Section 351 of the Internal Revenue Code lets you move property into a corporation you control and receive stock in return without paying tax on the transfer itself. The gain doesn’t vanish. It’s baked into the basis of the shares you receive, so tax comes due when you sell those shares. Congress built this rule so the tax code wouldn’t discourage people from incorporating a business or contributing more assets to one they already own. The mechanics look simple on the surface, and that’s where people get hurt: several adjacent code sections can turn a supposedly tax-free incorporation into a fully taxable event.
The Three Requirements
Section 351(a) defers gain and loss when three things are true at once: you transfer property to a corporation, you receive stock in that corporation, and immediately after the exchange the transferors as a group control at least 80 percent of the corporation. Miss any one and the IRS treats the whole transaction as a sale at fair market value.
Property is defined broadly. Cash, equipment, inventory, real estate, patents, and other intellectual property all count. Services do not, and neither do a few other items carved out by the code. The stock you receive can be common or preferred, and it can span multiple classes, but it has to be actual equity. Debt instruments, options, and warrants are not stock for this purpose.
How the 80 Percent Control Test Works
Section 368(c) defines control as 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. Both thresholds have to be met. The test looks at the transferors as a group, not individually. A sole founder incorporating a proprietorship clears it alone. Five co-founders clear it together as long as their combined ownership hits both 80 percent tests immediately after the exchange.
“Immediately after” is where deals unravel. If you have a binding agreement to sell some of your new shares to an outside buyer, courts have used the step transaction doctrine to collapse the incorporation and the sale into one event. The transferor group is then treated as never having held the required 80 percent, and every transferor loses tax-free treatment, not just the person who sold. Nontaxable dispositions of the new stock, like gifts or a tax-free reorganization, are treated more leniently because they don’t cut against the continuity-of-investment logic behind Section 351.
Your Basis in the New Stock
Section 351 defers tax; Section 358 explains how. Your basis in the stock you receive equals your basis in the property you transferred, decreased by any money or other property (boot) you received and increased by any gain you recognized on the exchange. In a clean transfer with no boot, your stock basis is simply your old property basis.
Say you contribute equipment with a $40,000 adjusted basis and a $100,000 fair market value. Your stock basis is $40,000. Sell the shares later for $100,000 and you recognize $60,000 of gain then — the same gain a direct sale of the equipment would have produced, just deferred.
The Corporation’s Basis
Section 362(a) gives the corporation a carryover basis: the transferor’s basis, increased by any gain the transferor recognized. Contribute equipment with a $40,000 basis and recognize no gain, and the corporation’s basis in that equipment is $40,000. The corporation uses that figure for depreciation and for gain on any future sale.
Section 362(e) adds a limit. If the transfer produces a net built-in loss — total adjusted basis of transferred property exceeds aggregate fair market value — the corporation’s basis can be pushed down to fair market value. The rule blocks taxpayers from stashing artificial losses inside a corporation by transferring underwater assets.
Boot: When Part of the Exchange Is Taxable
If you receive anything other than stock — cash, notes, other property — that extra consideration is boot. Section 351(b) says you recognize gain up to the amount of boot received, but never loss. Contribute property with a $50,000 basis and a $120,000 fair market value in exchange for stock plus $15,000 cash and you recognize $15,000 of gain, even though your built-in gain was $70,000. The other $55,000 stays deferred in your reduced stock basis.
Nonqualified Preferred Stock
Not every share of preferred stock counts as stock for Section 351 purposes. Section 351(g) treats “nonqualified preferred stock” as boot. Preferred stock is nonqualified if any of the following applies within 20 years of issuance:
- You can force the company or a related party to buy back the stock.
- The company is required to redeem the stock.
- The company has the right to redeem and, as of the issue date, is more likely than not to do so.
- The dividend rate floats with interest rates, commodity prices, or a similar index.
The idea is that preferred stock with these features looks more like debt than equity. If you receive nonqualified preferred stock alongside regular stock, treat it as boot and recognize gain accordingly.
