Thursday, September 29, 2022
Doron Narotzki (Akron; Google Scholar) & Melanie McCoskey (Akron; Google Scholar), The Code Section 267 Related Party Rules: When Do They Apply to Section 351 Transactions?, 136 J. Tax'n __ (2022):
Code Section 351 states that property transferors do not recognize gain or loss when they have control of the corporation immediately after the exchange. If the control requirements are not met, any realized loss that would be allowed under Code Section 351 may be disallowed under the Code Section 267 related party rules. One question that has not been addressed clearly in any primary source of authority is the proper time for testing to determine whether the related party rules apply. This article attempts to provide a review of the relevant legislation and court cases in order to provide guidance on this issue.
In a transaction in which a person transfers loss property to a corporation in exchange for stock in which Code Section 351 does not apply, the question arises as to whether the loss will be disallowed pursuant to Code Section 267. There is no primary or substantive authority to determine when the control requirement under Code Section 267 must be met in order to disallow the loss in such a transaction. Instead, we have analyzed relevant authority based on the sale or exchange of property from a shareholder to a corporation.
Based on the analysis of Code Sections 267 and 1239 and the relevant court cases, it seems like there are two ways of looking at this matter. In the first, the appropriate time for determining control is when negotiations are taking place, that is, before the transaction actually occurs. The other alternative is to compare this issue to Code Section 1239 and Treas. Reg. § 1.1239-1(c)(3)(ii) which states that we test for the control immediately after the exchange. Prior to the 1986 issuance of Treas. Reg. § 1.1239-1(c)(3), both Code Sections 267 and 1239 analyzed the time for determining control as during the time when negotiations were taking place. However, Treas. Reg. § 1.1239-1(c)(3)(ii) states that the time for determining control in a Code Section 1239 transaction is immediately after the exchange. Since the analysis has diverged for the two code sections, we suggest that the practitioner rely on the analysis under Code Section 267 since that is the code section with which we are concerned. Accordingly, in the scenario in which B is not related to A, and therefore does not own more than 50 percent of the stock in X Corporation, B should be allowed to deduct the $10,000 loss on the property contributed to the corporation if the transaction falls outside of the scope of Code Section 351.