Editor: Greg A. Fairbanks, J.D., LL.M.
On May 29, 2020, the IRS released a generic legal memorandum (GLAM 2020-005), which discussed certain tax consequences of a contribution made by a sole shareholder of a corporation, where the shareholder contributes money or other property to its wholly owned corporation for no consideration (referred to herein as a meaningless gesture transaction).
This discussion includes a summary of the applicable law as background, the facts and the analysis for the IRS's conclusions in the GLAM, and the remaining issues regarding the potential scope of the conclusions in the GLAM.
Basis and holding period in Sec. 351 transactions: Secs. 358 and 1223(1)
Generally, a contribution of appreciated property to a corporation results in a recognition event to the transferor. Sec. 351 provides an exception, however, and the transferor recognizes no gain or loss as long as (1) property is transferred to a corporation by one or more persons solely in exchange for stock in that corporation (the exchange requirement), and (2) immediately after the exchange, the transferor or transferors are in control of the transferee corporation (see Sec. 351(a) and Regs. Sec. 1.351-1(a)(1)).
When a transfer of property qualifies as a transaction under Sec. 351, the transferors obtain basis in the stock of the transferee corporation equal to the basis of all property exchanged: (1) decreased by the fair market value (FMV) of any boot received and the amount of loss recognized on the exchange; and (2) increased by the amount treated as a dividend, if any, and the amount of gain recognized on the exchange (not including any portion of the gain that was treated as a dividend) (Sec. 358(a) and Regs. Sec. 1.358-1(a)).
Sec. 1223(1) and Regs. Sec. 1.1223-1(a) require that, in determining the period for which a taxpayer has held property received in an exchange, there shall be included the period for which he held the property exchanged if (1) in the taxpayer's hands the property received has the same basis in whole or in part as the property exchanged and (2) the property exchanged was at the time of exchange a capital asset under Sec. 1221 or property used in a trade or business described in Sec. 1231.
Rev. Rul. 85-164
One important piece of guidance that has been issued by the IRS regarding the treatment of holding periods of stock received in Sec. 351 transfers is Rev. Rul. 85-164.
In Rev. Rul. 85-164 an individual contributed three assets to a newly formed corporation in exchange for stock and securities of the new corporation. Two of the assets were capital assets with holding periods over one year, while the third asset was accounts receivable.
In the revenue ruling, the taxpayer selected specific items for exchange in order to determine the basis and holding periods in the stock and securities received and attempted to claim that the accounts receivable were exchanged for the stock, while the other two capital assets were exchanged for the securities. The IRS ruled, however, that the taxpayer was not permitted to determine the basis and holding periods of the stock and securities received by designating specific property to be exchanged for particular stock or securities. Instead, the IRS ruled that the aggregate basis of the three assets transferred should be allocated among the stock and securities received in proportion to the FMVs of the stock and the securities. The IRS further ruled that each of the stock and securities would have split holding periods, with the two different holding periods determined by referring to the assets deemed exchanged for each portion of the stock and securities (with the portions being determined based on FMVs of the property).
Meaningless gesture doctrine
One issue that has been addressed by the IRS and courts is whether the exchange requirement of Sec. 351 is met in transactions where the transferor already owns 100% of the transferee corporation and additional stock is not issued in exchange for the contribution of property (i.e., a meaningless gesture transaction).
In this type of situation, upon an initial reading of Sec. 351, the exchange requirement does not appear to be met because the transferor does not receive stock of the transferee corporation in return for the contribution of property. However, recognizing that the issuance of additional stock would be a "meaningless gesture," the IRS and courts have consistently held that "the exchange requirements of section 351 are met where a sole stockholder transfers property to a wholly-owned corporation even though no stock or securities are issued therefor" (Lessinger, 872 F.2d 519 (2d Cir. 1989); see also Rev. Rul. 64-155).
