Overview of IRC Section §351 and Contributing Property
Are you considering establishing a corporation? Perhaps you have considered contributing property as consideration for your interest while another member would like to contribute cash. You may even find yourself in a situation where a third person would like to donate his services in exchange for an interest in the corporation. Each of these situations can have significant tax consequences, so you must plan to maximize the benefit of the formation. This article was drafted by a Denver Business Attorney and Denver tax attorney to provide information related to the contribution of a property when you form a corporation.
Features of IRC Section §351
One of the most attractive features of forming a corporation is in §351 of the tax code. This provision allows persons to contribute property to a corporation without recognizing gain if done correctly.
Alternatively, §351 may stop some members from recognizing a loss, which may be a negative factor. As a general rule, the exchange of stock for property creates a §1001 event taxable. However, Congress wanted to make a way where taxpayers could still contribute property to a corporation without getting hit with a huge tax liability. This resulted in §351, but this code section does create requirements for it to apply.
Requirements in IRC Section §351
Many requirements must be met, and the whole transaction may trigger immediate tax consequences if the conditions are not met. Remember that simply contributing property to a corporation does not eliminate the gain nor create a step-up basis, similar to §1014. Instead, the tax consequences will linger in the background until any realized gains or losses must be recognized in the future.
Section §351 of the Internal Revenue Code applies only to the contribution of property, which does not include services. However, there are exceptions, but you must be careful when creating a corporation with someone who plans to provide any services in their interest. The contribution of services may completely ruin a §351 transaction, depending on the value.
Requirements in IRC Section §368(c)
Under Section §368(c) of the Internal Revenue Code, members must also acquire control of the corporation’s formation. This section requires that the members contributing to the property possess 80% of the voting power and 80% of shares of all other classes of stock issued by the corporation.
Non-Recognition and IRC Section §351
Additionally, the non-recognition portion of Internal Revenue Code Section §351 applies only to situations where the members receive solely stock for their interest. However, in cases where members receive boot, or something other than stock, in exchange for their contribution, they may recognize gain or loss. Receiving something different than stock does not always ruin the §351 transaction entirely, but it may trigger profit or loss, which could defeat the entire purpose of the transaction.
Liabilities and IRC Section §351
Liabilities also create issues with IRC Section §351 transactions where the corporation assumes the debt. It is not uncommon to have machines or other equipment carrying a note or obligation to consider one’s interest. As mentioned above, the courts did not want to discourage taxpayers from transferring property to a corporation simply because a liability encumbered it. Instead, the whole purpose of §351 was to encourage entity formations.
As a general rule, if liabilities are incurred on a property for legitimate business purposes, these will not trigger gain or loss upon formation. Instead, the penalties will be accounted for on the member’s basis in the corporation. However, there is an exception where the liabilities exceed the basis of the property. Under §357(c), there will be gain recognition, but only to the extent that the liabilities exceed the basis.
Forming a corporation can have many benefits, but you must consider all the contributions made before determining the overall tax consequences to the newly formed corporation and its shareholders.
Consider speaking with a Denver business attorney and Denver tax attorney regarding the business and tax implications of forming a corporation and contributing property to the corporation. Planning the contributions in the beginning can help avoid significant tax liability in the future.
You can contact The McGuire Law Firm to speak with a Denver Business Attorney or Denver Tax attorney. Call us at 720-833-7705 or John@jmtaxlaw.com