Business Entities · Forming a corporation

IRC Section 351 exchange

Section 351 is the corporate counterpart of the partnership contribution rules, and it is deliberately harder to satisfy. A partnership takes property tax-free from anyone at any time; a corporation does so only where the transferors, taken together, come out of the transaction in control of it. That single condition generates most of the difficulty, because it is tested at a moment rather than over a period, and because two things that look like contributions — services, and the corporation’s own unsecured debt — do not count toward it.

The rule

The nonrecognition. no gain or loss is recognised if property is transferred to a corporation by one or more persons solely in exchange for stock in that corporation and immediately after the exchange those persons are in control of it (IRC § 351(a))^TY2026

What control means. 80 percent — control means the ownership of stock possessing at least that percentage of the total combined voting power of all classes of stock entitled to vote and at least that percentage of the total number of shares of all other classes of stock of the corporation (IRC § 368(c))^TY2026

What is not property. stock issued for services, for indebtedness of the transferee corporation not evidenced by a security, or for interest on such indebtedness accruing on or after the beginning of the transferor's holding period, is not considered issued in return for property — so a service provider's shares do not count toward the control test and the service provider has compensation income (IRC § 351(d))^TY2026

Money or other property received. where the exchange would qualify but for the receipt of money or other property in addition to stock, gain is recognised but not in excess of the money received plus the fair market value of the other property received, and no loss is recognised (IRC § 351(b))^TY2026

The transferor’s basis. the basis of the stock received is the same as the basis of the property exchanged, decreased by the fair market value of any other property received, by any money received and by any loss recognised, and increased by any amount treated as a dividend and by any gain recognised on the exchange (IRC § 358(a)(1))^TY2026

The corporation’s basis. where property is acquired by a corporation in a transaction to which IRC § 351 applies, or as paid-in surplus or a contribution to capital, its basis is the same as it would be in the hands of the transferor, increased by the gain recognised to the transferor on the transfer (IRC § 362(a))^TY2026

Capped where the property is worth less. where the transferee's aggregate adjusted bases in property transferred in an IRC § 351 transaction would exceed the fair market value of that property immediately after the transaction, the aggregate bases are capped at that fair market value, the reduction being allocated among the properties in proportion to their built-in losses (IRC § 362(e)(2))^TY2026

Liabilities. the assumption of a liability of the taxpayer by another party to the exchange is not treated as money or other property and does not prevent the exchange being within IRC § 351, except as IRC § 357(b) and (c) provide (IRC § 357(a))^TY2026

Current figures

How it works in practice

Three conditions have to hold and each is exact. Property must be transferred — not services. It must be transferred solely in exchange for stock, subject to the boot rule that handles anything else. And the transferors as a group must be in control immediately after the exchange.

The control test is two tests, not one. IRC § 368(c) requires at least eighty percent of the total combined voting power of all voting classes and at least eighty percent of the total number of shares of every other class. A group holding ninety percent of the voting stock and seventy percent of the non-voting preferred does not have control, and the second limb is counted in shares rather than by value — one of the few places in the Code where a raw share count decides an outcome.

“Immediately after the exchange” means what it says, and it is a group test. Several transferors acting together are aggregated, so a person contributing a small amount of property alongside a large transferor is inside the transaction. That is the mechanism behind the common planning step of having an existing shareholder contribute a modest amount of property alongside a new one, so that the new transferor’s shares are counted in the control group.

The services rule in IRC § 351(d) is what makes that step necessary and it cuts two ways. A person receiving stock for services has compensation income measured by the value of the stock, and those shares are not treated as issued for property — so they do not count toward the eighty percent. A founder contributing cash and a co-founder contributing only work therefore risks the whole transaction: if the service provider’s shares are large enough, the property transferors fall below control and the cash transferor recognises gain they never expected.

Boot is handled by ceiling rather than exclusion. Under IRC § 351(b) gain is recognised up to the money plus the fair market value of other property received, and no loss is recognised at all. The asymmetry is deliberate and it is the same one that runs through IRC § 311 and IRC § 267: losses do not come out of these transactions.

The basis rules keep the gain alive on both sides. The transferor takes a substituted basis in the stock — the basis of what they gave up, adjusted for boot and recognised gain (IRC § 358(a)(1)). The corporation takes a transferred basis in the property, increased by any gain the transferor recognised (IRC § 362(a)). And the corporation recognises nothing on issuing its own stock, under IRC § 1032.

