What Is a 351 Exchange and How Does It Work?

A 351 exchange, governed by Section 351 of the Internal Revenue Code, allows for the transfer of property to a corporation for its stock without an immediate tax liability. This provision is often used when starting a new corporation or adding assets to an existing one. The regulation facilitates a change in the form of an investment, from direct ownership of property to indirect ownership through stock, by deferring any tax event until the shareholder sells the stock.

Core Requirements for a Tax-Free Exchange

For a transfer to qualify for tax-free treatment under Section 351, several requirements must be met. These rules ensure the transaction is a continuation of an investment rather than a disguised sale. The conditions involve the type of property transferred, what is received in return, and the level of ownership held by the transferors after the exchange.

Transfer of Property

The first condition is that “property” must be transferred to the corporation. The term is interpreted broadly to include tangible assets like cash and machinery, and intangible assets such as patents and intellectual property. A significant exclusion from this definition is services rendered. A person who receives stock in exchange for services must treat its value as compensation, which is taxed as ordinary income. This distinction is important in formations where some founders contribute capital and others contribute expertise.

If a person contributes both property and services for stock, the entire value of the stock can fall under Section 351. This is permissible as long as the property contributed is more than nominal in value compared to the stock received for services. The IRS scrutinizes these transactions to ensure the property contribution is not just a pretext to avoid taxes on service compensation.

Exchange for Stock

The second requirement dictates that the property must be exchanged solely for the corporation’s stock. This stock can be voting or non-voting common or preferred stock. The logic behind this rule is that the transferor has not “cashed out” of their investment but has instead changed its form by continuing it through corporate ownership. Receiving other assets in addition to stock, known as “boot,” can make the exchange partially taxable.

“Control” Immediately After

The final requirement is that the person or group transferring property must have “control” of the corporation immediately after the exchange. Control is defined under Internal Revenue Code Section 368 as owning at least 80% of the total combined voting power of all voting stock and at least 80% of the total shares of all other classes of stock.

This 80% threshold applies to the group of transferors as a whole if they contribute property as part of a single, integrated plan. It does not matter if one transferor receives 10% of the stock and another receives 75%, as long as their combined ownership meets the 80% tests.

The phrase “immediately after the exchange” implies that a pre-arranged plan to dispose of stock that drops the transferors’ ownership below the 80% threshold could disqualify the transaction. For instance, if a transferor has a binding agreement to sell more than 20% of the voting stock right after receiving it, the control requirement would not be met.

Understanding “Boot” and Assumed Liabilities

Transactions often include elements beyond a simple property-for-stock exchange. When a shareholder receives cash or other property (boot) or the corporation assumes liabilities, specific rules determine the tax outcome.

Defining and Taxing “Boot”

In a 351 exchange, “boot” is any non-stock compensation received by the transferor, such as cash or debt instruments. Receiving boot does not disqualify the transaction, but it triggers a taxable gain. The amount of gain recognized is the lesser of the boot’s fair market value or the total realized gain on the property transferred. The realized gain is the difference between the fair market value of everything received (stock and boot) and the adjusted basis of the property given up.

For example, a shareholder transfers property with an adjusted basis of $50,000 and a fair market value of $100,000. In exchange, they receive stock worth $80,000 and $20,000 in cash. The realized gain is $50,000 ($100,000 value received – $50,000 basis), and the boot is $20,000, so the recognized gain is $20,000.

Assumption of Liabilities

It is common for a corporation to assume the transferor’s liabilities, such as a mortgage. Under Section 357, the assumption of liabilities is generally not treated as boot and does not trigger a taxable gain. However, an exception exists if the total liabilities assumed exceed the total adjusted basis of all property transferred by the shareholder. In that case, the excess amount is treated as a taxable gain.

This provision prevents a shareholder from cashing out of an investment by borrowing against a property in excess of its basis and then transferring the debt to a corporation tax-free. Consider a shareholder who transfers property with an adjusted basis of $100,000, subject to a $120,000 mortgage, in exchange for stock. The liabilities assumed ($120,000) exceed the basis ($100,000) by $20,000, which is a taxable gain to the shareholder.

Determining Tax Basis After the Exchange

A consequence of a tax-deferred exchange is the calculation of tax basis for both the shareholder’s new stock and the corporation’s new property. These calculations ensure that any deferred gain or loss is recognized upon a future sale.

Shareholder’s Basis in Stock (Substituted Basis)

The shareholder’s basis in the stock received is a “substituted basis,” derived from the property they transferred. This calculation ensures the deferred gain is preserved in the stock. The formula is the basis of the property transferred, minus the fair market value of any boot received, minus any liabilities assumed by the corporation, plus any gain recognized on the exchange.

For instance, a shareholder transfers property with a $60,000 basis, receives $5,000 in cash (boot), and the corporation assumes a $10,000 liability. The shareholder recognizes a $5,000 gain, and the stock basis is $60,000 (property basis) – $5,000 (boot) – $10,000 (liability) + $5,000 (gain recognized), resulting in a stock basis of $50,000.

Corporation’s Basis in Property (Carryover Basis)

The corporation’s basis in the property it receives is a “carryover basis,” meaning it is the same as the shareholder’s adjusted basis in the property just before the transfer. This rule prevents the corporation from getting a “stepped-up” basis equal to the property’s fair market value without a corresponding tax payment. The basis is then increased by the amount of any gain the shareholder recognized on the transaction.

Using the previous example, the corporation takes the shareholder’s original $60,000 property basis and adds the $5,000 gain the shareholder recognized. The corporation’s new basis in the property is $65,000.

How to Report the Transaction

Properly documenting a 351 exchange with the IRS is a procedural requirement for both the transferor and the corporation. Both parties must attach detailed statements to their federal income tax returns for the year the exchange occurs.

Shareholder/Transferor Reporting

Each person who transfers property in a 351 exchange must file a comprehensive statement with their income tax return. This statement, as outlined in Treasury Regulation 1.351-3, serves as a formal record of the transaction and must include:

• A complete description of the property contributed and its adjusted tax basis.
• The number of stock shares received and their fair market value.
• The fair market value of any other property or cash (boot) received.
• The amount of any liabilities of the transferor that were assumed by the corporation.

Corporation Reporting

The corporation receiving the property also has a reporting obligation and must attach a similar statement to its tax return. This corporate statement provides the IRS with a complete picture of the transaction from the company’s perspective. It must include:

• A full description of the property received from the transferors and the basis it carries in those assets.
• The total number of its outstanding shares before and after the exchange.
• Details of the stock and other property it distributed to each transferor.
• Information about any liabilities it assumed.