THE TECHNICAL SIDE "THE LAW BEHIND THE REVOLUTION"
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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.
Escrow Recovery Program is a patent pending proprietary process. We will not delve into every aspect Priority Services 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. In this overview, we will not address capital gains, ordinary income, why we use a Nevada C-Corporation, and their related issues because we have exhaustively addressed those issues in other writings. Those topics should be well understood by the reader already. If not, please review the Revolution's other publications such as Property Tax Reality and/or Building Real Estate Wealth (both available from the person who provided this discourse to you or by e-mailing Priority Services Group at info@priorityservicellc.com).
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 purchased with "after tax dollars" to "fund" their new business venture (called 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 Priority Service's clients transfer real estate 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.
Because the process relies so heavily on the principals relating to corporate capital contributions, before we venture into the more complex "laws" surrounding the program, we must first discuss corporate capital contributions. Below you will find a very good discussion of this subject from 1120 Account, Inc.
CORPORATION CAPITAL CONTRIBUTIONS
1120 Accountant, Inc. 1782 Columbia Rd. NW, # 404, Washington, DC 20009 Copyright © 1995-2004 1120 Accountant, Inc.™ All Rights Reserved
Contributions to capital of a corporation are called "paid-in capital." A corporation does not recognize gain or loss when it issues stock in exchange for cash or property. [IRC §1032].
Transfers Of Property: Generally, when property is transferred to a corporation in exchange for stock, the transaction is treated as if the property were sold to the corporation at FMV (fair market value).
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
Control: 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.
Solely in Exchange for Stock: Non-recognition of gain under §351 only applies to amounts paid "solely in exchange for stock." If the shareholder receives cash or other property in addition to corporation stock, gain is recognized up to the amount of cash or FMV of other property they received. 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.
Property Subject To Liabilities: In a Section 351 exchange, if a corporation shareholder contributes property subject to liabilities; the shareholder's basis in the corporation stock received is reduced by the amount of liability relief. Relief of liabilities is generally not considered in determining gain on the transaction. However, if liabilities exceed the shareholder's adjusted basis in the property, gain is recognized on the excess, and the shareholder's basis in the corporation stock is zero [IRC §357(c)].
To understand more fully what corporation capital contributions are and why the Revolution 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's clients. In 1997, the U.S. 9th Circuit Court of Appeals heard the case of Peracchi vs Commissioner (full text available at FindLaw for Legal Professionals - Case Law, Federal and State Resources, Forms, and Code.htm). 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: It doesn't matter if the capital contribution occurs at the creation of the corporation or if--as here--the company is already up and running: 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].
But when a shareholder like Peracchi contributes property to a corporation in a non-recognition transaction, a cost basis does not preserve the unrecognized gain. Rather than take a basis equal to the fair market value of the property exchanged, the shareholder must substitute the basis of that property for what would otherwise be the cost basis of the stock. This preserves the gain for recognition at a later day: The gain is built into the shareholder's new basis in the stock, and he will recognize income when he disposes of the stock.
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).
Continuity of investment is the cornerstone of non-recognition under section 351. Non-recognition assumes that a capital contribution amounts to nothing more than a nominal change in the form of ownership; in substance the shareholder's investment in the property continues.
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:
(1) The taxpayer receives property which would be permitted to be received under section 351 or 361 without the recognition of gain if it were the sole consideration, and
(2) As part of the consideration, another party to the exchange assumes a liability of the taxpayer, then such assumption shall not be treated as money or other property, and shall not prevent the exchange from being within the provisions of section 351 or 361, as the case may be.
Section 357 (b), Exception:
(1) In general: For purposes of this section, section 358(d), section 362(d), section 368(a)(1)(C), and section 368(a)(2)(B), except as provided in regulations -
(A) A recourse liability (or portion thereof) shall be treated as having been assumed if, as determined on the basis of all facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability (or portion), whether or not the transferor has been relieved of such liability; and
(B) Except to the extent provided in paragraph (2), a non-recourse liability shall be treated as having been assumed by the transferee of any asset subject to such liability.
(2) Exception for non-recourse liability
The amount of the non-recourse liability treated as described in paragraph (1)(B) shall be reduced by the lesser of -
(A) The amount of such liability which an owner of other assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is expected to, satisfy; or
(B) The fair market value of such other assets (determined without regard to section 7701(g)).
What this is trying to say is that if the transfer of the real estate is without the transfer of liability (the corporation not actually liable for the mortgage on the real estate as is the case with the Escrow Recovery Program's process) then the transfer is a non-recourse transfer and acceptable under the IRC. If a transfer were undertaken wherein the corporation assumes the full liability for the mortgage and any other debt on the property, the extent of the assumption of that debt would be taxable to the person transferring the property. This is called "boot" in the code. Boot amounts to cashing out of the liability for the transferring party (in many cases referred to as "shareholder" in the code), which would be fully taxable. That is why the Escrow Recovery process only transfers the current and future equity and income derived from the property and the transferring party remains solely liable for all the debt associated with the property. The ONLY allowable part of the income derived from the sale of the property that could be reimbursed to the transferring party would be for documentable expenses personally paid for from the personal funds of the transferring party. Those expenses are very narrowly focused on items that are acceptable deductions at the time of sale of the property or would be classified as normal and ordinary for a corporation in the real estate business.
Continuing on, here is what the CPA Journal had to say in 1993 regarding the assumption of liabilities and avoiding the traps in IRC Section 357 (full text available at Assumption of liabilities; avoiding the traps in IRC Sec 357.htm):
Assumption of Liabilities--General Treatment under IRC Sec. 357(a):
Transfers under IRC Sec. 351, especially the incorporation of an existing business, usually include a transfer of liabilities to the corporation, such as trade accounts payable or notes payable in connection with property being transferred. Generally, the transfer of liabilities does not constitute the receipt of boot by the shareholder-- whether the corporation actually assumes the debt or merely takes property subject to it.
