Often, assets can be contributed to a corporate entity by owners in exchange for an interest in ownership, without the recognition of gains or losses. Both Internal Revenue CodSection 351 and Section 721 of the Internal Revenue Code provide for this general rule. However, Partnerships, Limited Liability Companies, and investment companies should be aware that these provisions both include exceptions to the nonrecognition rules. Without understanding these exceptions, unintended tax consequences can result.      

What is Section 721?

Section 721(a) of the Internal Revenue Code allows for tax-efficient formation for partnerships by deferring the recognition of gains or losses on property contributions. These property contributions could include cash, real estate, intellectual property, or various other assets. Specifically, this provision states that “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”  

Section 721 can be applied to many situations concerning the formation, funding, or restructuring of partnerships, including:

• Ensuring a new partner’s contribution of property in exchange for a partnership interest does not result in a recognized gain or loss 
• Preventing immediate taxation on more contributions after formation of the partnership 
• Helping to make sure when partners contribute their interests to a new or surviving partnership under a merger or consolidation, a taxable event is not triggered
• Allowing for contributions without immediate tax consequences under the formation of a joint venture structured as a partnership
• Contributing property to a partnership in exchange for an interest under a real estate transaction while deferring capital gains on appreciated property 
• Allowing the contribution of intangible assets, such as intellectual property, without immediate taxation

Certain exceptions under Section 721 should be noted. If a contribution is followed by a distribution that would qualify as a property sale, it could be treated as a disguised sale and prompt a taxable event under various other sections of the Internal Revenue Code. Other exceptions where capital gains or losses would be recognized at the time of contribution can include transfers of appreciated property to a partnership with related foreign partners; contributions involving excess liabilities; and contributions of accounts receivable or inventory under certain circumstances.   

What is Section 351? 

Section 351 of the Internal Revenue Code focuses on corporate entities. Section 351 requires that a contributor of property maintain control of the corporation to qualify for tax deferral. Like Section 721, property can include physical or abstract assets under Section 351. Services rendered in exchange for stock are not considered property under this section — in such cases, the value of any stock that has been received in exchange for services is usually taxable as compensation.  

This provision is commonly used by individuals who decide to start a business and wish to avoid immediate tax consequences when assets such as equipment and inventory are transferred into the new corporation in exchange for stock. Section 351 can also allow for tax-deferred restructuring regarding certain corporate reorganizations in which assets are transferred in exchange for stock between related corporations.   

What are the Differences Between Sections 351 and 721?

While both sections deal with tax-deferred exchanges of property, there are several differences between Sections 351 and 721 of the Internal Revenue Code. Section 351 applies to corporations and governs the tax treatment of property contributions in exchange for stock. Section 721 applies to partnerships and Limited Liability Companies taxed as partnerships. Section 721 specifically deals with the tax treatment of property contributions to a partnership in exchange for a partnership interest. 

Unlike Section 721, Section 351 requires a transferor group in control of the company.       

Contact an Experienced New York Tax Attorney

Understanding the Internal Revenue Code and whether Section 351 or 721 applies to your situation can be complicated. It’s essential to have a knowledgeable tax attorney who can best advise you and assist you with making the best decisions for your company. Brinen & Associates provides trusted counsel to business owners and entrepreneurs for a wide array of issues involving tax matters and corporate reorganizing. Call (212) 330-8151 or send us a message to learn more about how we can help.