Owners of real property or other assets with built-in gain (and a low tax basis) may wish to transfer the appreciating property to a newly formed corporation in exchange for stock. By exchanging property for shares of a corporation’s stock, the property owner can also realize tax benefits through Section 351 of the Internal Revenue Code (IRC).
Many times, transferring property to a corporation in exchange for stock results in a taxable event. The IRS eviews this transaction as the property owner “cashing out” his or her assets for a capital gain (so long as the asset has appreciated). Through a Section 351 exchange, the entity that transferred the appreciated property in exchange for stock may defer taxes on the gain or loss of the otherwise-taxable event until they sell the shares of stock.
The federal government created this provision in the Internal Revenue Code to encourage the creation of corporations. It is often used by property owners who transfer their property into corporations they created themselves.
Eligibility Criteria for 351 Exchanges
Not every property-for-stock transaction is eligible for tax deferral under Section 351. Property owners must satisfy three main prerequisites in order to take advantage of this tax treatment:
- The transferor (property owner) must transfer property—and ONLY property—to the corporation. In other words, the transferor may not provide services for the stock. The law spells out what property is not, in the context of Section 351, so it is important to make sure contributions would actually be considered property before exchanging.
- The transferor must receive STOCK for the property. Section 351 exchanges must be relatively clean transactions: property for stock. Confer with your attorney before assuming the contributions would actually be considered property.
- The transferor must receive controlling stock for the property. In exchange for the property, the transferor (or a group of transferors if there are multiple people transferring property) must receive enough stock (at least 80 percent) so that he or she (or they, if a group) actually assumes a controlling share of the corporation.
Example of a Potential Section 351 Exchange
Let’s picture two individuals who wish to form a corporation. Individual 1 has an asset with a fair market value of $500 and a tax basis of $300. Individual 2 wants to contribute services to the corporation and, in exchange, receive 30 percent ownership in the new corporation. Both individuals wish to receive controlling stock in exchange for their contributions.
This transaction, while exceedingly common in the business world, would not qualify either individual for preferential Section 351 tax treatment, as it violates the first criteria we explained above. Individual 1 will have to report a capital gain of $200 (the difference between the fair market value and tax basis of the property contributed). Additionally, because Individual 2 contributed services/non-property for 30 percent ownership, Individual 2 will be taxed on the fair market value of the services contributed.
Therefore, Individuals 1 and 2 will pay taxes upon contributing to the corporation.
These same principles apply to an partnership, or an LLC taxed as a partnership, but the rules are more lenient than with corporations.
Consult an Experienced California Business Attorney Before the Transaction
Owning property that’s useful to a future or existing corporation is a good thing to have. Executing the transaction with Legal Zoom or some DIY legal service could help you go through with your transaction, but knowledgeable legal counsel can help you realize advantageous tax treatments and other financial benefits you never knew existed.
The other side of the coin is improperly executing what you thought would qualify as a Section 351 exchange. Furthermore, being taxed sooner rather than later might also work to your advantage. Regardless of your situation, experienced legal representation will help you get the most out of your property and company. Reach out to our firm today to get the help of a true business advisor.
Dahl Law Group