Further, this discourse chronicles the following:
In Lessinger v. Commissioner, 872 F2d 519, 89-1 USTC Para. 9254, (1989), the 2nd Circuit held that "Where the transferor undertakes genuine personal liability to the transferee, adjusted basis in IRC Sec. 357(c) refers to the transferee basis in the obligation, which is its face amount." The court reasoned that the corporation must have a basis in the note equal to its principal amount since a later receipt of the principal does not result in income recognition. The court also found that the transaction did not violate legislative intent in enacting IRC Sec. 357(c); since the transferor's liability to the corporation was a real obligation, enforceable by corporate creditors, the taxpayer did not experience the enrichment, which IRC Sec. 357(c) seeks to prohibit.
In relating to what was just stated, should the transferring party have FULL liability for the debt associated with the property transferred to the corporation (non-recourse debt to the corporation) then the associated liability is not relieved and thereby, no tax liability ("boot") would be allocated to the transferring party.
Now lets go back and see what the U.S. 9th Circuit Court of Appeals case of Peracchi vs Commissioner (full text available at FindLaw for Legal Professionals - Case Law, Federal and State Resources, Forms, and Code.htm) said regarding this matter:
Assumption of Liabilities: Section 357(a)
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)]. This non-recognition does not mean that the potential gain disappears. Once again, the basis provisions kick in to reflect the transfer of gain from the shareholder to the corporation: The shareholder's substitute basis in the stock received is decreased by the amount of the liability assumed by the corporation [See I.R.C. S 358(d), (a)]. The adjustment preserves the gain for recognition when the shareholder sells his stock in the company, since his taxable gain will be the difference between the (new lower) basis and the sale price of the stock.
Sasquatch and The Negative Basis Problem: Section 357(c)
Highly leveraged property presents a peculiar problem in the section 351 context. Suppose a shareholder organizes a corporation and contributes as its only asset a building with a basis of $50, a fair market value of $100, and mortgage debt of $90. Section 351 says that the shareholder does not recognize any gain on the transaction. Under section 358, the shareholder takes a substitute basis of $50 in the stock, and then adjusts it downward under section 357 by $90 to reflect the assumption of liability. This leaves him with a basis of minus $40. A negative basis properly preserves the gain built into the property: If the shareholder turns around and sells the stock the next day for $10 (the difference between the fair market value and the debt), he would face $50 in gain, the same amount as if he sold the property without first encasing it in a corporate shell [See Crane v. Commissioner, 331 U.S. 1, 14 (1947)].
But skeptics say that negative basis, like Bigfoot, doesn't exist. Compare Easson v. Commissioner, 33 T.C. 963, 970 (1960) (there's no such thing as a negative basis) with Easson v. Commissioner, 294 F.2d 653, 657-58 (9th Cir. 1961) (yes, Virginia, there is a negative basis). Basis normally operates as a cost recovery system: Depreciation deductions reduce basis, and when basis hits zero, the property cannot be depreciated farther. At a more basic level, it seems incongruous to attribute a negative value to a figure that normally represents one's investment in an asset. Some commentators nevertheless argue that when basis operates merely to measure potential gain (as it does here), allowing negative basis may be perfectly appropriate and consistent with the tax policy underlying non-recognition transactions [See, e.g., J. Clifton Fleming, Jr., The Highly Avoidable Section 357(c): A Case Study in Traps for the Unwary and Some Positive Thoughts About Negative Basis, 16 J. Corp. L. 1, 27-30 (1990)]. Whatever the merits of this debate, it seems that section 357(c) was enacted to eliminate the possibility of negative basis [See George Cooper, Negative Basis, 75 Harv. L. Rev. 1352, 1360 (1962)].
Section 357(c) prevents negative basis by forcing a shareholder to recognize gain to the extent liabilities exceed basis. Section 357(c) provides that gain shall be recognized if "the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property transferred pursuant to such exchange":
Reading on, the court held that:
[footnote: Peracchi owned all the voting stock of NAC both before and after the exchange, so the control requirement of section 351 is satisfied. Peracchi received no boot (such as cash or securities) which would qualify as "money or other property" and trigger recognition under 351(b) alone. Peracchi did not receive any stock in return for the property contributed, so it could be argued that the exchange was not "solely in exchange for stock" as required by section 351. Courts have consistently recognized, however, that issuing stock in this situation would be a meaningless gesture: Because Peracchi is the sole shareholder of NAC, issuing additional stock would not affect his economic position relative to other shareholders [See, e.g., Jackson v. Commissioner, 708 F.2d 1402, 1405 (9th Cir. 1983)].
Reading on, the court held that:
The Code seems to recognize that economic exposure of the shareholder is the ultimate measuring rod of a shareholder's investment [Cf. I.R.C. S 465 (at-risk rules for partnership investments)]. Peracchi therefore is entitled to a step-up in basis to the extent he will be subjected to economic loss if the underlying investment turns unprofitable [Cf. HGA Cinema Trust v. Commissioner, 950 F.2d 1357, 1363 (7th Cir. 1991)].
Reading on, the court held that:
But what if, as the IRS fears, NAC never does enforce the note? If 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. Perachhi 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, Perachhi has increased his economic investment in the corporation, and a corresponding increase in basis is wholly justified.
In the Priority Service Group 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 discussed above) and therefore would be entitled to a fully tax free exchange.
