Two people fund the same new corporation on the same day. One walks away with zero gain on a building worth triple its basis. The other reports ordinary compensation income. The difference is what each contributed.
When people transfer property to a new corporation, they usually receive stock in return. Trading property is generally taxable, and gain is the value received minus the property's basis (the owner's investment in the property).
An IRC §351 exchange is the exception. It lets a shareholder move property into a corporation without recognizing gain or loss, so nothing is reported as income or deducted now. Congress treats the exchange as a change in the form of ownership, not a sale.
§351 applies only when all three of these conditions are met at the moment of the exchange:
- One or more persons transfer property to the corporation.
- The transfer is solely in exchange for stock of that corporation.
- Immediately after the exchange, those transferors are in control of the corporation.
Common mistakes
- Netting liabilities against the wrong basis. §357(c) compares total liabilities to the aggregate basis of all property that shareholder transferred, not to the basis of the mortgaged asset alone.
- Recognizing a loss because boot was received. Boot never triggers loss recognition in a §351 exchange; it can only pull gain into income. A transferor with a $40,000 built-in loss who receives $15,000 cash recognizes $0, not $15,000.
- Counting service shares in the control numerator. Shares issued for services rendered to a corporation sit in the denominator only. Take a group holding 780 property shares out of 1,000 total. It fails at 78 percent, even if counting the service shares would have pushed it to 88 percent.
Bottom line
- §351 requires property, solely for stock, with transferors holding at least 80 percent of voting power and 80 percent of shares of every nonvoting class immediately after; it is mandatory, not elective.
- Stock for services is ordinary compensation income at fair market value, and those shares are excluded from the control numerator unless the transferor also contributes property worth at least 10 percent of the services-stock value.
- Boot triggers gain equal to the lesser of realized gain or boot fair market value; losses are never recognized.
- Shareholder stock basis equals transferred basis, plus gain recognized, minus boot received, minus liabilities assumed; corporate basis is carryover basis plus the transferor's recognized gain.
Exam shortcut
Run the same four-question loop on every formation stem. Ask first: did this person transfer property, or services? Services alone means ordinary income and the shares leave the control numerator. Recount the percentage before anything else. Then compute liabilities minus basis for that shareholder only. A positive number is §357(c) gain. A negative number is zero, never a loss. Then add cash and other boot, capped at realized gain.
The full lesson (about 4,376 words, 29 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 1
- 2
- 3A
- 3B
- 4
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