What is a Section 351(a) Tax-Free Exchange?
Generally, transferring property into a corporation in exchange for its stock is a taxable event. The transaction is treated as if you sold property to the corporation in return for cash.
The difference between the stock value received and the tax basis in the property transferred to the corporation will result in a gain or loss.
Concern about the tax liability that could result from incorporating a currently unincorporated business and the barrier to incorporation it could present, prompted Congress to enact Section 351 to remove this barrier to incorporation of an unincorporated business.
The idea was to allow unincorporated businesses to develop, unimpeded by any immediate tax consequence resulting from the exchange of property for stock.
In other words, Congress thought that any gain on an exchange of property for stock should be deferred (put off) until a future time, such as when the stock received in the exchange was eventually disposed of by the shareholder.
Note that a loss on an exchange is not deductible if you own, directly or indirectly, more than 50% of the stock.
Exchanging Property for Stock in a Corporation
Whether you're setting up a new corporation with just yourself or other people, such as partners in a partnership, or getting involved in an existing corporation, under IRC Section 351(a) you can defer (put off) any resulting tax consequence.
Under section 351(a):
No gain or loss is recognized (reported) provided:
- You receive ONLY STOCK in exchange for your property, and
- You are in CONTROL of the corporation immediately after the exchange.
Section 368(c) defines control:
Control means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of outstanding shares of all other classes of stock of the corporation.
Transferor group: If you, along with others, transfer property into a corporation, your group is referred to a transferor group.