A transaction involving Section 351 of the Internal Revenue Code is a straightforward means for an individual to transfer property to a corporation in exchange for stock without recognizing a gain or loss. The transfer of property must be made in exchange for stock in the corporation. Immediately after the transfer, the transferor or transferors must then control the corporation that received the property. Control is defined as possessing at least eighty percent of voting rights and eighty percent of any non-voting stock.
If the exchange is a property for stock, any gain the transferor has made on the property will not be recognized because of the transfer. However, other aspects of the exchange may trigger a taxable gain. For example, if the deal includes money or other property being returned to the transferor, that boot is subject to recognition as a gain.
What if a Debt Is Transferred?
Suppose a debt is transferred from the individual to the corporation along with property. In that case, it will not be considered a boot unless the liability exceeds the adjusted basis of the transferred property.
How Does a 351 Transaction Work?
Let’s review some illustrations:
Scenario A: Entrepreneur Sally owns a loom that she uses to create wool décor. When Sally decides to incorporate as Wooly Wonders, she transfers ownership of the loom, with an adjusted basis of $200,000, to Wooly Wonders in exchange for all 100 shares of the newly issued stock. Sally has a loan of $100,000 on the loom, which she also transfers to the new company. Sally can defer recognizing the gain on her loom and will not need to recognize the transfer of debt as a gain. The reason is that Sally still controls the loom, just under a different financial structure.
Scenario B: Entrepreneur Sally transfers the loom, with a value of $500,000, to Wooly Wonders in exchange for all 100 shares of stock. Sally paid $100,000 for the loom when she bought it, and she has no debt to transfer. Therefore, the gain is $400,000, but Sally can defer recognizing that gain until she sells the stock.
Scenario C: Entrepreneur Sally transfers the loom, valued at $500,000, to Wooly Wonders in exchange for the 100 shares and $100,000 cash. Sally had originally purchased the loom for $100,000, so the gain is still $400,000, but using a 351 transaction, Sally will only recognize a gain on the boot of $100,000.
Scenario D: Sally transfers the loom, valued at $500,000, to Wooly Wonders. Joe transfers a macrame machine, valued at $300,000. Each had an original purchase price of $100,000. However, Sally receives 80 of the 100 shares of stock in the new corporation, and Joe gets 20 shares of stock and $100,000. In this situation, Sally's transaction would be eligible for a 351 deferral. Joe's transaction would not. He has not received 80% of the voting or total shares of the corporation's issued stock. He will recognize the gain on the macrame machine.
As with any financial maneuver, investors should review the potential consequences of their actions with a trusted advisor before proceeding.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
