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Corporate and partnership formations involving underwritings.

Internal Revenue Code section 351 allows nonrecognition - or tax-free treatment - to a person who transfers property to a corporation solely in exchange for stock only if he or she owns at least 80% of the stock immediately after the transfer.

When a taxpayer transfers property to a new company (Newco) in conjunction with a "firm commitment" underwriting, it is possible to fail the requirements of section 351. The underwriter is regarded as a "transferor" of property to Newco, and the underwriter's sale of Newco stock to the public is considered in the IRC section 351 control test. The control test is failed if public purchasers, who are not transferors, end up owning more than 20% of Newco's stock.

The IRS has proposed regulations to alleviate this problem. IRC regulations section 1.743-1(a) says the public has transferred property directly to the corporation in exchange for stock if the transaction constitutes a "qualified underwriting transaction." This occurs when the underwriter acts as an agent of the corporation (a best efforts underwriting) or when the corporation's ownership of stock is transitory (a firm commitment underwriting). The IRS also has proposed identical rules in partnership formations.

Observation: Applying the rules in partnership formations may have a negative impact: If the public is treated as transferring property directly to the partnership, rather than purchasing a partnership interest from the underwriter, public purchasers would not benefit from an IRC section 754 election to increase the basis of partnership property and enjoy increased depreciation-amortization deductions. The regulations say the basis of partnership property won't be adjusted as the result of a contribution of property to the partnership.
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Article Details
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Author:Willens, Robert
Publication:Journal of Accountancy
Article Type:Brief Article
Date:Nov 1, 1995
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