Corporate Tax | Just Tax

Incorporation Analysis (§§ 351, 357, 358, 362, 368(c), 1032)

This checklist guides the complete tax analysis of a corporate formation under § 351 and its related provisions. Use it when one or more persons transfer property to a corporation in exchange for stock, or when reviewing a formation's tax consequences.

Step 1. Transferors and Their Contributions

"No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation." (IRC § 351(a))

• The transferor group defines whether § 351 applies.
  • The statute requires that "one or more persons" transfer property and that "such person or persons" be in control immediately after the exchange.
  • The identity of each transferor, the property each contributes, and the stock each receives are the foundational facts that drive the entire analysis.
  • This Step builds the factual schedule. Step 2 tests whether each contributed item qualifies as "property." Step 3 tests the 80% control requirement under § 368(c).
• Who counts as a "person."
  • Treas. Reg. § 1.351-1(a)(1) defines "one or more persons" to include individuals, trusts, estates, partnerships, associations, companies, or corporations, citing § 7701(a)(1).
  • A corporate transferor that distributes part or all of the stock it receives to its shareholders is still counted toward the control test. The downstream distribution is disregarded. (Treas. Reg. § 1.351-1(a)(1))
  • Non-U.S. entities classified as partnerships or corporations under § 301.7701-2 and § 301.7701-3 are persons for this purpose.
• A person transferring only services is not a transferor.
  • § 351(d)(1) provides that stock issued for services "shall not be considered as issued in return for property."
  • Treas. Reg. § 1.351-1(a)(1)(i) states that "the person who performed the services is not a transferor of property."
  • The service provider does not count toward the 80% control test under § 368(c).
  • The service provider recognizes ordinary compensation income equal to the FMV of the stock received. (§ 61(a)(1)) (See James v. Commissioner discussion below)
• A person transferring both property and services IS a transferor for the property portion.
  • Treas. Reg. § 1.351-1(a)(1)(ii) treats the property contribution as valid if the property is not "of relatively small value" and the primary purpose is not to qualify other persons' exchanges.
  • If the property contribution is meaningful, the person counts as a transferor for control purposes, but only the stock received in exchange for property counts toward the control calculation.
  • The portion of stock received for services still generates ordinary income.
• The accommodation transferor trap.
  • Treas. Reg. § 1.351-1(a)(1)(ii) disregards a purported property transfer if two prongs are both satisfied. (1) The property is of relatively small value in comparison to the stock already owned or to be received for services by that person. (2) The primary purpose of the transfer is to qualify under § 351 the exchanges of property by other persons transferring property.
  • If both prongs are met, the nominal transferor does not count toward control, and the other transferors may fail the 80% test.
  • In Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd, 469 F.2d 219 (1st Cir. 1972), a trust that already owned 95% of a corporation's stock purchased an additional 418 shares for cash. The Tax Court held this was a nominal transfer to help other stockholders qualify under § 351. The trust was not a legitimate transferor, the control test failed, and all gain on the other transfers was recognized.
  • CAUTION. Do not assume a small cash injection from an existing shareholder automatically creates a qualifying transferor group. Courts look at purpose, not just form.
  • Rev. Proc. 77-37, 1977-2 C.B. 568, provides that for advance ruling purposes, a transferor must contribute property valued at at least 10% of the stock already owned (or to be received for services).
  • TRAP. The Rev. Proc. 77-37 safe harbor applies only to advance ruling requests. It is not a substantive legal standard. A contribution below 10% can still qualify if the primary purpose is bona fide. A contribution above 10% can still fail if the primary purpose is accommodation.
• Catalog of contributed items, bases, and FMVs.
  • Build a schedule listing every item contributed by each transferor, the transferor's adjusted basis, and the item's fair market value at contribution.
  • Cash. Cash is property under § 351(a). (Rev. Rul. 69-357, 1969-1 C.B. 101) (Halliburton v. Commissioner, 78 F.2d 265 (9th Cir. 1935)). A cash contributor has basis equal to the face amount and generally realizes no gain or loss. The corporation takes a carryover basis equal to the cash amount under § 362(a).
  • Tangible personal property. Machinery, equipment, inventory, vehicles, and fixtures. State the adjusted basis under § 1011 and the FMV. Watch for depreciation recapture under §§ 1245 and 1250, which converts some or all realized gain to ordinary income even within § 351.
  • Real property. Land, buildings, and leasehold improvements. State adjusted basis and FMV. Watch for § 1250 recapture on depreciable real estate.
  • Intangible assets. Patents, trademarks, copyrights, trade secrets, technical data, manufacturing know-how, and contract rights all constitute property for § 351. (G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987)) (Rev. Rul. 64-56, 1964-1 C.B. 133) (Rev. Proc. 69-19, 1969-2 C.B. 301). The IRS takes the position that know-how transfers must constitute a grant of "all substantial rights" to qualify. (Rev. Rul. 64-56). Courts have rejected applying a capital gains "all substantial rights" test to § 351. (E.I. du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973)). See full discussion in Step 2.
  • Goodwill and going-concern value. Goodwill associated with a corporate name and goodwill existing independent of any name both constitute property. (Rev. Rul. 79-288, 1979-2 C.B. 139). Going-concern value is treated as property by extension.
  • Contingent and inchoate rights. A letter of intent, development rights, and other contractual opportunities with economic value can be property even if not legally enforceable. (United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984)). The Eleventh Circuit held that a letter of intent outlining major terms of a proposed loan and lease agreement constituted a "sufficient bundle of rights and obligations to be deemed property," drawing an analogy to goodwill.
  • Accounts receivable. Accounts receivable are property. (Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S. 826 (1974)). A cash-basis transferor has zero basis in uncollected receivables. The corporation takes zero carryover basis under § 362 and recognizes ordinary income on collection. See Step 2 for full treatment.
  • Liabilities transferred with property. Each liability assumed by the corporation is part of the amount realized. See Step 4 for the § 357 liability analysis.
• Services versus property contributions.
  • § 351(d)(1) excludes services from the definition of property. Stock issued for services is compensation, not a nonrecognition exchange.
  • In James v. Commissioner, 53 T.C. 63 (1969), James agreed to secure financing and perform development work for an apartment project. He received 10 shares of corporate stock described as issued for "property" (a loan commitment and FHA commitment). The Tax Court held the financing commitments were not assets James personally owned. They were products of his services. The stock was taxable compensation. The other transferors (who contributed land) failed the control test because James was not a property transferor, so their exchange was also taxable.
  • The § 83(b) election. A service provider who receives stock subject to a substantial risk of forfeiture may file a § 83(b) election within 30 days of transfer to include the stock's FMV in gross income immediately. If the election is made, the holding period begins at transfer and subsequent appreciation is capital gain. If no election is made, income is deferred until vesting, and all appreciation through the vesting date is taxed as ordinary compensation. The election is irrevocable without IRS consent, and no deduction is allowed if the stock is later forfeited. (§ 83(b)) (Treas. Reg. § 1.83-2). This is a parallel analysis outside § 351 proper but critical when a founder or employee receives stock for services.
• § 351 is not elective.
  • If all statutory requirements are satisfied, nonrecognition is mandatory. The transferor cannot elect out, even if recognition would produce a better tax result. (Bradshaw v. United States, 683 F.2d 365 (Ct. Cl. 1982), also reported at 50 AFTR 2d 82-5238, 82-2 USTC ¶ 9665 (Ct. Cl. 1982)). The Court of Claims stated in footnote 17, "Application of § 351 is mandatory if all of the conditions precedent therefor are satisfied," citing Pocatello Coca-Cola Bottling Co. v. United States, 139 F. Supp. 912, 915 (D. Idaho 1956). In Bradshaw, Thomas Swift transferred land to his wholly-owned corporation in exchange for five promissory notes. The court held the transaction was a sale, not a § 351 transfer, because the notes were not "stock or securities." The court emphasized that had § 351 applied, it would have applied mandatorily. The taxpayers could not have elected out. The only way to avoid § 351 was to structure the transaction so its requirements were not met.
  • Gus Russell, Inc. v. Commissioner, 36 T.C. 965 (1961), confirms that a transaction precisely within the terms of § 351 results in nonrecognition regardless of the parties' intent.
  • TRAP. Even when boot is received, loss is NEVER recognized. § 351(b)(2) states flatly that "no loss to such recipient shall be recognized." A transferor who contributes depreciated property and receives boot realizes a loss but cannot deduct it. The deferred loss is preserved in the stock basis under § 358.

Step 2. What Counts as "Property" Under § 351(a)

"It is this cardinal element of continuing control by the taxpayer (i.e. that a third party does not at the time acquire substantial interest in the property transferred, or control over it) which supports the nonrecognition of gain under section 351. In contrast, an important test for the capital gains provisions is whether there has been a full and complete divestiture by the taxpayer of his interests in the assets." (E.I. du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973))

• Step 2 tests the property classification of each item cataloged in Step 1.
  • Every item on the contribution schedule must be classified as either property (which can support § 351 nonrecognition) or non-property (which cannot).
  • If an item is not property, the transferor who contributed it is not a transferor for control purposes, and the exchange of that item for stock may be taxable.
• The broad judicial definition of property.
  • Courts construe "property" expansively under § 351. The term is broader than "capital assets" and is not limited by capital gains concepts. (E.I. du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973)). The Court of Claims rejected the IRS position that a nonexclusive patent license could not be property because it would not qualify for capital gains treatment. The court held that § 351 "speaks of 'property,' not 'capital assets'" and that "the bare words of the statutes do not compel, or even favor, their parallel application." The decisive factor is continuing control through stock ownership, not full divestiture.
  • Tangible personal property and real property unequivocally qualify. Inventory, machinery, equipment, fixtures, raw materials, land, buildings, and leasehold interests are all property. Depreciation recapture under §§ 1245 and 1250 may change the character of gain but does not affect whether the item is property.
  • Cash is property. (Rev. Rul. 69-357, 1969-1 C.B. 101). Cash has a basis equal to face amount. No gain or loss is realized on a cash contribution.
  • Intellectual property is property. Patents, trademarks, copyrights, technical data, manufacturing know-how, and contract rights all constitute property. (G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987)). In Searle, a pharmaceutical company transferred a comprehensive bundle of intangibles to a Puerto Rican subsidiary. The Tax Court held the transfers valid under § 351 and stated that "the basic philosophy underlying § 351 is that a transfer of appreciated or depreciated property to a corporation controlled by the transferor is merely a change in the form of ownership." The IRS had sought to allocate more than 92% of the subsidiary's gross income back to the parent under § 482. The court held this was an abuse of discretion.
  • Unpatented know-how and secret processes are property. (Rev. Rul. 64-56, 1964-1 C.B. 133) (Rev. Proc. 69-19, 1969-2 C.B. 301, amplified by Rev. Proc. 74-36, 1974-2 C.B. 491). Rev. Rul. 64-56 held that a transfer of "all substantial rights" in unpatented secret processes to a foreign corporation was a transfer of property under § 351.
  • Nonexclusive patent licenses are property. (E.I. du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973)). DuPont transferred a royalty-free, nonexclusive license to make, use, and sell herbicides under French patents to its subsidiary. The IRS argued the license was not property because a nonexclusive license does not constitute a "sale or exchange" for capital gains purposes. The Court of Claims rejected this position, holding the license was property because DuPont retained "continuing control" through its stock ownership. Post-DuPont, the IRS stated it would no longer maintain that § 351 requires transfer of "all substantial rights" in intellectual property.
  • Goodwill and going-concern value are property. (Rev. Rul. 79-288, 1979-2 C.B. 139). The IRS ruled that the transfer of a certificate of registration of a corporate name, all rights under common law and an international treaty to use the corporate name, all goodwill associated with the corporate name, and goodwill existing independent of the corporate name, all constituted property under § 351(a).
  • Inchoate and contingent rights with economic value are property. (United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984)). Stafford, a real estate developer, contributed his interest in a letter of intent concerning a hotel development to a limited partnership. The letter was not a legally binding contract. The Eleventh Circuit held it was nonetheless property because it "encompassed a sufficient bundle of rights and obligations to be deemed property." The court stated that "an enforceable contract would perhaps be assured of property status, but the absence of enforceability does not necessarily preclude a finding" of property. The court drew an analogy to goodwill and noted that "a taxpayer can create property by his provision of personal services."
• Accounts receivable and the assignment of income doctrine.
  • Accounts receivable are property under § 351(a). (Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S. 826 (1974)). Hempt Bros. was a cash-basis partnership that transferred approximately $662,820 in accounts receivable and $350,000 in physical inventory to a newly formed corporation. The Third Circuit held the receivables were property, adopting the broad definition from DuPont.
  • A cash-basis transferor has zero basis in uncollected accounts receivable because the income has not yet been recognized. The corporation takes a carryover basis of zero under § 362(a).
  • The corporation recognizes ordinary income when it collects the receivables.
  • The assignment of income doctrine does not override § 351 for going concern incorporations. The court in Hempt Bros. rejected the argument that the partnership (rather than the corporation) should be taxed on collection. The court stated that "the purpose of § 351 is to facilitate movement into the corporate form by preventing immediate recognition of gain or loss when there has been a mere change in the form of ownership."
  • CAUTION. Advising a cash-basis client who contributes receivables. The client gets no basis in the stock for the receivables. The corporation pays tax on collection. The economic burden shifts from the individual (who would have paid tax at individual rates) to the corporation (which pays tax at corporate rates). Model the total tax cost. Consider whether the client should collect receivables before incorporation or whether an S election is warranted.
  • Zero-basis inventory contributed by a cash-basis taxpayer similarly passes with zero carryover basis. The corporation takes the taxpayer's zero basis, and the tax-benefit doctrine does not create basis in previously deducted inventory. (Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974)).
• Items that are not property.
  • Services. § 351(d)(1) provides that stock issued for services "shall not be considered as issued in return for property." Treas. Reg. § 1.351-1(a)(1)(i) confirms that the person who performed services "is not a transferor of property." A person contributing only services is taxed on the FMV of stock received as compensation under § 61(a)(1). (James v. Commissioner, 53 T.C. 63 (1969)). See Step 1 for the services versus property analysis and the § 83(b) election.
  • Transferee indebtedness not evidenced by a security. § 351(d)(2) excludes from the definition of property any "indebtedness of the transferee corporation which is not evidenced by a security." If a shareholder lends money to the corporation and the debt is not evidenced by a security (for example, a demand note or open account), the debt instrument is not property. If the debt is evidenced by a security, its surrender can qualify as a property transfer.
  • Interest accrued on or after the beginning of the holding period. § 351(d)(3) excludes "interest on indebtedness of the transferee corporation which accrued on or after the beginning of the transferor's holding period for the debt." A creditor who exchanges accrued interest for stock cannot obtain § 351 nonrecognition.
  • Stock rights and warrants. Treas. Reg. § 1.351-1(a)(1) states explicitly that "stock rights and stock warrants are not included in the term stock." Receipt of stock rights or warrants in a purported § 351 exchange means the transferor has not received solely stock, and the exchange may not qualify under § 351(a).
  • Pre-incorporation contracts and promoter expenses. A contract negotiated by a promoter on behalf of a corporation not yet formed is generally not the promoter's property. When the corporation adopts the contract, the promoter is typically treated as having rendered services. (See James v. Commissioner, 53 T.C. 63 (1969)). An exception may apply if the promoter negotiates the contract in his own name and acquires legally enforceable, transferable rights. (Compare United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984), where a letter of intent with economic value was held to be property despite being non-binding).

Step 3. The 80% Control Test Under § 368(c)

"For purposes of sections 351, 368, and 721, the term 'control' means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." (IRC § 368(c))

