A Section 351 exchange is a way to obtain ownership in a corporation by exchanging property for stock An individual’s ownership in a corporation is represented by stock while delaying tax. Without Section 351, giving property to a corporation and getting something valuable (corporate stock) in return would be treated by the IRS as a sale of the property and would result in recognizing a gain or loss. Section 351 applies to S corporations (S-corps) and C corporations (C-corps).
Key takeaways
- When the rules below are followed, no gain or loss is immediately recognized:
- Rule 1: Property must be transferred for a valid business purpose.
- Rule 2: New shareholders must meet the control test.
- Rule 3: Stock is the only thing that can be received in exchange for the contribution.
- Section 351 is not advantageous when property would be contributed in a loss position.
- Section 351 treatment may be intentionally invalidated by failing the control test or by structuring the property transfer as a sale.
- Intentional sales should be structured so that two reasonable parties would engage in them.
- New basis rules apply when Section 351 criteria are not met.
- A Section 351 transaction is reported by attaching a detailed statement to the tax returns of both the new shareholder and the receiving corporation.
Why Section 351 Is Necessary
When making exchanges with a corporation, if the value of what you get is more than what you give, you generally end up with gain and taxable income. In a Section 351 exchange—which is a useful tool in very ordinary circumstances—the act of contributing property to the corporation would be “tax-deferred” as no gain would be calculated until you get rid of your stock.
Property includes things, such as cash, patents, and uncollected accounts receivables (A/Rs). Each state determines its own processes for transferring property, and contracts or other legal documents may be required to support the transaction.
Imagine you and a group of friends form a business but haven’t picked an entity type. The group starts operations and needs equipment, and you generously offer to purchase equipment out of your own pocket. This equipment costs you $12,000. After an exhaustive internet search, the team decides that it would be best for your business to start a C-corp.
In exchange for stock in this new corporation, you may want to contribute the equipment you bought with your own personal funds. Just as you are ready to contribute it, you discover that everything you purchased can also be used to mine cryptocurrency and is now worth $50,000. In exchange for your equipment that has appreciated in value, you are granted $50,000 in corporate stock.
Now that the value of the stock you received is more than the $12,000 basis Basis for a brand new asset would generally start with what you paid for it and either increase or decrease for specific accounting adjustments. of what you contributed, you would ordinarily have to pay tax on the difference between the $12,000 you put into your purchase and the $50,000 of stock you received.
If certain criteria are met, Section 351 provides an exception to gain recognition and allows you to continue ownership of the company and not pay tax at the time of the contribution.
A typical example of a basis adjustment would be depreciation. This kind of adjustment would apply to assets, such as real estate, equipment, and furniture.
Criteria for Section 351 Tax Deferral
Here are the criteria for meeting the Section 351 exchange definition of eligibility and avoiding tax on corporate contributions.
1. A Property Transfer Must Take Place
As a general rule, when transferring property, the item being transferred should be something that can be retitled—and services do not count as property. Stock received for services gives rise to taxable income to the new shareholder. That taxable income would be equal to the value of the stock.
2. All You Can Get Is Stock
Stock is the only thing that can be received in exchange for the property contributed. Anything additional received by the new shareholder could trigger taxation. For example, if you contribute a patent to the corporation and receive both stock and cash, gain may have to be recognized at the time of the patent contribution.
3. Those Who Contribute Property Must Have Control
The control test requires that whoever contributes property owns “at least 80% of the total combined voting power of all classes of stock” and “at least 80% of the total number of shares of all other classes of stock issued by the corporation.” These percentages must apply immediately after the transfer.
Expert insight
The test isn’t arbitrary. The IRS is in the business of collecting federal revenue, and inserting code sections that specifically exempt tax seems counterintuitive. The IRS allows for this Section 351 exception because maintenance of control shows that the transfer was done for continuity of ownership in the business and not just to avoid tax on selling assets to a business.
For purposes of our example, “ownership” references both voting power and number of shares.
Let’s pretend Anyco, Inc. is currently owned by Jane Doe, Joe Schmoe, and Jillian Jack. Alex Newbie contributes cash in exchange for stock that represents 10% ownership. This transaction would not meet Section 351 criteria and could be taxable because it fails the control test. By only being granted 10% ownership (less than the required 80%), Alex does not have control.
However, if Jillian already had 70% ownership and also contributed property for additional stock shares at the same time Alex contributed property for 10% ownership, the transaction could still be eligible for tax deferral since the combined ownership of the transferors (Jillian and Alex) is 80% after the transfer.
In the scenario above, Jillian would need to contribute property worth at least 10% of the value of her 70% for Alex’s transfer to also meet the Section 351 definition of control.
4. There Is Valid Reason for the Transfer
There must be a valid business purpose for transferring the property. Transactions should be structured with the purpose of conducting commerce and not just squirreling assets away from the IRS. Document your business purpose in case it is ever challenged by the IRS.
Tax Basis for Calculating the Deferred Gain
At some point, you’ll want to sell the stock you obtained from contributing property in the Section 351 exchange. When that time comes, any gain that was deferred when that property was contributed will then need to be recognized.
