Potential unintended tax problems can arise when investments are transferred to a corporation. In particular, the transfer of an investment with an unrealized loss can result in unanticipated consequences as a result of the superficial loss rules. These rules prevent an individual from claiming a capital loss when the individual transfers an investment with an unrealized loss to a corporation that is controlled by the individual. The unrealized loss is added to the cost of the investment now owned by the corporation, which preserves the ability of the corporation to claim the loss when the investment is eventually sold to an arm’s length person. This result seems equitable until you analyze what happens when the proceeds are distributed by the corporation.
Consider the following example. Mr. X transfers an investment with a cost of $1,000 to Xco for its fair market value of $500. He takes back a note (or an adjustment to the shareholder loan account) for $500 — in other words, Xco now owes him $500.
Mr. X’s loss of $500 is denied but is added to Xco’s cost of the investment. As a result Xco’s cost of the investment, for tax purposes, is $1,000. If the investment increases in value from $500 to $1,000 and Xco sells it, there is no tax liability for Xco as the cost is $1,000.
The problem arises when Xco distributes the proceeds from the sale of the investment. In this example, only $500 can be distributed to Mr. X without tax (paying off the debt that Xco owes Mr. X). The remaining $500 would be a taxable dividend resulting in a tax liability to Mr. X. If Mr. X had retained and sold the investment, there would be no tax liability.
While it may be possible to plan around this problem, taxpayers and their advisers should be aware of this risk when considering transfers to corporations.
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