Contributions of Property, Stock-for-Property Exchanges

23.1 Contributions of Property, Stock-for-Property Exchanges

Contributing property to a corporation in exchange for company stock can open up significant tax benefits under Internal Revenue Code (IRC) Section 351. This tax benefit generally allows shareholders to defer gain (or in some cases, loss) when transferring assets such as cash, equipment, real estate, or intangible property into a corporation in return for its shares, provided that certain statutory requirements are met. This often proves advantageous when forming a new corporation or capitalizing an existing one.

Understanding the rules that govern contributions of property and stock-for-property exchanges is critical to structuring business formations and expansions efficiently. Below, we delve into the essentials of Section 351, the requirement for shareholders to maintain control, and the nuances surrounding the receipt of additional consideration, known as “boot.”

Introduction to Section 351 Basics

Under Section 351 of the IRC, no gain or loss is recognized (i.e., it is deferred) by a shareholder or the corporation when the following main conditions are satisfied: • One or more persons (including individuals, trusts, estates, or other entities) transfer property to a corporation.
• Immediately after the exchange, the transferors (collectively) control at least 80% of the corporation’s voting power and at least 80% of each class of nonvoting shares.
• The exchange is solely for stock in the corporation (not including stock warrants or debt instruments).

The fundamental policy rationale behind this deferral is that the taxpayer’s economic position has not substantially changed. They originally owned the property contributed and now own essentially the same value in stock form—just in a different structure.

Types of Property That Qualify

The property contributed under Section 351 may take many forms, including: • Real property (e.g., land, buildings).
• Tangible personal property (e.g., machinery, equipment).
• Intangible property (e.g., intellectual property, patents, trademarks, goodwill).
• Cash.

However, services rendered, unperformed future services, or intangible self-created assets (e.g., immediate recognition intangible associated with one’s labor rather than a capital asset) are not considered “property” for Section 351 purposes. A person who contributes services instead of property typically recognizes ordinary compensation (and the corporation might be permitted a compensation deduction) but does not qualify for nonrecognition of gain or loss under Section 351.

Corporate Control Requirements

The control requirement—often referred to as the “80% rule”—is a crucial aspect of Section 351. Immediately following the exchange, the persons contributing property must collectively own: • At least 80% of the total combined voting power of all voting stock.
• At least 80% of the total number of shares of each class of nonvoting stock (if any).

If multiple individuals or entities transfer property to the corporation, they must make their contributions in close coordination (often referred to as being “part of the same transaction”). For instance, if two shareholders transfer property at different times and are not acting in concert, each transfer might fail to qualify for nonrecognition if the 80% threshold is not separately met after each transfer.

The control test can be deceptively complex, especially when certain types of shareholders (like partnerships or foreign entity structures) are involved. Additionally, a shareholder who contributes only nominal property relative to the total shares received (for example, a pinch of intangible property worth $1 in exchange for 50% of the stock) can come under scrutiny by the IRS, which may argue that such a nominal contribution is disqualified from Section 351 treatment.

Boot Considerations

“Boot” refers to any non-stock property or form of consideration a shareholder receives in addition to the corporation’s stock. Common examples of boot include cash, debt securities, or the corporation’s assumption of liabilities in excess of the contributed property’s basis. Receipt of boot creates a partial realization event, causing a shareholder to recognize gain (but not loss) to the extent of the lesser of: • The amount of boot received, or
• The realized gain on the property contributed.

Once boot is present, the transaction is partially taxable and can significantly complicate basis calculations. The basis of any stock received is generally reduced by the value of the boot received (less any recognized gain). Meanwhile, the corporation’s basis in the contributed property is increased by any gain recognized by the transferor.

Common Boot Scenarios

• Cash Boot: If a transferring shareholder receives $10,000 cash plus stock for contributed land with a fair market value (FMV) of $100,000 and a basis of $50,000, some portion of gain will be recognized immediately.
• Assumption of Liabilities: If the corporation assumes a mortgage or other liabilities on contributed property, these assumed liabilities reduce the shareholder’s stock basis. If liabilities assumed by the corporation exceed the shareholder’s basis, the difference may trigger gain recognition.
• Other Consideration: The corporation might issue short-term notes or distribute personal-use assets or intangible rights as part of the exchange. Each element of the transaction must be weighed to confirm whether it qualifies as stock or if it constitutes boot.

Basis Adjustments for Shareholders and the Corporation

Following a Section 351 transaction, basis becomes critical for both the shareholders and the corporation:

Shareholder’s New Stock Basis
The shareholder’s stock basis starts with the basis of the property contributed.
• Subtract any boot received.
• Add any gain recognized.
• Subtract liabilities transferred to the corporation if the liabilities exceed the basis.

Corporation’s Basis in Assets
The corporation’s basis in each contributed asset equals the shareholder’s adjusted basis in that property right before the exchange, plus any gain recognized by the contributing shareholder.

