Section 351 Tax-Free Conversion: Control Test, Boot, and Basis

A Section 351 tax-free conversion lets you move property into a corporation in exchange for its stock without paying tax on the built-in gain at the time of transfer. The tax isn’t erased. It’s deferred until you sell the stock, or until the corporation sells the property. To qualify, the people contributing property must together own at least 80% of the corporation immediately after the exchange, and the rules on boot, assumed liabilities, and reporting all have to be followed.

What You Can Transfer, and What Doesn’t Count

The definition of “property” under Section 351 is broad. Cash, real estate, equipment, inventory, patents, trademarks, copyrights, and goodwill all qualify. If you can transfer ownership of it, it almost certainly counts.

Three things are explicitly excluded. Stock issued for services is not a Section 351 exchange. Neither is stock issued for unsecured debt the corporation itself owes you, or stock issued for interest that accrued on corporate debt during your holding period. If you receive stock for any of these, the fair market value of that stock is ordinary income in the year you receive it, taxed at rates from 10% to 37% for 2026.¹

The services exclusion catches founders most often. If you contribute both equipment and labor, the stock has to be split between the two, and the labor portion is taxable right away. Warrants, stock rights, and options don’t qualify as “stock” for these purposes either. If you receive warrants instead of shares, they count as boot.

The 80% Control Test

A Section 351 exchange works only if the transferors as a group control the corporation immediately after the transfer. Control has a specific meaning under Section 368(c): at least 80% of the total combined voting power of all voting stock, and at least 80% of the total shares of every other class of stock.²

The measurement is collective. If three partners each contribute property and together hold 80% or more of the stock right after the exchange, the test is met even if one contributed far less than the others. Every person who contributes property as part of the same coordinated plan counts toward the group total.

“Immediately after” doesn’t mean you have to hold the shares indefinitely, but the ownership has to be genuine, with no pre-existing obligation to sell. If a transferor has already agreed to sell shares to an outside buyer before the exchange closes, the IRS can disregard those shares when calculating the 80% threshold. A prearranged sale can knock the entire group below the line.¹

Falling below 80% converts the whole transaction into a taxable sale. Every transferor recognizes gain equal to the difference between the fair market value of the stock received and the adjusted basis of the property transferred. There is no partial credit for coming close.

When You Still Owe Tax: Boot and Assumed Liabilities

Even a qualifying exchange can produce taxable gain in two situations. The first is receiving something other than stock. The second is having the corporation take over your debts in certain ways.

Boot

Anything you receive besides stock is “boot.” Cash is the most common form. Promissory notes, debt instruments, and other non-stock property also count. Boot doesn’t blow up the exchange. You recognize gain equal to the lesser of the boot received or the total built-in gain in the property you transferred.¹

Boot can trigger gain, but never loss. Even if the property you transferred was worth less than your basis, receiving boot doesn’t let you deduct the difference.

A quick example. You transfer equipment with a $50,000 basis and a $120,000 fair market value. You receive stock worth $100,000 plus $20,000 in cash. Your realized gain is $70,000, and the boot is $20,000. You recognize $20,000 of gain, the lesser of the two. The remaining $50,000 stays deferred.

Assumed Liabilities

Corporations usually take over existing debts as part of the exchange, such as a mortgage on a building or an equipment loan. The general rule is that liability assumptions are not boot and don’t trigger gain.³ Two exceptions can undo that.

First, if the total liabilities the corporation assumes exceed the combined adjusted basis of the property you transfer, the excess is taxable gain. Transfer property with a $200,000 aggregate basis and $250,000 of assumed liabilities, and $50,000 is gain. This comes up more often than expected with heavily leveraged real estate and equipment.

Second, if the IRS decides the principal purpose of an assumption was to avoid federal income tax, or that the assumption lacked a genuine business purpose, every assumed liability is recharacterized as cash boot, not just the problematic one.³ The taxpayer carries the burden of showing a legitimate business reason for each debt transferred.

Your Basis in the Stock, and the Corporation’s Basis in the Property

The deferred tax lives in the basis figures. Getting them wrong means paying too much or too little later.

