THE LAW BEHIND "THE REVOLUTION"
(INTERNAL REVENUE CODE SECTION 351)
In this edition of the Real Estate Revolution, we will provide our readers with a basic overview of the laws behind the Escrow Program.
We continue to hear attorneys and CPAs as well as other allegedly knowledgeable professionals frivolously state that the Revolution can't do what it does. Interestingly, all this so-called expert advice is usually stated without the benefit of even having any understanding of how the process really works let alone how the Internal Revenue Code and court cases taken together do, in fact, provide the unquestionable basis for this unique program.
The Escrow Program is a patent pending proprietary process. We will not delve into every aspect the Priorit Service Group employs in undertaking its program. However, in an effort to aid those interested individuals in understanding the legal, tax and technical aspects of the process, we will provide some of the "authority" for our program. That authority finds its basis in the little known Internal Revenue Code Section 351-transfer process, which is a much-preferred alternative to the cumbersome and limited 1031 exchange.
The 351-transfer process allows homeowners and real estate investors to defer (and possible eliminate) the tax liability on the sale of real estate and/or commercial property (property) by reinvesting the gain. By using the 351 strategy employed by Priority Services Group, the money received from a sale of property does not necessarily need to be reinvested in real estate (a requirement in 1031 exchanges), and unlike 1031 exchanges, the transferring party (owner of the property) will (without a penalty) have an unlimited amount of time to reinvest the proceeds from the sale of the property.
In a nutshell, in the 351-transfer (exchange) process, a property owner transfers his/her property to a C-Corporation in exchange for the stock of that corporation. When accomplished, the "basis" in the property exchanged for the stock becomes the "value" of the stock received in exchange for the property.
To begin with, we should first address the most fundamental basis regarding the program. That basis is 2 fold. The first is that the government WILL assist people interested in venturing into business for themselves by allowing them to utilize previously owned assets to "fund" their new business venture (the IRC calls this a capital contribution). The second is that the "Code" states categorically that in order for a transfer of real estate to a corporation be tax free, there MUST be a verifiable business reason for the transfer. The majority of our clients transfer property to a corporation in order to provide a source of funding (by selling the property) for that corporation to undertake the business of buying, holding, renting and selling real estate.
IRC Code §351 Transfers-Non-recognition Of Gain Or Loss: "No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation. According to Reg. §1.351-1(a)(1), the phrase "immediately after the exchange" does not necessarily require simultaneous exchanges, as long as the transfers are made pursuant to a predetermined agreement. Under §351, shareholder(s) control the corporation if, immediately after the transfer, they own at least: (1) 80% of the combined voting power of all outstanding voting stock, and (2) 80% of the shares of all classes of corporation stock.
To understand more fully what corporation capital contributions are and why the Priority Service Group draws so heavily upon this premise, it is important to delve deeper into what has already been stated and how this might benefit Priority Service Group's clients.
In 1997, the U.S. 9th Circuit Court of Appeals heard the case of Peracchi vs Commissioner. Here is what the court said regarding capital contributions:
The Code tries to make organizing a corporation pain-free from a tax point of view. A capital contribution is, in tax lingo, a "non-recognition" event: A shareholder can generally contribute capital without recognizing gain on the exchange. It's merely a change in the form of ownership, like moving a billfold from one pocket to another [See I.R.C. S 351], so long as the shareholders contributing the property remain in control of the corporation after the exchange, section 351 applies: and,
Corporations may be funded with any kind of asset, such as equipment, real estate, intellectual property, contracts, leaseholds, securities or letters of credit. The tax consequences can get a little complicated because a shareholder's basis in the property contributed often differs from its fair market value. The general rule is that an asset's basis is equal to its "cost" [See I.R.C. S 1012].
The fact that gain is deferred rather than extinguished doesn't diminish the importance of questions relating to basis and the timing of recognition. In tax, as in comedy, timing matters. Most taxpayers would much prefer to pay tax on contributed property years later--when they sell their stock--rather than when they contribute the property (if he ever does, this emphasis is mine).
Now I think it prudent to address the central issue relating to the transfer of real estate that is subject to a mortgage. This single issue relating to transfers subject to liabilities is the most important issue to understand. We will first look to the United States Code Title 26 regarding Section 357 (a), Assumption of Liabilities: Again, we turn to the 1997, the U.S. 9th Circuit Court of Appeals heard the case of Peracchi vs Commissioner to address this issue. Here is what the court said regarding the Assumption of Liabilities:
The property Peracchi contributed to NAC (NAC was Peracchi's corporation- emphasis mine) was encumbered by liabilities. Contribution of leveraged property makes things trickier from a tax perspective. When a shareholder contributes property encumbered by debt, the corporation usually assumes the debt. And the Code normally treats discharging a liability the same as receiving money: The taxpayer improves his economic position by the same amount either way [See I.R.C. S 61(a)(12)}. NAC's assumption of the liabilities attached to Peracchi's property therefore could theoretically be viewed as the receipt of money, which would be taxable boot [See United States v. Hendler, 303 U.S. 564 (1938)].
The Code takes a different tack. Requiring shareholders like Peracchi to recognize gain any time a corporation assumes a liability in connection with a capital contribution would greatly diminish the non-recognition benefit section 351 is meant to confer. Section 357(a) thus takes a lenient view of the assumption of liability: A shareholder engaging in a section 351 transaction does not have to treat the assumption of liability as boot, even if the corporation assumes his obligation to pay [See I.R.C. S 357(a)].
Reading on, the court held that: But what if, as the IRS fears, NAC goes bankrupt, the note will be an asset of the estate enforceable for the benefit of creditors, and Peracchi will eventually be forced to pay in after tax dollars. Peracchi will undoubtedly have worked the deferral mechanism of section 351 to his advantage, but this is not inappropriate where the taxpayer is on the hook in both form and substance for enough cash to offset the excess of liabilities over basis. By increasing his personal exposure to the creditors of NAC, Peracchi has increased his economic investment in the corporation, and a corresponding increase in basis is wholly justified.
In the Escrow Program process, the "note" is the mortgage and the liability to pay that mortgage remains (by contract) solely with the transferring party, even though by the terms of that same contract, the corporation can continue to build its equity and income by paying the expenses associated with the real estate that was transferred.
However, the corporation is not the final place a creditor would look to for payment should the corporation not pay the expenses related to the real estate or should the corporation file for bankruptcy. Instead, a creditor would look solely to the transferring party for payment of the mortgage. Therefore, until the transferred property is sold, the transferring party has a substantial economic investment in the property (amounting to the note (mortgage) discussed above) and therefore would be entitled to a fully tax free exchange.