• The dual 80-percent requirement. § 368(c) imposes two independent prongs, both of which must be satisfied. (Treas. Reg. § 1.368-2(e))
  • Voting power prong. The transferor group must own stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote.
  • Non-voting stock prong. The transferor group must own at least 80 percent of the total number of shares of each class of all other (non-voting) stock of the corporation. (Rev. Rul. 59-259, 1959-2 C.B. 115)
    • TRAP. The non-voting prong applies to each class of non-voting stock separately, not in the aggregate. If the corporation has Class A non-voting preferred and Class B non-voting preferred, the transferors must hold at least 80 percent of the shares of each class.
  • No value component. Unlike § 1504(a)(2), which requires 80 percent of voting power and 80 percent of total stock value, § 368(c) is purely mechanical. Voting power and share count alone control the analysis. (Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders § 3.02[1])
  • Only issued and outstanding stock counts. Authorized but unissued shares are disregarded in the control computation. (Louangel Holding Corp. v. Anderson, 9 F. Supp. 550 (D. Md. 1934))
  • CAUTION. Check the corporate charter for multiple classes of stock before performing the control calculation. A class of non-voting stock with only a few shares outstanding can trap an otherwise compliant transfer.
• Momentary control suffices. The transferor need hold control for only an instant after the exchange. The words "immediately after" in § 351(a) require no durational holding period. (American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1948), aff'd, 177 F.2d 513 (3d Cir. 1949))
  • Facts. A group of associates ("the Associates") purchased the assets of American Austin Car Co. out of bankruptcy for $5,000 cash plus assumption of approximately $219,100 in liabilities. On June 3, 1936, the Associates transferred those assets to a newly formed corporation, American Bantam Car Co., in exchange for 300,000 shares of no-par common stock, representing 100 percent of all issued stock. On June 8, 1936 (five days later), the Associates entered into a written contract with underwriters providing for the sale of preferred stock to the public and the transfer of common stock to underwriters as compensation. The Associates eventually transferred more than 20 percent of their common stock to the underwriters. The IRS challenged whether the Associates had "control" of American Bantam "immediately after" the June 3 exchange.
  • Holding. The Tax Court held for the taxpayer. The Associates did control American Bantam immediately after the June 3 exchange. The court stated, "The statutory words 'immediately after the exchange' require control for no longer period. In fact, momentary control is sufficient." The June 8 underwriting agreement was a separate legal event, not a binding commitment existing at the time of the exchange. The board resolution accepting the Associates' offer attached "no strings whatsoever" to the issuance of stock. Only stock actually issued on June 3 was counted in the control determination, and no preferred stock had been issued or contracted for at that time.
  • Key rule. Control is measured at the instant of the exchange, not by looking backward from some later point. Post-exchange events that are not the product of a pre-exchange binding commitment do not retroactively destroy control.
• Control followed by gift does NOT break control. A voluntary gift is not a taxable disposition. Control is measured immediately after the exchange, before the gift. The transferor who has the absolute right to keep the stock satisfies § 368(c), even if he promptly gives the stock away. (Wilgard Realty Co. v. Commissioner, 127 F.2d 514 (2d Cir. 1942)) (D'Angelo Associates, Inc. v. Commissioner, 70 T.C. 121 (1978)) (Stanton v. United States, 512 F.2d 13 (3d Cir. 1975))
  • Wilgard Realty Co. facts and holding. W.H.H. Chamberlin organized Wilgard Realty Co., Inc. and transferred real estate to it in exchange for all of the corporation's stock plus the assumption of liabilities on two mortgages. Chamberlin intended, at the time of the transfer, to give away about three-fourths of the stock he received, and he did so on the same day. There was no binding obligation to make the gift. Chamberlin was free at any time up to the moment he gave the stock away to change his mind. The Second Circuit held that Chamberlin was in control immediately after the exchange. The court reasoned, "He was under no obligation to make the gift. There is neither claim nor proof that he was bound to carry out his intention to give any of it away when he received the stock or that he was not free at any time up to the very moment he gave it away to change his mind and use it for any lawful purpose." The subsequent gift did not negate control.
  • The critical distinction. A gift does not break control because the transferor retains the legal right to determine whether to keep the stock at the moment control is measured. The court in Wilgard Realty drew the line between (1) cases where the recipient had "foregone or relinquished the right to have such control as its ownership would give and was bound upon receipt of the stock to dispose of it as previously arranged" and (2) cases where the recipient "has not only the legal title to it 'immediately after the exchange' but also the legal right then to determine whether or not to keep it with the control that flows from such ownership." (Citing Bassick v. Commissioner, 85 F.2d 8 (2d Cir. 1936)) (Hazeltine Corp. v. Commissioner, 89 F.2d 513 (3d Cir. 1937)) (Heberlein Patent Corp. v. United States, 105 F.2d 965 (2d Cir. 1939))
  • D'Angelo Associates facts and holding. Dr. and Mrs. D'Angelo incorporated D'Angelo Associates, Inc. on June 21, 1960. At their direction, the corporation issued 10 shares to Mrs. D'Angelo and 50 shares to their five children (ages 12, 10, 9, 8, and 6), 10 shares each, held in trust under the New York Uniform Gifts to Minors Act. Dr. and Mrs. D'Angelo then transferred rental property to the corporation in exchange for cash and a demand note. The Tax Court held that § 351 applied. The court treated the formation, stock issuance, and property transfer as an integrated transaction. The court found that "the issuance of the stock by petitioner to the D'Angelo children is the direct consequence of 'the absolute right' of Dr. and Mrs. D'Angelo to designate who would receive all of the stock." The loss of control through the gift did not preclude § 351(a) because the transferors possessed the power to designate the distributee of the stock, which is the touchstone of control.
  • Stanton v. United States holding. The Third Circuit held that where a transferor has the absolute right to designate who will receive stock issued by the corporation in exchange for property, the transferor has the requisite control under § 351, even if the stock is issued directly to third parties or trusts. The power to direct the disposition of stock, not its momentary possession, is what satisfies § 368(c).
  • Practical bottom line. If the transferor group receives 100 percent of the stock and then gifts a portion to family members or trusts, control is satisfied. If the corporation issues stock directly to donees at the transferor's direction, control is also satisfied under D'Angelo and Stanton. The only requirement is that the gift not be the product of a pre-exchange binding obligation.
• Prearranged sales destroy control. Where the transferor has a binding obligation to sell stock as part of the incorporation transaction, the sale is integrated with the exchange and control is measured after the sale. The transferor is treated as never having had the legal right to keep the stock. (Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025 (1976))
  • Facts. Dee Shook owned a sawmill. After the mill was damaged, Shook partnered with Milo Wilson to rebuild a larger sawmill. On July 16, 1964, Shook and Wilson formed S&W Sawmill, Inc. Shook executed a bill of sale and deed transferring the sawmill's assets to S&W in exchange for 364 shares of common stock, representing 100 percent of S&W's outstanding shares. On the same day, Wilson and Shook entered into an agreement whereby Wilson was entitled to purchase half of S&W's shares (182 shares). Shook deposited stock certificates representing 182 shares with an escrow agent and executed an irrevocable proxy granting Wilson voting rights in half of the shares. Wilson made all required payments during 1965 and 1966 and claimed interest deductions. On July 1, 1967, Intermountain Lumber Co. purchased all outstanding S&W stock. The Commissioner determined that Shook's transfer was nontaxable under § 351, meaning Intermountain took a carryover basis. Intermountain challenged this, arguing § 351 did not apply because Shook lacked control.
  • Holding. The Tax Court held that § 351 did not apply because Shook did not have the requisite control of S&W "immediately after the exchange." The court found that Shook, "as part of the transaction by which the shares were acquired, has irrevocably foregone or relinquished at that time the legal right to determine whether to keep the shares." The simultaneous sale agreement was an integral part of the incorporation transaction that effectively reduced Shook's ownership to 50 percent. The court examined the substance of the agreements, not merely legal title. The escrow of shares, the irrevocable proxy, and the evidence that both parties intended equal co-ownership from the beginning all supported the conclusion that the transaction "worked more than a mere change in form."
  • Comparison to American Bantam. The critical difference is the presence of a binding commitment. In American Bantam, there was no written contract prior to the exchange, only an informal oral understanding of a general plan. In Intermountain Lumber, the sale agreement was executed the same day as the transfer, with an escrow and irrevocable proxy, creating a legally binding obligation to dispose of half the stock.
• The step-transaction doctrine. Courts may collapse a series of formally separate steps into a single integrated transaction for tax purposes. If the doctrine applies, steps taken before or after the § 351 exchange may be integrated with the exchange, potentially destroying the control that appears to exist on paper. The IRS needs to satisfy only one of three alternative tests. (Commissioner v. Clark, 489 U.S. 726, 738 (1989))
  1. The binding commitment test. Steps will be collapsed if, at the time the first step is entered into, there was a legally binding commitment to undertake the later step(s). (Commissioner v. Gordon, 391 U.S. 83 (1968))
     • Facts. AT&T held approximately 90 percent of Pacific Telephone and Telegraph Company. In 1961, AT&T decided to divide Pacific into two subsidiaries. Pacific transferred assets for operations in Oregon, Washington, and Idaho to a new corporation, Pacific Northwest Bell Telephone Company, in exchange for all of Northwest's common stock and debt paper. Pacific then distributed to its shareholders transferable rights entitling them to purchase about 57 percent of Northwest's common stock at $16 per share (below market value of $26). Pacific notified shareholders that "it is expected that within about three years after acquiring the stock of the New Company, the Company by one or more offerings will offer for sale the balance of such stock." In 1963, the remaining Northwest stock was distributed. The issue was whether the 1961 distribution was part of a Type D reorganization under § 355.
     • Holding. The Supreme Court held that the 1961 distribution did not qualify as part of a Type D reorganization because the distribution requirement of § 355(a)(1)(D) was not satisfied at the time of the 1961 distribution. The Court refused to treat the 1961 and 1963 distributions as a single integrated step. The Court stated, "If one transaction is to be characterized as a 'first step,' there must be a binding commitment to take the later steps." There was no binding commitment in 1961 to complete the 1963 distribution.
     • Scope of Gordon. The Gordon holding is narrowly confined to its facts. The Court did not intend the binding commitment test as the universal touchstone of the step-transaction doctrine. Courts have consistently refused to extend Gordon beyond multi-step distributions in D reorganizations. (King Enters., Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969) ("The opinion in Gordon contains not the slightest indication that the Supreme Court intended the binding commitment requirement as the touchstone of the step transaction doctrine in tax law."))
     • Application to § 351. The binding commitment test is the most stringent of the three tests. If the transferor had a legally enforceable obligation to dispose of stock at the time of the exchange, the step-transaction doctrine applies and control is destroyed. If the transferor was free to change his mind, the test is not satisfied.
  2. The mutual interdependence test. Steps will be collapsed if they are so interdependent that the legal relations created by one transaction would have been fruitless without completion of the entire series. (American Bantam Car Co., 11 T.C. at 405. Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir. 1980))
     • The key question is whether the first step would have occurred without the subsequent steps. If the incorporation would have proceeded regardless of the later stock disposition, the test is not satisfied.
     • In American Bantam, the court found the public offering of preferred stock was "not a sine qua non of the general plan" and the incorporation would have gone forward without it. The test therefore failed.
     • In Intermountain Lumber, by contrast, the evidence showed Shook would not have transferred the sawmill assets to S&W without Wilson's participation and funding. The steps were mutually interdependent.
  3. The end result test. Steps will be collapsed if they appear to be "really arranged parts of a single transaction intended from the outset to reach the ultimate result." (Penrod v. Commissioner, 88 T.C. 1415 (1987))
     • Facts. The Penrod family owned a corporation. As part of a plan to acquire another company, the corporation issued stock to the Penrod shareholders. The shareholders then sold a portion of the stock they received to third parties. The IRS argued that the stock issuance and subsequent sale should be stepped together.
     • Holding. The Tax Court rejected the IRS's argument and held that the step-transaction doctrine did not apply. The court found insufficient evidence that the shareholders intended to sell the stock at the time of the original acquisition. However, the court provided the classic modern formulation of the end result test, quoting King Enterprises. The court also quoted King Enterprises for the proposition that "the step transaction doctrine would be a dead letter if restricted to situations where the parties were bound to take certain steps."
     • Firm and fixed plan requirement. Where the taxpayer is the sole shareholder of a closely held corporation and could easily change his mind, the Tax Court demands "compelling evidence of the taxpayer's commitment to the plan" before finding a firm and fixed plan existed. (Penrod, 88 T.C. at 1434)
  4. The key distinction for § 351 practitioners. The modern framework, crystallized in Rev. Rul. 2003-51, 2003-1 C.B. 938, turns on whether the post-exchange disposition is a taxable sale or a nontaxable transfer.
     • If the transferor makes a prearranged taxable sale of stock to a non-transferor, § 351 does not apply. The sale is inconsistent with Congress's intent in enacting § 351 to facilitate the rearrangement of the transferor's interest in its property. (Rev. Rul. 2003-51)
     • If the transferor makes a nontaxable disposition (gift, § 351 transfer to another corporation, § 354 exchange, partnership liquidation under Rev. Rul. 84-111), § 351 continues to apply. The nontaxable disposition is not inconsistent with the purposes of § 351. (Rev. Rul. 2003-51. Rev. Rul. 84-111, 1984-2 C.B. 88)
• Rev. Proc. 77-37 safe harbor. The IRS has established a 10 percent safe harbor for purposes of issuing advance rulings on § 351 transactions.
  • The 10 percent floor. For advance ruling purposes, the IRS will not issue a favorable ruling unless each transferor contributes property with a fair market value equal to at least 10 percent of the fair market value of the stock already owned (or to be owned) by all other transferors.
  • Ruling purposes only. The 10 percent safe harbor applies solely for advance ruling purposes. A contribution below 10 percent may still qualify under § 351 if the transferor has a genuine business purpose for the transfer.
  • Genuine business purpose exception. A transferor who contributes less than 10 percent may still be part of the control group if the transfer is made for a genuine business purpose and is not merely a device to bring another transferor within the control group.
  • TRAP. Do not confuse the safe harbor with the substantive rule. The 10 percent floor is an administrative convenience for the IRS ruling process, not a statutory requirement. A client who contributes 5 percent of the stock value in a bona fide business transaction still satisfies § 351 if the control test is otherwise met. The IRS simply will not issue a ruling on that transaction.
  • If a ruling is needed and a transferor falls below 10 percent. Consider having the small contributor transfer additional property to reach the threshold, or document the genuine business purpose for the small contribution with a contemporaneous business plan, valuation, and board minutes explaining the commercial rationale for the transfer.

Step 4. Services Contributions and § 83

Step 4A. The § 83(a) General Rule for Service Provider Stock

"(a) General rule. If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable." (IRC § 83(a))

• The two triggering events. Income is recognized at the earlier of (a) when the property becomes transferable by the service provider, or (b) when the property is no longer subject to a substantial risk of forfeiture. (§ 83(a)(1))
• The amount of income. Ordinary income equals the FMV of the stock at the triggering date (determined without regard to restrictions that will lapse) minus any amount paid by the service provider for the stock. (§ 83(a)(2))
• Restrictions that will never lapse are taken into account. When computing FMV, ignore vesting conditions and other lapse restrictions. Include only restrictions that by their terms will never lapse. (§ 83(a)(1))
• The "substantial risk of forfeiture" defined. Property is subject to a substantial risk of forfeiture if the persons' rights to full enjoyment of the property are conditioned upon the future performance of substantial services. (Treas. Reg. § 1.83-3(c)(1))
• Typical forfeiture condition. Stock is commonly subject to forfeiture if the service provider ceases employment before a specified date. If employment continues through the vesting date, the substantial risk of forfeiture lapses. (Treas. Reg. § 1.83-3(c)(2), Example)
• Transferable means freely assignable. The stock is transferable once the service provider can sell, assign, or pledge the stock to any person without restriction. (Treas. Reg. § 1.83-3(d))

Step 4B. The § 83(b) Election Mechanics

"(b) Election to include in gross income in year of transfer. (1) In general. Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income for the taxable year in which such property is transferred, the excess of (A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over (B) the amount (if any) paid for such property. (2) Election. An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary." (IRC § 83(b)(1)-(2))

• The election is optional but binding. A service provider may elect to accelerate income inclusion to the date of transfer. Once made, the election is irrevocable without the consent of the Commissioner. (§ 83(b)(2))
• The 30-day deadline is absolute. The written election statement must be filed not later than 30 days after the date the property was transferred. (Treas. Reg. § 1.83-2(b))
  • The 30-day period includes weekends and holidays. If the 30th day falls on a weekend or federal holiday, the deadline is the next business day only if the 30th day itself is a non-business day. Count calendar days, not business days.
  • TRAP. There is no extension available. A late election is void and cannot be cured by request for relief, private letter ruling, or any other mechanism. Treas. Reg. § 1.83-2(c) states that an election not made within the 30-day period "will not be valid."
• Where to file. The election statement is filed with the IRS Service Center where the person making the election files their individual tax returns. (Treas. Reg. § 1.83-2(d))
• Copies required. The electing individual must provide a copy of the election statement to (a) the person for whom the services are performed (the corporation), and (b) if different, the transferee of the property. (Treas. Reg. § 1.83-2(e))
• Required contents of the election statement. (Treas. Reg. § 1.83-2(e)) The written statement must include all of the following:
  1. The name, address, and taxpayer identification number of the taxpayer making the election.
  2. A description of each property with respect to which the election is made.
  3. The date or dates on which the property was transferred.
  4. The taxable year for which the election is made.
  5. The nature of the restriction or restrictions to which the property is subject.
  6. The fair market value of the property at the time of the transfer (determined without regard to any lapse restriction).
  7. The amount (if any) paid for the property.
  8. A statement that the election is being made under § 83(b).
• Form 15620 option. As of November 2024, taxpayers may file Form 15620 in lieu of a written statement. The form incorporates all required elements from Treas. Reg. § 1.83-2(e). Either the form or a properly drafted written statement is acceptable. (IRS Form 15620, released November 7, 2024)
• Proof of filing is essential. Send the original by certified mail, return receipt requested. Retain the certified mail receipt and return receipt with the taxpayer's permanent records. The taxpayer bears the burden of proving timely filing if the IRS disputes receipt.

Step 4C. Consequences of Making the § 83(b) Election

• Immediate ordinary income at transfer. The service provider includes in gross income the excess of the stock's FMV at the time of transfer (ignoring lapse restrictions) over the amount paid for the stock. (§ 83(b)(1)(A)-(B))
• No income at vesting. Because § 83(a) does not apply once the election is made, no additional income is recognized when the stock vests. All appreciation from the transfer date to the vesting date escapes ordinary income taxation. (§ 83(b)(1)). "If such election is made, subsection (a) shall not apply"
• Character of future appreciation is capital gain. When the stock is eventually sold, the service provider recognizes capital gain or loss equal to the sale price minus basis. Basis equals the amount paid for the stock plus the amount included in income under the § 83(b) election (i.e., FMV at transfer). (§ 83(b)(1). Treas. Reg. § 1.83-4(a))
• Holding period begins at transfer. Because the election treats the stock as owned from the transfer date, the holding period for capital gains purposes commences on the date of transfer, not the vesting date. (Treas. Reg. § 1.83-4(a))
• Dividends before vesting are actual dividends. Once the election is made, dividends paid on the restricted stock are treated as true dividends (eligible for qualified dividend treatment if other requirements are met) rather than compensation income. (CCA 200115015)
• No deduction if stock is forfeited. This is the harshest consequence of the election. If the stock is subsequently forfeited, the service provider receives no deduction for the income previously recognized under the election. (§ 83(b)(1)). "if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture"
  • TRAP. The forfeiture loss is a capital loss only if the stock was sold. A pure forfeiture (stock returned to the corporation) produces no deduction whatsoever. The service provider has paid tax on income they never economically enjoy.
• Corporation receives immediate deduction under § 83(h). The corporation is allowed a deduction equal to the amount included in the service provider's income, in the taxable year in which or with which ends the service provider's taxable year of inclusion. For a calendar-year service provider and calendar-year corporation, the deduction is taken in the year of transfer. (§ 83(h))
  • The corporation's deduction is under § 162 and is treated as a compensation deduction.
  • EXAMPLE. Founder receives 1,000,000 shares of restricted stock at FMV of $0.001 per share, subject to 4-year vesting. Founder pays nothing. Founder timely files a § 83(b) election. Founder recognizes $1,000 of ordinary income at transfer. Corporation takes a $1,000 compensation deduction. When the stock vests 4 years later at FMV of $5.00 per share, no additional income is recognized. On later sale at $10.00 per share, founder recognizes $9,999,000 of capital gain ($10,000,000 sale proceeds minus $1,000 basis).