In Rev. Rul. 64-155, the IRS held that a domestic corporation's contribution to its wholly owned foreign subsidiary corporation is considered an exchange of property described in Sec. 351 despite the fact that the domestic corporation received no additional shares of the foreign subsidiary. This ruling, as well as cases such as Lessinger, illustrate the application of the meaningless gesture doctrine to Sec. 351 transactions.
While the IRS and courts have applied the meaningless gesture doctrine in different contexts, they have not addressed the effect that the meaningless gesture transaction has on the holding period of the stock that the contributing shareholder owns. In a typical Sec. 351 exchange in which stock is actually issued, if the property transferred is a capital asset, the transferor's holding period in the new stock received will be determined based on the assets that are transferred, and if the transferor transfers cash, the transferor will have a new holding period that begins on the day of the Sec. 351 exchange. This presents a problem in a meaningless gesture transaction because the contributing shareholder does not actually receive any new shares.
In 2009, the IRS issued proposed regulations that would have dealt with meaningless gesture transactions under Sec. 351. The proposed regulations provided that if there was a Sec. 351 transfer and there was no actual issuance of stock, then there would be a deemed issuance of stock followed by a recapitalization of all of the taxpayer's shares (both deemed and actual) into the amount of shares that the taxpayer actually owned, resulting in the taxpayer having separate blocks of shares with different bases and holding periods (Prop. Regs. Sec. 1.358-2(g)(3)). These regulations, however, were never finalized and were eventually withdrawn in 2019.
GLAM 2020-005
In GLAM 2020-005, the IRS laid out two situations in which a taxpayer attempts to use a meaningless gesture transaction to take advantage of a longer holding period that it already has in its existing stock. In both situations the shareholder contributed property with negligible value to a newly formed corporation in exchange for the corporation's stock on Jan. 1, year 1.
Situation 1: On Aug. 1, year 1, the shareholder transfers a substantial amount of money to the corporation for no consideration, and then on Feb. 1, year 2, the shareholder sells all of the stock of the corporation in a transaction in which the shareholder recognizes gain. The shareholder then claims that all of the stock has a holding period that exceeds one year since the stock has been held since Jan. 1, year 1.
Situation 2: The shareholder buys property on March 1, year 1, and that property appreciates in value. Then on Aug. 1, year 1, the shareholder transfers the appreciated property to the corporation for no consideration, and on Feb. 1, year 2, the shareholder sells all of the stock of the corporation in a transaction in which the shareholder recognizes gain. The shareholder then claims that all of the stock has a holding period that exceeds one year.
IRS analysis
Important to note here, prior to the discussion of the IRS's analysis, are the consequences to the transactions in Situations 1 and 2 if stock had actually been issued at the time of the subsequent contributions. In Situation 1, the shareholder made a contribution of money on Aug. 1, year 1. If stock had actually been issued in connection with that contribution, the shareholder would have taken basis in the newly issued shares equal to the amount of money contributed, and the shareholder would have had a holding period in the newly issued stock that started on Aug. 1, year 1, the date of the contribution.
In Situation 2, the shareholder would have taken basis in the newly issued shares equal to the basis that the shareholder had in the property contributed on Aug. 1, year 1, under Sec. 358, and, under Sec. 1223(1), the shareholder would have had a holding period in the newly issued stock that started on March 1, year 1, the day the shareholder acquired the property contributed. Therefore, in both situations, when the shareholder sold the shares on Feb. 1, year 2, the shareholder would have had short-term capital gain on the newly issued stock but would have long-term capital gain on the stock that was issued on Jan. 1, year 1.
In GLAM 2020-005, the shareholder was trying to take the position that because there were no newly issued shares, the shareholder would determine its holding period, based on when the original shares were actually issued on Jan. 1, year 1. In GLAM 2020-005, the IRS advised that this was not the proper treatment and made several conclusions regarding the transactions in Situations 1 and 2.
First, the IRS concludes, consistent with the extensive case law on the meaningless gesture doctrine, that in each of Situations 1 and 2, the shareholder recognizes no gain or loss on the transfer of property on Aug. 1, year 1, under Sec. 351(a), "even though Shareholder does not receive any additional stock."
