Receiving boot in a Section 351 transaction forces you to recognize gain on what would otherwise be a tax-free incorporation exchange, up to the fair market value of the boot you got. Boot is anything the corporation gives you other than its own stock: cash, notes, other property, or nonqualified preferred stock. The gain flows into your stock basis, changes the corporation’s basis in the property it received, and can shift from capital gain to ordinary income depending on what you contributed.
What Counts as Boot
Section 351(b) treats any non-stock consideration as boot. The common forms are cash, promissory notes or other debt instruments issued by the corporation, and property the corporation already owned before the exchange.1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor Under current law, only stock qualifies for nonrecognition; debt securities do not, regardless of maturity.
Nonqualified preferred stock is the trap that surprises transferors who thought they were receiving equity. Section 351(g) treats preferred stock as boot if, within 20 years of issuance, the holder can force the corporation to redeem it, the corporation must redeem it, or the corporation can redeem it and is more likely than not to do so. Preferred stock also counts as nonqualified if its dividend rate floats with interest rates, commodity prices, or similar indices.1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor These features make the instrument behave like debt, so Congress denied it stock treatment.
Assumed liabilities are handled separately under Section 357 and are covered further down. They are not automatically boot, but they can become boot in two specific situations.
The Gain You Recognize: The Lesser-of Rule
Section 351(b) caps recognized gain at the lesser of two amounts: your realized gain on the exchange, or the fair market value of the boot you received.1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor You never pay tax on more than your actual economic profit, and you never pay tax on more than the value you pulled out of the deal.
To find realized gain, add the fair market value of the stock and the fair market value of the boot, then subtract your adjusted basis in the property you transferred. Then compare that number to the boot’s fair market value and use whichever is smaller.
Two examples show how the cap works from different starting points.
High built-in gain. You transfer property with a $10,000 basis and $100,000 fair market value. You receive $50,000 of stock and $50,000 of cash. Realized gain is $90,000. Boot is $50,000. You recognize $50,000. The remaining $40,000 of gain stays deferred inside your stock basis.
Low built-in gain. Same structure, but your property has an $80,000 basis and $100,000 fair market value. Realized gain is only $20,000. Even though you received $50,000 of boot, recognized gain is capped at $20,000, because that is all the profit you actually had.
Losses work differently. If your basis exceeds what you received, Section 351(b)(2) blocks loss recognition even when boot is present.1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor The unrecognized loss stays with you through your stock basis and is available when you sell the stock.
Whether the Gain Is Ordinary or Capital
The character of your recognized gain tracks the character of the property you transferred. Inventory produces ordinary income. Capital assets produce capital gain. For an individual, that difference can be significant because long-term capital gains are taxed at lower rates.
Contributing several assets at once complicates the analysis. The IRS treats the transaction as a series of separate exchanges, one per asset, and requires you to allocate the boot among the assets in proportion to their fair market values. You then apply the lesser-of rule asset by asset. If you transfer $60,000 of inventory and a $40,000 capital asset, 60 percent of the boot is allocated to the inventory and 40 percent to the capital asset, and each piece is computed on its own.2Internal Revenue Service. Chief Counsel Advice 200840036
Depreciable business equipment (Section 1231 property) brings depreciation recapture into the picture. Gain up to the amount of prior depreciation is recharacterized as ordinary income before any capital gain treatment applies.
The Section 1239 Trap
Section 1239 catches many transferors who assumed they would get capital gain rates. When you transfer property to a corporation you control, and the property will be depreciable in the corporation’s hands, any recognized gain is recharacterized as ordinary income regardless of how the asset was treated in your hands. Control for this purpose means owning more than 50 percent of the corporation’s stock value, a lower bar than the 80 percent test used to qualify for Section 351 in the first place.3Office of the Law Revision Counsel. 26 U.S. Code 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers The practical takeaway: if boot triggers gain on equipment, buildings, or similar property you contribute to your own corporation, expect ordinary rates.