Step 4D. Consequences of NOT Making the § 83(b) Election

• No income at transfer. Under the default rule, the service provider recognizes no income when the restricted stock is initially transferred. (§ 83(a))
• Ordinary income at vesting. When the stock vests (becomes transferable or the substantial risk of forfeiture lapses), the service provider recognizes ordinary income equal to the FMV of the stock at the vesting date minus any amount paid. (§ 83(a)(1)-(2))
  • All appreciation from the transfer date to the vesting date is taxed as ordinary income.
  • TRAP. If the stock has appreciated significantly during the vesting period, the service provider faces a large ordinary income tax bill at vesting, potentially without liquid assets to pay the tax.
• Character of post-vesting appreciation is capital gain. When the stock is sold after vesting, gain or loss is computed as sale price minus basis. Basis equals the amount paid plus the amount included in income at vesting (i.e., FMV at vesting). (§ 83(a). Treas. Reg. § 1.83-4(a))
• Holding period begins at vesting. Because the stock is not treated as owned until vesting, the holding period for capital gains purposes begins on the vesting date, not the transfer date. (Treas. Reg. § 1.83-4(a))
• Dividends before vesting are compensation. Dividends paid on unvested stock are treated as additional compensation income (not eligible for qualified dividend rates) because the service provider is not treated as the owner of the stock for tax purposes until vesting. (Treas. Reg. § 1.83-1(a)(1))
• No income on forfeiture before vesting. If the stock is forfeited before it vests, the service provider recognizes no income and has no tax consequence. (Treas. Reg. § 1.83-1(a)(1))
• Corporation deducts at vesting under § 83(h). The corporation takes a compensation deduction equal to the amount included in the service provider's income at vesting, in the taxable year in which or with which ends the service provider's taxable year of inclusion. (§ 83(h))
  • EXAMPLE. Same facts as above but no § 83(b) election. No income at transfer. At vesting 4 years later, founder recognizes $5,000,000 of ordinary income ($5.00 FMV x 1,000,000 shares). Corporation takes a $5,000,000 deduction. On later sale at $10.00, founder recognizes $5,000,000 of capital gain ($10,000,000 minus $5,000,000 basis). The founder pays ordinary income tax on $5,000,000 at vesting rather than $1,000 at transfer.

Step 4E. The § 83(h) Corporate Deduction

"(h) Deduction by employer. In the case of a transfer of property to which this section applies or a cancellation of a restriction described in subsection (d), there shall be allowed as a deduction under section 162, to the person for whom were performed the services in connection with which such property was transferred, an amount equal to the amount included under subsection (a), (b), or (d)(2) in the gross income of the person who performed such services." (IRC § 83(h))

• The deduction mirrors the service provider's income inclusion. The corporation receives a deduction equal to the exact amount included in the service provider's gross income under § 83(a), § 83(b), or § 83(d)(2). (§ 83(h))
• Character of the deduction is § 162 compensation. The deduction is treated as a compensation expense under § 162, not as a § 212 expense. The corporation must satisfy the ordinary and necessary business expense requirements. (§ 83(h))
• Timing of the deduction tracks the service provider's inclusion year. The corporation deducts the amount in the taxable year in which, or with which, ends the taxable year of the service provider in which the amount is included in gross income. (§ 83(h))
  • If the service provider makes a § 83(b) election, the corporation deducts in the year of transfer.
  • If no § 83(b) election, the corporation deducts in the year of vesting.
• Cash method corporations must wait. A cash method corporation deducts the amount in the year the corresponding compensation is includible in the service provider's income, which may differ from the year of payment if the corporation is on the accrual method. (Treas. Reg. § 1.83-6(a)(1))
• Deduction is lost if § 83(b) stock is forfeited. If the service provider makes a § 83(b) election and the stock is later forfeited, the service provider gets no deduction. The corporation's deduction is not recaptured. However, if the corporation previously deducted the amount, the deduction stands. (§ 83(b)(1). Treas. Reg. § 1.83-2(a))

Step 4F. Hybrid Transferors (Property Plus Services)

• A person who transfers both property and services may still be a transferor for the control test. The critical question is whether the property transferred is "not merely nominal." If the property contribution has genuine economic substance, the person counts as a transferor for purposes of the § 368(c) control test. (Treas. Reg. § 1.351-1(a)(1)(ii). Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd, 469 F.2d 219 (1st Cir. 1972))
• Treas. Reg. § 1.351-1(a)(1)(i) and (ii) work together. Subparagraph (i) excludes persons who perform services and transfer no property. Subparagraph (ii) excludes persons whose property transfer is of relatively small value and whose primary purpose is to qualify other persons' exchanges. (Treas. Reg. § 1.351-1(a)(1)(i)-(ii))
  • If the property transfer is not merely nominal and the primary purpose is a genuine investment or business purpose (not just to help others satisfy the control test), the person qualifies as a transferor.
• The stock received for property qualifies under § 351. To the extent stock is issued in exchange for qualifying property, the transferor recognizes no gain or loss under § 351(a), assuming the control test is met. (Treas. Reg. § 1.351-1(a)(1))
• The stock received for services is taxed under § 83. To the extent stock is issued for services, the service provider recognizes ordinary income under § 83(a), even if the property transferor group satisfies the control test. (Treas. Reg. § 1.351-1(a)(1)(i)) (§ 351(d)(1))
• Allocation between property and services is required. When a single person receives stock for both property and services, a reasonable allocation must be made between the property component (§ 351) and the services component (§ 83). (Rev. Rul. 64-56, 1964-1 C.B. 133. Treas. Reg. § 1.351-1(a)(1)(i))
  • The allocation should be based on the relative fair market values of the property and services contributed.
  • Document the allocation contemporaneously in the contribution agreement or other corporate records.
• Kamborian is the leading case on nominal property. In Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd, 469 F.2d 219 (1st Cir. 1972), four stockholders of International transferred their stock in Campex to International in exchange for International common stock. A fifth stockholder, the Elizabeth Kamborian Trust, purchased only 42 shares of Class A and 376 shares of Class B at the same time. The Trust already owned 5,000 shares of Class A and 45,000 shares of Class B. The Tax Court held that the Trust's purchase was a nominal transfer of relatively small value, the primary purpose of which was to qualify the other stockholders' exchanges under § 351. The Trust was not a transferor, the control test failed, and all gain was recognized. (Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd, 469 F.2d 219 (1st Cir. 1972))
  • The 10% safe harbor in Rev. Proc. 77-37 is for advance ruling purposes only. It is not a substantive legal test. A transfer of less than 10% may still qualify if the primary purpose is not to manufacture control. (Rev. Proc. 77-37, 1977-2 C.B. 568)
• Example from Treas. Reg. § 1.351-1(b)(2). Individuals C and D each transfer property to a newly organized corporation for 45 shares each. At the same time, the corporation issues 10 shares to E in payment for organizational and promotional services. E transferred no property. C and D collectively own 90% and are in control. C and D recognize no gain. E recognizes ordinary income equal to the FMV of the 10 shares. (Treas. Reg. § 1.351-1(b)(2), Example 2)

Step 4G. Documentation Checklist and Practice Pointers

• Draft the § 83(b) election statement before closing. Do not wait until after the transfer. Prepare the election statement as part of the incorporation documents. Have the client sign and date it on the date of transfer.
• Contents checklist for the election statement.
  1. Transferor's full legal name, address, and taxpayer identification number.
  2. Description of the property (e.g., "1,000,000 shares of common stock of XYZ Corp., par value $0.001 per share").
  3. Date of transfer.
  4. Taxable year in which the election is made.
  5. Nature of the restrictions (e.g., "subject to forfeiture if the taxpayer ceases to be employed by XYZ Corp. before [date]").
  6. FMV of the property at transfer without regard to lapse restrictions.
  7. Amount paid for the property.
  8. Amount to include in gross income (FMV minus amount paid).
  9. Clear statement that the election is made under § 83(b).
• Filing protocol.
  1. Prepare the original election statement.
  2. File with the appropriate IRS Service Center within 30 days. Use certified mail, return receipt requested.
  3. Retain the certified mail receipt and the return receipt.
  4. Provide a copy to the corporation on or before the filing date.
  5. Retain a copy with the transferor's permanent tax records.
• CAUTION. Do not rely on the corporation to file the election. The service provider, not the corporation, is responsible for making the election. Corporate counsel representing the company should remind service providers of the deadline but should not file the election on their behalf without a clear engagement letter.
• CAUTION. The 30-day clock starts on the date of transfer, not the date of agreement. The date of transfer is the date the stock is actually issued to the service provider, not the date the employment agreement or stock purchase agreement is signed. Confirm the exact transfer date before counting the 30 days.
• The § 83(b) election advisory decision. Walk through the following factors:
  1. Is the FMV at transfer very low (e.g., startup stock with minimal value)? If YES, the election is more attractive because the immediate income inclusion is small.
  2. Is significant appreciation expected before vesting? If YES, the election converts that appreciation from ordinary income to capital gain.
  3. Is the risk of forfeiture low? If NO, the risk of forfeiture without a deduction makes the election dangerous.
  4. Does the client have liquid funds to pay the tax on the immediate inclusion? The tax is due in the year of transfer even though the stock cannot yet be sold.
  5. Will the corporation benefit from an immediate deduction? Consider the corporation's tax rate and whether the deduction is valuable now or later.
• Hybrid transferor tracking. In any transaction where a person contributes both property and services, prepare a written allocation of the stock received between the property component and the services component. This allocation controls both the § 351 nonrecognition analysis and the § 83 income inclusion.

Step 5. Liability Assumption Under § 357

When the corporation assumes liabilities of the transferor as part of a § 351 exchange, the transferor must navigate three overlapping statutory regimes. Analyze them in sequence. § 357(a) sets the general rule of nonrecognition. § 357(b) imposes a tax-avoidance override. § 357(c) requires gain recognition when liabilities exceed basis.

Step 5A. § 357(a) General Rule

"Except as provided in subsections (b) and (c), if (1) the taxpayer receives property which would be permitted to be received under section 351 or 361 without the recognition of gain if it were the sole consideration, and (2) as part of the consideration, another party to the exchange assumes a liability of the taxpayer, then such assumption shall not be treated as money or other property, and shall not prevent the exchange from being within the provisions of section 351 or 361, as the case may be." (IRC § 357(a))

• The general rule is nonrecognition. When a corporation assumes a liability of the transferor in a § 351 exchange, that assumption is not treated as money or other property (boot). The transferor does not recognize gain solely because the corporation took on the debt. (IRC § 357(a))
• § 357(a) does not stand alone. The nonrecognition rule is expressly subject to the exceptions in § 357(b) (tax avoidance taint) and § 357(c) (excess liability gain). Always check both subsections before concluding that no gain is recognized. (IRC § 357(a) ("Except as provided in subsections (b) and (c)"))
• § 358(d) operates as a basis reduction, not a gain trigger. For purposes of computing the transferor's basis in the stock received, liabilities assumed by the corporation are treated as money received by the transferor. This reduces stock basis dollar-for-dollar. It does not itself cause gain recognition. (IRC § 358(d)(1))
  • § 358(d)(2) exception. The § 358(d)(1) basis reduction does not apply to the amount of any liability excluded under § 357(c)(3) (trade or business liabilities). Those liabilities do not reduce stock basis. (IRC § 358(d)(2))
• The § 357(a) nonrecognition rule applies only if the exchange would otherwise qualify under § 351. If the liability assumption is so large that the transferor contributes no net value, the exchange may fail § 351 entirely under the net-value requirement. See the discussion of liabilities exceeding FMV in Step 5C below. (Prop. Reg. § 1.351-1(a)(1)(iii))
• EXAMPLE. A transfers Blackacre (FMV $200,000, adjusted basis $120,000) to Newco, subject to a $50,000 mortgage, in exchange for 80% of Newco stock. Newco assumes the $50,000 mortgage. Under § 357(a), the assumption is not boot. A recognizes no gain on the assumption itself. A's stock basis is $120,000 + $0 gain recognized - $50,000 liability assumed = $70,000. (IRC §§ 357(a), 358(a), 358(d)(1))

Step 5B. § 357(b) Tax-Avoidance Taint

"If, taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption was made, it appears that the principal purpose of the taxpayer with respect to the assumption described in subsection (a) (A) was a purpose to avoid Federal income tax on the exchange, or (B) if not such purpose, was not a bona fide business purpose, then such assumption (in the total amount of the liability assumed pursuant to such exchange) shall, for purposes of section 351 or 361 (as the case may be), be considered as money received by the taxpayer on the exchange." (IRC § 357(b)(1))

• The dual test is disjunctive. Either prong triggers § 357(b). Prong (A) asks whether the principal purpose of the liability assumption was tax avoidance on the exchange. Prong (B) asks whether, if tax avoidance was not the principal purpose, the principal purpose was still not a bona fide business purpose. Satisfying either prong is sufficient. (IRC § 357(b)(1)(A), (B))
  • The inquiry focuses on the principal purpose of the taxpayer with respect to the assumption, not the incorporation transaction as a whole. Tax avoidance as a secondary or incidental motive is not enough. (Treas. Reg. § 1.357-1(b))
• The taint is binary and global. If § 357(b) applies to any single liability, all liabilities assumed in the exchange are treated as money received (boot). The taint does not stay confined to the problematic liability. (IRC § 357(b)(1) ("in the total amount of the liability assumed pursuant to such exchange"))
  • Treas. Reg. § 1.357-1(c) confirms this reading. The total amount of liabilities assumed, and not merely the particular liability with regard which the tax-avoidance purpose existed, is treated as money received.
• The burden of proof is heightened. § 357(b)(2) places the burden on the taxpayer to prove by the "clear preponderance of the evidence" that the tax-avoidance taint does not apply. The regulations describe this as proof to an extent that is "unmistakable." (IRC § 357(b)(2). Treas. Reg. § 1.357-1(c))
• Factors suggesting improper purpose include the following patterns.
  • The taxpayer borrowed against the property immediately before, and in contemplation of, the transfer, using the loan proceeds for purely personal purposes (paying personal income taxes, purchasing a personal residence, or buying tax-exempt securities). (Harrington v. Commissioner, T.C. Memo. 1971-325 (loan proceeds used for personal purposes shortly before § 351 transfer supported finding of tax avoidance purpose)) (Slappey Drive Indus. Park v. United States, 561 F.2d 572 (5th Cir. 1977) (borrowing against property in close proximity to transfer with no business purpose triggered § 357(b)))
  • The liability was created or incurred primarily to generate tax benefits in connection with the exchange, with no genuine business purpose. (Treas. Reg. § 1.357-1(b))
  • The time interval between borrowing and transfer is short, and there is no credible explanation for the borrowing apart from the anticipated incorporation. (Patterson v. Commissioner, 195 F.2d 657 (10th Cir. 1952) (discussing the relevance of timing and surrounding circumstances in assessing principal purpose under § 357(b)))
• § 357(b) overrides § 357(c). § 357(c)(2)(A) provides that the excess-liability gain rule of § 357(c)(1) does not apply to any exchange to which § 357(b)(1) applies. If the tax-avoidance taint is present, § 357(c) does not limit the result. The controlling rule is § 357(b), and all liabilities become boot. (IRC § 357(c)(2)(A). Treas. Reg. § 1.357-2(a))
• Gain recognized under § 357(b) is capped at realized gain. Even when all liabilities are treated as boot, the transferor recognizes gain only to the extent of the lesser of (1) total liabilities treated as boot or (2) total realized gain on the exchange. (IRC § 351(b) (gain recognized is lesser of boot received or realized gain))
• CAUTION. A client who takes out a home equity loan against business property two weeks before incorporation, and deposits the proceeds in a personal account, has created a textbook § 357(b) problem. One tainted liability poisons every liability in the exchange.

