Question

Sam and Devon agree to go into business together selling college-licensed clothing. According to the agreement, Sam will contribute inventory valued at $100,000 in return for 80 percent of the stock in the corporation. Samâs tax basis in the inventory is $60,000. Devon will receive 20 percent of the stock in return for providing accounting services to the corporation (these qualify as organizational expenditures). The accounting services are valued at $25,000.

Required:
a. What amount of income gain or loss does Sam realize on the formation of the corporation? What amount, if any, does he recognize?

Answer 1

Sam realizes a gain of $40,000 by transferring inventory to the new corporation but does not recognize any gain due to IRC Section 351's non-recognition rules. Devon also does not recognize income for providing accounting services in exchange for stock.

Step-by-step explanation:

Sam realizes a gain of $40,000 on forming the corporation, which is the difference between the inventory's fair market value ($100,000) and his tax basis ($60,000). However, under the Internal Revenue Code Section 351, if a person transfers property to a corporation in exchange for stock and is in control of the corporation immediately after the exchange, generally no gain or loss is recognized.

Here, control is defined as owning at least 80% of the corporation's stock. Since Sam owns 80% of the stock after the transaction, he does not recognize any gain. The accounting services provided by Devon are valued at $25,000, and since they qualify as organizational expenditures, they are generally deductible by the corporation over a period of time, and not recognized as income by Devon. Devon does not incur any taxable event as the receipt of stock for services is also covered under the non-recognition provisions if certain conditions are met.