Section 351 transaction

Table of Contents

• What Is Section 351 Transaction?

• History and Origin

• Key Takeaways

• Formula and Calculation

• Interpreting the Section 351 Transaction

• Hypothetical Example

• Practical Applications

• Limitations and Criticisms

• Section 351 Transaction vs. Section 721 Transaction

• FAQs

What Is Section 351 Transaction?

A Section 351 transaction is a provision in the U.S. Internal Revenue Code (IRC) that allows individuals or entities to transfer property to a corporation without immediately recognizing gain or loss for tax purposes. This provision falls under the broader category of corporate tax planning. The primary objective of a Section 351 transaction is to facilitate the formation of new corporations or the contribution of additional assets to existing ones without triggering an immediate tax event on appreciated assets.⁴⁹, ⁵⁰

For a transaction to qualify under Section 351, specific conditions must be met: property must be transferred to a corporation solely in exchange for the corporation's stock, and immediately after the exchange, the transferor or group of transferors must be in control of the corporation. Control is generally defined as owning at least 80% of the total combined voting power of all classes of voting stock and at least 80% of the total number of shares of all other classes of stock.⁴⁶, ⁴⁷, ⁴⁸ This non-recognition rule is a key element in tax-efficient business structuring.⁴⁴, ⁴⁵

History and Origin

Section 351, or a similar provision, has been a part of U.S. tax law since the Revenue Act of 1921. Its legislative history indicates a policy to avoid imposing a tax when there has been a mere change in the legal form of ownership rather than a substantive change in economic interest.⁴², ⁴³ The intent was to encourage the creation and restructuring of corporations by removing immediate tax barriers that might otherwise arise when entrepreneurs contribute assets to a new business entity in exchange for ownership stakes.⁴¹ This provision acknowledges the "continuity of interest" principle, where the taxpayer's economic interest in the transferred property continues, albeit in a different form (corporate stock instead of direct asset ownership).⁴⁰ Over the years, while minor variations have been made to the code section, its fundamental purpose of facilitating tax-deferred corporate formations has remained consistent.³⁹

Key Takeaways

• A Section 351 transaction allows for the tax-deferred transfer of property to a corporation in exchange for stock.
• The transferor(s) must control the corporation (at least 80% of voting power and 80% of other stock classes) immediately after the exchange.
• The primary benefit is the deferral of capital gains tax on appreciated assets at the time of transfer.
• Services rendered in exchange for stock are generally not considered "property" under Section 351 and are taxable as compensation.
• If "boot" (money or other property in addition to stock) is received, gain may be recognized up to the amount of the boot.

Formula and Calculation

A Section 351 transaction does not involve a specific formula or calculation in the traditional sense, as its primary function is to determine when gain or loss is not recognized rather than to calculate a specific value. However, the recognition of gain when "boot" is involved follows a specific rule.

If Section 351(a) would apply but for the fact that money or other property (known as "boot") is received in addition to stock, then gain is recognized by the recipient, but not in excess of the sum of the money received and the fair market value of the other property received. No loss is recognized in such a scenario.³⁷, ³⁸

The basis of the stock received by the transferor in a Section 351 transaction is generally calculated as:

This adjustment ensures that any deferred gain or loss is preserved in the basis of the stock, to be recognized upon a subsequent taxable event, such as the sale of the stock.³⁶

Interpreting the Section 351 Transaction

Interpreting a Section 351 transaction revolves around understanding its implications for tax liability and the continuity of an investor's economic interest. When a transaction qualifies under Section 351, it signifies that the IRS views the exchange as a mere change in the form of ownership, not a disposition event that would trigger immediate taxation. This is crucial for entrepreneurs and businesses looking to incorporate or reorganize without incurring upfront capital gains tax on appreciated assets.³⁴, ³⁵

The "control" requirement is central to this interpretation. It ensures that the transferors maintain a substantial interest in the corporation after the exchange, reinforcing the idea of continuity rather than a sale.³³ Failure to meet this 80% control threshold, or the inclusion of services rather than property, can result in the transaction being fully taxable, negating the benefits of Section 351.³¹, ³² This provision acts as a facilitator for business formation and expansion by allowing a tax-efficient pooling of resources.³⁰

Hypothetical Example

Sarah owns a successful graphic design business as a sole proprietorship. She has a portfolio of intellectual property, including proprietary software and client contracts, with an adjusted basis of $50,000 but a fair market value (FMV) of $300,000. Sarah decides to incorporate her business to limit her personal liability and attract potential investors in the future.

She forms "Creative Designs Inc." and transfers all her intellectual property to the new corporation in exchange for 100% of its common stock. Since Sarah transferred property to the corporation solely in exchange for stock, and she controls 100% of the corporation immediately after the exchange, this transaction qualifies as a Section 351 transaction.

Under Section 351, Sarah does not recognize any gain on the transfer. Her basis in the stock of Creative Designs Inc. becomes $50,000 (the same as the basis of the property transferred). If Sarah were to sell this stock later for $300,000, she would recognize a capital gain of $250,000 at that time. This defers the tax on the appreciation of her intellectual property until a liquidity event occurs, such as selling her shares. This strategy allows for a seamless transition from a sole proprietorship to a corporate structure without immediate tax implications, aligning with principles of asset protection.