Step 5C. § 357(c) Excess-Liability Gain

"In the case of an exchange to which section 351 applies, if the sum of the amount of the liabilities assumed exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be." (IRC § 357(c)(1))

• The computation is aggregate across all transferred assets. Sum every liability assumed by the corporation. Sum the adjusted basis of all property transferred by the transferor. If total liabilities exceed total adjusted basis, the excess is recognized gain. The transferor cannot avoid § 357(c) by pointing to individual assets whose basis exceeds their attached liability. All liabilities and all asset bases are netted together. (IRC § 357(c)(1)) (Rev. Rul. 66-142, 1966-1 C.B. 93 (gain computed on aggregate basis of all property transferred)) (Treas. Reg. § 1.357-2 (computation of gain where liabilities exceed basis))
• Character of the gain is determined by reference to the assets transferred. The excess liability gain takes the character of the transferred assets. Allocate the gain among the transferred assets by relative fair market value. If the transferred assets include both capital assets and non-capital assets, apportion the gain proportionally. The holding period for determining whether capital gain is long-term or short-term references the transferor's holding period in each asset. (Treas. Reg. § 1.357-2(b) (character and holding period of gain determined by reference to transferred assets, apportioned by FMV))
• § 357(c)(3) excludes certain trade or business liabilities from the computation. A liability transferred in a § 351 exchange is excluded from the "liability" total for purposes of § 357(c)(1) if two conditions are met. (IRC § 357(c)(3))
  • Requirement (A). The payment of the liability would give rise to a deduction (for example, trade accounts payable of a cash-basis taxpayer, accrued salaries payable, or accrued rent payable), or the payment would be described in § 736(a) (partnership payments to a retiring partner). (IRC § 357(c)(3)(A)(i), (ii))
  • Requirement (B). The incurrence of the liability did not result in the creation of, or an increase in, the basis of any property. This exception-to-the-exception prevents exclusion of purchase-money mortgage debt, construction loans, or liabilities used to acquire or improve property. (IRC § 357(c)(3)(B))
• § 736(a) payments are excluded under § 357(c)(3)(A)(ii) but do not qualify for additional favorable treatment. A partnership § 736(a) payment (whether a distributive share or guaranteed payment to a retiring partner) is excluded from the liability total under § 357(c)(3)(A)(ii). However, the § 357(c)(3) exclusion does not apply if the liability increased the basis of property, per § 357(c)(3)(B). (IRC § 357(c)(3)(A)(ii), (B))
• § 357(c) gain is real recognized gain. It is not boot under § 351(b). This distinction matters. Boot gain under § 351(b) is limited to the lesser of boot received or realized gain. § 357(c) gain is an independent recognition event. It is the excess of liabilities over basis, period. It does not depend on whether the transferor also received other boot. (IRC § 357(c)(1). Treas. Reg. § 1.357-2(a))
• § 357(b) overrides § 357(c). If the tax-avoidance taint of § 357(b) applies, § 357(c) drops out entirely. The transferor's gain is computed under § 357(b), not under § 357(c). In nearly every case, § 357(b) produces a larger gain because it treats all liabilities as boot rather than only the excess over basis. (IRC § 357(c)(2)(A). Treas. Reg. § 1.357-2(a))
• The Crane and Tufts principles underlie § 357(c). The Supreme Court held in Crane v. Commissioner, 331 U.S. 1 (1947), that a taxpayer's basis in property includes the full amount of nonrecourse debt, and the Court held in Commissioner v. Tufts, 461 U.S. 300 (1983), that the amount realized on disposition includes the full amount of nonrecourse debt even when it exceeds FMV. § 357(c) operationalizes these principles for § 351 exchanges by requiring gain recognition when the liability (included in amount realized) exceeds basis (which may include the liability itself). (Crane v. Commissioner, 331 U.S. 1 (1947) (basis includes full nonrecourse mortgage). (Commissioner v. Tufts, 461 U.S. 300 (1983) (amount realized includes full nonrecourse liability even when liability exceeds FMV))
• Net-value concern when liabilities exceed FMV. Even if § 357(c) does not apply (because basis equals or exceeds liabilities), or even if § 357(a) fully protects the transferor, the exchange may fail to qualify under § 351 if aggregate liabilities assumed exceed the aggregate fair market value of the property transferred. In that situation, the transferor contributes no net value, and the transaction may be recast as a sale or a § 301 distribution. Prop. Reg. § 1.351-1(a)(1)(iii) addresses this scenario, and multiple Chief Counsel Advisories have applied it. (Prop. Reg. § 1.351-1(a)(1)(iii)) (CCA 201433014) (CCA 201552026) (Meyer v. United States, 121 F. Supp. 898 (Ct. Cl. 1954), cert. denied, 348 U.S. 929 (1955) (no net value where liability exceeded property value)))
  • If this concern is present, the transferor should contribute additional unencumbered property with FMV sufficient to cover the excess of liabilities over the FMV of the encumbered property.
• The § 357(c)(3) safe harbor for cash-basis trade payables. The classic application involves a cash-basis sole proprietorship with trade accounts payable and accrued expenses. Those payables are excluded from the liability total because payment would give rise to a deduction, and they typically did not create or increase the basis of property. Congress enacted § 357(c)(3) in 1976 in response to Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir. 1972), in which the Second Circuit held that the literal reading of § 357(c) produced an absurd result for cash-basis taxpayers. (Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir. 1972) (reversing Tax Court, holding trade accounts payable of cash-basis taxpayer should not be treated as liabilities for § 357(c) purposes because literal reading produced absurd result). (Treas. Reg. § 1.357-2, Ex. (7) (cash-basis service proprietorship with $180,000 in salaries payable and rent payable excluded from liability total under § 357(c)(3)(A)(i), resulting in zero gain)))
  • TRAP. A cash-basis transferor with trade receivables (zero basis) and trade payables still faces risk. The receivables have zero basis and count as property with zero basis in the § 357(c) computation, while the payables may be excluded under § 357(c)(3). The result can be unexpected gain if the excluded payables are large enough that the remaining liabilities exceed the remaining asset bases. (Raich v. Commissioner, 46 T.C. 604 (1966) (cash-basis taxpayers' trade receivables had zero basis, and liabilities exceeded adjusted basis by $34,741, producing § 357(c) gain)))
• The circuit split on shareholder promissory notes. When a shareholder executes a promissory note to the corporation as part of the exchange, courts disagree on whether the note counts as property with basis for purposes of the § 357(c) calculation.
  • The Tax Court holds that a shareholder note has zero basis. The taxpayer incurred no cost in making the note. (Alderman v. Commissioner, 55 T.C. 662 (1971) (promissory note did not increase basis. § 357(c) gain applied))
  • The Second Circuit and Ninth Circuit hold that a bona fide note has basis equal to its face amount, which can eliminate § 357(c) gain. (Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989) (shareholder note to corporation had basis equal to face amount, eliminating § 357(c) gain). (Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998) (enforcing shareholder note against operating business with bankruptcy risk, note had basis equal to face amount))
  • CAUTION. Outside the Second and Ninth Circuits, do not rely on a shareholder note to defeat § 357(c) gain. The Tax Court position remains the majority rule in most jurisdictions. (Owen v. Commissioner, 881 F.2d 832 (9th Cir. 1989) (continuing personal liability on assumed loans is irrelevant to § 357(c) gain)))
• EXAMPLE. B transfers the assets of a cash-basis sole proprietorship to Newco in exchange for 100% of its stock. The assets consist of equipment (FMV $300,000, adjusted basis $80,000), accounts receivable (FMV $50,000, adjusted basis $0), and cash ($20,000). Newco assumes a bank loan of $120,000 (used to acquire the equipment, so § 357(c)(3)(B) prevents exclusion) and trade accounts payable of $40,000. The trade accounts payable are excluded under § 357(c)(3)(A)(i). Total liabilities counted for § 357(c) = $120,000. Total adjusted basis = $80,000 + $0 + $20,000 = $100,000. B recognizes § 357(c) gain of $20,000 ($120,000 liabilities minus $100,000 basis). The gain is characterized by reference to the equipment (the primary transferred asset) and is long-term or short-term depending on B's holding period in the equipment. (IRC § 357(c)(1). Treas. Reg. § 1.357-2(b))

Step 6. Basis in Stock Received Under § 358

"The basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged, decreased by the fair market value of any other property except money received by the taxpayer, the amount of any money received by the taxpayer, and the amount of loss to the taxpayer which was recognized on such exchange, and increased by the amount which was treated as a dividend and the amount of gain to the taxpayer which was recognized on such exchange not including any portion of such gain which was treated as a dividend." (IRC § 358(a)(1))

• The § 358(a)(1) Substituted Basis Formula. The shareholder's basis in stock received in a § 351 exchange is computed in four steps.
  1. Start with the transferor's adjusted basis in the property transferred to the corporation.
  2. Decrease that amount by the sum of (i) any money received and (ii) the fair market value of any other property (boot) received. (§ 358(a)(1)(A)(i) and (ii))
  3. Increase that amount by the amount of gain recognized on the exchange. (§ 358(a)(1)(B)(ii)) The increase for gain recognized prevents the recognition of gain from disappearing for tax purposes. It embeds the taxed gain into the stock basis.
  4. Decrease that amount by the amount of any loss recognized on the exchange. (§ 358(a)(1)(A)(iii)) In § 351 exchanges, this component is almost always zero because § 351(b)(2) bars loss recognition.
  5. The resulting figure is the shareholder's aggregate basis in all stock received. If only one class of stock is issued, the entire basis amount attaches to those shares. If multiple classes are issued, allocate basis pro rata by relative FMV per Treas. Reg. § 1.358-2(b).
  6. The formula in summary terms is as follows. Stock basis equals adjusted basis of property transferred, minus boot received (cash plus FMV of other property), plus gain recognized, minus loss recognized. (§ 358(a)(1). Treas. Reg. § 1.358-1(a))
  7. EXAMPLE. Shareholder contributes property with $100 adjusted basis and $150 FMV. Corporation assumes a $40 liability. Shareholder receives only stock worth $110. Under § 358(a)(1), stock basis is $100 (basis of property) minus $0 (no boot) plus $0 (no gain recognized) equals $100. Under § 358(d)(1), reduce basis by $40 liability treated as money received. Final stock basis is $60. The shareholder holds stock worth $110 with a $60 basis, embedding $50 of deferred gain. If the shareholder instead recognized $10 of gain (e.g., from boot or § 357(c)), stock basis would be $100 minus $0 plus $10 minus $40 liability, yielding $70.
• The § 358(a)(2) Basis in Boot Received. Any property received in the exchange other than stock of the transferee corporation (i.e., boot) takes a basis equal to its fair market value as of the date of the transaction. (§ 358(a)(2)) This is a stepped-up basis rule. Because gain is already recognized to the extent of the lesser of realized gain or boot FMV under § 351(b), the boot receives a fresh basis to prevent double taxation. The holding period for boot property begins the day after the exchange. It does not tack the holding period of the transferred property.
  • CAUTION. Do not allocate any of the transferor's historical property basis to boot. Boot stands on its own with a basis equal to FMV. Only stock receives substituted basis under § 358(a)(1).
• § 358(d)(1) Liabilities Assumed Are Treated as Money Received. Where the corporation assumes a liability of the transferor as part of the exchange, that assumption is treated as money received by the transferor for basis computation purposes. (§ 358(d)(1)) The liability assumption reduces the transferor's basis in the stock received dollar for dollar.
  • CRITICAL. § 358(d)(1) is a basis reduction rule, NOT a gain recognition rule. The assumption of a liability reduces stock basis but does not, by itself, trigger gain recognition. Gain recognition on liabilities occurs only under § 357(c) when the total liabilities assumed exceed the total adjusted basis of property transferred. If § 357(c) does not apply, the liability simply reduces basis.
  • Holdcroft Transp. Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946). The court held that the assumption of a liability by a transferee is properly incorporated into the basis framework. The liability assumption is part of the cost of acquiring the transferred asset and its payment does not give rise to a deductible expense for the transferee. This case established the foundational principle underlying § 358(d).
  • EXAMPLE. Transferor contributes a building with $70,000 adjusted basis and $150,000 FMV. The corporation assumes a $50,000 mortgage. The transferor receives only stock. Under § 358(a)(1), preliminary stock basis is $70,000. Under § 358(d)(1), reduce basis by $50,000 liability treated as money. Final stock basis is $20,000. The transferor's realized gain of $80,000 ($150,000 FMV plus $50,000 liability relieved minus $70,000 basis minus $50,000 liability offset) is entirely deferred because the $50,000 liability does not exceed the $70,000 basis.
• § 358(d)(2) Exception for § 357(c)(3) Trade-or-Business Liabilities. Paragraph (1) of § 358(d) does not apply to the amount of any liability excluded under § 357(c)(3). (§ 358(d)(2)) Liabilities that qualify for the § 357(c)(3) trade-or-business exception (i.e., liabilities the payment of which would give rise to a deduction, or § 736(a) payment obligations) are NOT treated as money received for basis purposes. This prevents a double benefit. Those liabilities escape gain recognition under § 357(c)(3), and they also escape basis reduction under § 358(d)(2). The transferor's stock basis remains undiminished by the amount of qualifying trade liabilities.
  • EXAMPLE. A cash-basis service proprietorship transfers all assets to a newly formed corporation. The assets have a total adjusted basis of $150,000. Trade payables of $90,000 (deductible when paid) and salaries payable of $90,000 (also deductible when paid) are assumed by the corporation. Under § 357(c)(3), these liabilities do not trigger gain even though total liabilities of $180,000 exceed total asset basis of $150,000. Under § 358(d)(2), the liabilities do not reduce stock basis. The proprietor's stock basis is $150,000.
  • TRAP. If a liability partially qualifies under § 357(c)(3) and partially does not, bifurcate the treatment. Only the qualifying portion is excluded from § 358(d)(1). The nonqualifying portion reduces basis as money received.
• § 358(h) Special Rule for Certain Liability Assumptions. If, after applying all other provisions of § 358, the basis of stock received exceeds the FMV of that stock, then such basis shall be reduced (but not below FMV) by the amount of any liability assumed in the exchange with respect to which § 358(d)(1) does not apply. (§ 358(h)(1)) This provision was enacted to prevent a specific abuse. A taxpayer could transfer high-basis, low-FMV property coupled with a contingent liability to create stock with an artificially inflated basis, then sell the stock to accelerate a loss. § 358(h) closes that gap.
  • The provision applies when two conditions are met. First, after computing basis under § 358(a)(1), (d), and other applicable rules, the stock basis exceeds the stock's FMV. Second, a liability was assumed in the exchange that escaped treatment as money under § 358(d)(1). This typically occurs when § 358(d)(2) applies (a § 357(c)(3) liability) or when the liability is contingent and not otherwise treated as money.
  • § 358(h)(2) provides two exceptions. The rule does not apply if (A) the trade or business with which the liability is associated is transferred to the corporation as part of the exchange, or (B) substantially all of the assets with which the liability is associated are transferred to the corporation as part of the exchange. (§ 358(h)(2)(A) and (B))
  • § 358(h) applies to transfers after October 18, 1999. (Community Renewal Tax Relief Act of 2000)
  • EXAMPLE. A transferor contributes an asset with $100,000 basis and $60,000 FMV to Newco. Newco assumes a contingent environmental remediation liability with an estimated value of $40,000 that would be deductible when paid. The transferor receives Newco stock worth $60,000. Under § 358(a)(1), preliminary stock basis is $100,000. Under § 358(d)(2), the contingent liability is not treated as money because it would be deductible under § 357(c)(3)(A)(i). Stock basis would remain $100,000, creating a $40,000 built-in loss in stock worth only $60,000. § 358(h) reduces stock basis by the $40,000 liability (but not below the $60,000 FMV). Final stock basis is $60,000.
  • TRAP. § 358(h) operates as a backstop to § 358(d). After applying § 358(d)(1) and (d)(2), always check whether the resulting stock basis still exceeds the stock's FMV. If it does, and a liability escaped § 358(d)(1) treatment, § 358(h) may trigger a further basis reduction.
• The Basis Cannot Exceed FMV When No Gain Is Recognized. Under § 358(a)(1), if the transferor recognizes no gain and receives no boot, stock basis equals the transferor's adjusted basis in the contributed property. When that property has a built-in loss (basis exceeds FMV), the stock inherits the same built-in loss. This outcome flows directly from the statutory formula. It is not an independent statutory cap, but it is a critical practical result. The transferor walks away with stock whose basis exceeds its value, and the deferred loss is trapped in the stock until disposition. Practitioners should flag this result for clients because the loss is not currently deductible and may be difficult to extract.
  • CAUTION. Do not mistakenly reduce stock basis to FMV in this situation unless § 358(h) or § 362(e)(2)(C) applies. The general § 358(a)(1) formula preserves the full substituted basis even when it exceeds FMV. The built-in loss remains embedded in the stock.
• Basis Allocation Across Multiple Classes of Stock. When a transferor receives stock of more than one class (or both stock and securities), the aggregate basis computed under § 358(a)(1) must be allocated among the classes by relative FMV. (Treas. Reg. § 1.358-2(b))
  • The regulation provides that the basis of the property transferred (as adjusted under § 358) shall be allocated among all stock and securities received in proportion to the fair market values of the stock of each class and the securities of each class. (Treas. Reg. § 1.358-2(b))
  • If only common stock of a single class is received, the entire basis attaches to those shares. No allocation is necessary.
  • Basis allocated to a particular class equals total stock basis multiplied by (FMV of that class divided by total FMV of all stock and securities received).
  • Arrott v. Commissioner, 136 F.2d 449 (3d Cir. 1943). The court permitted averaging of basis where stock was received in a reorganization, determining basis in new shares by averaging basis in old shares. This case and Bloch v. Commissioner, 148 F.2d 452 (9th Cir. 1945) (which permitted tracing), created inconsistent pre-regulation approaches. Treas. Reg. § 1.358-2(b) now resolves this by mandating FMV-proportional allocation.
  • EXAMPLE. A transferor contributes property with $120,000 adjusted basis to a corporation, receiving 100 shares of common stock (FMV $72,000) and 100 shares of preferred stock (FMV $48,000). No boot is received. Total stock basis under § 358(a)(1) is $120,000. Common stock receives $72,000 divided by $120,000 times $120,000, which equals $72,000. Preferred stock receives $48,000 divided by $120,000 times $120,000, which equals $48,000. Per-share basis is $720 for common and $480 for preferred.

