House Bill Inadvertently Would Tax Business Formation

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Tax Policy

Federal tax reform under consideration may significantly impact state and local governments. In this article, Thompson Coburn LLP's Steve Gorin discusses a proposal to eliminate a federal tax subsidy for state and local governments to offer incentives to attract businesses.

Steven B. Gorin

By Steve Gorin

Steve Gorin is a partner in Thompson Coburn LLP. This article has not been reviewed internally and does not necessarily represent the views of Thompson Coburn LLP. For more information about Steve, see and (including over 1,400 pages of technical materials on structuring private businesses available free to BNA subscribers).

Section 3304 of H.R. 1 that the House approved would enact a new I.R.C. § 76. Page 36 of the Section-by-Section Summary by the House Committee on Ways and Means when H.R. 1 was first issued explains, “This provision would remove a Federal tax subsidy for State and local governments to offer incentives and concessions to businesses that locate operations within their jurisdiction (usually in lieu of locating operations in a different State or locality).”

State and Local Subsidy Removed

However, new I.R.C. § 76 goes much further and may tax the formation of a business or the injection of capital into a business by investors.

New I.R.C. § 76(b)(2) would provide:

Treatment limited to value of stock. For purposes of this subsection, a contribution of money or other property to a corporation shall be treated as being in exchange for stock of such corporation only to the extent that the fair market value of such money and other property does not exceed the fair market value of such stock.

New I.R.C. § 76(b)(3) would extend this treatment to LLCs and other entities taxed as partnerships.

New I.R.C. § 76 does not attempt to coordinate with I.R.C. § 351 (1986), which generally does not tax the controlling shareholders' contribution of property to a corporation in exchange for stock. It also does not attempt to coordinate with I.R.C. § 721 (1986), which generally does not tax a partner's contribution of property to a corporation in exchange for a partnership interest.

At first glance, this provision makes sense. If I put money into my own company, isn't my ownership in the company worth what I put in? Unfortunately, it doesn't quite work this way for many businesses – especially when people come together to form a business.

That is because ownership in any privately-owned business would include valuation discounts for lack of control and lack of marketability.


Here is an example:

A, B, and C decide to form a partnership to manufacture and sell widgets.

Each contributes $10,000 to the partnership, for a total contribution of $30,000.

If A tried to sell his partnership interest to a third party, who is not a strategic investor but rather a hypothetical investor in the general marketplace, the buyer would not pay $10,000. That's because the buyer would have to engage in significant due diligence and also would not be able to control the business – owning only 1/3 of it. Discounts for lack of control and lack of marketability can easily add up to 40% or more in such a situation. In other words, A's sale price would be $6,000, which is $10,000 minus $4,000 (40% discount multiplied by $10,000). The IRS’ formal position in the estate and gift tax area, Revenue Ruling 93-12, reasoned along the lines of the idea that the value of A's interest would be determined without attributing to A any assumption that B and C will cooperate with A in voting; and the same principles would apply for income tax purposes.

So, A's partnership interest is worth $6,000, B's is worth $6,000, and C's is worth $6,000.

The total value of the partnership interests issued is $18,000 ($6,000 + $6,000 + $6,000).

The partnership would report taxable income on $12,000, the excess of the $30,000 contributions it received over the $18,000 in partnership interests it issued.

The partnership would not be taxed on that, because partnerships do not pay income tax – their partners do. Rather, each of A, B, and C would be taxed on $4,000 (1/3 of $12,000).

Unintended Result

As mentioned at the beginning of this article, the House did not appear to intend this result when it passed H.R. 1. If Congress chooses to tax incentives and concessions provided to businesses, the language for new I.R.C. § 76 needs to be narrowed to address specifically what it was intended to cover and provide expressly that it does not affect the operation of I.R.C. §§ 351 and 721. The revised language might authorize the Treasury Department to provide anti-abuse provisions so that a nominal equity interest owned by a State or local government cannot prevent incentives and concessions from being taxed, but any such authorization should also recognize that State and local government pension funds frequently invest only to make money for their participants and that such investments should not be targeted by this new rule. To avoid burdening pension funds and other legitimate governmental investors, any anti-abuse rules should not be effective until final regulations are promulgated after full notice and hearing.

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