Securing capital gains in a public offering.

When a corporation and its founding shareholders issue a public offering of stock before it has generated a substantial amount of taxable income--a situation common in the high-tech industries--there is a good chance the entity will be considered a collapsible corporation.

Generally, such a corporation is formed for the production of property. Its principal shareholders sell its stock before realizing a substantial part of the taxable income derived from its property. The shareholders receive the penalty for this classification: The gain from the stock sale is considered ordinary income, taxed at top marginal rates rather than at capital gains rates.

This penalty can be avoided if the corporation executes an Internal Revenue Code section 341(f) consent. When the consent is executed, the principal shareholders of an otherwise collapsible corporation can safely sell stock on a capital gains basis. In exchange for this benefit, the corporation is not permitted to engage in certain otherwise tax-free transactions. For example, if it desires to form a joint venture, the transfer of property will be treated as a taxable transaction even though, under normal circumstances, the formation of a joint venture is a wholly tax-free transaction. In addition, a consenting corporation is unable to engage in tax-free asset swaps.

Observation: Since the advent of the Tax Reform Act of 1986, which eliminated most avenues previously available to a corporation for disposing of assets on a tax-free basis, the pain of a section 341(f) consent has been greatly minimized. Despite its advantages, very few corporations have chosen to use the section 341(f) consent. Nonetheless, those eligible to use it should do so.

--Robert Willens, CPA, managing director at Lehman Brothers, New York City.

FYI 

* A CPA was charged with 19 counts of assisting in the preparation of false tax returns. In United States v. Julius Klausher (95-1451, 2nd Cir., March 27, 1996), the judge told the jury that if it found the deductions were false, then it must find that the returns were false. The court said that whether or not the false deductions had substantial influence on the amount of taxable income reported, the deductions made the tax returns inaccurate and thus were material matters. In this case, materiality was decided by the court, not the jury.

* In private letter ruling 9612008, the Internal Revenue Service said the medical benefits provided by an employer to former employees under a severance plan were excluded from the terminated employees' income under Internal Revenue Code section 106. Because the payments were made on account of prior-years employment, the terminated workers were considered employees.

--Compiled by Michael Lynch