Practical Applications

Section 351 transactions are widely applied in various corporate and financial planning scenarios, primarily within tax law and corporate finance.

• Business Incorporations: This is perhaps the most common application. Individuals or groups forming a new corporation often transfer existing business assets (e.g., equipment, real estate, intellectual property) into the new entity in exchange for stock. Section 351 allows this initial transfer to be tax-free, avoiding immediate capital gains on appreciated assets.²⁸, ²⁹
• Corporate Restructurings: Section 351 can facilitate certain internal corporate reorganizations where assets are transferred between related corporations in exchange for stock. This allows for efficient restructuring of corporate ownership without triggering taxable events.²⁷
• Estate Planning: In some cases, appreciated assets held personally can be transferred to a corporation owned by family members in a Section 351 transaction, as part of a broader estate planning strategy. This can help consolidate assets and simplify future transfers.
• Joint Ventures: When multiple parties contribute different types of property to form a new corporate joint venture, Section 351 can ensure that the formation is tax-efficient for all contributing parties, provided the control requirements are met collectively.

An academic perspective on the nuances and challenges in Section 351 transactions, particularly regarding implied deferred tax liabilities, can be found in scholarly articles on tax law, highlighting the complexity and ongoing analysis of this provision.²⁶

Limitations and Criticisms

While a Section 351 transaction offers significant tax advantages, it also comes with certain limitations and potential criticisms. One major drawback is the potential for double taxation in the case of a C corporation. If the corporation later sells the assets it received in a Section 351 transfer, it will pay tax on any gain realized. If the corporation then distributes the profits to shareholders as dividends, the shareholders will pay taxes again on those dividends. This contrasts with other business structures, such as partnerships, where income is typically taxed only once.²⁴, ²⁵

Another limitation relates to the "property" requirement. Section 351 explicitly states that stock issued for services is not considered issued in return for property, and the value of such stock is taxable as compensation to the recipient.²², ²³ This means that individuals contributing only services (e.g., expertise or labor) in exchange for stock will not qualify for the non-recognition treatment, and their stock does not count towards the 80% control test for other property transferors.²¹

Furthermore, the "immediately after the exchange" control requirement can be complex. If, pursuant to a pre-existing binding agreement, the transferor loses control of the corporation by selling a significant portion of the stock received to a third party who is not also a transferor of property, the Section 351 treatment may be invalidated.²⁰ This highlights the importance of careful transaction structuring to ensure compliance.

Finally, while Section 351 defers gain, it does not eliminate it. The deferred gain is embedded in the basis of the stock received, meaning that if the stock is later sold, the gain will be recognized at that time. This can create an "implied deferred tax liability" which can affect the true value of the stock.¹⁹

Section 351 Transaction vs. Section 721 Transaction

Section 351 transactions and Section 721 transactions are both provisions within the U.S. Internal Revenue Code that allow for the tax-deferred contribution of property in exchange for an ownership interest in a business entity. However, a fundamental difference lies in the type of entity to which the property is transferred.

While both sections aim to facilitate the tax-efficient formation and restructuring of businesses, the distinct control requirement and the different tax treatments associated with corporate versus partnership structures are key differentiators. Understanding these distinctions is crucial for proper entity selection and tax planning.¹¹, ¹²

FAQs

What type of property can be transferred in a Section 351 transaction?

"Property" in a Section 351 transaction is broadly defined and can include tangible assets (like cash, real estate, equipment, inventory) and intangible assets (like patents, copyrights, trade secrets, or goodwill). However, services rendered or indebtedness not evidenced by a security are explicitly excluded and are not considered property for Section 351 purposes.⁸, ⁹, ¹⁰

Is a Section 351 transaction truly "tax-free"?

A Section 351 transaction is generally "tax-deferred" rather than entirely "tax-free." While no gain or loss is recognized at the time of the transfer, the unrecognized gain or loss is preserved in the tax basis of the stock received. This means that the deferred gain will be subject to taxation when the stock is eventually sold in a taxable transaction.⁶, ⁷

What happens if I receive cash or other property in addition to stock in a Section 351 transaction?

If you receive cash or other property (known as "boot") in addition to stock in a Section 351 transaction, you will generally recognize gain up to the amount of the boot received. However, you will not recognize any loss. The receipt of boot can complicate the tax treatment and requires careful consideration.⁴, ⁵

Can a Section 351 transaction be used to transfer assets to an existing corporation?

Yes, a Section 351 transaction can be used to transfer additional property to an existing corporation, not just to a newly formed one. The same conditions regarding the transfer of property for stock and the control requirement immediately after the exchange must still be met by the transferor or group of transferors.³ This flexibility makes it a valuable tool for ongoing corporate capitalization.

How is the 80% control requirement determined for a Section 351 transaction?

The 80% control requirement is determined by looking at 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 shares of all other classes of stock of the corporation. This control must be held by the person(s) transferring property immediately after the exchange.¹, ² This is often referred to as the stock control test.