Preface: Code Section 351 tax-free exchanges permit corporations to receive assets without taxation of the gains on those assets in certain instances. How does it work?

Contributing Property to a Corporation with Section 351

A Section 351 tax-free exchange permits a deferral of taxable gain on contributions of property or money to a corporation. With Section 351, no gain or loss is recognized when in compliance with the following tax code parameters i) you receive only stock in the exchange for your property, and ii) you are in control of the corporation immediately following the exchange of property for stock. Section 368(C) enumerates control to be the transferor group has possession of 80% of the total voting power of all classes of stock and at least 80% of the total number of outstanding shares of all other classes of stock in the corporation after the transfer. The stock cannot be nonqualified preferred stock, [stock that the holder has the right to require the issuer to redeem or buy back the stock].

For example, if Ron incorporates his developing woodworking business and contributes manufacturing equipment and delivery vehicles with a fair market of $450,000 and an adjusted basis of $100,000 to his new corporation Woodcrafters, Inc., Section 351 permits the $350,000 of taxable gain on the assets contributed to Woodcrafters, Inc. to be deferred.

Along with the Section 351 tax-free exchange, a statement must attached to both the transferors tax return and the corporations tax return that includes all pertinent facts and circumstances of the exchange or property for stock. Your tax accountant prepares those statements.

When contributing property to a corporation two valuation concerns arise; i) the value assigned to the stock received, and ii) the value assigned to the property assigned or transferred into the corporation.

First the received stock basis. If Ron contributed the equipment and vehicles to Woodcrafters, Inc. his basis in the stock received from the exchange would be his adjusted basis in the assets or $100,000. Not the fair market value of the assets of $450,000. The gain is recognized at time of sale of the stock received in the difference between the stock basis and fair market value of the stock. Secondly, the basis the corporation assumes for the property is the transferor’s basis in the property.

Say Ron’s depreciation schedules for cost basis in the assets contributed was $100,000; the corporation would depreciate the new assets at that cost basis of $100,000. In addition, if Ron had received boot (money or property added to an exchange or transaction to equal value) of $50,000 on his contribution of the assets from his business into Woodcrafters, he would be subject to a gain on the value of the boot received. Section 351 tax-free exchanges cannot occur for services or indebtedness. So Ron could not provide $15,000 of consulting services to his corporation tax free, and issue stock with a basis of $15,000.

Summary: Section 351 tax-free exchanges permits business owners to transfer assets into a corporation and defer the taxable gain on difference between cost basis and the fair market value that would occur on the sale of the assets. If you’re considering a Section 351 tax-free exchange for your business, contact your tax accountant to ensure you’re in compliance with Section 351 rules.