Revenue Code 391: Understanding Section 351 Exchanges
Understand the tax framework for contributing property to a corporation in exchange for stock. See how Section 351 governs tax deferral and basis.
A search for “Revenue Code 391” within the U.S. Internal Revenue Code (IRC) yields no results because the section does not exist; this search is often made by individuals seeking information on IRC Section 351. Section 351 allows one or more persons to transfer property into a corporation in exchange for stock without triggering an immediate tax liability. This facilitates business formation by treating the transaction as a change in investment form, not a taxable sale.
Core Requirements for a Tax-Free Exchange
For a transaction to receive tax-free treatment, three conditions must be met. First, one or more persons must transfer “property” to the corporation. The term “property” is defined broadly to include tangible assets like cash and equipment, and intangible assets like patents. However, services rendered to the corporation do not qualify as property and are treated as taxable compensation.
Second, the property must be exchanged solely for the corporation’s stock, which includes common and preferred stock. This requirement excludes other financial instruments like stock rights or certain debt securities, ensuring the transferor maintains an equity stake.
Third, the person or group transferring property must have “control” of the corporation immediately after the exchange. Control requires owning at least 80% of the total combined voting power of all voting stock and at least 80% of all other classes of non-voting stock. For example, if two individuals transfer property and collectively receive 80% of the voting stock, they meet the control test.
Beyond these rules, the transaction must have a valid non-tax business purpose. This means the exchange must be motivated by a genuine business reason, not just tax avoidance, or the IRS may challenge its tax-free status.
Tax Implications of the Transaction
While a Section 351 exchange is tax-free, receiving non-stock consideration can create tax consequences. If a shareholder receives cash or other property in addition to stock, this is called “boot.” The receipt of boot can trigger a taxable gain, limited to the lesser of the total gain realized on the property transfer or the fair market value of the boot received.
A shareholder receives a “substituted basis” in the new stock. The basis of the stock received is equal to the basis of the property transferred, decreased by any boot received and increased by any gain recognized. This calculation ensures any unrecognized gain on the original property is preserved in the stock for future taxation.
The corporation assumes a “carryover basis” in the property it receives, meaning the corporation’s basis is the same as the shareholder’s basis just before the transfer. This basis is increased by any gain the shareholder recognized. This rule prevents the assets from getting a “stepped-up” basis to fair market value, which would provide an unfair tax advantage.
Reporting the Exchange
Both the shareholders transferring property and the corporation receiving it must attach a detailed statement to their federal income tax returns for the year of the exchange. This documentation provides transparency to the IRS, and failure to file it can lead to penalties.
The shareholder’s statement must describe the property transferred, its adjusted basis, and the fair market value of all stock, cash, or other property received. The corporation’s statement must detail all property it received, the transferor’s basis in that property, and information about the stock and assets it distributed. Both parties must also disclose any shareholder liabilities the corporation assumed as part of the exchange.