§351 & §721 Nonrecognition Transactions & Built-In Losses

13.2 §351 & §721 Nonrecognition Transactions & Built-In Losses

Forming a business entity and transferring property can have complex tax implications, especially when assets have built-in gains or losses. Two critical sections of the Internal Revenue Code—§351 (for corporations) and §721 (for partnerships and limited liability companies)—offer tax deferral possibilities when transferring property to business entities. Under either section, if certain criteria are met, neither the contributor nor the newly formed or existing entity recognizes immediate gain or loss. This “nonrecognition” is an integral strategy in tax planning, allowing owners to transfer property without triggering large up-front tax liabilities while continuing to build capital within the entity.

In this chapter, we will explore the purpose, mechanics, and nuances of §§351 and 721, focusing on built-in losses, intangible or intellectual property (IP) assets, and decision-making frameworks to determine whether gain or loss recognition can be deferred.

Importance of Nonrecognition Transactions

Nonrecognition transactions can be extremely valuable for businesses seeking to:

• Transfer appreciated assets (e.g., real property, patents, trademarks, or goodwill) without triggering tax on unrealized gains.
• Consolidate intellectual property (IP) into a single entity for licensing, research and development, or branding strategies.
• Contribute assets that have a built-in loss to a new or existing entity, while ensuring compliance with specific statutory requirements that disallow or minimize the use of losses where certain conditions are not met.
• Facilitate reorganizations, spin-offs, mergers, or acquisitions without creating near-term tax burdens.

Foundational Overview of §§351 and 721

Both §§351 and 721 share a common goal: deferral of gain or loss, provided the transaction meets statutory requirements. However, each section applies to different entity types:

• IRC §351 specifically governs transfers of property to corporations.
• IRC §721 covers contributions of property to partnerships (and limited liability companies treated as partnerships).

In both cases, the primary rationale is that the transferor’s economic position has not substantially changed. Instead of “cashing out,” the contributor receives an ownership interest (stock in a corporation; partnership or LLC units in a partnership). Because the transaction is effectively a continuation of the contributor’s investment, tax recognition is deferred.

Essential Requirements Under §351

Under IRC §351, a taxpayer may form or capitalize a corporation and receive stock in return for property contributions without recognizing gain or loss if:

1. Property Transfer: The contributor(s) must transfer “property” to the corporation. “Property” is broadly defined, encompassing tangible assets (e.g., equipment, buildings) as well as intangible and intellectual property (e.g., patents, copyrights, formulas, processes, and goodwill).
2. Control Test (80% Requirement): Immediately after the exchange, the contributing shareholder(s) as a group must own at least 80% of the total combined voting power of all classes of stock entitled to vote, and at least 80% of the total number of shares of all other classes of stock.
3. Stock for Property: The contributor(s) must receive stock in the corporation in exchange for the property.

If these conditions are satisfied, the exchange does not trigger immediate recognition of gain or loss. Instead, any built-in gain or loss is preserved in the shareholder’s stock basis and in the corporation’s basis in the contributed property.

Built-In Loss Property Special Rules

If the aggregate adjusted basis of contributed property exceeds its fair market value (FMV) (i.e., a net built-in loss), special rules may require a step-down in the basis of the contributed asset(s) or an adjustment to the shareholder’s stock basis. Congress enacted these rules to prevent duplication of losses at both the shareholder and corporate levels.

Essential Requirements Under §721

IRC §721 operates similarly but applies to partnerships (or multi-member LLCs taxed as partnerships). The main requirements are:

1. Property Transfer: The partner transfers “property” (again, broadly defined) to the partnership. Services are excluded from nonrecognition; typically, service contributions lead to compensation recognition by the contributing partner.
2. Exchange for a Partnership Interest: The partner receives a partnership interest, reflecting a right to share in profits and losses, as well as in future distributions.
3. Continuation of Ownership: The partner’s economic situation is viewed as “continuing” through a new ownership structure.

In a §721 transaction, the partnership takes a “carryover basis” in the contributed property, equal to the partner’s adjusted basis in that property. Simultaneously, the contributing partner receives an “outside basis” in the partnership interest that typically equals the basis of the contributed property. Any built-in gain is thus preserved but not recognized at the time of contribution.

Built-In Losses in Partnership Context

Similar to §351 rules, when the contributed property has a built-in loss, the partnership must ensure that this loss is not duplicated, especially if multiple partners are involved. Specific rules may require partnerships to implement remedial allocations or send the built-in loss specifically to the contributing partner, preventing other partners from benefiting disproportionately from that loss.

Special Considerations for Intangible & IP Assets

Intangible or IP assets (e.g., patents, trade secrets, trademarks, brand names, software, customer lists, or goodwill) qualify as “property” for §§351 and 721, assuming they have an ascertainable value and can be owned, transferred, or licensed.

