AGGREGATE BASIS OF DIFFERENT ASSETS TRANSFERRED TO CONTROLLED CORP. IN 351 EXCHANGE IS ALLOCATED AMONG STOCK AND SECURITIES RECEIVED IN PROPORTION TO THE FAIR MARKET VALUES

Rev. Rul. 85-164

ISSUE

May a transferor determine the bases and holding periods of stock and securities received in a transfer under section 351 of the Internal Revenue Code by designating the specific property to be exchanged for particular stock or securities?

FACTS

A, an individual, was engaged in a business as a sole proprietor. The assets of the sole proprietorship consisted of trade accounts receivable with an adjusted basis of zero and a fair market value of 60x dollars, machinery with an adjusted basis of 5x dollars and a fair market value of 10x dollars, and real estate (land and building) with an adjusted basis of 25x dollars and a fair market value of 30x dollars. A had held the real estate and machinery for over one year. Both the real estate and machinery were property described in section 1231 of the Code.

In order to limit personal liability, A transferred all of the assets associated with the sole proprietorship to a new corporation, Y, in exchange for all of Y's stock and securities. A transferred the accounts receivable to Y in exchange for 100 shares of common stock, the fair market value of which was 60x dollars. A transferred the machinery and real estate to Y in exchange for the securities, which had a principal amount and a fair market value of 40x dollars. The selection of specific items for exchange was made to allocate assets with a high basis and long-term holding period to the securities.

LAW AND ANALYSIS

Section 351(a) of the Code provides that no gain or loss will be recognized if property is transferred to a corporation by a person solely in exchange for stock or securities in such corporation and immediately after the exchange such person is in control (as defined in section 368(c)) of the corporation.

Section 358(a)(1) of the Code and section 1.358-1 of the Income Tax Regulations provide that in the case of an exchange to which section 351 applies in which only non-recognition property is received, the basis of all of the stock and securities received in the exchange shall be the same as the basis of all property exchanged therefor. Section 358(b)(1) directs that, under regulations prescribed by the Secretary, the basis determined under subsection (a)(1) shall be allocated among the properties permitted to be received without the recognition of gain or loss.

Section 1.358-2(a) of the regulations prescribes rules for the allocation of basis among nonrecognition property received in corporate reorganization exchanges governed by sections 354, 355, 356 and 371(b). In general, these rules allow limited tracing of the basis of old stock or securities into new only with respect to (i) persons who owned stock or securities of more than one class, or both stock and securities, before the exchange and (ii) corporate recapitalizations under section 368(a)(1)(E). In all other cases, including exchanges under section 351, section 1.358-2(b)(2) provides that the basis of property transferred shall be allocated among all the stock and securities received in proportion to the fair market values of the stock of each class and the securities of each class.

Section 1223(1) and section 1.1223-1(a) of the regulations 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 (i) in the taxpayer's hands the property received has the same basis in whole or in part as the property exchanged and (ii) for exchanges after March 1, 1954, the property exchanges was at the time of exchange a capital asset as defined in section 1221 or property used in a trade or business as described in section 1231.

Rev. Rul. 62-140, 1962-2 C.B. 181, holds that a share of stock received in exchange for a debenture and a cash payment had a split holding period. The portion of each share received attributable to ownership of the debenture was treated as including the period for which the taxpayer held the debenture and the portion of each share received attributable to the cash payment was treated as held beginning with the data following the date of acquisition.

Rev. Rul. 68-55, 1968-1 C.B. 140, holds that when the property is transferred to a corporation under section 351(a) of the Code each asset must be considered transferred separately in exchange for a proportionate share of each of the various categories of the total consideration received.

In the instant case, A formed Y by transferring all of the business assets of the sole proprietorship to Y in exchange solely for all of Y's stock and securities. Y will continue to carry on the business that A conducted, and A will remain in control of Y. The transfer, therefor, is subject to section 351 of the Code, with the bases and holding periods of the Y stock and securities in the hands of A determined under sections 358 and 1223 of the Code respectively.

HOLDING

A may not determine the bases and holding periods of the Y stock and securities received by designating specific property to be exchanged for particular stock or securities. Under sections 1.358-1 and 1.358-2(b)(2) of the regulations, the aggregate basis of the property transferred is allocated among the stock and the securities received in proportion to the fair market values of each class. The holding period of the Y stock and securities received by A is determined by referring to the assets deemed exchanged for each portion of the stock and securities. The aggregate basis of the property transferred was 30x dollars. Since the stock and securities A received had fair market values of 60x dollars and 40x dollars, respectively, a basis of 18x dollars (60/100x X 30x) is allocated to the Y stock received by A, and a basis of 12x dollars (40x/100x X 30x) is allocated to the Y securities received. In addition, each share of Y stock and each security received by A has a split holding period and a split basis for purposes of determining long-term or short-term capital gain or loss. That fraction of each share of Y stock or security attributable to the real estate and machinery (40x/100x) is traded as including the period (over one year) for which A held the real estate and machinery and has a basis solely attributable to the real estate and machinery (e.g., the 40x/100x of each share of stock attributable to the real estate and machinery will have a basis of .18x dollars (18x/100 shares)). The fraction of each share of Y stock or security attributable to the accounts receivable (60x/100x) has a holding period beginning on the day after the exchange and has a zero basis. If part or all of the stock or securities received in the exchange is disposed of at a time when the split holding period is relevant in determining tax liability, the same fractions will be applied to apportion the amount realized among the above components of the stock or security.

This holding would be unaffected if A were to make a transfer in exchange for securities at separate times, and the transfers were part of a single integrated transaction.

EFFECT ON OTHER REVENUE RULINGS

Rev. Ruls. 68-55 and 62-140 are amplified.