Section 351
By Section 1032 provides no gain or loss is recognized by a corporation on the issuance of its stock to a new owner, whether in exchange for cash or otherwise. Similarly, a shareholder’s acquisition of stock for cash is not a taxable event but is instead an investment creating a cost basis under Section 1012 on which gain or loss can be calculated when the stock is sold or becomes worthless. However, often (particularly at the initial formation of a business), property other than cash is contributed to a corporation in exchange for stock of that company. In such cases, absent the application of Section 351, the default treatment would be a taxable sale or exchange. The new shareholder would recognize gain or loss equal to the difference between the adjusted basis of the property contributed and the value of the stock received.
Section 351 is the key exception to that taxable treatment. Section 351(a) provides the transferor shareholder recognizes no gain or loss on transfer of property solely in exchange for stock if the transferor (or transferors joining in such contribution in exchange for stock) are in control of the corporation immediately after the exchange. Section 368(c) defines control in the Section 351 context to mean “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” Importantly, Section 351(a) contemplates transfers by one or more persons allowing for a control group to be formed where multiple owners (typically at the formation of the new corporation) join together. For example, if owner A and owner B form a new corporation, and A contributes $50 of cash for 50 shares while B contributes equipment with a fair market value of $50 and a tax basis of $10 for 50 shares, the entire transaction can be a tax-free contribution under Section 351(a). A and B together received 100% of the new corporation’s shares even though separately they each received only 50%. That A contributed cash while B contributed other property does not prevent them from being a control group.
Where the Section 351(a) requirements are met, the transferee corporation takes a transferred basis in the assets received under Section 362. Pursuant to Section 358, the transferor’s basis in the stock received is the same as its basis in the property contributed to the corporation.
In some situations the transferor may receive from the corporation cash or other property in addition to stock. The additional property is referred to as boot and is taxable under Section 351(b) as a sale or exchange. Notwithstanding the existence of boot, the portion of the exchange that otherwise qualifies for Section 351(a) treatment can be tax-free.
In some situations the IRS has refused to accept a purported Section 351 transaction as a tax-free transaction. In Rev. Rul. 68-349 for example, an individual transferred property to a newly formed corporation. At the same time another corporation transferred all of its assets to the new corporation and then immediately liquidated, distributing the new corporation’s stock to its shareholders. Although the individual and the shareholders of the liquidated corporation were collectively in control of the transferee immediately after the transaction, Section 351 treatment was denied by the IRS on the grounds that the new company was simply a continuation of the liquidated corporate transferor. Although not specifically required by the Section 351 statute, commentators have interpreted Rev. Rul. 68-349 to mean there must be a non-tax business purpose behind a transaction for it to be tax-free under Section 351. That requirement is easily met when a new business is formed but might be uncertain in other situations.
John G. Hodnette is an attorney with Fox Rothschild in Charlotte.