Contributors of IP assets frequently rely on these nonrecognition provisions for strategic and financial planning. Key points:

• Valuation: Intangible property often lacks a clear market price, making valuation more complex. Careful documentation of fair market value is critical to substantiate basis and to ensure future amortization or depreciation is calculated correctly.
• Control Requirement (for §351): If IP contributions come from multiple owners, they must collectively meet the 80% control threshold. If a single IP owner is contributing intangible property to an existing corporation, the requirement may be harder to satisfy unless additional stock is issued to the contributor in a qualifying transaction.
• Exclusivity of Use: Some intangible assets (e.g., software or brand rights) could be licensed, retained, or only partially conveyed to the entity. Partial transfers might compromise the property contribution or complicate basis allocations, possibly affecting the nonrecognition outcome.
• Built-In Loss with Intangibles: If intangible property has declined in value (e.g., a patent that lost commercial viability), the built-in loss rules may reduce or reallocate the basis to prevent duplicative losses.

Decision Trees for Recognizing or Deferring Gain/Loss

Below are decision trees that provide a high-level approach to determining whether gain or loss from contributed property is recognized or deferred. These diagrams focus especially on intangible/IP assets, but they also apply generally to other forms of property.

Decision Tree: §351 Contributions to Corporations

    flowchart TD
	    A((Start)) --> B{Is contributor transferring property?}
	    B -->|No| C(Does not qualify for §351<br>Gain/Loss recognized)
	    B -->|Yes| D{Does contributor and any co-contributors<br>collectively own ≥80% control post-exchange?}
	    D -->|No| E(Does not qualify for §351<br>Gain/Loss recognized)
	    D -->|Yes| F(§351 applies<br>No immediate gain/loss recognition)
	    F --> G{Any built-in loss property?}
	    G -->|No| H(Deferral maintained<br>Carryover basis)
	    G -->|Yes| I{Is there a net built-in loss<br>across all contributed assets?}
	    I -->|No| H(Deferral maintained<br>Carryover basis)
	    I -->|Yes| J(College of basis steps down<br>or reduce stock basis per §362(e)(2))

In this flowchart, intangible/IP assets fit within the “property” category. If all requirements are met, no immediate gain or loss is recognized. If the 80% control test fails or the transfer does not involve property, the transaction generally does not qualify under §351.

Decision Tree: §721 Contributions to Partnerships

    flowchart TD
	    A((Start)) --> B{Is contributor transferring property<br>(not services)?}
	    B -->|No| C(Services: Compensation recognized<br>Not eligible for §721)
	    B -->|Yes| D(§721 applies<br>No gain/loss recognized)
	    D --> E{Does the property<br>have built-in loss?}
	    E -->|No| F(Carryover basis<br>Gain/loss deferred)
	    E -->|Yes| G(Allocate built-in loss<br>to contributing partner<br>per §704(c) rules<br>to avoid duplication)

In the partnership context, intangible or IP assets contributed for a partnership interest typically enjoy the nonrecognition treatment, as represented by the flowchart. However, service contributions fall outside the scope of §721 and often result in immediate income recognition to the service partner.

Built-In Gains and Losses

“Built-in” gain or loss arises when an asset’s fair market value diverges from its adjusted basis at contribution. For example, if a patent with a $50,000 basis has an FMV of $200,000, there is a built-in gain of $150,000.

• Built-In Gain: Under §§351 and 721, the built-in gain is deferred until a later taxable event (e.g., sale of asset by the corporation or partnership, or sale/exchange of the ownership interest).
• Built-In Loss: If the asset’s FMV is below its basis, a built-in loss exists. Both §351 and §721 incorporate rules preventing duplication of this loss. Essentially, the entity and the contributor cannot both realize the same economic loss. Special basis adjustments serve to curtail or eliminate potential duplication.

Example: Built-In Gain in Contributed Patent

Suppose Dr. A has a patent with an adjusted basis of $40,000 and an FMV of $300,000. Dr. A transfers the patent to a newly formed C corporation. Dr. A receives 100% of the corporation’s stock in return, satisfying the 80% control requirement. Under §351:

• No immediate gain recognized.
• Basis of the stock to Dr. A is $40,000 (carryover basis in the patent).
• Corporation’s basis in the patent is also $40,000, preserving the $260,000 built-in gain within the corporation.

Later, if the corporation sells the patent for $300,000, it will recognize the $260,000 gain at that time.

Example: Net Built-In Loss for Multiple Assets

Owner B contributes two assets to a new corporation:
• A trademark with a basis of $50,000 and FMV of $60,000 (built-in gain of $10,000).
• A software license with a basis of $200,000 and FMV of $140,000 (built-in loss of $60,000).

The aggregate basis is $250,000, while the total FMV is $200,000, indicating a net built-in loss of $50,000. Under §362(e)(2), the corporation or the contributor must adjust basis—either reduce the corporation’s basis in one or both assets from $250,000 down to $200,000 or reduce the shareholder’s basis in the stock by $50,000. This ensures that no double-dipping of the $50,000 built-in loss occurs.

