To qualify for a Section 351 tax-free exchange, you need three things to line up at once: you transfer property to a corporation, you receive that corporation’s stock in return, and you (together with anyone else contributing property as part of the same plan) own at least 80 percent of the corporation immediately after the exchange.1Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor Miss any one of the three and the transfer becomes a taxable sale, with gain or loss measured by the difference between the fair market value of what you gave up and your basis in it. Get all three right and any built-in gain rides along with your stock, deferred until you sell.
The rules apply equally to C corporations and S corporations. There’s no special S corporation override for formation transactions.
The Three Requirements in Detail
You Must Transfer Property
Property is read broadly. Cash, equipment, inventory, real estate, patents, trademarks, and trade secrets all count. Accounts receivable from an active business generally count too, though the IRS has applied assignment-of-income principles to receivables transferred with a tax avoidance motive, especially when the corporation isn’t running an active business.
The underlying idea is that property must carry a tax basis that can roll over into the stock you receive. Three things routinely fail that test, and stock issued for them can’t count toward the 80 percent calculation:1Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor
- Services performed for the corporation. The fair market value of stock received for work (consulting, management, software development) is ordinary income to the recipient in the year received.
- Unsecured indebtedness of the corporation that isn’t evidenced by a security.
- Interest on corporate debt that accrued during or after the transferor’s holding period.
A founder who contributes both property and services can’t blend the two. The service portion is taxable ordinary income. Only the property portion qualifies for nonrecognition.
You Must Receive Stock
Since 1989, the statute covers stock only, not securities. If you receive a corporate note, bond, or other debt instrument along with your stock, the debt piece is treated as boot (see below). Nonqualified preferred stock is also treated as boot rather than qualifying stock. Preferred stock falls into that category when the holder can require the issuer to redeem it or when the dividend rate can fluctuate with market rates.
You Must Have 80 Percent Control Immediately After
Control means owning at least 80 percent of the total combined voting power of all classes of voting stock, and at least 80 percent of the total shares of every other class of stock outstanding.2Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations Both prongs have to be met.
Multiple contributors can pool their transfers to reach the threshold, which is how co-founders typically form a corporation together. Each contributes something different, and together they cross 80 percent. Only people transferring property count in the group, though. A co-founder receiving stock purely for services doesn’t help you meet the test, even if that person is central to the business.
The phrase “immediately after the exchange” is where deals go wrong. If a transferor has already agreed to sell or gift shares as part of the same overall plan, the IRS can apply the step transaction doctrine and collapse the moves into a single transaction. If the prearranged disposition drops the group below 80 percent, the entire exchange loses its tax-free status. This most often surfaces when an investor contributes assets and simultaneously sells a block of the received stock to an outside buyer.
Boot: Receiving Cash or Other Property Alongside Stock
You don’t have to receive only stock. But anything else you receive is called boot, and boot forces gain recognition up to the lesser of your built-in gain or the amount of boot received.1Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor The presence of boot doesn’t blow up the whole exchange; it just makes part of your gain taxable now.
You can never recognize a loss in a Section 351 exchange, even if you received boot on property that had declined in value.
When the Corporation Assumes a Liability
Transferring an asset with a mortgage or other liability attached is common, and normally the corporation’s assumption of that debt is not treated as boot.3Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability Two situations change that.
First, if the total liabilities the corporation takes on exceed the total adjusted basis of all property you transfer, the excess is taxable gain. Contribute a building with a $200,000 basis and a $350,000 mortgage, and you recognize $150,000 of gain. Liabilities that would produce a deduction when paid (trade payables of a cash-basis business, for example) are excluded from the excess calculation.
Second, if the principal purpose of the assumption was to avoid federal income tax, or if there was no genuine business reason for it, the entire assumed liability is treated as cash received. The burden is on the taxpayer to show a legitimate purpose by a clear preponderance of the evidence, and the rule reaches the full liability rather than just a suspicious portion.
What Happens to Basis and Holding Period
The deferral is built into the basis rules. Your basis in the stock you receive equals your basis in the property you gave up, decreased by any money or fair market value of boot received, and increased by any gain you recognized.4Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees A liability the corporation assumes is treated as money received for basis purposes, which reduces your stock basis further.
A short example: you transfer equipment with a $60,000 basis and a $50,000 loan the corporation assumes. No boot, no recognized gain. Your stock basis is $10,000. When you eventually sell the stock, that lower basis pulls the deferred gain back into your return.
The corporation, for its part, takes a carryover basis in the property, equal to your basis increased by any gain you recognized.5Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations It uses that figure for depreciation and for gain or loss when it sells.
Your holding period tacks. If the property you contributed was a capital asset or Section 1231 property (business real estate or depreciable business equipment held more than a year), your holding period in that property carries over to the stock.6Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property Held it three years before contributing? The stock is already long-term the day you receive it. Tacking doesn’t apply to inventory or other non-capital property; there, your stock holding period starts on the exchange date.
Transfers Section 351 Doesn’t Cover
Even when the mechanical requirements are met, Section 351 does not protect a transfer of property to a corporation that qualifies as an “investment company.” The statute defines that category broadly, reaching entities whose assets consist primarily of stocks, securities, cash, foreign currency, derivatives, precious metals, and interests in REITs, mutual funds, or partnerships.1Office of the Law Revision Counsel. 26 USC 351 – Transfer to Corporation Controlled by Transferor The purpose is to stop taxpayers from pooling diversified portfolios into a corporation and achieving diversification without recognizing gain.
Occasionally taxpayers deliberately want the exchange to be taxable, usually to give the corporation a stepped-up basis in appreciated property when the transferor has losses to absorb the gain. The usual method is to issue enough stock to non-contributing parties that the property transferors fall below 80 percent, “busting” the 351.
What You Have to File
Both the corporation and each “significant transferor” must attach a disclosure statement to the federal income tax return for the year of the exchange.7eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed The statement lists the corporation’s name and employer identification number, the dates of the transfer, and the fair market value and adjusted basis of all property transferred. Any liabilities assumed, cash received, or other boot must be itemized separately.
Who counts as a significant transferor depends on whether the stock is publicly traded. For publicly traded stock, the threshold is 5 percent of the corporation’s total outstanding stock by vote or value. For stock that isn’t publicly traded, it’s just 1 percent. In most closely held corporations formed under Section 351, every transferor will clear that 1 percent line and need to file.
The statement is due with the return, including any extensions. Taxpayers must also keep permanent records of the amounts, basis, and fair market value of everything transferred, plus details of any liabilities assumed or extinguished. Getting those numbers down at closing is far easier than reconstructing them years later, when the stock is finally sold and the deferred gain comes due.