The US Congress enacted Section 362(e) of the IRC as part of the American Job Creation Act in 2004 in an effort to combat loss duplication transactions.
The term refers to transactions that create multiple tax losses for one economic loss. In other words, loss duplication transactions enable corporations to acquire property tax-free.
Businesses previously incorporated as sole proprietorships or partnerships could also obtain property while avoiding federal taxes by restructuring their organization into corporations before the American Job Creation Act was passed.
Let’s dive deeper into Section 362 of the IRC and explore its tax implications regarding property transfer to corporations.
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The Brief History of Loss Duplication Transactions
The loss duplication transaction phenomenon is as old as the US federal tax system. The IRS has spent most of its history finding ways to combat this tax loophole that enabled taxpayers to transfer property to corporations tax-free. Section 351 of the IRC stipulates that shareholders don’t recognize losses under the following conditions:
- If a shareholder transfers property to a corporation.
- If a shareholder acquires a corporation’s stock in exchange for property.
- If a shareholder controls 80% of the corporation’s stock in the aftermath of the exchange.
In this context, the term property refers to any transferable asset except services. Also, a shareholder can choose any stock type.
Hence, before Section 362 of the IRC was enacted, shareholders would receive a substituted tax basis for the stocks they’ve obtained, thereby equalling the tax basis of the property they’ve transferred to a corporation.
On the other hand, corporations were also not required to recognize a gain or loss. Instead, they could receive a carryover tax basis of the acquired property that equals the shareholder’s tax basis for the same property before the transfer.
Such a state of affairs enabled corporations to duplicate losses they could deduct from their federal taxes.
The Enactment of IRS Section 362
Section 362 of the IRC regulates transactions described in Section 351.
It stipulates that:
‘If property is transferred to a corporation as a capital contribution or in an exchange to which § 351 applies and the aggregate basis of the transferred property exceeds its aggregate value immediately after the transaction, then the transferee corporation’s basis in such property shall not exceed the fair market value of such property.‘
Section 362(e) (2) (C) indicates that ‘the parties to the transaction can make an irrevocable election to apply the reduction to the transferor’s basis in the stock received in the exchange instead of to the transferee’s basis in the property received in the exchange.’
The first version of Section 362 was enacted in 2004, but the IRS made final adjustments to this section almost a decade later. The section’s final draft set the rules both parties involved in property transfer must follow.
Hence, a corporation and the transferor must make an election of their tax return.
In addition: ‘The transferor and transferee can make a joint election to reduce the transferor’s basis in the stock received to its fair market value, and no reduction of the transferee’s basis in the property received will be required.’
The Step-Down Rule
Section 362 of the IRC offers a simple solution to the loss duplication transaction issue because it regulates transactions of properties with built-in losses and prevents corporations and taxpayers from multiplying losses by transferring assets.
It does so by limiting a transferee’s tax basis to the property’s fair market value if the tax bases exceed the fair market value for the property in question.
However, this scenario only covers situations when a single property is transferred to a corporation. The Step Down rule also applies to property transactions involving multiple assets with built-in losses or gains.
Consequently, a proportionate share of the property’s built-in loss must be multiplied by the transaction’s overall built-in loss. The resulting sum has to be subtracted from the tax basis for each property with built-in loss.
This rule doesn’t apply to transactions involving multiple assets with a combined tax basis equal to or less than their fair market value. However, the Step Down Rule applies if the combined tax bases of all transferred assets exceed their market value.
What Does Section 362 Mean For Newly Founded Corporations?
The enactment of Section 362 nearly eradicated loss duplication transactions because it prevented corporations from avoiding taxes when obtaining property with built-in losses.
Hence, newly founded businesses incorporated as corporations must adjust the tax basis for each property they own or acquire. The IRS imposes strict penalties on taxpayers who fail to report participating in a reportable transaction.
As a result, both parties involved in a transaction that meets Section 351 criteria could face fines if they don’t follow the rules for such transactions set forth in Section 362.
It’s important to note that property acquired from S corporations, trusts, or partnerships is also subject to anti-property loss importation rules. Hence, corporations must adhere to Section 362 regulations when acquiring property from other businesses.
Frequently Asked Question
This section of the Internal Revenue Code defines circumstances under which corporations acquire property as contributions to capital and have zero bases for that property.
Subsections a and b of Section 362 indicate that the property’s tax basis cannot exceed its fair market value, even if the transferor opts to recognize gains through the assumption of liability.
Yes, property importation for loss duplication purposes is considered tax fraud and is subject to different penalties.
Aggregate built-in loss combines all built-in losses for each property included in a transaction. It is used to determine the circumstances under which the Step-Down Rule applies to a transaction.
Contact a CPA
The complexity of Section 362 makes it incomprehensible to most business owners. Still, if you’re considering registering your business as a corporation, you must know its tax implications.
Go to choicetaxrelief.com or call 866-8000-TAX to book a meeting with a CPA who can interpret Section 362 of the IRC for you and help you understand how to acquire property for a corporation while remaining compliant with federal tax regulations.
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Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