Step 7. Corporate Basis in Contributed Property Under § 362

"If property was acquired by a corporation in connection with a transaction to which section 351 applies, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer." (IRC § 362(a))

• The § 362(a) General Carryover Basis Rule. The corporation's basis in property received in a § 351 exchange is the same as the transferor's adjusted basis immediately before the exchange, increased by any gain the transferor recognized on the transfer. (§ 362(a)) This is a substituted basis rule. The corporation steps into the transferor's tax shoes with respect to the contributed asset's basis, subject to the gain-recognition increase and the built-in-loss limitations in § 362(e).
  • The formula is straightforward. Corporate basis in the asset equals transferor's adjusted basis plus gain recognized by the transferor on that asset. (§ 362(a))
  • The gain-recognition increase applies simultaneously at both the shareholder and corporate levels. The gain recognized by the transferor (which increases the transferor's stock basis under § 358(a)(1)(B)(ii)) simultaneously increases the corporation's basis in the transferred assets under § 362(a). Both sides of the transaction are stepped up to reflect gain that was recognized and taxed. This parallel adjustment prevents the same gain from being taxed twice.
  • EXAMPLE. A transferor contributes equipment with $50,000 adjusted basis and $80,000 FMV, receiving stock worth $70,000 and $10,000 cash. The transferor recognizes $10,000 gain (lesser of $30,000 realized gain or $10,000 boot). The transferor's stock basis under § 358 is $50,000. The corporation's basis in the equipment under § 362(a) is $50,000 plus $10,000, or $60,000. The $10,000 of taxed gain is embedded in both the stock basis and the corporate asset basis.
  • TRAP. § 362(a)(2) covers property acquired "as paid-in surplus or as a contribution to capital." The same carryover-basis-plus-gain rule applies. The distinction between § 362(a)(1) (§ 351 exchanges) and § 362(a)(2) (contributions to capital) matters only for non-shareholder contributions, which take a zero basis under § 362(c).
• § 362(b) The Parallel Rule for Reorganizations. § 362(b) applies the same carryover-basis-plus-gain-recognized formula to property acquired by a corporation in connection with a reorganization to which part III of subchapter C applies. (§ 362(b)) § 362(b) does not apply to § 351 exchanges. For § 351 formations, § 362(a) is the operative provision. The two subsections share identical mechanics but govern different transactional contexts. A practitioner handling a § 351 exchange should cite and apply § 362(a), not § 362(b).
• § 362(e)(1) Importation of Net Built-In Loss. If the transferor and corporation are not both subject to U.S. tax on the same gain or loss, and the transferor contributes property with an aggregate adjusted basis that exceeds aggregate FMV, the corporation's basis in each imported asset is limited to FMV. (§ 362(e)(1)(A)) This provision prevents the importation of built-in losses from tax-exempt or foreign transferors into the U.S. corporate tax system.
  • Three requirements must be satisfied. First, the transaction must be described in § 362(a) or (b). Second, the property must be "importation property," defined as property where (i) gain or loss is not subject to U.S. tax in the transferor's hands immediately before the transfer, and (ii) gain or loss would be subject to U.S. tax in the transferee's hands immediately after the transfer. (§ 362(e)(1)(B)) Third, there must be an "importation of a net built-in loss," meaning the transferee's aggregate adjusted bases of importation property would exceed the aggregate FMV of such property. (§ 362(e)(1)(C))
  • If all three requirements are met, each importation property takes a basis equal to its FMV immediately after the transaction. (§ 362(e)(1)(A)) This applies to every importation property, including assets with built-in gains.
  • § 362(e)(1) has priority over § 362(e)(2). If a transaction is described in both provisions, § 362(e)(1) applies first. (§ 362(e)(2)(A)(i))
  • EXAMPLE. A foreign partnership not subject to U.S. tax contributes three assets to a domestic corporation. Asset 1 has $40 basis and $150 FMV. Asset 2 has $120 basis and $30 FMV. Asset 3 has $140 basis and $20 FMV. Aggregate basis is $300. Aggregate FMV is $200. All three assets are importation property. Under § 362(e)(1), the corporation's basis in Asset 1 is $150, in Asset 2 is $30, and in Asset 3 is $20. Even Asset 1, which had a built-in gain, takes a basis equal to its FMV.
  • TRAP. The importation test looks at the transferor's U.S. tax status immediately before the transfer. A foreign corporation that has a U.S. trade or business may still be subject to U.S. tax on gain from the contributed assets. If so, the assets are not importation property and § 362(e)(1) does not apply. Always verify the transferor's actual U.S. tax exposure before assuming § 362(e)(1) applies.
• § 362(e)(2) Duplication of Built-In Loss in § 351 Transactions. If a transferor contributes built-in loss property in a § 351 exchange and the aggregate adjusted basis of transferred property exceeds aggregate FMV, the corporation's aggregate basis in the property is capped at aggregate FMV. (§ 362(e)(2)(A)) This provision prevents the same economic loss from being deducted twice, once at the corporate level and once at the shareholder level.
  • The requirement has two prongs. First, property is transferred in a transaction described in § 362(a) that is not described in § 362(e)(1). Second, the transferee's aggregate adjusted bases of the transferred property would (but for this rule) exceed the aggregate FMV of such property immediately after the transaction. (§ 362(e)(2)(A)(i) and (ii))
  • If the rule applies, the required basis reduction is allocated among the built-in loss properties in proportion to their respective built-in losses immediately before the transaction. (§ 362(e)(2)(B)) Gain properties are not reduced.
  • EXAMPLE. A transferor contributes Asset A (basis $200, FMV $100, built-in loss $100) and Asset B (basis $90, FMV $100, built-in gain $10) to a corporation. Aggregate basis is $290. Aggregate FMV is $200. Net built-in loss is $90. Under § 362(e)(2)(A), the corporation's aggregate basis is capped at $200. Under § 362(e)(2)(B), the $90 reduction is allocated entirely to Asset A, the only built-in loss property. The corporation's basis in Asset A is $110 ($200 minus $90). The corporation's basis in Asset B is $90 (unchanged). The transferor's stock basis is $290 (exchanged basis under § 358).
  • CAUTION. § 362(e)(2) applies on an aggregate basis. A single built-in gain asset and a single built-in loss asset can trigger the rule even if the gain and loss partially net out. The test is aggregate basis versus aggregate FMV, not net gain or loss.
• § 362(e)(2)(C) Election to Reduce Transferor's Stock Basis Instead. The transferor and transferee may jointly elect to have § 362(e)(2)(A) not apply. (§ 362(e)(2)(C)(i)(I)) If the election is made, the corporation takes a full carryover basis in the transferred property (no reduction at the corporate level), but the transferor's basis in the stock received is reduced and cannot exceed the FMV of the stock immediately after the transfer. (§ 362(e)(2)(C)(i)(II))
  • The election is made on a property-by-property basis. Both the transferor and the transferee must elect. (§ 362(e)(2)(C)(i)) The election must be made at such time and in such form and manner as the Secretary prescribes, and once made it is irrevocable. (§ 362(e)(2)(C)(ii))
  • Under Notice 2005-70, 2005-2 C.B. 694, the election is made by attaching a certification to the timely filed original federal income tax return for the taxable year of the exchange. The certification must include a statement that the transferor and transferee elect to apply § 362(e)(2)(C), identify the transaction and the property, and contain sufficient information to apprise the Service of the facts.
  • The election preserves the built-in loss at the corporate level (where it may be recovered through depreciation or amortization based on the higher carryover basis) in exchange for a lower stock basis at the shareholder level. The transferor's reduced stock basis means less loss (or more gain) on a future sale of the stock.
  • EXAMPLE. Same facts as above. Asset A has $200 basis and $100 FMV. Asset B has $90 basis and $100 FMV. Without the election, the corporation's basis in Asset A is $110 (reduced) and the transferor's stock basis is $290. With the § 362(e)(2)(C) election, the corporation's basis in Asset A is $200 (full carryover), the corporation's basis in Asset B is $90 (unchanged), and the transferor's stock basis is $200 (capped at FMV). The $90 built-in loss is preserved at the corporate level for potential depreciation recovery, but the transferor's stock basis is reduced by $90.
  • TRAP. The election is irrevocable. Before making it, model both scenarios. If the corporation will hold the asset long-term and generate substantial depreciation deductions from the higher basis, the election may be advantageous. If the transferor expects to sell the stock soon at a loss, the lower stock basis will reduce or eliminate that loss.
• § 1223(2) Corporation's Holding Period in Contributed Property. The corporation's holding period in property received in a § 351 exchange includes the period during which the transferor held the property. Tacking applies automatically. (§ 1223(2))
  • The statute provides that in determining the period for which the taxpayer has held property, there shall be included the period for which such property was held by any other person, if under this chapter such property has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in the taxpayer's hands as it would have in the hands of such other person. (§ 1223(2))
  • Because the corporation takes the transferor's adjusted basis under § 362(a) (possibly increased by recognized gain), the "same basis" requirement is satisfied. The corporation's holding period tacks to the transferor's holding period regardless of the character of the property.
  • Unlike § 1223(1) (which governs the shareholder's holding period in stock and requires the transferred property to be a capital asset or § 1231 property), § 1223(2) has NO character requirement. The corporation tacks the transferor's holding period even if the contributed property was inventory, accounts receivable, or other ordinary-income property.
  • Rev. Rul. 85-164, 1985-2 C.B. 117. When multiple properties with different holding periods are transferred to a corporation, each share of stock received by the shareholder takes a split holding period allocated in proportion to the FMV of the transferred properties. The corporation, however, tacks the respective holding periods of each individual asset directly. The corporation's holding period in Asset A includes the transferor's holding period of Asset A. The corporation's holding period in Asset B includes the transferor's holding period of Asset B.
• Cross-Reference to Step 6. The Mirror Image. The corporation's basis adjustments under § 362 are the mirror image of the shareholder's basis adjustments under § 358. When gain is recognized at the shareholder level, both the shareholder's stock basis and the corporation's property basis increase by the same gain amount. The shareholder's gain recognition increases stock basis under § 358(a)(1)(B)(ii). The identical gain recognition increases corporate asset basis under § 362(a). Walk through both computations side by side. If the numbers do not match on the gain-recognition component, an error exists in the analysis.
  • Step 6 computed the shareholder's stock basis. This step computes the corporation's asset basis. The two computations are linked by the amount of gain recognized by the transferor. That gain figure is the common thread. Verify that the same gain amount appears in both the § 358(a)(1) stock-basis computation and the § 362(a) corporate-asset-basis computation.

Step 8. Boot and Gain Recognition Under § 351(b)

"If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock permitted to be received under subsection (a), other property or money, then (1) gain (if any) to such recipient shall be recognized, but not in excess of (A) the amount of money received, plus (B) the fair market value of such other property received; and (2) no loss to such recipient shall be recognized." (IRC § 351(b))

• § 351(b)(1) gain recognized to the extent of boot received.
  • If an exchange would qualify under § 351(a) but for the fact that the transferor receives boot, the transferor recognizes gain only to the extent of the boot received.
  • The recognized gain equals the LESSER of two amounts.
    1. The realized gain on the exchange (FMV of all consideration received, including stock, boot, and liabilities relieved, minus the adjusted basis of property transferred).
    2. The FMV of boot received (cash plus FMV of other property, including NQPS under § 351(g)).
  • The formula. Recognized Gain = Lesser of (Realized Gain, Boot Received).
  • EXAMPLE. Shareholder contributes property with $100 adjusted basis and $180 FMV, and receives stock worth $150 plus $30 cash. Realized gain is $80 ($150 stock + $30 cash minus $100 basis). Boot is $30. Gain recognized equals the lesser of $80 realized gain or $30 boot, which is $30.
  • If the transferor has NO realized gain (e.g., aggregate basis equals or exceeds aggregate FMV of consideration received), then NO gain is recognized even if boot is received. Boot cannot create gain where none exists.
  • CAUTION. Do not confuse realized gain with recognized gain. Realized gain is the economic profit on the exchange. Recognized gain is the taxable portion, capped by the boot amount.
• § 351(b)(2) loss is NEVER recognized.
  • No loss is recognized in a § 351 exchange, even if the transferor receives boot and has a realized loss.
  • This is a one-way ratchet. Boot can trigger gain recognition. Boot can NEVER trigger loss recognition.
  • If the transferor has a realized loss, the loss is deferred in the stock basis under § 358(a). The stock takes a substituted basis that preserves the loss for potential future recognition on a sale of the stock.
  • EXAMPLE. Shareholder contributes property with $100 adjusted basis and $80 FMV, and receives stock worth $60 plus $20 cash. Amount realized is $80 ($60 stock + $20 cash). Realized loss is $20 ($80 amount realized minus $100 basis). No loss is recognized. The $20 deferred loss is preserved in stock basis.
  • TRAP. The one-way ratchet means a transferor cannot use boot to trigger recognition of a built-in loss on property contributed to a corporation. If the client wants to recognize a loss, do NOT contribute the loss property in a § 351 exchange. Sell it first, then contribute the proceeds.
• Boot defined.
  • "Boot" means money plus the fair market value of "other property" received in the exchange. (§ 351(b)(1)(A) and (B))
  • "Other property" includes anything other than stock of the transferee corporation.
    • Cash.
    • Corporate debt instruments (bonds, notes, debentures).
    • Stock rights and stock warrants (Treas. Reg. § 1.351-1(a)(1) expressly excludes these from the definition of "stock").
    • Tangible or intangible personal property distributed by the corporation to the transferor (e.g., a capital asset the corporation already owned).
    • Nonqualified preferred stock (NQPS) under § 351(g), which is treated as "other property" (boot) even though it counts as stock for the § 368(c) control test.
  • Liabilities assumed are generally NOT boot.
    • § 357(a) provides that liabilities assumed by the transferee corporation or taken subject to a liability are NOT treated as boot for gain recognition purposes.
    • EXCEPTION. If § 357(b) applies (liabilities incurred without a bona fide business purpose or with tax avoidance as a principal purpose), ALL liabilities assumed by the corporation are treated as money received (boot). (§ 357(b)(1))
    • EXCEPTION. If § 357(c) applies (liabilities in excess of basis), the excess is treated as gain FROM THE EXCHANGE, not boot. § 357(c) gain operates independently from § 351(b) boot gain. See the § 357(c) subsection below.
  • NQPS as boot under § 351(g).
    • If the transferor receives ONLY NQPS (and no other stock), § 351(a) does not apply at all and the exchange is fully taxable. (§ 351(g)(1)(A))
    • If the transferor receives NQPS plus other qualified stock, § 351(b) applies and the NQPS is treated as boot. (§ 351(g)(1)(B))
    • Even though NQPS is boot for gain recognition purposes, it is still treated as stock for purposes of the § 368(c) control test. (§ 351(g)(1)(B) limits NQPS treatment to "other property" solely for purposes of applying § 351(b), implying it retains its character as stock for all other purposes including control.)
• Boot allocation methodology when multiple assets are transferred.
  • When boot is received along with stock in exchange for multiple transferred assets, the boot must be allocated among the transferred assets to determine the character of the recognized gain. (Rev. Rul. 68-55, 1968-1 CB 140)
  • The allocation method. Boot is allocated among transferred assets in proportion to the relative FMV of each asset.
    • Step 1. Compute the total FMV of all assets transferred.
    • Step 2. For each asset, divide its FMV by the total FMV to obtain a percentage.
    • Step 3. Multiply the total boot received by each asset's percentage to obtain the boot allocated to that asset.
  • Gain recognized on an asset-by-asset basis. After allocating boot, compute gain for each asset separately.
    • For each asset, recognized gain equals the lesser of (1) the realized gain on that asset (FMV minus basis), or (2) the boot allocated to that asset.
    • If an asset has a realized LOSS, no loss is recognized on that asset regardless of boot allocated. (Rev. Rul. 68-55, 1968-1 CB 140)
    • Do NOT net gains and losses across assets. Each asset stands alone.
  • EXAMPLE. Transferor contributes Asset A (capital asset, FMV $90,000, basis $50,000) and Asset B (inventory, FMV $30,000, basis $28,000) in exchange for stock worth $100,000 and $20,000 cash boot. Total FMV is $120,000. Boot allocated to Asset A is $15,000 ($20,000 times 90/120). Boot allocated to Asset B is $5,000 ($20,000 times 30/120). Realized gain on Asset A is $40,000. Recognized gain on Asset A is lesser of $40,000 or $15,000, which is $15,000 of long-term capital gain. Realized gain on Asset B is $2,000. Recognized gain on Asset B is lesser of $2,000 or $5,000, which is $2,000 of ordinary income. Total recognized gain is $17,000.
  • TRAP. Boot allocated to a loss asset does not trigger gain or loss. The loss is simply deferred. If Asset B in the example above had a basis of $35,000 (realized loss of $5,000), the $5,000 of boot allocated to it would produce ZERO gain or loss.
• Character of recognized gain.
  • The character of gain recognized under § 351(b) follows the character of the underlying assets transferred. (Rev. Rul. 67-192, 1967-2 CB 140)
  • If multiple assets with different characters are transferred (e.g., a capital asset, § 1245 depreciable property, and inventory), allocate the recognized gain among the assets using the boot allocation methodology above.
  • Depreciation recapture provisions (§§ 1245, 1250) apply to the extent gain is recognized on the transfer of depreciable property. The recognized gain is ordinary income to the extent of accumulated depreciation, with any excess characterized according to the normal rules for the asset.
  • § 1239 (gain on sale or exchange of depreciable property between related parties taxed as ordinary income) applies to gain recognized in a § 351 exchange if the transferor and transferee corporation are related parties.
  • If the corporation transfers appreciated property to the shareholder as boot, the corporation recognizes gain under § 311(b) as if it sold the property at FMV. The character of that corporate-level gain depends on the character of the distributed asset in the corporation's hands.
• Relationship to § 357 (liability assumptions).
  • § 357(a) general rule. Liabilities assumed by the corporation or taken subject to a liability are NOT treated as boot for purposes of § 351(b). The transferor does not recognize gain solely because the corporation assumes a liability.
  • § 357(b) tax avoidance liabilities. If a liability is incurred without a bona fide business purpose or with tax avoidance as a principal purpose, the ENTIRE amount of ALL liabilities assumed by the corporation is treated as boot. (§ 357(b)(1)) This is the "taint" rule. One bad liability taints all liabilities in the exchange.
  • § 357(c) excess liabilities over basis. If the sum of liabilities assumed by the corporation exceeds the total adjusted basis of the property transferred, the excess is treated as gain from the exchange. (§ 357(c)(1))
    • The § 357(c) gain is recognized IN ADDITION TO any § 351(b) boot gain. The two provisions operate independently.
    • § 357(c) gain is NOT capped by realized gain. Even if the transferor has zero realized gain (because basis equals or exceeds FMV), § 357(c) gain is still recognized on the excess of liabilities over basis.
    • § 357(c) gain is treated as gain from the exchange and increases the corporation's basis in the property under § 362(a).
    • § 357(c) gain is allocated among transferred assets in proportion to their relative FMVs. (Cohen & Whitney, 48 Tax Law. 959 (1995))
    • If § 357(c) applies AND boot is received, compute each gain separately and sum them. The § 351(b) gain is limited to realized gain and boot. The § 357(c) gain is the excess of liabilities over basis.
  • No double counting. When computing stock basis under § 358, liabilities assumed reduce basis under § 358(d). Boot received reduces basis under § 358(a)(1)(B). Gain recognized (from both § 351(b) and § 357(c)) increases basis. See Step 6 for the complete basis computation.
  • CAUTION. § 357(c) excludes certain cash-basis liabilities (accounts payable and other amounts that would give rise to a deduction when paid). (§ 358(d)(2)) Do not include these in the § 357(c) calculation.
• Basis mechanics summary (cross-reference to Step 6).
  • The recognized gain computed under § 351(b) feeds directly into the § 358(a)(1) stock basis computation.
  • Stock Basis = Adjusted Basis of Property Transferred + Gain Recognized (§ 351(b) and § 357(c)) - FMV of Boot Received - Liabilities Assumed (§ 358(d)).
  • The boot amount reduces basis under § 358(a)(1)(B). The gain recognized increases basis under § 358(a)(1)(A). These two amounts often offset each other dollar-for-dollar, leaving the stock basis equal to the original property basis (minus any liabilities assumed).
  • The corporation's basis in the property received equals the transferor's adjusted basis plus any gain recognized by the transferor (from both § 351(b) and § 357(c)). (§ 362(a))
  • See Step 6 (Transferor Stock Basis Under § 358) for the complete basis formula and worked examples.
  • See Step 7 (Corporate-Level Basis Under § 362) for the corporation's basis computation and the § 362(e)(2) built-in loss limitation.