Second, the IRS concludes in GLAM 2020-005 that in both Situations 1 and 2, the shareholder's stock in the corporation "has a split basis and a split holding period to reflect the initial transfer and the subsequent transfer." The IRS then cites, as a comparison, Rev. Rul. 85-164, noting that in Rev. Rul. 85-164, the shares the transferor received in a Sec. 351 exchange had split basis and split holding periods for the purpose of determining long-term or short-term capital gain.
Third, having addressed the fact that the shareholder in Situations 1 and 2 of GLAM 2020-005 now has a split holding period in the corporation's stock, the IRS advises on the consequences of the sale of the stock on Feb. 1, year 2, in each situation. In Situation 1, the portion of the share attributable to the money transferred in the subsequent transfer had a holding period that started on the date of the subsequent transfer (Aug. 1, year 1), and in Situation 2, the portion of the share attributable to the property transferred in the subsequent transfer had a tacked holding period that started on the date the property was acquired by the shareholder (March 1, year 1). Therefore, for both Situations 1 and 2, the IRS concludes, that "to the extent attributable to the subsequent transfer, Shareholder's stock has a holding period less than one year at the time of the sale of the stock on February 1, Year 2," and thus, "the gain attributable to the sale of this portion of the Corporation stock is short-term capital gain."
Scope of GLAM 2020-005 and impact on other Code sections
While GLAM 2020-005 only makes conclusions regarding the specific fact patterns of Situations 1 and 2, the IRS makes two statements to expand the scope of GLAM 2020-005 beyond those fact patterns.
First, after the IRS explains its analysis in GLAM 2020-005, it advises that Situations 1 and 2 simply illustrate two common forms of transactions that are being recommended to taxpayers as a means of artificially extending holding periods. The IRS then states that the same analysis may:
apply to similar situations, such as transactions in which (i) Shareholder is not an individual; (ii) Shareholder initially acquires Corporation's stock in a taxable transaction; (iii) Corporation is not a domestic corporation; (iv) the relative values of the initial transfer and the subsequent transfer are different from those described in Situations 1 and 2; (v) stock of Corporation is issued in the subsequent transfer, but the value of such stock does not reflect the value of the money or property transferred to it in the subsequent transfer; (vi) Shareholder is not the sole shareholder of Corporation, but the relationship between Shareholder and other shareholders is such that the subsequent transfer for no consideration represents compensation, a gift, or another transfer of value from Shareholder to the other shareholders; or (vii) Shareholder does not dispose of all of Corporation's stock in a single transaction.
Second, GLAM 2020-005 specifies that "the same principles that apply to this benefit apply to benefits under other Code provisions that require minimum holding periods." Due to the statements in GLAM 2020-005 that the GLAM is addressing situations where taxpayers are attempting to artificially extend holding periods through the use of a meaningless gesture transaction, the scope of GLAM 2020-005 can be interpreted to be narrowly tailored to only apply to transactions where a taxpayer is attempting to engage in these types of abusive transactions. However, even if the scope of GLAM 2020-005 is interpreted narrowly, the IRS has indicated its intent to issue guidance regarding meaningless gesture transactions as they see necessary (see Foster, "IRS Alleviates Some Angst About 'Meaningless Gesture' Guidance," 169 Tax Notes Federal 476 (Oct. 19, 2020), regarding comments an IRS panelist made at a Practising Law Institute Conference). Therefore, even if GLAM 2020-005 does not directly apply, a taxpayer should be wary of any situation in which the use of a meaningless gesture transaction results in different tax consequences than if the transferee corporation actually issued stock to the transferor.
The statements the IRS made in GLAM 2020-005, as well as the comments the Service has made regarding GLAM 2020-005, cause some uncertainty as to how far it can be extended. It appears clear that the IRS intends to extend GLAM 2020-005 to other holding period requirements in the Code. Some examples of these would be the one-year holding period under Sec. 245A regarding dividends-received deductions by domestic corporations from foreign corporations, the two-year holding period under Sec. 1059 for extraordinary dividends, the three-year holding period under Sec. 1061 regarding the tax treatment of carried interest, and the five-year holding period under Sec. 1202 regarding gain exclusion for investment in qualified small business stock. It also appears likely that the IRS might look to apply GLAM 2020-005 to any set of facts where a taxpayer engages in a meaningless gesture transaction, where, absent a rule requiring split holding periods, the taxpayer could extend the holding period of the additional investment back to the original issuance of stock.
