Are you considering establishing a corporation? Perhaps you have thought about putting in 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 contribute his services in exchange for an interest in the corporation. Each of these situations can have major tax consequences so you must plan ahead to maximize the benefit of the formation. This article has been drafted by a Denver Business Attorney and Denver tax attorney to provide information related to the contribution of property when you form a corporation.
One of the most attractive features of forming a corporation is found in §351 of the tax code. This provision allows for persons to contribute property to a corporation without recognizing gain, if done properly. 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 which is taxable. However, Congress wanted to create 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.
Keep in mind that simply contributing property to a corporation does not eliminate the gain completely nor create a step up in basis, similar to §1014. Rather, the tax consequences will linger in the background until any realized gains or losses must be recognized in the future. There are many requirements that must be met and if any one is not met, the whole transaction may trigger immediate tax consequences.
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 type of services as their interest. In fact, the contribution of services may completely ruin a §351 transaction, depending on the value.
Members must also acquire, under Section §368(c) of the Internal Revenue Code, control on formation of the corporation. This requires that the members who are contributing the property possess 80% of the voting power and 80% of shares of all other classes of stock issued by the corporation.
Additionally, the nonrecognition 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 other than stock does not always ruin the §351 transaction entirely, but it may trigger gain or loss, which could defeat the entire purpose of the transaction.
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 that carry a note or other obligation used as consideration for one’s interest. As mentioned above, the courts did not want to discourage taxpayers from transferring property to a corporation simply because it was encumbered by a liability. Rather, the whole purpose of §351 was to encourage entity formations.
As a general rule, if liabilities are incurred on property for legitimate business purposes, then these too will not trigger gain or loss upon formation. Rather, the liabilities will be accounted for in the member’s basis in the corporation. However, there is an exception where the liabilities exceed the basis in 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 types of contributions that will be made before determining the overall tax consequences to both the newly formed corporation and its shareholders. You may consider speaking with a Denver business attorney and/or 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 a large tax liability in the future.
You can contact The McGuire Law Firm to speak with a Denver Business Attorney or Denver Tax attorney. 720-833-7705 or John@jmtaxlaw.com