Gains are generally calculated by subtracting basis Basis for a brand new asset would generally start with what you paid for it and either increase or decrease for specific accounting adjustments. from the payment received in the sale. In its simplest form, when a transfer meets the Section 351 criteria, the basis of your newly acquired stock is the same basis as the property you contributed.
If you contribute property with a basis of $10,000 to the corporation and get 100 shares of stock, your new stock basis would be $10,000. In anticipation of future sale, the corporation will also need to record basis in the assets you contributed. The corporation’s basis in the assets it obtained from you is the same as your stock basis.
If you contributed property with a basis of $10,000 and a value of $15,000, the corporation would record that property on its books with a basis of $10,000. You would also record stock basis of $10,000.
When you sell your stock down the road, it will hopefully have increased in value. An increase in value means more cash in your pocket, but it also increases your potential for taxable gain.
If your appreciated stock is worth $18,000 when you sell it, a basis of $10,000 leaves you with a gain of $8,000. With a basis of $12,000, your gain would be $6,000. Lower basis increases your gain.
Our samples above assume that the value of your property is greater than the basis. If the property that you contribute is worth less than the basis, you and the corporation will have to make a formal election with the IRS regarding the new basis you will each record. One of you will record new basis using the higher number, and the other will record the basis using the lower number.
Here are two options to determine the number each party would record:
- For both parties to formally agree that the corporation would record the received asset basis as the lower number (FMV) and you would record your stock basis as the higher number (the old basis of the asset).
- For both parties to formally agree that the corporation takes the higher number (old basis of the asset) while you take the lower number (FMV).
The IRS wants to rein in how much loss can be taken down the road. By requiring these elections, the transaction is structured so that only one of you would get a future loss.
Anyco, Inc [EIN 00-0000000] certifies that Al [SSN 111-11-1111] makes an election under § 362(e)(2)(C) with respect to a transfer of property described in § 362(e)(2)(A)on January 6, XXXX.
Stock and asset sales often occur long after the original Section 351 contribution. Store your records somewhere you can find them years down the road.
Opting Out of Section 351 Treatment
Opting out of a Section 351 treatment is not possible. Section 351 is mandatory and applies automatically if all four criteria referenced above are met. So, if you don’t want Section 351 to apply, you need to ensure the transaction doesn’t qualify.
Here are two ways to avoid Section 351:
- Fail the control test
- Going back to our sample scenario above, Alex Newbie’s receipt of 10% ownership in exchange for his transfer of property failed the control test—and by extension, eligibility for Section 351 gain exclusion. If Alex received enough stock and voting power to meet the control test but contributed services instead of property in exchange for stock received, that transaction would also fail the criteria for Section 351 gain exclusion.
- Structure the transaction as a sale
- Intentionally structuring the transfer as a sale is another way to avoid Section 351 treatment. Even with a deliberate sale structure, the IRS has sometimes recharacterized the transactions as subject to Section 351 treatment.
Under Section 351 rules, neither gain nor loss related to the exchange can be taken at the time of contribution to the corporation. That’s great news if you are transferring property to a corporation that is worth more than you originally paid for it since gain would be deferred until you sell your stock.
However, Section 351 is not so great when the basis in the asset that you transfer to the corporation is more than what the asset is worth. In that case, if all four Section 351 criteria are met, you would have a loss that you cannot take. This is one reason you may want to avoid a Section 351 application, which would potentially free up gains and losses.
Tax courts have frequently sided with the IRS. Proper documentation will help validate the sale transaction should it come under scrutiny. Examples of useful records would include sale contracts or promissory notes with clear, reasonable terms and corporate memos spelling out details of the sale.
Reporting the Section 351 Transaction
Attach an informational statement to your personal tax return for the year that the transfer took place. In most cases, you will also need to attach a similar statement to the corporate tax return. While the IRS has not issued a specific form for this information, the attached statement must include specific detail, including the items provided below:
- Statement Pursuant to REG 1.351 -3(b)
- Receiving corporation’s name
- Receiving corporation’s taxpayer identification number (TIN)
- Tax year of the transaction
- Name and taxpayer identification number for each transferor
- Asset transfer date
- FMV of property received by the corporation in the exchange
- Basis of property received by the corporation in the exchange
Both you and the corporation should retain records showing the basis and value of the property exchanged. These details should be included in the corporate minutes and used as support for the transaction in the event of IRS inquiry.
Frequently Asked Questions (FAQs)
When you give up property and get something in return, that transaction would ordinarily be treated by the IRS as a sale. A sale could result in reportable income in the year of the contribution. IRS code Section 351 defers the tax until the stock is sold.
When property is contributed to a corporation solely in exchange for 80% of stock and voting rights, generally, a Section 351 transaction is achieved. Only stock can be received for the property contributed and services do not count as property.
A Section 351 transaction is reported by attaching a detailed statement to the tax returns of both the new shareholder and the receiving corporation.
Bottom Line
A section 351 transfer is an exchange of property for stock where tax is deferred until the stock is sold—and this deferral can be useful when the property contributed has appreciated. A more detailed tax strategy may be required when the contributed property has decreased in value. As individual circumstances may vary, you should consult your tax advisor for personalized advice before engaging in the financial transactions referenced here.