26 USC 351: Control Test, Boot, and Liability Assumptions

Under Section 351 of the Internal Revenue Code, a tax-free transfer to a corporation lets you contribute property in exchange for the corporation’s stock without recognizing gain or loss at the time of the transfer. Three conditions have to line up: you transfer property rather than services, you receive stock rather than cash or other consideration, and the people contributing property own at least 80% of the corporation immediately after the exchange. When all three hold, tax on any appreciation in the contributed property is deferred until you later sell the stock.¹

Deferral is not forgiveness. The built-in gain migrates into the basis of the stock you receive and into the corporation’s basis in the property. Miss a detail and the whole transaction can become taxable, so the specifics below matter more than the headline rule.

What Counts as Property

“Property” sweeps in a lot: real estate, equipment, inventory, cash, patents, trademarks, copyrights, and contract rights all qualify. Liquid assets and hard-to-value intangibles both work.

Services do not. Stock issued for past or future work is compensation income to the recipient, taxed at ordinary rates.² The Fifth Circuit confirmed this in United States v. Frazell, holding that stock received for professional services was fully taxable regardless of the transferor’s intent.³ Two other items get the same treatment as services: unsecured debt the receiving corporation already owes you, and interest on that debt that accrued during your holding period.

Personal goodwill is the gray zone. Owners converting a practice or sole proprietorship often want to treat goodwill tied to their reputation and client relationships as property. It can qualify, but only if it is a genuinely transferable asset the corporation can exploit without your ongoing involvement. If the “goodwill” is really a promise that you’ll keep showing up, it collapses back into services and becomes taxable.

The 80% Control Test

Control means at least 80% of the total combined voting power of all voting stock and at least 80% of the total number of shares of every class of nonvoting stock.⁴ Both prongs have to be satisfied at the same moment.

Several people contributing property in the same transaction can pool their ownership to reach the threshold. Only people who actually contribute property and receive stock count. A co-founder who takes stock purely for services is not a transferor of property, so their shares are excluded when you measure whether the property contributors hit 80%.¹

Accommodation Transferors

A common workaround is to have an existing shareholder throw in a small amount of property so a new shareholder’s contribution can clear the 80% line as part of a joint transaction. Treasury regulations shut this down when the existing shareholder’s contribution is “relatively small in value” compared to the stock they already hold and the primary purpose is to help the others qualify. The accommodation contribution is disregarded, and the remaining transferors have to meet the 80% test on their own.⁵

Prearranged Dispositions of Stock

“Immediately after” is more than a snapshot. If a transferor is already bound to sell their stock to a third party at the time of the exchange, the IRS treats the stock as never having been held for control purposes. In Intermountain Lumber Co. v. Commissioner, an incorporator’s binding obligation to sell shares as payments were received meant he had effectively relinquished ownership, the control requirement failed, and the entire transaction lost its tax-deferred status.⁶

The IRS has clarified that a binding commitment to make a nontaxable disposition of the stock (such as a tax-free reorganization) does not necessarily break control, because that kind of follow-on fits the purpose of Section 351. A binding commitment to make a taxable sale, by contrast, destroys it.⁷

Stock, Boot, and Nonqualified Preferred

Full nonrecognition requires that you receive only stock. Voting or nonvoting works, as does common or preferred, with the exception for certain preferred stock covered below. Debt instruments, stock options, and warrants are not stock for this purpose.

Anything else you receive is “boot.” Boot includes cash, non-stock property, and certain debt-like preferred stock. If you receive boot alongside stock, you recognize gain up to the lesser of your realized gain or the value of the boot. Realized gain of $50,000 and $20,000 of cash boot produces $20,000 of recognized gain. Realized gain of $10,000 and the same $20,000 of boot produces $10,000.⁸

Losses are the asymmetric part of the rule. You can never recognize a loss in a Section 351 exchange, even when you receive boot. A loss on contributed property that’s worth less than your basis gets trapped, carried into your stock basis instead of being deducted at the time of the exchange.⁹

Nonqualified Preferred Stock

Preferred stock that behaves too much like debt is reclassified as boot under Section 351(g). Four features flip it into “nonqualified” status:

The holder can require the corporation to redeem the stock.
The corporation is required to redeem the stock on a set schedule.
The corporation has a redemption right that, as of the issue date, is more likely than not to be exercised.
The dividend rate varies with interest rates, commodity prices, or similar benchmarks.

The first three apply only if the redemption right or obligation can be exercised within 20 years of issue and isn’t subject to a remote contingency. Redemption triggered only by death, disability, or mental incompetency of the holder is excepted.¹⁰ Received alongside regular stock, nonqualified preferred is treated as boot and you recognize gain on its fair market value. If nonqualified preferred is all you receive, Section 351 doesn’t apply, and the entire exchange is taxable.

Disproportionate Stock

When multiple contributors receive stock in proportions that don’t match the value of what each put in, the IRS looks past the form. The excess may be recharacterized as a gift, compensation for services, or payment of an obligation, depending on who the parties are to each other.⁵ Section 482 lets the IRS reallocate income among related businesses when the share split doesn’t reflect economic reality.¹¹

When the Corporation Assumes Your Liabilities

Contributing mortgaged property doesn’t by itself blow up the exchange. The corporation’s assumption of debt attached to the property is generally not treated as boot. The trouble starts when the total liabilities assumed exceed the total adjusted basis of all property you contributed. The excess is treated as gain from a sale or exchange.¹²

One carve-out matters in practice. Liabilities whose payment would produce a deduction (trade payables, accrued expenses, and the like) are excluded from the excess-liability calculation. Contribute a building with a $500,000 mortgage and $100,000 of accrued cleanup costs that would be deductible when paid, and only the $500,000 counts against basis.¹³ The exclusion doesn’t apply if the liability already created or increased basis in the property.