Practical Strategies & Best Practices

• Verify Control Threshold: For corporation formations under §351, ensure that the 80% control requirement is meticulously met. If multiple contributors add property, coordinate timing so each contributor transfers assets as part of “one integrated plan.”
• Appraise Intangible Assets: Properly appraise intangible property. A reliable valuation is crucial for confirming whether a built-in gain or loss exists and for establishing basis for future amortization or depreciation.
• Document the Transaction: Detailed legal agreements, valuations, and board minutes (or partnership operating agreements) help demonstrate intent and compliance with IRC requirements. Adequate documentation also reduces IRS challenges.
• Built-In Loss Elections: In cases of net built-in losses, consult with tax advisers to determine the optimal approach to basis adjustments, ensuring compliance with §362(e)(2) or the corresponding partnership rules under §704(c).
• Monitor Future Transactions: Keep track of subsequent transactions involving contributed assets—such as sales, distributions, or dispositions. These events often trigger the recognized gain or loss initially deferred.
• Watch for Services: Avoid mixing property transfers with service contributions if the intention is to enjoy nonrecognition for the property. Services compensation remains taxable and could inadvertently jeopardize a transaction if improperly structured.
• Avoid Step Transactions: The IRS may recharacterize multiple steps as one transaction if the steps are prearranged. This can invalidate the 80% control requirement or alter the nature of the exchange.

Common Pitfalls and Potential Challenges

• Inadvertent Termination of Nonrecognition: A last-minute investor might acquire a portion of the company or partnership interest immediately after formation, reducing the original contributor(s) below the 80% threshold for §351.
• Misclassification of Services: Partners contributing knowledge, “know-how,” or specialized skills must carefully distinguish between intangible property (e.g., a patent) and mere services (e.g., consulting).
• Underestimating Valuation Challenges: IP valuations can be highly subjective. Overvaluation or undervaluation can lead to controversies with the IRS.
• Double Counting Losses: Failing to address net built-in losses can cause duplication or confusion in subsequent years, attracting IRS scrutiny.
• Failure to Track Stock or Partnership Basis: Overlooking adjustments to basis can lead to inaccurate gain or loss computations later, significantly affecting tax liabilities.

Case Study: Software Development Partnership

Two software developers, Alice and Bob, propose forming a partnership (AB, LLC) to develop and commercialize a new app:

• Alice contributes $100,000 cash for a 50% interest.
• Bob contributes an existing software prototype with an adjusted basis of $20,000 and an FMV of $150,000, plus intangible goodwill in the app’s brand name, valued at $50,000, with a basis of $0.

Under §721, Bob does not recognize gain on the $180,000 total FMV of the contributed property ($150,000 for the prototype + $30,000 intangible “built-in” portion, if specifically valued). Bob’s outside basis in the partnership interest is $20,000, the carryover basis from the software prototype (assuming $0 basis in the brand). The partnership takes a $20,000 inside basis in the prototype software and $0 in the goodwill or brand (assuming no cost basis). There is a built-in gain of $180,000 locked into the property. If AB, LLC later sells these intangibles, or they become worthless, the tax consequences will reflect Bob’s built-in gain or potential loss at the time of contribution.

Refining Your Approach: Managing Built-In Losses

Taxpayers who anticipate contributing assets with a net built-in loss can consider:

1. Selling Property Prior to Contribution: Sometimes, it may be more advantageous to sell the property to realize a loss (subject to limitations), rather than contribute it at a reduced basis.
2. Making a Special Basis Shift: If the combined contributions have a net built-in loss, coordinate with the entity to execute basis reduction at the entity or shareholder/partner level to optimize the outcome.
3. Splitting Contributions: Separate intangible assets with built-in gains from those with built-in losses if doing so could meet strategic goals, subject to ensuring compliance with both §351 or §721 requirements (including control for corporations).

References and Further Exploration

• IRS Publication 544: “Sales and Other Dispositions of Assets,” which provides an overview of recognizing gain or loss and references to nonrecognition provisions.
• 26 U.S. Code §351 and 26 U.S. Code §721: Full statutory texts detailing rules and exceptions.
• Treas. Reg. §1.351-1 through §1.351-3 and §1.721-1: For deeper guidance on definitions, elections, and special situations.
• AICPA Tax Section: Offers whitepapers and practical guides on entity formation and nonrecognition transactions.

Conclusion

IRC §§351 and 721 are critical in facilitating tax-deferred formation, capitalization, and reorganization of corporations and partnerships. By understanding how built-in gains and losses are preserved—and potentially restricted—taxpayers can more effectively plan contributions of tangible and intangible property without triggering unwanted immediate gain or loss. Control requirements, basis adjustments, and careful attention to the valuation of IP assets are all crucial to a successful deferral strategy.

Decision trees serve as a useful visual tool to confirm transaction eligibility under §351 or §721 and to highlight how built-in loss considerations may affect basis allocations. Whether contributing real estate, cash, or intangible property, you should always document transactions thoroughly and seek professional advice to ensure compliance and maximize the advantages of tax deferral.

Test Your Knowledge: IRC 351 & 721 Nonrecognition Strategies Quiz

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