These rules aim to preserve the original basis for tax purposes. Absent the deferral, a shareholder would otherwise be taxed or the corporation might “step up” the asset’s basis to fair market value, which would affect depreciation and future gain or loss calculations.

Practical Illustrations

Below is a simplified example of a Section 351 exchange involving real property and cash as boot.

Suppose Shareholder A contributes real estate with a $60,000 basis and $100,000 FMV to a newly formed corporation. In return, A receives 80% of the corporation’s common stock (FMV $90,000) plus $10,000 cash (boot).
• Realized gain = $40,000 ($100,000 FMV – $60,000 basis).
• Boot received = $10,000.
• Recognized gain = $10,000 (equal to the lesser of the realized gain or the amount of boot).
• Shareholder A’s stock basis = property basis ($60,000) – boot received ($10,000) + recognized gain ($10,000) = $60,000.
• Corporation’s basis in the real estate = $60,000 + $10,000 recognized gain = $70,000.

Diagram: Section 351 Flow of Property and Stock

    flowchart LR
	    A["Shareholder <br/> (Contributing Property)"] -- "Property" --> B["Corporation"]
	    B["Corporation"] -- "Stock" --> A["Shareholder <br/> Receives Stock"]
	    B["Corporation"] -- "Possible Boot (e.g., Cash)" --> A["Shareholder <br/> May Recognize Gain"]

In this diagram, the shareholder contributes property (which may include real estate, equipment, or intangible assets) to the corporation. In exchange, the shareholder receives newly issued stock. If boot (such as cash or excess liability assumption) is involved, the shareholder may recognize partial gain.

Control and Services Issues

A common pitfall: an individual who attempts to include “services rendered” to achieve the 80% control threshold. Services are not considered property for Section 351. This can present complexities if someone is contributing intangible property plus some measure of personal services to the corporation. The portion attributed to services does not help satisfy the control test.

A special twist arises when multiple individuals form a corporation:
• Party A contributes $100,000 in cash (clearly property) for 50% of the shares.
• Party B contributes services worth $100,000 (not considered property) for the other 50%.

Because Party B is not contributing property, the corporation does not meet the “property-for-stock” requirement for deferral on A’s contribution. Thus, A would not qualify for Section 351 nonrecognition unless B’s services are excluded from the control test or B also contributes a meaningful amount of property.

Liability in Excess of Basis

Another challenge is where the corporation assumes liabilities that exceed the shareholder’s basis in the contributed property. Under general principles, nonrecourse debt assigned to the corporation can create immediate gain recognition if the debt surpasses the basis in the property transferred. This scenario arises in real estate transactions where the land or building is heavily mortgaged but its basis to the shareholder is low.

Best Practices for Structuring Contributions

• Carefully coordinate multi-contributor transactions so that all property contributions occur as part of a single, integrated plan, ensuring that the control requirement is collectively met.
• Avoid or minimize boot to maximize deferral. If boot is necessary (e.g., for working capital or partial liquidity), structure it so that gain is minimized.
• Document property values meticulously and obtain valuations that support the FMV. This is especially important for intangible property to avoid IRS scrutiny.
• Consider the impact on the corporation’s tax basis, which can affect depreciation, amortization, and future gain or loss.
• Address any state and local tax implications, especially if the property is located in a jurisdiction with different recognition rules.

Common Pitfalls

• Failing the 80% control requirement by distributing shares to persons who did not contribute property or by splitting contributions across disjointed transactions.
• Overlooking the immediate gain recognized if liabilities exceed basis.
• Improperly treating services as “property,” which can invalidate nonrecognition for all contributors involved in the same transaction.
• Neglecting basis calculations post-transaction, leading to errors in subsequent sales, liquidations, or distributions.
• Incorrectly categorizing or recording intangible assets, which can raise IRS questions about valuation or eligibility.

Interplay with Subsequent Corporate Transactions

The corporation and its shareholders must be mindful of how these basis decisions will affect future events, such as distributions, partnerships, partial liquidations, or the eventual sale of the corporation. In some instances, planning with Section 351 merges seamlessly with the strategies for corporate liquidations (explored further in the next subsection, “Corporate Liquidations vs. Sales of Shares”).

Taxpayers also frequently compare Section 351 to analogous rules for partnerships (Section 721) and S corporations. While the fundamental principle of nonrecognition is similar, the specific rules and control thresholds vary by entity type.

Conclusion

A properly executed Section 351 transaction can be a powerful planning tool, allowing taxpayers to bolster a corporation’s capitalization without triggering immediate taxes on the contributed property’s built-in gain. To harness these benefits sustainably, practitioners and examinees should remain vigilant about the details governing corporate control and boot. Thorough documentation of the fair market values, basis, and the structure of each component of the transaction is paramount.

By mastering the principles of Section 351 transactions, you will be well equipped to assist clients or employers in optimizing the formation or expansion of a corporation. Appropriately navigating boot implications, ensuring the 80% control benchmark, and accounting for basis adjustments lay the cornerstone for tax-efficient business structuring.

Test Your Knowledge of Section 351: Corporate Control and Boot

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