Even where liabilities don’t exceed basis, Section 357(b) lets the IRS treat the whole assumed liability as boot if the principal purpose was federal income tax avoidance or there was no legitimate business reason for the assumption. The full liability, not just the excess over basis, is then cash in the transferor’s hands.¹⁴ The taxpayer in Peracchi v. Commissioner tried to sidestep the excess-liability problem by contributing a personal promissory note to add basis; the Ninth Circuit sided with him, holding the note had basis equal to face value, but the case shows how aggressively the IRS attacks transfers where the liabilities look like the real motive.

Basis After the Transfer

Because Section 351 defers rather than erases gain, the basis numbers on both sides of the transaction determine the eventual tax bill.

Your Basis in the Stock

Your basis in the stock you receive starts at the basis you had in the property you contributed. You then decrease it by any cash received, the fair market value of any non-stock property received, and any loss recognized. You increase it by any gain recognized on the exchange and any amount treated as a dividend. Liabilities the corporation assumes are treated as cash received, which reduces your stock basis.¹⁵ Contribute property with a $100,000 basis and a $30,000 mortgage, and your stock basis is $70,000.

The Corporation’s Basis in the Property

The corporation takes a transferred basis, inheriting whatever basis the contributor had. If the contributor recognized gain on the exchange, the corporation’s basis increases by that recognized gain. When the gain arises solely from assumed liabilities under Section 357(c), the resulting basis increase can’t push the corporation’s basis above the property’s fair market value.¹⁶

Built-in Loss Property

If the aggregate basis of property a transferor contributes exceeds the aggregate fair market value, Section 362(e)(2) caps the corporation’s basis at fair market value to prevent the built-in loss from being duplicated at both levels. The reduction is spread across the contributed assets in proportion to each asset’s built-in loss.¹⁷

An election lets the transferor and transferee push the limitation to the shareholder side instead. If both agree, the corporation keeps the full transferred basis, and the shareholder’s basis in the stock is reduced to fair market value. That trade-off makes sense when the corporation plans to use the property and the shareholder plans to hold the stock for the long term.

Holding Period

When you contribute a capital asset or Section 1231 business asset, the holding period of that property tacks onto the holding period of the stock you receive. Three years of ownership before the exchange gives you stock treated as held for three years from day one, which can matter for long-term capital gains treatment on a later sale.¹⁸ Tacking does not apply to contributed inventory or other non-capital property; for those, the stock’s holding period starts fresh on the exchange date.

The Investment Company Trap

Section 351 does not apply to a transfer that effectively diversifies a concentrated portfolio tax-free. A transfer is treated as a transfer to an “investment company” when two things coincide: the transfer results in diversification of the transferors’ interests, and the corporation is a regulated investment company, a REIT, or a corporation holding more than 80% of its assets (excluding cash and nonconvertible debt) in readily marketable stocks, securities, or interests in those entities.⁵

Diversification usually happens when two or more people contribute non-identical assets. A single person moving one stock position into a wholly owned holding company generally does not create diversification. But if the contribution is a step in a broader plan to diversify through a later transaction, the IRS collapses the steps and treats the original transfer as diversifying anyway.

Reporting the Exchange

A qualifying Section 351 exchange generates no tax bill, but it does generate paperwork on both sides.

Each “significant transferor” attaches a statement to their tax return for the year of the exchange. The statement identifies the corporation by name and EIN, gives the dates of the transfers, and reports the fair market value and basis of the contributed property broken into categories: loss importation property, loss duplication property, property on which gain or loss was recognized, and all other property. Any related private letter rulings have to be referenced.¹⁹

The corporation files a parallel statement with its return, naming every significant transferor and reporting the fair market value and basis of what it received using the same categories. If all of that information already appears in transferor statements attached to the same return, the corporation can skip its own filing, which mostly comes up in single-owner formations.¹⁹

Missing a statement doesn’t automatically disqualify the exchange, but it can extend the statute of limitations and attract IRS attention. Getting the disclosures right at filing is cheaper than defending them later.

1
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor
2
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor – Section 351(d)
3
Justia. United States v. Frazell, 335 F.2d 487 (5th Cir. 1964)
4
Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations – Section 368(c)
5
eCFR. 26 CFR 1.351-1 – Transfer to Corporation Controlled by Transferor
6
CaseMine. Intermountain Lumber Co. v. Commissioner
7
Internal Revenue Service. Revenue Ruling 2003-51 – Section 351 Transfer to Corporation Controlled by Transferor
8
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor – Section 351(b)
9
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor – Section 351(b)(2)
10
Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor – Section 351(g)
11
Office of the Law Revision Counsel. 26 USC 482 – Allocation of Income and Deductions Among Taxpayers
12
Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability – Section 357(c)
13
Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability – Section 357(c)(3)
14
Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability – Section 357(b)
15
Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees
16
Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations
17
Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations – Section 362(e)(2)
18
Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property
19
eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed