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Abstract

Most people take for granted that the fair market value of property exchanged for other property is of equal value. However, in the case of transfers of appreciated property to a corporation in a transaction qualifying for non-recognition under Section 351, the creation of a second unrealized gain in the hands of the transferee corporation—and thus a newly created implied deferred tax liability on such gain when later realized—reduces the value of the stock issued to the shareholder. Despite this, in Section 351 settings academics, textbook and casebook writers, the Treasury, and the courts take a standard approach of equating the value of the transferred-in property and the transferee stock is- sued in return.

The failure to factor in the IDTL leads to an overstated amount re- alized—and thus realized gain—for transferors in Section 351 settings. The IDTL is of no immediate effect for transferor shareholders and transferee corporations under Section 351(a), which provides for non- recognition of the realized gain. However, it is of immediate effect if boot is also involved, as Section 351(b) requires recognition (i.e., taxa- tion) of the lesser of the boot received or the realized gain. This Article argues that the transferor’s amount realized—and thus realized gain, and thus recognized gain—should be reduced to reflect the IDTL.

This Article supports its argument with analogies to GAAP’s ac- counting guidance on formal deferred tax liabilities, empirical research on the effect of taxes—including deferred taxes—on stock value, and published advice recommending shareholders in a Section 351 setting factor IDTL when negotiating share allocations. Furthermore, the standard approach of value equivalency in Section 351 settings is especially inapt in light of the many estate and gift tax court decisions—after the legislative demise in 1986 of General Utilities—that now allow discounts for the lurking IDTL when determining the value of closely held corporations.

This Article also shows how the Treasury erred in 2006 when it changed the Section 1.351-3 regulations that have long required the parties to Section 351 transactions to file statements about values and basis in the transfers. First, the 2006 change requires the transferee to disclose the value of property received by the transferee, as opposed to the pre-2006 requirement to disclose the value of stock issued by the transferee. Second, information required in the 2006 change is arguably inconsistent with Revenue Procedure 83-59, which directs taxpayers seeking a private letter ruling related to Section 351 to represent that the transferor will receive stock approximately equal in value to the property transferred into the transferee. Furthermore, the presence of the IDTL means that it will be difficult for parties to make the “value for value” representation required in their PLR requests.

This Article offers advice to parties in a Section 351 transaction. It also proposes amendments to the 1.351-1 and -3 regulations.

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