Sec. 351 Nontaxable Transaction Explanation and Example

Sec. 351 covers nontaxable contributions between the shareholders and the corporation. In order to qualify as a nontaxable event, the transaction must meet the Sec. 351 requirements:

1. Transferred property,
2. transferred property in exchange for stock, and
3. the shareholders contributing property (transferring group) own 80% of the corporation's stock immediately after the exchange.

It is important to note that the Sec. 351 nontaxable contribution rule applies to new corporate formations as well as contributions to existing corporations as long as the three requirements are met.

Lets begin with defining the above terms:

Transferred property

• refers to both tangible and intangible property exchanged for stock
• property does not include services; if the shareholder exchanges services for stock, the shareholder recognizes ordinary income (FMV)

"In exchange for stock"

• anything other than stock is NOT stock; therefore, any property other than stock is called boot, which triggers new rules discussed below

Transferring group

• includes only persons transferring property to the corporation in exchange for stock
• does not include persons transferring services
• special rules apply; please see the special rules section below

"80% control"

• control is defined as the ownership of 80% of total voting rights of voting stock and 80% of total non-voting stock
• the group must be in control immediately after transfer; however, the transfer does NOT have to be simultaneous
• the group may establish control through an integrated transfer plan

Sec. 351 Transfer (without boot) Example

If the Sec. 351 requirements are met, the transfer will result in a nontaxable contribution between the shareholder and the corporation. Please see example below:

Example 1:

Facts: In 2019, Dan, Mike, and Sam contributed property to form a corporation. Dan contributed land (AB = $200,000), Mike contributed equipment (AB = $150,000), and Sam contributed legal services. In exchange, Dan and Mike each received $200,000 of stock, while Sam received $100,000 of stock. What are the tax effects?

First, you must determine if it qualifies as a Sec. 351 transfer.

• Transferring group = Dan, Mike
• Because Sam contributed services, she will not be included in the transfer group
• Therefore, the transferring group controls 80% of the corporation [400 (Dan+Mike)/500]

Sec. 351 requirements met! The transfer will be tax-free. The shareholder basis in the stock equals the AB in the property. For services, the stock AB equals the value of stock received. 

Sec. 351 Transfer with boot Example

Before the example, lets discuss boot and its impact. To refresh, boot is non-stock property. Boot includes cash, warrants, stock rights, etc. If a shareholder receives boot, the shareholder recognizes gain equal to the lesser of:

• Gain realized [(Stock value + FMV boot)-(AB of property contributed)] OR
• FMV of boot received

The shareholder never recognizes loss.

Example 2:

Facts: In a Sec. 351 transfer, Dan transfers property in exchange for $300,000 stock and $50,000 cash. Dan transfers equipment with a FMV of $350,000 and a AB of $150,000. Assuming all the requirements are met for a Sec. 351 transfer, what are the tax effects?

Amount realized = 300,000+50,000 (boot) = 350,000                                            

AB of property transferred = 150,000                                            

Gain realized = 200,000                                            

The lesser of gain realized and FMV of boot is $50,000. The shareholder will have a taxable gain of $50,000 on the transfer.

Additionally, the taxable gain will affect the shareholder's basis in the stock and the corporation's basis in the property.

Shareholder stock basis = FMV stock - deferred gain 

In the situation above, the deferred gain is $150,000. Therefore, the stock basis is $150,000.

Corporation's AB in a Sec. 351 property exchange = Shareholder's AB in property + Gain recognized by the shareholder

In the situation above, the property AB is $150,000, and the gain recognized is $50,000. Therefore, the corporation's AB in the property is $200,000.

Special Rules

Special Rule #1: Transferring both property and services

• If the person transfers both property and services, all the stock applies to the 80% control requirement if the FMV of the property is at least 10% of the service value 
• FMV of property ≥  10 % of service value
• If not, only include the stock attributable to the exchange of property

Special Rule #2: Existing Shareholder transfers

• The transferring group includes existing shareholders if the existing shareholders transfer property with a FMV that is at least 10% of their stock value
• FMV of property ≥ 10% of stock already owned
• If not, do not include the stock value in the transferring group

Special Rule #3: Transfer of liabilities in excess of basis

• If the shareholder transfers property with a liability (i.e. mortgage), the shareholder generally does not recognize a gain. 
• However, if the total liabilities are greater than the total AB, the excess is treated as boot and gain is recognized. 

Final Thoughts

When it comes to a Sec. 351 transfer of property between shareholders and a corporation, it is important to understand the three requirements of Sec. 351 as well as the taxable impact of boot. The Sec. 351 property transfer examples above should help to improve that understanding. As always, please comment any questions or concerns relating to the tax matter. Additionally, please suggest any tax topics you would like explained in the future.