000, the corporation's basis in the property).
The example shows that by applying the rules under Section 362(e)(2)(A) only one party, in this case you, can deduct a loss. Limiting the amount of loss than can be deducted is the purpose of these rules.
Section 362(e)(2)(C) Enacted in 2004
You can ignore Section 362(e)(2)(A) and, instead, you (or you and your transferor group) and the corporation may agree to make an irrevocable election to apply the loss limitation rules of Section 362(e)(2)(C).
Section 362(e)(2)(C):
This section allows you (the transferor(s)) to use the lower fair market value for the stock you receive (instead of the higher adjusted basis) and allows the corporation (the transferee) to use the higher adjusted basis for the property it receives (instead of the lower fair market value). Section 362(e)(2)(C) of the code applies the opposite treatment under Section 362(e)(2)(A).
How to Make the Election to Apply Section 362(e)(2)(C)
Both you (the transferor(s)) and the corporation (the transferee) make this election by attaching a statement to the tax return by the due date (including extensions) for the tax year in which the transaction occurred.
Section 362(e)(2)(C) was enacted as part of the American Jobs Creation Act of 2004. It generally provides the following:
- If the aggregate basis of property that is transferred to a corporation as a capital contribution or in a Section 351 exchange, exceeds its aggregate value immediately after the transaction, then,
- an irrevocable joint election may be made by the transferor (you or you and the transferor group) and the transferee (the corporation) to reduce the transferor's basis in the stock received to it's fair market value, and
- there is no requirement to reduce the transferee's basis in the property received (meaning, the corporation can use the higher adjusted basis in the property transferred to it).
- the election is filed with the return by each party to the transaction in the tax year the transaction occurred.
- the election under Section 362(e)(2)(C) is not available to exchanges subject to Section 362(e)(1), (which has to do with limitations on built-in losses).
Example: Applying the rules of Section 362(e)(2)(C):
Under Section 362(e)(2)(C) you use the lower fair market value of the property transferred to the corporation as your stock basis. The corporation uses the higher adjusted basis of the property transferred to it as its basis in the property.
Let's say you transfer property into the corporation with an adjusted basis of $5,000. The property has a fair market value of $2,000. You receive all the stock of the corporation in exchange for your property. The value used for your basis in the stock is $2,000, the lower fair market value of the property at the time of the exchange. The corporation's basis in the property it receives from you is $5,000, the higher adjusted basis in the property transferred to it. If you were to sell your stock for $2,000, you would have a no gain or loss (amount realized on the sale of $2,000 minus your adjusted basis in the stock of $2,000).
If the corporation was to immediately sell the property it received from you for its fair market value of $2,000, it would have a loss of $3,000 (amount realized on the sale of $2,000 minus its adjusted basis in the property of $5,000).
The example shows that by applying the rules under Section 362(e)(2)(C) only one party, in this case the corporation, can deduct a loss. Limiting the amount of loss than can be deducted is the purpose of these rules.