What Is IRC Section 351 (Not Revenue Code 352)?

Internal Revenue Code (IRC) Section 351 allows for the transfer of property to a corporation in exchange for its stock without triggering an immediate tax liability. This rule facilitates business creation by allowing founders to contribute assets like cash, equipment, or real estate and receive ownership shares on a tax-deferred basis. The underlying principle is that the transaction represents a change in the form of ownership, not a cash-out event that should be taxed.

Key Requirements for a Section 351 Exchange

For a transaction to receive tax-deferred treatment, several requirements must be met. The first is that property must be transferred to the corporation. Property is a broad term that includes tangible assets, cash, and even certain intangible assets, but it specifically excludes services. Stock received in exchange for past or future work is treated as taxable compensation and does not qualify.

The property must be exchanged for the corporation’s stock. Following this exchange, the person or group of people who transferred property must have control of the corporation immediately after the transfer. The Internal Revenue Code defines control with a two-part test under Section 368. The group of transferors must collectively own at least 80% of the total combined voting power of all voting stock and at least 80% of the total number of shares of all other classes of stock, such as non-voting preferred stock.

This control test is measured at the moment the exchange is complete. If a transferor has a pre-existing binding agreement to sell the stock received to a third party, it could cause the entire group to fail the 80% control test, making the transaction taxable for all involved.

Receiving Other Property or Debt Relief

If a transferor receives something other than stock, such as cash or other property known as “boot,” the transaction is not automatically disqualified. While receiving boot does not void the tax-deferred status of the stock portion, it can trigger a taxable gain. The amount of gain recognized is limited to the lesser of the total gain realized on the property transfer or the fair market value of the boot received.

The treatment of debt assumed by the corporation is a distinct consideration. When the new corporation takes on liabilities associated with the transferred property, it is not considered boot for gain recognition purposes.

However, there are exceptions under Section 357. If the total liabilities assumed exceed the tax basis of the property transferred by a shareholder, that excess amount is treated as a taxable gain. If the principal purpose for the corporation assuming the debt was tax avoidance or lacked a bona fide business purpose, all assumed liabilities for that transferor are treated as boot.