Liabilities the Corporation Assumes
When the corporation takes over your debts as part of the transfer, that assumption is generally not boot. Section 357(a) provides this relief so that owners with mortgaged property or outstanding business loans can incorporate without a tax bill on the debt shift alone. Two exceptions override that treatment, and both come up regularly.
Liabilities Exceeding Basis
Section 357(c) says that if the total liabilities assumed exceed the total adjusted basis of all property transferred, the excess is gain. Transfer property with a $200,000 basis subject to $250,000 in liabilities and you recognize $50,000. One practical fix: contribute more unencumbered property or cash to lift total basis above the liability figure before the transfer.
Liabilities Assumed for Tax Avoidance
Section 357(b) is harsher. If the principal purpose of the assumption was avoiding federal income tax, or there was no genuine business purpose for it, the entire amount of the assumed liabilities is treated as cash received. Not just the excess over basis. All of it. A mortgage that came with the building you’re transferring is almost always fine. A personal credit card balance shifted to the corporation right before incorporation is not.
What Section 351 Doesn’t Cover
Stock Issued for Services
Section 351(d) says stock issued for services is not stock issued for property. That has two consequences. The person receiving those shares reports their fair market value as ordinary compensation. And those shares don’t count toward the 80 percent control test, which can sink the deal for everyone in the group.
There is a workaround for co-founders contributing both services and property. If a person transfers at least some qualifying property along with the services, the shares tied to the property contribution do count toward control. The service shares still produce ordinary income for that person, but they won’t disqualify the group, provided the property piece is more than nominal.
Transfers to Investment Companies
Section 351(e) shuts down tax-free treatment when the transfer is to an “investment company” and the effect is diversification of the transferors’ holdings. Investment company is defined broadly and reaches corporations holding stocks, securities, cash, foreign currency, precious metals, futures contracts, and similar financial assets. Two people with concentrated single-stock portfolios who contribute them to a new corporation, effectively trading single-stock risk for a diversified pool inside a corporate wrapper, will find Section 351 unavailable. The transfer is fully taxable.
Cash-Basis Receivables
Cash-basis owners incorporating a going business often transfer accounts receivable that haven’t been included in income yet. The IRS has generally ruled that the assignment of income doctrine does not override Section 351 in these cases, so long as there’s a valid business purpose and the corporation continues the business. If the arrangement looks like a scheme to shift income to a lower-taxed entity without real substance, the IRS will apply assignment of income principles and require the transferor to pick up the receivables when the corporation collects them.
Depreciable Property and the Ordinary Income Trap
Even with Section 351 doing its job on the transfer, Section 1239 can bite later. Any gain recognized on a sale or exchange of depreciable property between related persons is treated as ordinary income rather than capital gain. You are a related person if you own more than 50 percent of the corporation’s stock, directly or through the constructive ownership rules. Since most Section 351 transferors clear that threshold easily, any gain that does get recognized on depreciable assets — from boot, for instance — will be taxed at ordinary rates.
Reporting and Recordkeeping
Treasury Regulation Section 1.351-3 requires every “significant transferor” to attach a disclosure statement to the federal income tax return for the year of the exchange. You are a significant transferor if, immediately after the exchange, you owned at least 5 percent of the corporation’s stock (by vote or value) for publicly traded stock, or at least 1 percent for stock that isn’t publicly traded. The corporation files its own parallel disclosure.
The statement has to describe the property transferred, the adjusted basis of each asset, the fair market value of the stock received, and any boot or liabilities involved. For transfers that also qualify as transfers to a foreign corporation under Section 6038B, failure to file draws a penalty equal to 10 percent of the fair market value of the transferred property, capped at $100,000. The cap is removed if the failure was intentional, and in that case the assessment statute of limitations stays open until three years after the IRS finally gets the required information.
Even on a purely domestic transfer, poor records create audit exposure. The IRS can challenge the tax-free treatment years later if you cannot show the 80 percent control test was met, the basis figures were right, and the liability assumptions had a genuine business purpose. Hold those records as long as you hold the stock. For a closely held business, that can be decades.