How Boot Changes Your Stock Basis
The deferral machinery in Section 351 runs on basis. Any gain you do not recognize now gets embedded in the stock you received, so you pay tax on it later when you sell the stock. Section 358 adjusts the formula when boot is involved.4Office of the Law Revision Counsel. 26 U.S. Code 358 – Basis to Distributees
Start with the adjusted basis of the property you transferred. Subtract the money you received and the fair market value of any other boot. Add back the gain you recognized. That is your basis in the stock.
Say you contribute property with a $50,000 basis and receive stock plus $10,000 of cash, recognizing $10,000 of gain. Stock basis is $50,000 minus $10,000 plus $10,000, which equals $50,000. The add-back for recognized gain prevents you from being taxed on the same $10,000 twice when you eventually sell the stock.
With more deferred gain in the picture, basis drops. Contribute property worth $100,000 with a $30,000 basis, receive $80,000 of stock and $20,000 of cash, and recognized gain is $20,000. Stock basis is $30,000 minus $20,000 plus $20,000, which equals $30,000. The remaining $50,000 of deferred gain lives inside that basis until you sell.
How Boot Changes the Corporation’s Basis
The corporation does not get a fair-market-value step-up. Under Section 362, it takes your adjusted basis in the property and adds the gain you recognized.5Office of the Law Revision Counsel. 26 U.S. Code 362 – Basis to Corporations In the second example above, the corporation’s basis in $100,000 of property is $50,000 (your $30,000 basis plus the $20,000 recognized). The remaining $50,000 of built-in gain rides along with the property and gets recognized when the corporation later sells it.
When Assumed Liabilities Become Boot
Section 357(a) is the general rule: the corporation assuming your debts is not treated as boot.6Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability This is what lets you incorporate mortgaged real estate or a going business with trade payables without an immediate tax bill. Those assumed liabilities do still reduce your stock basis. Two exceptions can convert the assumption into recognized gain.
Tax-Avoidance Purpose
Section 357(b) applies if the principal purpose of the assumption was to avoid federal income tax or if the assumption lacked a bona fide business purpose. When it applies, all assumed liabilities are treated as cash boot, and the burden is on you to show a legitimate business reason.6Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability Borrowing heavily against appreciated property shortly before the transfer is the classic pattern that draws scrutiny.
Liabilities Exceeding Basis
Section 357(c) triggers gain whenever the total assumed liabilities exceed the total adjusted basis of the property you transferred. The excess is treated as gain from a sale or exchange, and it is recognized even if you received no cash or other boot at all.6Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability Transfer property with a $10,000 basis subject to a $15,000 mortgage, and $5,000 is immediately taxable. The gain’s character follows the property transferred, and multi-asset transfers use the same relative-value allocation described above. The rule exists because stock basis cannot go below zero.
An exception in Section 357(c)(3) removes certain deductible liabilities from this calculation, most importantly accrued trade payables for a cash-basis taxpayer, so long as those liabilities did not previously create or increase basis in any property.6Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability
What You Have to File
Treasury Regulation 1.351-3 requires every significant transferor to attach a statement to the tax return for the year of the exchange. The statement identifies the corporation by name and EIN, gives the transfer dates, and reports the fair market value and basis of the property transferred, with separate reporting for property on which gain or loss was recognized and for loss duplication property.7eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed
The corporation files a parallel statement identifying every significant transferor, listing dates, and reporting fair market value and basis of property received, with separate reporting for importation property, loss duplication property, and property that triggered gain or loss. The corporation can skip the filing only if all the required information already appears in the transferor’s statement attached to the same return.7eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed
U.S. persons transferring property to a foreign corporation in a Section 351 exchange must also file Form 926 under Section 6038B.
The stakes for getting the numbers wrong come from Section 6662. Standard accuracy-related penalties run at 20 percent of the underpayment for negligence, disregard of rules, or substantial understatement, and jump to 40 percent for gross valuation misstatements.8Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments Boot-inclusive Section 351 exchanges attract valuation disputes because the gain, its character, and every basis figure depend on the fair market values you assigned. Overstated basis in contributed property, undervalued boot, and misallocated boot across assets with different characters are the recurring problem areas, and contemporaneous independent appraisals are the best defense.