Three friends pool a building, a patent, and legal services into a new C corporation, expecting tax-free treatment under §351. Two qualify, one walks away with $50,000 of ordinary compensation income, and a missed 80% control test would have made the entire transaction a taxable sale. The rules below decide who pays and who defers.
A corporation comes into existence under state law when articles of incorporation are filed with the secretary of state. For federal tax purposes, the entity is a C corporation by default from its date of incorporation. Three formation steps:
- State filing creates the legal entity and limits shareholder liability
- Shareholders contribute cash, property, or services in exchange for shares
- The board adopts bylaws, issues stock certificates or book-entry shares, and opens corporate bank accounts
The corporation obtains an EIN on Form SS-4, elects a tax year on its first Form 1120, and may file Form 2553 within 2 months 15 days of the start of the desired tax year to elect S status.
Common mistakes
- Counting service-provider shares toward the 80% control test. The 10% small-property rule under Reg. §1.351-1(a)(1)(ii) only saves a mixed property-and-services contributor; pure service-shares never count.
- Recognizing a loss when boot is received. §351 NEVER allows loss recognition; the loss is preserved in the carryover basis. A $50,000 loss in a §351 with $10,000 boot still produces $0 recognized loss.
- Forgetting §357(c) when liabilities exceed basis. Boot rules and §357(c) stack. A transferor with $200,000 liabilities, $150,000 basis, and $30,000 cash boot recognizes $50,000 §357(c) plus $30,000 boot, for $80,000 total.
Bottom line
- §351 nonrecognition requires (1) transfer of property, (2) solely in exchange for stock, (3) the transferor group owns 80% of voting and 80% of each class of nonvoting stock immediately after
- Services rendered for stock are NOT property; the provider recognizes ordinary income equal to stock FMV, and those shares do not count toward the 80% control test
- Boot triggers gain equal to the LESSER of realized gain or boot FMV; loss is never recognized in a §351 exchange
- §357(a) treats assumed liabilities as non-boot; §357(c) recognizes gain when total liabilities assumed exceed total adjusted basis of property transferred
Exam shortcut
Control test first. Count only stock issued for property when checking 80%. If service-provider shares break 80%, the entire transaction is taxable as a sale. Boot gain formula: LESSER of realized gain or boot FMV. Then add §357(c) excess separately. They stack, they do not offset. Brother-sister attribution skips siblings. If the only common ownership is sibling-to-sibling, there is no controlled group.
The full lesson (about 3,154 words, 21 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 3
Browse all free EA Part 2 lessons or jump into free EA Part 2 practice questions.