Step 9. Nonqualified Preferred Stock Under § 351(g)

"In the case of a person who transfers property to a corporation and receives nonqualified preferred stock, (A) section 351(a) shall not apply to such transferor, and (B) if (and only if) the transferor receives stock other than nonqualified preferred stock, (i) section 351(b) shall apply to such transferor, and (ii) such nonqualified preferred stock shall be treated as other property for purposes of applying subsection (b)." (IRC § 351(g)(1))

• § 351(g)(1) treats NQPS as boot.
  • Nonqualified preferred stock received in a § 351 exchange is treated as "other property" (boot) for purposes of § 351(b), even though it is "stock" in form. (§ 351(g)(1)(B)(ii))
  • If the transferor receives only NQPS and no other stock, then § 351(a) does not apply at all. The exchange is fully taxable as though no § 351 exchange occurred. (§ 351(g)(1)(A))
  • If the transferor receives NQPS plus other qualified stock (common stock or qualified preferred stock), then § 351(b) applies and the NQPS is treated as boot. Gain recognized equals the lesser of realized gain or the FMV of the NQPS received. (§ 351(g)(1)(B))
  • NQPS remains stock for the control test. Even though NQPS is boot for gain recognition purposes, it is still treated as stock for purposes of the § 368(c) control test. A transferor who receives NQPS counts that NQPS toward the 80% control requirement. (Steptoe & Johnson LLP, "§ 351 Outline")
  • TRAP. Do not confuse boot treatment under § 351(g)(1) with non-stock status for control. NQPS is boot for gain recognition but is stock for control.
• The four-clause definition of NQPS under § 351(g)(2)(A). Preferred stock is NQPS if it has any one of the following four features.
  1. The holder has the right to require the issuer or a related person to redeem or purchase the stock. (Put right) (§ 351(g)(2)(A)(i))
  2. The issuer or a related person is required to redeem or purchase the stock. (Mandatory redemption) (§ 351(g)(2)(A)(ii))
  3. The issuer or a related person has the right to redeem or purchase the stock, and as of the issue date, it is more likely than not that the right will be exercised. (Likely-to-be-exercised call) (§ 351(g)(2)(A)(iii))
  4. The dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices. (Indexed dividend) (§ 351(g)(2)(A)(iv))
• § 351(g)(2)(B) imposes a 20-year limitation on clauses (i) through (iii).
  • Clauses (i), (ii), and (iii) apply only if the right or obligation may be exercised within the 20-year period beginning on the issue date. (§ 351(g)(2)(B))
  • If the redemption right or obligation cannot be exercised until after 20 years from the issue date, that feature is disregarded for NQPS purposes. The stock is not NQPS by reason of that feature.
  • A contingency that, as of the issue date, makes remote the likelihood of redemption or purchase also prevents NQPS treatment under clauses (i) through (iii). (§ 351(g)(2)(B))
  • CAUTION. The 20-year limitation does not apply to clause (iv) (indexed dividends). Any floating-rate preferred stock, regardless of duration, is automatically NQPS.
• § 351(g)(2)(C) excludes certain rights from the NQPS determination.
  • Rights exercisable only upon the death, disability, or mental incompetency of the holder are disregarded. This is the estate planning exception. (§ 351(g)(2)(C)(i)(I))
  • Rights to redeem or purchase stock transferred in connection with the performance of services (representing reasonable compensation) are disregarded if exercisable only upon the holder's separation from service from the issuer or a related person. (§ 351(g)(2)(C)(i)(II))
  • The death, disability, and incompetency exception does not apply if the stock is issued by a publicly traded corporation or a corporation that is becoming publicly traded as part of the transaction. (§ 351(g)(2)(C)(ii))
• § 351(g)(3) provides a qualified preferred stock exception.
  • Preferred stock is not NQPS if it qualifies as "preferred stock" under § 351(g)(3)(A) and does not fall within any of the four NQPS clauses. This is the "plain vanilla" preferred exception. (Treas. Reg. § 1.356-7(a))
  • The two-prong test for "preferred stock." To be "preferred stock" under § 351(g)(3)(A), the stock must satisfy both of the following.
    • The stock is limited and preferred as to dividends.
    • The stock does not participate in corporate growth to any significant extent. Stock is not treated as participating in corporate growth unless there is a real and meaningful likelihood of the shareholder actually participating in the earnings and growth of the corporation. If there is no real and meaningful likelihood of dividends beyond the preference being paid, the mere possibility of such payments is disregarded. (§ 351(g)(3)(A))
  • Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67 (2012). The Tax Court held that class C stock was not NQPS because it did not participate in corporate growth to any significant extent. The stock gave holders a guaranteed fixed annual income preference in the form of a set cumulative dividend and, upon redemption, a fixed payout unrelated to corporate growth. There was no reasonable likelihood of the stock meaningfully participating in corporate earnings because the subsidiary had no accumulated earnings and was expected to have little to no earnings before the stock would most likely be redeemed. Both parties relied on the regulations under § 305 for interpretive guidance on the meaning of "participate in corporate growth to any significant extent." (CCA 201716045, citing Gerdau Macsteel)
• § 1504(a)(4) qualified preferred stock is a separate standard.
  • § 1504(a)(4) defines preferred stock that is excluded from "stock" for purposes of the affiliated group consolidated return rules. Its requirements are stricter than § 351(g)(3) and serve a different purpose. (§ 1504(a)(4))
  • The four requirements for § 1504(a)(4) stock are (1) the stock is not entitled to vote, (2) the stock is limited and preferred as to dividends, (3) the stock has liquidation rights that do not exceed its issue price (except for a reasonable redemption or liquidation premium), and (4) the stock is not convertible into another class of stock. (§ 1504(a)(4)(A) through (D))
  • § 1504(a)(4) QPS is not automatically NQPS for § 351 purposes. A stock can satisfy § 1504(a)(4) and also be QPS under § 351(g)(3), but the two tests are independent. Stock can be QPS under § 351(g) without qualifying under § 1504(a)(4). For example, voting preferred, convertible preferred, or preferred with redemption rights exercisable only after 20 years may be QPS under § 351(g)(3) but fail § 1504(a)(4). (RSM US, "Identifying § 1504(a)(4) Stock")
  • Both provisions use the same standard for "does not participate in corporate growth to any significant extent," and courts cross-reference interpretive materials between the two provisions.
• Interaction with § 351(b).
  • Because NQPS is treated as "other property" (boot) under § 351(g)(1), the gain recognition formula from Step 8 applies directly.
  • Gain recognized equals the lesser of realized gain or the FMV of the NQPS received. (§ 351(g)(1)(B)(ii), incorporating § 351(b)(1))
  • If the transferor receives only NQPS (no other stock), then § 351(a) does not apply at all. The transferor recognizes the full realized gain. (§ 351(g)(1)(A))
  • No loss is recognized, even if the transferor realizes a loss. The § 351(b)(2) loss nonrecognition rule applies. (§ 351(b)(2))
  • EXAMPLE. A transferor contributes property with a basis of $10,000 and FMV of $50,000 in exchange for common stock worth $30,000 and NQPS worth $20,000. Realized gain is $40,000. The NQPS is boot with FMV of $20,000. Recognized gain equals the lesser of $40,000 or $20,000, so gain recognized is $20,000.
• Planning to avoid NQPS treatment.
  • Structure preferred stock without any of the four prohibited features in § 351(g)(2)(A).
  • Use fixed-rate, non-redeemable preferred with no put or call features.
  • Ensure redemption rights, if any, cannot be exercised within 20 years of the issue date.
  • Ensure the stock qualifies for the § 351(g)(3) QPS exception by having a fixed dividend rate and no meaningful participation rights.
  • Consider whether common stock might be more appropriate than preferred stock if the desired economic arrangement can be achieved through common stock terms.
  • If the corporation will join or form a consolidated group, separately analyze whether the preferred stock also satisfies § 1504(a)(4).

Step 10. Anti-Abuse Doctrines and Judicial Doctrines

Even when a transaction satisfies all technical requirements of § 351, judicial doctrines and anti-abuse rules may recharacterize or disregard the transaction. This step addresses the doctrines most commonly applied to corporate formations.

Step 10A. Step-Transaction Doctrine

• The step-transaction doctrine and § 351. The step-transaction doctrine may collapse a multi-step formation into a single taxable transaction if the steps are prearranged parts of an integrated plan. In the § 351 context, the most common application is prearranged sales of stock received in the exchange. See Step 3 (Intermountain Lumber analysis) for the control-immediately-after requirement. The doctrine also applies when built-in loss property is contributed followed by planned steps to extract the loss benefit, and when multi-step incorporations use intermediate transfers that should not be respected as separate transactions.
• Three alternative tests. Courts apply one of three alternative (not cumulative) tests. Meeting any single test may cause collapse.
  1. Binding commitment test. Steps taken pursuant to a binding commitment are treated as a single transaction. The standard requires an actual contractual obligation to complete later steps, not merely an expectation or understanding. Courts generally require that prior to taking the series of steps, the parties have bound and committed themselves to reach a specific last step. This is the most restrictive of the three tests. The Tax Court has noted that adherence to this test alone would render the step-transaction doctrine a dead letter. (Penrod v. Commissioner, 88 T.C. 1415, 1429 (1987), quoting King Enterprises, Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969)). (Commissioner v. Gordon, 391 U.S. 83 (1968). facts AT&T distributed Pacific Northwest Bell stock to shareholders with a plan stating it "expected" to sell the balance of the stock within about three years. The Supreme Court refused to treat the 1961 and 1963 distributions as a single step because there was no binding commitment to complete the later steps at the time of the first distribution. The Court held that for an initial transfer to be treated as merely the first step in a divestiture, "it must be clearly identifiable as such at the time it is made and there must be a binding commitment to take the later steps." The Court acknowledged the test's validity but found it was not met on the specific facts.)
  2. Mutual interdependence test. Steps that are fruitless without completion of the entire series are treated as parts of a single transaction. Each step must depend on every other step for its commercial purpose. The test focuses on the relationship between the steps rather than the taxpayer's intent. It asks whether each step had independent significance or whether each step had meaning only as part of the whole transaction. (Redding v. Commissioner, 630 F.2d 1169 (7th Cir. 1980), cert. denied, 450 U.S. 913 (1981). The Seventh Circuit held that steps are collapsed when "the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.")
  3. End result test. Steps that are prearranged parts of a single transaction aimed at an end result are treated as integrated. A firm and fixed plan at the time of the exchange suffices. The test focuses on whether the taxpayer intended to reach a particular result by structuring a series of transactions in a certain way. The intent the court examines is not tax avoidance motive but whether the steps were prearranged means to an end. (Penrod v. Commissioner, 88 T.C. 1415 (1987). Penrod and his family owned Mitchell Bank. They formed a holding company, transferred bank stock in a § 351 exchange, then immediately redeemed minority shares. The Tax Court applied the end result test and held that the redemption and formation were integrated steps of a single transaction aimed at the end result of a corporate restructuring with specific ownership changes.) (King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). The Court of Claims held that transactions are collapsed when "a series of formally separate steps are really prearranged parts of a single transaction intended from the outset to reach the ultimate result.")
• CAUTION. The three tests are applied disjunctively. A court need find only that one test is satisfied to collapse the steps. Do not assume that the absence of a binding commitment alone will save the transaction. The end result test and mutual interdependence test are broader and more commonly invoked by courts.
• Defensive strategies for multi-step formations. Separate each step with meaningful time intervals where feasible. Ensure each step has its own independent business purpose and substance. Document the independent commercial rationale for each step. Avoid formal agreements or understandings that commit the parties to future steps at the time of the initial transfer. Structure transactions at arm's length with market-based pricing. Maintain contemporaneous business records, board minutes, and analyses supporting non-tax purposes for each step.

Step 10B. Economic Substance Doctrine

"In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction." (IRC § 7701(o)(1))

• Codification in § 7701(o). The economic substance doctrine was codified by § 1409 of the Health Care and Education Reconciliation Act of 2010. It applies to transactions entered into on or after March 30, 2010. Under § 7701(o)(4), "economic substance doctrine" means the common law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
• The two-prong conjunctive test. § 7701(o)(1) provides that a transaction shall be treated as having economic substance only if both prongs are satisfied. Congress adopted the conjunctive test to resolve pre-codification circuit splits in which some circuits required only one prong (disjunctive approach) and others required both. (H.R. Rep. No. 111-443, at 297-98 (2010).)
  • § 7701(o)(1)(A). Objective economic substance. The transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position. This is not a de minimis threshold. The change must be more than trivial or incidental.
  • § 7701(o)(1)(B). Substantial business purpose. The taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The purpose must be more than de minimis or nominal. Tax reduction motives may coexist with non-tax business purposes. The question is whether a substantial non-tax purpose exists.
• § 7701(o)(2). Profit potential safe harbor. The potential for profit of a transaction shall be taken into account in determining whether the requirements of both prongs are met only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit. The statute does not specify a minimum required return. Taxpayers may also rely on measures other than profit potential to satisfy the two prongs. (§ 7701(o)(5)(A) requires the present value of potential pre-tax profit to be substantial relative to the present value of expected net tax benefits. § 7701(o)(5)(B) provides that foreign taxes are treated as expenses for this purpose.)
• § 7701(o)(4). Definition of economic substance. "Economic substance doctrine" means the common law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
• Relevancy threshold. § 7701(o) applies only to transactions "to which the economic substance doctrine is relevant." § 7701(o)(5)(C) provides that the determination of relevance shall be made "in the same manner as if this subsection had never been enacted," meaning courts apply pre-codification common law standards.
  • TRAP. A post-codification circuit split exists on the relevancy inquiry. The Tax Court, in Patel v. Commissioner, 165 T.C. No. 10 (2025), held that § 7701(o) requires a threshold relevancy determination before applying the two-prong test. The court stated that "the statute says so, right there, on its face." In Liberty Global, Inc. v. United States, 2023 WL 8062792 (D. Colo. Oct. 31, 2023), the District Court reached the opposite conclusion, holding that there is "no 'threshold' inquiry that precedes the inquiry into a transaction's economic substance" and that "the doctrine's relevance is coextensive with the statute's test for economic substance." That case is currently on appeal to the Tenth Circuit. Determine which approach the relevant circuit is likely to follow.
• Transactions not subject to economic substance. IRS Notice 2010-62 states that the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of § 7701(o). The Joint Committee on Taxation technical explanation (JCX-18-10 (2010)) identified transactions that Congress did not intend the doctrine to apply to, including choice between capitalizing a business with debt or equity, choice of entity, tax classification of an entity, choices to use related parties in transactions, and tax-free reorganizations.
• Application to § 351. The doctrine is relevant to § 351 when the formation lacks a genuine business purpose or when the structure is a sham. A garden-variety incorporation to operate a business is unlikely to trigger the doctrine. A formation engineered solely to duplicate losses, create artificial basis, or generate tax attributes without genuine economic change is at risk.

Step 10C. Business Purpose Doctrine

• Origin and holding. Gregory v. Helvering, 293 U.S. 465 (1935). Mrs. Gregory owned all stock of United Mortgage Corporation, which held 1,000 shares of Monitor Securities Corporation. Gregory wanted to extract these shares and sell them for her individual profit. She formed a new corporation (Corporation B), transferred the Monitor shares to Corporation B in a purported reorganization, had Corporation B issue all its shares to her, dissolved Corporation B within a few days, and received the Monitor shares as a liquidating distribution. She then immediately sold the Monitor shares. No other business was transacted by Corporation B. The Supreme Court held that the transaction was a reorganization in form but not in substance. The Court described the undertaking as "an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else." The key rule is that "the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended." The Court acknowledged that "the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether to avoid them, by means which the law permits, cannot be doubted." But the transaction must still be what "the statute intended."
• Application to § 351. The business purpose requirement applies even when all statutory requirements of § 351 are technically met. A transaction that complies with the letter of the statute may still be disregarded if it lacks a business purpose and is undertaken solely for tax avoidance. A corporation formed solely as a temporary conduit, with no business function beyond achieving a tax result, is most vulnerable to challenge under this doctrine. (See also Step 10F below on application to § 351 formations specifically.)

Step 10D. Substance Over Form Doctrine

• Origin and holding. Commissioner v. Court Holding Co., 324 U.S. 331 (1945). facts Court Holding Company was a closely held corporation. Its shareholders (Minnie Miller and her husband) had negotiated a sale of the corporation's apartment building to a purchaser. Instead of the corporation selling the building directly, the corporation transferred the property to its shareholders as a liquidating dividend. The shareholders then formally conveyed the building to the purchaser. The Supreme Court held that the substance of the transaction was a corporate-level sale, not a liquidation followed by shareholder sales. The Court stated that "the incidence of taxation depends upon the substance of a transaction" and that "a sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title." The Court further held that "the tax consequences which arise from gains from a sale of property are not finally to be determined solely by the means employed to transfer legal title" and that "to permit the true nature of a transaction to be disguised by mere formalisms which exist solely to alter tax liabilities would seriously impair the effective administration of the tax policies of Congress."
• Application to § 351. This doctrine applies to § 351 when the formation is a disguise for a taxable sale. If a purported contribution of property is in substance a disguised sale, if stock issued in exchange for property is in substance a fee for services, or if an incorporation is in substance a continuation of a prior business with no genuine corporate purpose, the form will be disregarded in favor of substance.

