Section 351 of the Internal Revenue Code facilitates the growth of corporations. While those who own assets that come with built-in gain might wish to transfer their property into a new corporation in exchange for stock in the company, this provision permits them to do that. Although transferring property into a corporation can often result in a taxable event, Section 351 allows for the deferment of taxes on any gains or losses until the shares of stock are sold. A section 351 transfer is a complicated process, our New York business attorneys will help navigate you through the process.
What is Section 351?
Section 351 is a straightforward way for an individual to transfer property into a corporation under the Internal Revenue Code without recognizing a gain or loss. The section specifically provides for tax-free transfers of property to a corporation by one or more people only in exchange for stock in the corporation. For this section, stock can include both common and preferred stock — but stock rights, securities, and non-qualified preferred stock are excluded. Section 351 does not apply to situations involving transfer of property to an investment company.
What is the Criteria for a Section 351 Exchange?
Not all transactions involving property exchanged for stock are eligible for tax deferral treatment. There are three requirements that property owners must satisfy to take advantage of the tax treatment allowable under Section 351. The criteria includes:
- Section 351 only applies to transfers of property — Section 351 is clear regarding what constitutes property. Services may not be provided in exchange for stock. It’s crucial to make sure contributions qualify as property before moving forward with an exchange.
- Stock must be received by the transferor for the property — Section 351 only applies to property transferred in exchange for stock.
- Enough stock must be received to assume a controlling share of the corporation — Under Section 368(c), control as to the ownership of stock is defined as 80% of the total combined voting power of all classes of stock entitled to voting rights and 80% of the total of shares of all other classes of stock of the corporation.
Following a Section 351 transfer, the shareholder’s basis in the stock of the corporation is equal to the basis of all property exchanged — minus the fair market value of any boot received and the loss incurred in the exchange, plus any gain recognized. The corporation’s basis in the property after the transaction equals that of the shareholder’s in the property they contributed, in addition to any gain recognized by the shareholder in the exchange.
Importantly, the term “boot” refers to non-like-kind property that is added to an exchange in order to make the value of the traded goods equal. In a Section 351 transfer, boot can be either cash or property other than the qualified stock of the transferee corporation.
If the fair market value of the property that was transferred into the corporation is less than the basis of the shareholder in the transferred property, the corporation’s basis will equal the fair market value of the stock. But there is an exception to this rule if the corporation and shareholder sign an agreement that the shareholder’s basis will not exceed the stock’s fair market value.
Assumption of Shareholder Debt in the Exchange
Liabilities can be assumed by a corporation in a Section 351 transfer. The provision specifically allows for a corporation to assume shareholder debt associated with the transferred property. The debt the corporation assumes reduces the shareholder’s basis in the property. However, a shareholder’s basis will be treated as a gain to the shareholder if the debt assumed by the corporation is more than the shareholder’s basis in the contributed property.
The benefits of Section 351 can be lost if the shareholder’s primary purpose of the transfer avoided taxes, rather than for a legitimate business reason. Assuming more debt on property before transferring it into the corporation may be considered evidence that there was no valid purpose to transfer the property.
Contact an Experienced New York Business Attorney
Section 351 transfers can be complicated. A knowledgeable business law attorney can help you navigate the process and avoid potential pitfalls. Brinen & Associates is committed to providing skillful representation to shareholders, corporate owners, and entrepreneurs for a wide variety of business and tax-related matters. Call (212) 330-8151 or send us a message to learn how our New York Business attorneys can help.