Under §351 of the Internal Revenue Code, a business may be transferred to a corporation in exchange for its stock without the recognition of income or gain, so long as the transferors are “in control” of the corporation (under an 80 percent ownership standard) immediately after the transfer and certain other requirements are met. Conversely, if an appreciated business is sold to an unrelated person, the sale will generally result in income treated as capital gain, except to the extent attributable to such assets as inventory, receivables, or “recapture” with respect to depreciable property.
Starting from these rules of thumb, it may come as a surprise that the transfer of a business to a corporation for a combination of stock and cash (purportedly qualifying for nonrecognition treatment under §351, except to the extent of the cash received) may lead to a worse result in terms of character of income—more specifically, to ordinary income rather than capital gain—than would a sale to the same assets to an unrelated third party. A recent Tax Court memorandum decision, Fish v. Commissioner,1 illustrates how this might occur.