Under Section 358, your starting basis in the new stock equals the adjusted basis of the property you transferred, decreased by boot received and any loss recognized, and increased by any gain recognized.⁴ Assumed liabilities are treated as money received for this calculation, which further reduces stock basis.

Using the equipment example above: $50,000 original basis, minus $20,000 cash received, plus $20,000 gain recognized, equals a $50,000 stock basis. When you eventually sell the stock, the remaining $50,000 of built-in gain is taxed then.

Under Section 362(a), the corporation takes a carryover basis in the transferred property, meaning it inherits the transferor’s basis, increased by any gain the transferor recognized. That figure drives depreciation inside the corporation and gain or loss if the corporation later sells the asset. When transferred property has a built-in loss, a separate rule caps the corporation’s aggregate basis at the aggregate fair market value to prevent the loss from being duplicated at both the shareholder and corporate levels.⁵

Holding Period Carries Over

Under Section 1223, because your stock basis is determined by reference to the basis of the property you transferred, the holding period of the stock includes the time you held that property, as long as it was a capital asset or qualified business property at the time of the exchange.⁶ This is called tacking. If you held the property two years before incorporating and sell the stock a year later, your holding period is three years for capital gains purposes.

What You File

Both the transferor and the corporation must attach a statement to their income tax returns for the year of the exchange. Individual transferors attach it to Form 1040 (or the applicable entity return). The corporation attaches it to Form 1120.⁷ Each statement references Treasury Regulation Section 1.351-3 and describes what was transferred and received.

The information to compile:

Adjusted basis of each transferred asset (original cost, plus improvements, minus depreciation).
Fair market value of each asset at the time of transfer, supported by appraisals or market data.
The amount and type of each liability the corporation assumed.
Number of shares received, class of stock, and fair market value.
Any boot received, including cash, notes, or other non-stock property, and its fair market value.

Treasury Regulation Section 1.351-3 also requires permanent records of these figures, not just for the year of filing. The IRS can request them in any later examination. The reporting obligation applies to any “significant transferor,” which for non-publicly traded stock (the usual case for small business incorporations) means owning at least 1% of the corporation. For publicly traded stock the threshold is 5%.⁸ The corporation files regardless of how many transferors are involved.

Situations That Can Disqualify the Exchange

Section 351 is generous in concept and unforgiving in execution. A handful of situations turn what was meant to be a tax-free incorporation into a fully taxable event.

Prearranged Sales of Stock

If a transferor has already committed to sell shares to an outside buyer before or at the same time as the exchange, the IRS may treat those shares as never held by the transferor. That drops the group’s post-exchange ownership and can push it below 80%. The IRS has consistently treated transactions with prearranged sales as failing the control test.

Transfers to Investment Companies

Section 351(e) denies tax-free treatment when the transfer results in diversification of the transferors’ investment interests and the corporation qualifies as an investment company. That test is met when more than 80% of the corporation’s assets (excluding cash and non-convertible debt) are readily marketable stocks, securities, or interests in vehicles like regulated investment companies or REITs.¹ The rule blocks using Section 351 to pool and diversify investment portfolios tax-free.

Assignment of Income

Transferring accounts receivable for services already performed can trigger the assignment of income doctrine. If the IRS decides the receivable represents earned but untaxed income and the transfer was motivated by tax avoidance, the transferor may have to recognize that income anyway. This is a particular risk when a cash-basis sole proprietor incorporates and moves unbilled receivables into the new corporation without a clear operating reason.

No Business Purpose

Section 351 doesn’t explicitly require a business purpose, but the IRS and courts have disregarded transactions that lack economic substance. A transfer that is transitory and without substance can be recharacterized as something Section 351 doesn’t cover. A genuine operational reason for incorporating, such as liability protection, access to capital, or succession planning, supports the position that the exchange qualifies.

1
Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor
2
GovInfo. 26 U.S. Code 368(c) – Control Defined
3
Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability
4
Office of the Law Revision Counsel. 26 U.S. Code 358 – Basis to Distributees
5
Office of the Law Revision Counsel. 26 U.S. Code 362 – Basis to Corporations
6
Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property
7
Internal Revenue Service. Instructions for Form 1120
8
eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed