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What is a Section 351(a) Tax-Free Exchange?

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


Generally, transferring property into a corporation in exchange for its stock is a taxable event.

The transaction is treated as if you sold property to the corporation in return for cash.  The difference between the stock value received and the tax basis in the property transferred to the corporation will result in a gain or loss.

Background:

Concern about a tax liability as the result of incorporating your currently unincorporated business could act as a barrier to incorporation.

Consequently, years ago, Congress enacted Section 351 to remove this barrier to incorporation of an unincorporated business.

The idea was to allow unincorporated businesses to develop, unimpeded by any immediate tax consequence resulting from the exchange of property for stock.

In other words, Congress thought that any gain on an exchange of property for stock should be deferred (put off) until a future time, such as when the stock received in the exchange was eventually disposed of by the shareholder.

Note that a loss on an exchange is not deductible if you own, directly or indirectly, more than 50% of the stock.

Exchanging Property for Stock in a Corporation

Whether you're setting up a new corporation with just yourself or other people, such as partners in a partnership, or getting involved in an existing corporation, under IRC Section 351(a) you can defer (put off) any resulting tax consequence.

Under section 351(a):

No gain or loss is recognized (reported) provided:

1 - You receive ONLY STOCK in exchange for your property, and

2 - You are in CONTROL of the corporation immediately after the exchange.

Section 368(c) defines control:

Control means the ownership of stock possessing 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 outstanding shares of all other classes of stock of the corporation.

Transferor group: If you, along with others, transfer property into a corporation, your group is referred to a transferor group.

Qualifying For a Tax-Free Exchange Under Section 351(a)

Two requirements must be met to qualify for tax-free treatment under Section 351(a):

1 - You get ONLY STOCK in exchange for your property; NOT stock PLUS other property.

  • You (or you and your transferor group, for example, partners incorporating the partnership) may ONLY RECEIVE STOCK (other than nonqualified preferred stock) from the corporation in exchange for the property you transfer, and

2 - Control:

  • You (or you and your transferor group) must be in CONTROL of the corporation, immediately after the exchange.
  • Section 368(C) defines control and is covered below.

Nonqualified Preferred Stock: This is stock in which the holder of the stock has the right to require the issuer to redeem or buy it back or the issuer is required to redeem or buy it back. Also, the dividend rate on such stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock see IRC Section 351(g)(2).

General Rule Under Section 351(a)

No gain or loss shall be recognized if -

1 - Property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and

2 - Immediately after the exchange such person or persons are in control of the corporation (as defined in IRC Section 368(c).

Section 368(c)-Control Requirement

The second rule for getting tax-free treatment in an exchange is the extent of your control (or the control of you and others in the transferor group) after the exchange.

What is meant by control?

Section 368(c) defines control:

Control means the ownership of stock possessing 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 outstanding shares of all other classes of stock of the corporation.

The control requirement applies to both tax-free and partially taxable exchanges.

Attach a statement to your tax return. Both the corporation and any person involved in a nontaxable exchange of property for stock must attach to their income tax return a complete statement of all facts pertinent to the exchange.

For more information, see section 1.351-3 of the regulations.

Partially taxable exchanges: Another section under Section 351 applies to partially taxable exchanges. It is Section 351(b).

Valuation of Property and Stock in an Exchange

When you transfer property into a corporation, there are two valuation issues:

1 - The value assigned to the stock you receive from the corporation.

2 - The value assigned to the property being transferred to the corporation.

1) The value assigned to the stock you receive from the corporation:

The basis in the stock you receive (also called-the exchanged basis, carryover basis or transferred basis) is the same as the adjusted basis in the property you transfer.

Example:

  • Your stock basis is also $10,000.

2) The value to assign to the property being transferred to the corporation:

The corporation's basis in the property it receives in an exchange for its stock is the same basis you had in the property when transferred (in other words, the corporation takes your basis).

Example:

  • If your adjusted basis in the property transferred is $10,000.
  • The corporation's basis in the property is also $10,000.

(Data comprised from and See more at http://www.irs.gov/pub/irs-drop/rr-03-51.pdf and http://loopholelewy.com/index.htm)

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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