IRC § 362(e)(2) is the anti-duplication rule and is easy to miss. Where the aggregate bases of the transferred property would exceed its aggregate fair market value — a net built-in loss — the corporation’s aggregate basis is capped at fair market value, with the reduction allocated across the properties in proportion to their built-in losses. Without it, a built-in loss would exist twice: once inside the corporation and once in the shareholder’s stock basis. There is an election to reduce the transferor’s stock basis instead, which is the better answer where the shareholder expects to hold and the corporation expects to sell.

Scenarios

How this has changed

IRC § 351 itself has been stable for a very long time. Its conditions, the definition of control it borrows from IRC § 368(c), and the boot rule in subsection (b) are all as they have stood for decades.

The anti-duplication rule in IRC § 362(e)(2) is the meaningful addition, enacted in 2004. Before it, a transferor could contribute property with a built-in loss to a controlled corporation and the loss would exist in two places at once — inside the corporation on its transferred basis, and outside it in the shareholder’s substituted stock basis — so it could be recognised twice by selling first the property and then the stock. The cap closed that, and the accompanying election to reduce stock basis instead gives the parties a choice about where the single remaining loss sits. Material written before 2005 describes a symmetrical carryover basis rule with no cap, which for a net built-in loss is no longer right.

The IRC § 351(e) exception for transfers to an investment company has the same purpose as its partnership counterpart in IRC § 721(b) and has been in place throughout: a group of holders of different securities cannot achieve diversification tax-free by dropping them into a common corporation.

Exam focus

The control question is the reliable one. Compute the property transferors’ holding immediately after the exchange, exclude any shares issued for services, and test it against both limbs of IRC § 368(c). Questions often set the figure at seventy-five or seventy-nine percent and offer nonrecognition as a distractor.

The second reliable shape gives boot and asks for gain and basis. Gain is the lesser of realised gain and boot. Stock basis is old basis, less money and other property received, plus gain recognised. Corporate basis is old basis plus gain recognised. Working the three together is where the marks are.

Where a question mentions a service provider, check whether their shares are needed to reach control before treating the transaction as qualifying — and remember they have compensation income regardless.

Check yourself

1. Two people transfer property to a new corporation and receive 78 percent of its single class of voting stock; the remaining 22 percent goes to a third person for services. Does IRC § 351(a) apply?

Answer: no. IRC § 351(d)(1) provides that stock issued for services is not considered issued in return for property, so the service provider’s shares are outside the control group. The property transferors hold 78 percent, below the 80 percent required by IRC § 368(c), and both property transferors recognise their realised gain in full.

2. A group receives all of a corporation’s voting common but none of its outstanding non-voting preferred. Is the control test satisfied?

Answer: no. IRC § 368(c) requires at least 80 percent of the total combined voting power of all classes entitled to vote and at least 80 percent of the total number of shares of all other classes. The first limb is met and the second is not, and both are required. The second limb is measured in shares rather than by value.

3. A transferor with property worth $500,000 and a basis of $180,000 receives stock worth $440,000 and $60,000 of cash in a qualifying exchange. What gain is recognised, and what is the stock basis?

Answer: $60,000 of gain, and a stock basis of $180,000. Under IRC § 351(b)(1) gain is recognised but not in excess of the money received, and the realised gain of $320,000 exceeds it. Under IRC § 358(a)(1) the stock basis is the $180,000 old basis, decreased by the $60,000 of money received and increased by the $60,000 of gain recognised.

4. On the same facts, what is the corporation’s basis in the property?

Answer: $240,000. IRC § 362(a) gives the corporation the transferor’s basis, increased by the gain recognised to the transferor on the transfer — $180,000 plus $60,000. The corporation recognises nothing on issuing its own stock under IRC § 1032.

5. A transferor contributes assets with an aggregate basis of $900,000 and an aggregate fair market value of $600,000 to a controlled corporation. What basis does the corporation take?

Answer: $600,000. Under IRC § 362(e)(2)(A) the transferee’s aggregate adjusted bases in property transferred in a IRC § 351 transaction may not exceed its fair market value immediately after the transaction, and the $300,000 reduction is allocated among the properties in proportion to their built-in losses. The alternative is an election to reduce the transferor’s stock basis instead.