On the other hand, there are several situations where it is unclear if GLAM 2020-005 can be extended. In GLAM 2020-005, the IRS states an intention to challenge transactions in which a taxpayer ignores a meaningless gesture transaction in determining its holding period in order to artificially extend the holding period, but it remains unclear whether a taxpayer may proactively apply the same approach used in GLAM 2020-005 if the taxpayer would benefit from its application.
One example is illustrated in the following set of facts. First, the taxpayer forms a new corporation on Jan. 1, year 2, with cash. Then, on July 1, year 2, the taxpayer contributes appreciated capital assets that it has held since Jan. 1, year 1, to the corporation in a meaningless gesture transaction. Finally, on Dec. 1, year 2, the taxpayer sells the corporation's stock for a gain. In this set of facts, if the taxpayer is permitted to apply GLAM 2020-005, then the taxpayer would have long-term capital gain for the portion of the stock that relates to its subsequent contribution of property on July 1, year 2, because the holding period of that portion of stock would begin on Jan. 1, year 1, due to the fact that the stock's holding period is determined by reference to the property contributed under Secs. 358 and 1223(1).
If the taxpayer is not permitted to apply the reasoning of GLAM 2020-005, then the taxpayer would have to recognize short-term capital gain for the entire amount of the stock sold because the taxpayer only held it for 11 months before the sale. While it is unclear whether the stated scope of GLAM 2020-005 covers situations such as this, it would seem particularly taxpayer-unfavorable for the IRS to apply the reasoning of GLAM 2020-005 to Situations 1 and 2 described above but not permit the taxpayer to apply the reasoning proactively to this set of facts.
Another potential application of GLAM 2020-005 is to the active business requirement of Sec. 1202. Under the active business requirement, stock held by the taxpayer will only qualify for gain exclusion under Sec. 1202 if the corporation in which the taxpayer holds stock is considered an "active business" during substantially all of the taxpayer's holding period of the stock (Sec. 1202(c)(2)(A)). Due to the mechanical aspects of the active business test, it is possible for the corporation to be considered an active business in one tax year, while not being an active business in a different tax year. Therefore, the holding period of the taxpayer's stock is very important in determining whether this requirement is met, and if a taxpayer engages in one of the transactions outlined in GLAM 2020-005, whether that transaction affects the taxpayer's holding period for this purpose might be essential in determining whether this requirement is met.
A third potential application of the analysis in GLAM 2020-005 is the rate that a taxpayer should apply to its eligible gain in determining the amount of gain permitted to be excluded under Sec. 1202(a). Assuming the taxpayer meets all other requirements of Sec. 1202, the portion of eligible gain that the taxpayer is permitted to exclude depends on whether the stock was issued on or before or after Sept. 27, 2010 (see Secs. 1202(a)(1), (3), and (4)). GLAM 2020-005 does not explicitly advise treating the meaningless gesture transaction as a deemed issuance of stock but, rather, simply advises that a taxpayer treat its holding period similar to how the taxpayer would have treated its holding period if stock was actually issued in connection with the transaction. It remains unclear whether a transaction like the two analyzed in GLAM 2020-005 would impact the portion of eligible gain the taxpayer can exclude under Sec. 1202, because technically no new stock was issued in the subsequent contribution.
The issues discussed above illustrate just some of the uncertainty that still exists regarding the impact of a meaningless gesture transaction on the holding period and issue date of the stock of the contributing shareholder, and they demonstrate the need for the IRS to continue to provide guidance on the tax consequences of meaningless gesture transactions.
EditorNotes
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Contributors are members of or associated with Grant Thornton LLP.
