Meaning
Provision within the federal tax code allows for the transfer of property to a corporation in exchange for stock without the immediate recognition of gain or loss. Applying section 351 facilitates the initial formation of a company by preventing a tax liability when assets move into the new corporate shell. The rule stops being relevant once the exchange is complete and the control requirements are satisfied.
Exchange Qualification
Specific conditions must be met for the transaction to be tax free. An exchange qualification requires that the participants provide property, which can include cash or equipment, rather than just services. The stock received must be in the same corporation that receives the property.
This ensures that the event is a reorganization of ownership rather than a sale.
Control Requirement
Transferors must collectively hold at least eighty percent of the voting power after the swap. This control requirement ensures that the founders remain the primary owners of the new entity. If the group falls below this threshold, the transfer may be treated as a taxable event.
The cost of failing this test is an immediate tax bill on the appreciated value of the assets. This rule protects the government from people using corporations to hide capital gains. It forces a tight link between ownership and the contribution of value.
Basis Continuity
Tax basis of the property carries over from the individual to the corporation. Basis continuity ensures that the eventual tax liability is deferred rather than eliminated. If the corporation later sells the asset, it will use the original cost to calculate the gain.
This keeps the accounting records consistent across the transition.