Step 10E. Sham Transaction Doctrine

• The two-prong sham test. Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), aff'g 81 T.C. 184 (1983). facts Rice's Toyota World was a car dealership. Its principal officer purchased a used computer from a leasing company for over $1.4 million, using mostly nonrecourse notes. Rice leased the computer back to the seller for eight years. Rental payments exceeded Rice's obligations on the nonrecourse debt by only $10,000 annually. The seller's rent obligations were contingent on receiving adequate revenues from subleasing. Rice claimed accelerated depreciation and interest deductions. The Fourth Circuit affirmed the Tax Court's finding that the transaction was a sham. The court adopted a two-prong test. Both prongs must be satisfied for a transaction to be treated as a sham. First, the subjective business purpose prong: the taxpayer was motivated by no business purposes other than obtaining tax benefits. Second, the objective economic substance prong: the transaction has no economic substance because no reasonable possibility of profit exists. The court found Rice had no genuine business purpose and there was no reasonable possibility of profit. Where a transaction is a sham, the Commissioner may ignore the labels applied by the parties and tax the transaction according to its substance.
• Codified economic substance and the sham overlap. The sham transaction doctrine in its two-prong formulation closely parallels the codified economic substance test in § 7701(o). A transaction that is a sham in substance will almost certainly fail both prongs of § 7701(o)(1). The key difference is that the sham doctrine permits complete disregard of the transaction, whereas the economic substance doctrine may result in disallowance of specific tax benefits while leaving the transaction partially intact.
• ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). facts ACM Partners engaged in a complex contingent installment sale of mortgage-backed securities designed to generate artificial tax losses. Colgate-Palmolive realized $100 million in long-term capital gains. It formed the ACM Partnership with Merrill Lynch and ABN. The partnership invested $200 million in short-term securities, sold them for $140 million in cash plus contingent payments, used the cash to repurchase Colgate debt and redeem one partner's interest, and allocated capital losses to Colgate. Colgate filed an amended return to carry back the loss to offset the prior year's gain. The Third Circuit held that the transaction lacked economic substance and the losses were disallowed. The court found the transaction was "'created artificially' solely to create tax benefits" and that the partnership was "'not entitled to recognize a phantom loss from a transaction that lacks economic substance.'" The court held that the transaction must be rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions.

Step 10F. Penalty Framework

• § 6662(b)(6). Base 20% penalty. A 20% accuracy-related penalty applies to understatements attributable to transactions lacking economic substance within the meaning of § 7701(o) or failing to meet the requirements of any similar rule of law. This is a strict liability penalty. The penalty applies even if the taxpayer acted reasonably and in good faith. § 6664(c)(2) explicitly precludes the reasonable cause and good faith defense for transactions lacking economic substance. The substantial authority exception does not apply.
• § 6662(i). Enhanced 40% penalty for nondisclosure. The penalty increases to 40% for any portion of an underpayment attributable to one or more nondisclosed noneconomic substance transactions. A transaction is nondisclosed if the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return. Adequate disclosure requires sufficient information on the return to enable the IRS to identify the potential controversy involved. The 40% penalty is imposed in addition to the base 20% penalty, effectively doubling the penalty for nondisclosure.
• TRAP. No reasonable cause defense exists. Unlike most other accuracy-related penalties, the § 6662(b)(6) penalty cannot be avoided by showing reasonable cause or good faith reliance on a tax advisor. A taxpayer who relies on a § 351 formation that is later found to lack economic substance has no defense to the penalty. The only avoidance strategy is to ensure the formation has genuine economic substance and substantial business purpose, and to adequately disclose the transaction on the return.

Step 10G. Application to § 351 Formations Specifically

• Genuine business purpose as the primary defense. A § 351 formation will withstand judicial scrutiny if it has a genuine business purpose. Examples include operating a business in corporate form, limiting liability, facilitating investment, pooling assets, and achieving legitimate non-tax business objectives. Mere tax motivation does not invalidate a legitimate incorporation. Tax reduction motives may coexist with non-tax business purposes.
• Formations most at risk. The following formations receive heightened scrutiny and are most vulnerable to anti-abuse challenge:
  • A corporation formed solely as a temporary conduit to pass property through, with no ongoing business function.
  • A formation in which the transferor receives non-stock consideration that is effectively a purchase price for the contributed property (disguised sale).
  • A formation in which built-in loss property is contributed, followed by planned steps to extract the loss benefit at both shareholder and corporate levels. (§ 362(e)(2) was enacted specifically to address this pattern.)
  • A formation that is part of a larger prearranged plan that includes immediate dispositions of stock or assets.
  • A formation in which the steps are so numerous and interdependent that no step has independent significance.
  • A formation that uses related parties to create artificial tax attributes without genuine economic change.
• Decision framework for practitioners. For each § 351 formation, walk through the following inquiries:
  1. Does the formation have a genuine non-tax business purpose documented in board minutes, business records, and contemporaneous analyses? If NO, the formation is at risk under the business purpose doctrine. Reconsider the structure.
  2. Does the formation meaningfully change the taxpayer's economic position apart from federal income tax effects? If NO, the formation may lack economic substance under § 7701(o)(1)(A).
  3. Is the formation part of a prearranged plan that includes subsequent steps? If YES, apply the three step-transaction tests. If any test is met, the steps may be collapsed.
  4. Is the formation a disguise for a taxable sale? If YES, the substance over form doctrine may recharacterize the transaction.
  5. Has adequate disclosure been made on the return? If NO, and the formation lacks economic substance, the penalty increases from 20% to 40% under § 6662(i).
• CAUTION. The absence of tax avoidance intent is not a defense. A taxpayer may have the purest business motives and still lose if the transaction lacks objective economic substance. The § 7701(o) test is conjunctive. Both prongs must be satisfied. Focus on documenting the non-tax business purpose and ensuring genuine economic change, not merely on establishing good faith.

Step 11. § 1032 Nonrecognition for the Corporation

"No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation." (IRC § 1032(a))

• § 1032(a) is the corporate-level counterpart to § 351(a).
  • § 351(a) prevents gain recognition at the shareholder level (except to the extent of boot).
  • § 1032(a) prevents gain recognition at the corporate level when the corporation issues its own stock in exchange for money or other property.
  • Both provisions operate simultaneously in a qualifying § 351 exchange to produce tax-free treatment at both levels.
• The § 1032(a) shield is absolute for the corporation's own stock.
  • The rule applies to original issuances, treasury stock reissuances, and stock redemptions.
  • A corporation never recognizes gain or loss on dealing in its own stock, regardless of the amount of appreciation or depreciation in the stock.
  • Treas. Reg. § 1.1032-1(a) confirms that the disposition by a corporation of shares of its own stock (including treasury stock) for money or other property does not give rise to taxable gain or deductible loss, regardless of the nature of the transaction or the facts and circumstances involved.
• The corporation may issue appreciated stock without recognizing gain.
  • Even if the fair market value of the stock issued materially exceeds the corporation's basis in that stock (which is generally zero for newly issued shares), no corporate gain results.
  • EXAMPLE. Corporation X issues stock with a fair market value of $1,000,000 to Transferor A in exchange for assets worth $1,000,000. X recognizes no gain on the stock issuance even though X had zero basis in the newly issued shares.
• Corporate-level gain on boot property is NOT governed by § 1032.
  • When a corporation transfers boot property (property other than its own stock) to a transferor in a § 351 exchange, the corporation recognizes gain on that boot property as if it had sold the property.
  • The corporation's recognized gain equals the fair market value of the boot property minus the corporation's adjusted basis in that property.
  • This corporate-level gain is governed by the general gain/loss rules (analogous to § 311(b)), not by § 1032, because § 1032 covers only the corporation's own stock.
  • TRAP. The corporation recognizes gain on appreciated boot property even though the exchange overall qualifies under § 351. The nonrecognition shield of § 1032 does not extend to property the corporation distributes as boot.
  • If the corporation transfers depreciated property as boot, no loss is recognized. The general rule disallowing loss on distributions of property to shareholders applies by analogy.
• § 1032(b) addresses only the basis of property the corporation receives.
  • § 1032(b) is a cross-reference to § 362 for determining the corporation's basis in property acquired in exchange for its stock.
  • § 1032(a) shields only the exchange itself. If the corporation later sells the property it received in the exchange, it recognizes gain or loss on that subsequent sale based on its basis under § 362.
  • EXAMPLE. Corporation X receives Asset 1 (FMV $100,000, transferor's basis $60,000) in a § 351 exchange. X recognizes no gain at issuance under § 1032(a). X's basis in Asset 1 is $60,000 under § 362(a). If X later sells Asset 1 for $110,000, X recognizes $50,000 gain on the subsequent sale.
• CAUTION. § 1032 nonrecognition does not eliminate built-in gain in the transferred property.
  • The built-in gain is merely deferred at the corporate level.
  • The corporation's basis in the received property is the transferor's carryover basis under § 362(a), not the stock's fair market value.
  • Any pre-contribution appreciation will be recognized by the corporation when it later sells the property.
• Reporting note.
  • The § 1032 nonrecognition result is automatic when the statutory requirements are met. No election form is required.
  • Treas. Reg. § 1.351-3 requires a "significant transferor" (generally any transferor receiving stock representing 5% or more of total voting power or value) to attach a statement to their return describing the property transferred, its adjusted basis and FMV, the stock received, and any liabilities assumed.

Step 12. Adjacent Rules and Special Transactions

Beyond the core § 351 analysis, several adjacent rules affect the tax consequences of incorporation. This step addresses depreciation recapture, partnership incorporation methods, and organizational expenses.

Step 12A. § 1245 Recapture on Incorporation

"Paragraph (1) shall not apply to a disposition of section 1245 property (A) in a transaction described in paragraph (1), (2), (3), or (7) of section 371(a); [or] (B) as part of a transaction with respect to which gain or loss is not recognized (in whole or in part) under section 351 or 361." (IRC § 1245(b)(3))

• § 1245(a)(1) generally requires recapture of prior depreciation as ordinary income on disposition of § 1245 property.
  • The amount by which the lower of the recomputed basis or the amount realized exceeds the adjusted basis is treated as ordinary income.
  • This gain is recognized "notwithstanding any other provision of this subtitle," which would include § 351 absent an exception.
• § 1245(b)(3) provides an exception for § 351 exchanges.
  • When the basis of property in the hands of the transferee corporation is determined by reference to its basis in the hands of the transferor by reason of § 351, § 1245(a) applies only to the extent of gain otherwise recognized in the transaction.
  • In a pure § 351 exchange with no boot and no § 357(c) gain, the transferor recognizes zero gain and therefore recognizes zero § 1245 recapture.
  • If the transferor receives boot or has § 357(c) gain, the recognized gain is treated as § 1245 ordinary income to the extent of depreciation recapture potential.
  • Treas. Reg. § 1.1245-4(c) confirms that a § 351 transfer is not itself a recapture event.
• The recapture potential carries over to the corporation.
  • The corporation "steps into the shoes" of the transferor.
  • The corporation must recognize the recapture gain when it later sells the property.
  • The corporation's § 1245 recapture potential includes all prior depreciation deductions taken by the transferor plus any depreciation the corporation claims.
  • CAUTION. This is a deferral, not an elimination. The recapture gain will be recognized eventually, typically when the corporation disposes of the property.
  • EXAMPLE. Transferor A contributes equipment (original cost $50,000, accumulated depreciation $30,000, adjusted basis $20,000, FMV $40,000) to X Corporation in a pure § 351 exchange. A recognizes no gain. X takes a $20,000 carryover basis. X's § 1245 recapture potential is $30,000. If X later sells the equipment for $45,000, X recognizes $25,000 total gain, all of which is § 1245 ordinary income to the extent of the $30,000 recapture potential.
• When the corporation's gain on sale exceeds the total recapture potential, the excess is characterized based on the property's status in the corporation's hands.
  • Any gain in excess of total recapture potential may be § 1231 gain or capital gain depending on the property type and the corporation's use.

Step 12B. Partnership Incorporation Methods (Rev. Rul. 84-111)

• Rev. Rul. 84-111, 1984-2 C.B. 88, approves three alternative methods for incorporating a partnership, each with distinct tax consequences.
  • The ruling addresses the conversion of a partnership into a corporate form through three fact patterns.
  • Each method produces different results for basis tracing, recapture exposure, and partnership termination.
• Assets-Over Method.
  • The partnership transfers all of its assets to a newly formed corporation in exchange for all the outstanding stock of the corporation.
  • The corporation assumes the partnership's liabilities.
  • The partnership then distributes the corporate stock to the partners in liquidation of their partnership interests.
  • Tax consequences. The partnership recognizes no gain or loss under § 351(a) on the transfer of assets to the corporation. The corporation recognizes no gain or loss under § 1032(a) on the stock issuance. Partners receive stock with a basis equal to their basis in their partnership interests. The corporate basis in the assets is a carryover basis from the partnership under § 362(a).
  • TRAP. The partnership's subsequent distribution of the corporation's stock to the partners causes the partnership to lose "control" of the corporation within the meaning of § 368(c). The ruling holds that this subsequent loss of control does not defeat the § 351 nonrecognition on the initial asset transfer because the transfer and distribution are steps in an integrated plan.
• Assets-Up Method.
  • The partnership liquidates by distributing all of its assets to the partners.
  • Each partner takes a basis in the distributed assets equal to the partnership's basis in those assets under § 732.
  • Each partner then contributes their proportionate share of the assets to a newly formed corporation in a § 351 exchange.
  • Tax consequences. The partnership liquidation is governed by § 731. Each partner's contribution to the corporation is tested separately for § 351 qualification. Each partner receives corporate stock with a basis equal to their basis in the partnership interest (carried through the assets and into the stock). The corporate basis in the assets equals the partnership's historical basis.
  • CAUTION. If the partnership has § 751 "hot assets," the liquidation may trigger ordinary income to the partners. This method also exposes the partners to any recapture inherent in the partnership assets at the distribution level.
• Interests-Over Method.
  • The partners contribute their partnership interests to a newly formed corporation.
  • The corporation becomes a partner in the existing partnership, stepping into the shoes of the contributing partners.
  • The partnership continues in existence with the corporation as a partner.
  • Tax consequences. A partnership interest is "property" under § 351. Each partner's contribution of a partnership interest to the corporation qualifies for § 351 nonrecognition if the control test is met. The corporation takes a substituted basis in the partnership interest equal to the partners' aggregate basis in their partnership interests. The partnership does not terminate under § 708(b)(1) if only one partner's interest changes (the individual partners are replaced by a single corporate partner).
  • Advantage. This is the simplest structure, involving only one transfer step.
  • Disadvantage. The corporation holds an indirect interest in the partnership assets rather than direct ownership, which may complicate financing, collateral, and operational matters.
• Selecting among the three methods requires analysis of multiple factors.
  • If the partnership has § 751 hot assets or significant recapture potential, the assets-over or interests-over method may be preferable to avoid triggering gain at the partner level.
  • If direct asset ownership by the corporation is critical (for financing or collateral), the assets-over or assets-up method is required.
  • If simplicity and speed are paramount, the interests-over method involves the fewest steps.

Step 12C. Organizational and Start-Up Expenses

"A corporation may elect to treat organizational expenditures as deferred expenses. In the taxable year in which a corporation begins business, it may elect to deduct organizational expenditures in an amount equal to the lesser of (A) the amount of organizational expenditures, or (B) $5,000." (IRC § 248(a)(1))

• Organizational expenses under § 248.
  • § 248(a) permits a corporation to elect to deduct up to $5,000 of organizational expenditures in its first taxable year.
  • The $5,000 amount is reduced dollar-for-dollar when total organizational expenditures exceed $50,000. At $55,000 or more of total expenditures, no immediate deduction is available.
  • Any organizational expenditures not immediately deducted are amortized ratably over 180 months, beginning with the month in which the active trade or business begins.
  • Treas. Reg. § 1.248-1(b) defines organizational expenditures as expenditures that are (1) incident to the creation of the corporation, (2) chargeable to capital account, and (3) of a character that would be allowable as a deduction if incurred in connection with the operation of an existing business.
  • Specific qualifying expenditures include legal fees for drafting the corporate charter and bylaws, state incorporation and filing fees, expenses of temporary directors, and costs of organizational meetings of directors and shareholders.
  • Excluded expenditures include costs connected with issuing or selling stock (commissions, underwriting fees), costs of transferring assets to the corporation, and costs associated with a reorganization. These must be capitalized, not amortized under § 248.
  • The election is made by attaching a statement to the corporation's first income tax return or by claiming the deduction on the return for the taxable year in which the active trade or business begins. The election is irrevocable.
• Start-up expenses under § 195.
  • § 195(b)(1) permits a corporation to elect to deduct up to $5,000 of start-up expenditures, subject to the same dollar-for-dollar phase-out that applies to § 248 (complete phase-out at $55,000 of total expenditures).
  • Remaining start-up expenditures are amortized ratably over 180 months beginning with the month in which the active trade or business begins.
  • § 195(c)(1) defines start-up expenditures as amounts paid or incurred in connection with (1) investigating the creation or acquisition of an active trade or business, (2) creating an active trade or business, or (3) any activity engaged in for profit before the day the active trade or business begins, in anticipation of such activity becoming an active trade or business.
  • The expenditure must be one that would be deductible under § 162 if paid or incurred in connection with an existing active trade or business.
  • Specific qualifying expenditures include market research and surveys, advertising for the opening of the business, employee training wages before operations begin, consultant fees for business planning, and travel costs to scout locations or meet suppliers.
  • Excluded expenditures include interest under § 163, taxes under § 164, research and experimental expenditures under § 174, and amounts paid for depreciable or amortizable property.
  • Rev. Rul. 99-23, 1999-20 I.R.B. 3, distinguishes investigatory costs (incurred in a general search for a business to acquire, eligible for § 195) from acquisition costs (incurred after the taxpayer has focused on a specific business, which must be capitalized).
  • The election is made by claiming the deduction on the corporation's income tax return for the taxable year in which the active trade or business begins. The election is irrevocable and applies to all start-up expenditures related to the trade or business.
• § 248 and § 195 may be combined.
  • A corporation can elect both provisions in the same taxable year, potentially deducting up to $10,000 immediately ($5,000 organizational plus $5,000 start-up), subject to each separate phase-out.
  • Organizational expenses and start-up expenses are distinct categories. Do not commingle them. Legal fees for drafting the charter are organizational under § 248. Market research before opening is start-up under § 195.

Step 12D. § 1239 Related-Person Gain Recharacterization

• § 1239(a) recharacterizes gain on sales of depreciable property between related persons as ordinary income.
  • The statutory text provides that in the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation under § 167.
  • This recharacterization applies regardless of whether the gain would otherwise be capital gain or § 1231 gain.
• Related persons for § 1239 include an individual and a corporation controlled by that individual.
  • § 1239(c)(1) defines "controlled entity" to include a corporation more than 50% of the value of the outstanding stock of which is owned by or for such person.
  • Constructive ownership rules under § 267(c) apply in determining whether the more-than-50% threshold is met.
  • CAUTION. The § 1239 control threshold is more than 50%, not the 80% required for § 351. A transferor who owns 60% of a corporation is a related person under § 1239 even though 60% is insufficient for § 351 control.
• § 1239 applies to gain recognized in a § 351 exchange.
  • Rev. Rul. 60-302 held that gain recognized under § 351(b) (boot) and § 357(c) (liabilities in excess of basis) is subject to § 1239 recharacterization if the transferee corporation is a controlled entity with respect to the transferor.
  • If the transferor receives boot or has § 357(c) gain on a contribution of depreciable property to a controlled corporation, the entire recognized gain is taxable as ordinary income under § 1239.
  • EXAMPLE. Aaron forms Yellow, Inc., transferring a factory building (adjusted basis $200,000) and receiving all stock plus an $80,000 note. The building is encumbered by a $210,000 liability that Yellow assumes. The FMV of the building is $500,000. Aaron recognizes $90,000 of gain ($80,000 note boot plus $10,000 excess liability under § 357(c)). The entire $90,000 gain is ordinary income under § 1239 because Yellow, Inc. is a controlled corporation (more than 50% owned by Aaron) and the building is depreciable in Yellow's hands.
• If § 351 does not apply because the control requirement is not met, § 1239 may still apply.
  • In a taxable incorporation where control under § 368(c) is not achieved, the transfer is treated as a sale or exchange.
  • If the property is depreciable in the transferee corporation's hands and the transferor and corporation are related persons (more than 50% ownership), any capital gain is recharacterized as ordinary income under § 1239.
  • This is a critical trap. A transferor who fails § 351 because of insufficient ownership may face ordinary income treatment on what would otherwise be capital gain.
• § 1239 applies in addition to § 1245 recapture.
  • Both provisions can apply to the same transaction.
  • Gain recognized is first subject to § 1245 recapture to the extent of prior depreciation.
  • Any remaining recognized gain is recharacterized as ordinary income under § 1239 if the related-person test is met.
  • Even if no depreciation was taken on the property (so § 1245 does not apply), § 1239 still recharacterizes all recognized gain as ordinary income if the transferee will depreciate the property.
• § 1239 does not apply to losses.
  • If the transferor recognizes a loss on a sale or exchange of depreciable property to a related corporation, the loss remains a capital loss (subject to § 267 disallowance if the parties are related under § 267(b)).
  • § 1239 applies only to gains, not losses.

Step 13. State Tax Conformity Considerations

Federal § 351 nonrecognition does not automatically apply at the state level. This step addresses state conformity issues that can create unexpected state tax liabilities.

• Federal nonrecognition does not automatically carry over to state tax returns. Most states conform to the Internal Revenue Code in one of three ways. Rolling conformity automatically adopts the IRC as amended. Fixed-date conformity adopts the IRC as of a specific date. Selective conformity picks specific provisions to adopt or reject. Each model produces different results for § 351 transactions. (Cal. Rev. & Tax. Code § 23051.5) (N.Y. Tax Law § 208(9)) (Various state conformity statutes)

Step 13A. California-Specific Non-Conformity

• California conforms to § 351 nonrecognition but decouples from critical post-TCJA provisions. Cal. Rev. & Tax. Code § 23051.5 provides fixed-date conformity to the IRC as of January 1, 2015, with selective post-2015 adoption for certain provisions. California Form 100 instructions and Cal. Code Regs. Tit. 18, § 18662-3(B)(5)(E) explicitly recognize § 351 nonrecognition for real estate withholding exemption purposes. The FTB has acknowledged that transfers qualifying under federal § 351 are exempt from California withholding. However, California does NOT conform to numerous federal provisions that affect the post-formation tax treatment of contributed property and corporate deductions.
  • California does not conform to § 168(k) bonus depreciation. A corporation that claims 100% bonus depreciation on contributed property for federal purposes must use pre-TCJA depreciation schedules for California purposes. This creates a permanent difference requiring separate California depreciation computations. (2025 California Form 100 Instructions)
  • California does not conform to post-2021 § 174 R&E amortization. California still permits immediate deduction of research and experimental expenditures. If a transferor contributes R&E property or unamortized R&E costs, the corporation must track federal and California basis separately. (Cal. Rev. & Tax. Code § 23051.5) (Grant Thornton, "California updates general date conformity" (Oct. 2025))
  • California does not conform to § 163(j) as amended by the TCJA. California applies different interest limitation rules. A corporation formed with significant leverage must compute its California interest deduction limitation under separate state rules, not federal § 163(j). (2025 California Form 100 Instructions)
  • California does not conform to federal NOL modifications. California imposes a 20-year NOL carryforward rather than the federal unlimited carryforward. This affects planning if the corporation expects to generate losses in early years. (Cal. Rev. & Tax. Code § 24416)
  • California imposes an $800 minimum franchise tax. Every corporation doing business in California owes this tax regardless of income. This is a material planning cost for newly formed California corporations. (Cal. Rev. & Tax. Code § 23153)
  • The California Form 100 filing requirement. Every corporation doing business in California must file Form 100 annually. The § 351 exchange itself may require California disclosure even when no gain is recognized. (2025 California Form 100 Instructions)
• The practitioner must prepare separate federal and California basis schedules. Because California decouples from bonus depreciation, § 174 amortization, and § 163(j), the corporation's California adjusted basis in contributed assets will diverge from federal basis immediately after formation. Maintain dual basis schedules from day one.
• TRAP. California clients may face unexpected tax on the same transaction that is federally tax-free only in form. While § 351 nonrecognition applies in California, the post-formation utilization of deductions, depreciation, and losses from contributed property may produce materially different California taxable income. Model the first three years of federal and California tax side by side.

Step 13B. Other State Non-Conformity Issues

• States with fixed-date conformity may not follow current § 351 treatment. A state conforming to the IRC as of a date before a § 351 amendment may not recognize the current version of the statute. Check the state's specific conformity date against the federal effective date of any relevant provision.
  • States with notable partial conformity include Pennsylvania, New Jersey, and Massachusetts. Each decouples from specific federal provisions that may affect the post-formation treatment of contributed assets. (Various state conformity statutes)
  • Some states may not conform to § 357 liability assumption rules, § 358 basis computation, or § 362 carryover basis rules. This can produce gain at the state level even on a pure federal § 351 exchange.
• Selective conformity states may exclude § 351 nonrecognition entirely. A small number of states pick and choose which nonrecognition provisions to adopt. If a state does not conform to § 351, the transferor recognizes gain on the exchange for state tax purposes as if it were a taxable sale.
• The practitioner must check each state's conformity statute individually. There is no substitute for reading the state's conformity provision. Key questions for each state follow.
  1. Does the state conform to the IRC on a rolling basis, a fixed-date basis, or selectively?
  2. If fixed-date, what is the conformity date and does it include § 351?
  3. Does the state conform to § 357 (liability assumption rules)?
  4. Does the state conform to § 358 (stock basis rules)?
  5. Does the state conform to § 362 (corporate carryover basis)?
  6. Does the state conform to § 362(e)(2) (built-in loss limitation)?
  7. Does the state require a separate state-level election for § 351 treatment?
  8. Does the state impose a minimum franchise tax or filing fee on newly formed corporations?

Step 13C. Practitioner Guidance for Multi-State Formations

• State conformity verification for multi-state filings. If a state does not conform to § 351, the transferor may owe state tax on the exchange even when no federal tax is due. This state tax liability must be modeled in the planning phase, not discovered after the return is filed.
• State tax consequences of incorporation state selection. A Delaware corporation doing business in California files in both states. The Delaware formation may produce favorable corporate law outcomes but does not reduce California tax obligations. Weigh the state tax burden of each jurisdiction where the corporation will operate.
• State filing requirements for the year of formation. Many states require an initial return or franchise tax payment in the year of incorporation, even if the corporation has no income. Missed filings trigger penalties and interest that accumulate regardless of the corporation's federal tax posture.
• CAUTION. Do not assume that federal § 351 nonrecognition flows through to every state return. The most common practitioner error is preparing only a federal analysis and copying the federal result onto state returns without checking conformity. This error can produce significant underpayment penalties and interest at the state level.

Step 14. Documentation and Reporting Obligations

"The transferor and transferee of a transaction described in subparagraph (A) both elect the application of this subparagraph...subparagraph (A) shall not apply, and the transferor's basis in the stock received for property to which subparagraph (A) does not apply by reason of the election shall not exceed its fair market value immediately after the transfer." (IRC § 362(e)(2)(C)(i))

Step 14A. The § 351 Exchange Agreement

• Draft a written § 351 exchange agreement documenting every element of the transaction. There is no specific IRS form for a § 351 exchange. The nonrecognition treatment is mandatory when the statutory requirements are met. However, a well-drafted agreement is the foundational document that supports the nonrecognition position on audit and provides the factual record for all basis computations. Treas. Reg. § 1.351-3 requires a "significant transferor" (any transferor receiving stock representing 5% or more of total voting power or value) to attach a statement to their return describing the transfer. The exchange agreement serves as the source document for that statement.
  • Description of contributed property. The agreement must list each asset contributed, describe it with specificity, state its adjusted basis, and state its fair market value at the time of transfer. Include the method of valuation, whether appraisal, market comparables, or another acceptable method.
  • Stock issued in exchange. The agreement must specify the class of stock, number of shares, par value (if any), and fair market value of the shares issued. Document how the value of the stock was determined.
  • Valuation methodology. Disclose the appraisal firm or valuation method used. A qualified independent appraisal provides the strongest support. If no appraisal was obtained, document the alternative valuation method and its rationale.
  • Basis of contributed property. State the adjusted basis of each contributed asset as computed under federal rules and, if applicable, under state rules. If basis differs from federal for any state, maintain separate schedules.
  • Liabilities assumed. List every liability the corporation assumes or takes property subject to. For each liability, state the creditor, the original balance, the balance at transfer, the interest rate, maturity date, and terms. Specify whether the liability is a § 357(c)(3) deductible liability.
  • Boot transferred. If the transferor receives any cash or other property in addition to stock, describe it, state its fair market value, and explain its character. The boot amount drives gain recognized under § 351(b).
  • Control computation. Include a representation that the transferors of property, as a group, will own stock possessing at least 80% of the total combined voting power of all classes entitled to vote and at least 80% of the total number of shares of all other classes. (IRC § 368(c))

Step 14B. The § 83(b) Election

• File the § 83(b) election within 30 days of stock transfer for services. IRC § 83(a) provides that property transferred in connection with the performance of services is included in gross income at the earlier of when the property is no longer subject to a substantial risk of forfeiture or when it becomes transferable. § 83(b) allows the service provider to elect immediate inclusion of the property's fair market value in gross income, bypassing subsequent taxation of appreciation. The election is irrevocable. (IRC § 83(b))
  • The 30-day deadline is absolute. The election must be filed with the IRS Service Center where the transferor files returns within 30 days after the date the property was transferred. There is no relief for late filing. Treasury has repeatedly declined to grant extensions. The 30-day period begins on the date of transfer, not the date the stock certificate is issued or the date the board approves the issuance.
  • Delivery method. Use certified mail with return receipt requested. Retain the certified mail receipt and the return receipt as evidence of timely filing. The practitioner should maintain a copy in the permanent file with the mailing receipt stapled to it.
  • Required copies. The transferor must file the original election with the IRS, retain a copy for their records, and furnish a copy to the corporation. (Treas. Reg. § 1.83-2(c)) The corporation must retain the copy in its corporate records.
  • The election statement must include all required elements. (Treas. Reg. § 1.83-2(a))
    1. The name, address, and taxpayer identification number of the transferor.
    2. A description of the property with respect to which the election is being made (including the number of shares and the corporation's name).
    3. The date on which the property was transferred and the taxable year for which the election is made.
    4. The nature of any restrictions on the property (such as a vesting schedule, forfeiture provisions, or transfer restrictions).
    5. The fair market value of the property at the time of transfer, determined without regard to any restrictions other than restrictions that by their terms will never lapse.
    6. The amount paid for the property (if any).
    7. The amount to be included in gross income (the excess of fair market value over amount paid).
    8. A statement that a copy of the election has been furnished to the corporation.
• TRAP. A missed § 83(b) election can cost the service provider millions in ordinary income. If the stock appreciates substantially and the service provider did not make a timely § 83(b) election, the full appreciation from the date of grant through the vesting date is taxed as ordinary income on each vesting event. The character is ordinary income, not capital gain. The 30-day deadline is the single most important compliance deadline in a service provider incorporation.
• CAUTION. The corporation must not withhold the service provider's copy of the § 83(b) election. The election is the transferor's responsibility, but the corporation must receive a copy under Treas. Reg. § 1.83-2(c). Corporate counsel should confirm receipt and file the copy with the corporate minute book.

Step 14C. The § 362(e)(2)(C) Election Procedures

• The transferor and transferee may jointly elect to reduce stock basis rather than corporate property basis. IRC § 362(e)(2) generally requires the transferee corporation to reduce its basis in contributed property to fair market value when the aggregate adjusted basis of transferred property exceeds aggregate FMV. § 362(e)(2)(C) provides an alternative. If both parties elect, the corporation preserves its full carryover basis in the property, and the transferor reduces its stock basis to FMV. The election is irrevocable.
  • No IRS consent is required. The election is made by including a statement with the timely-filed return (including extensions) for the taxable year of the transfer. Both the transferor and the transferee must include the statement. (IRC § 362(e)(2)(C)(ii)) (Treas. Reg. § 1.362-4(d)(3))
  • The statement must include the following information. (Treas. Reg. § 1.362-4(d)(3)(ii))
    1. A statement that the transferor and transferee elect under § 362(e)(2)(C).
    2. The name and TIN of the transferor.
    3. The name and EIN of the transferee corporation.
    4. A description of each property to which the election applies.
    5. The amount of the basis reduction allocated to each property or the total basis reduction.
  • Both parties must file. The election is effective only if both the transferor and the corporation include the statement with their respective timely-filed returns. If one party files and the other does not, § 362(e)(2)(A) applies, and the corporation's basis in the property is reduced to FMV. The election is not made by filing a single joint statement.
• When to consider the § 362(e)(2)(C) election. The election is advantageous when the corporation needs the higher basis for depreciation, amortization, or future loss recognition. The cost is a reduced stock basis for the transferor, which means more gain on a future sale of the stock. Model both scenarios before making the election.
  • If the corporation will hold depreciable property and generate taxable income, the election may produce net present value savings through accelerated depreciation deductions.
  • If the transferor plans to sell the stock in the near term, the reduced stock basis may produce immediate taxable gain that outweighs the corporate-level benefit.

Step 14D. Substantiation and Record Retention

• Maintain a permanent file containing the following documents. The statute of limitations for a tax return is generally three years from the filing date. However, basis-related items affect gain on disposition, and the statute of limitations on an underreported gain does not begin to run until the return reporting the disposition is filed. Retain all formation documents permanently. (IRC § 6501(a)) (IRC § 6501(e))
  • Description of each contributed asset with adjusted basis and FMV documentation. For each asset, maintain a worksheet showing the original cost, adjustments to basis, depreciation or amortization taken, and the adjusted basis at transfer. Attach the appraisal or valuation support.
  • Appraisals or valuation analyses. An independent qualified appraisal provides the strongest audit defense. If an appraisal was not obtained, retain the alternative valuation methodology and all supporting data. The appraisal should be dated contemporaneously with the transfer.
  • The § 351 exchange agreement. The signed agreement is the primary document evidencing the transaction. Maintain the fully executed original.
  • Stock certificates and stock ledger entries. The stock ledger must accurately reflect the shares issued to each transferor, the date of issuance, the consideration received, and the resulting ownership percentages. Stock certificates should be numbered sequentially.
  • Documentation of liabilities assumed. For each liability, retain the loan agreement, promissory note, or other evidence of the debt. Document the balance immediately before and after the transfer. Confirm that the creditor has been notified of the assumption if required.
  • § 83(b) elections. Retain a copy of the executed election, the certified mail receipt, and the return receipt. These are the only evidence that the election was timely filed.
  • § 362(e)(2)(C) elections. Retain a copy of the election statement filed by both the transferor and the corporation. Confirm that both parties actually filed with their respective returns.
  • Correspondence with the IRS. Retain any letter rulings, determination letters, or other IRS communications related to the formation. A § 351 private letter ruling under Rev. Proc. 83-59 (as updated by Rev. Proc. 2025-1) provides the highest level of certainty.
  • State tax analysis and filings. Retain the state conformity analysis and all state returns for the year of formation and every subsequent year. State filing positions may be challenged independently of federal positions.
• Statute of limitations considerations. (IRC § 6501)
  • The general three-year statute applies from the date the return is filed.
  • If gross income is omitted in excess of 25% of the amount stated on the return, the statute extends to six years. (IRC § 6501(e)(1))
  • There is no statute of limitations for fraudulent returns or when no return is filed.
  • Basis computations affect the gain reported on a future disposition. The statute on the gain from a stock sale begins running when the return reporting that sale is filed, not when the formation return is filed. This is why permanent retention is recommended.

Step 14E. Corporate Records

• Update the corporate stock ledger to reflect the share issuance. The stock ledger is the official record of share ownership. For each shareholder, record the name, address, number of shares, class of shares, date of issuance, and consideration received. The ledger entry must match the § 351 exchange agreement.
• Prepare board resolutions authorizing the issuance of stock. The board of directors must formally authorize the issuance of shares to each transferor. The resolution should reference the § 351 exchange agreement, ratify the terms of the transfer, and approve the valuation methodology. The resolution should be adopted at a properly noticed board meeting or by unanimous written consent.
• Record contributed assets on the corporate balance sheet at the appropriate basis. The corporation's opening balance sheet must reflect each contributed asset at its carryover basis under § 362(a), increased by any gain recognized by the transferor. If § 362(e)(2) applies without a § 362(e)(2)(C) election, record the assets at FMV. If the election is made, record at carryover basis. Do not record assets at the stock's fair market value unless it equals carryover basis.
• Document any liabilities assumed on the corporate books. The corporation's opening balance sheet must reflect each liability assumed at its carrying amount. Set up the corresponding liability accounts (notes payable, accounts payable, accrued liabilities) and link each to the supporting documentation. If § 357(c) gain was recognized, that gain flows through the corporation's tax return and affects retained earnings.
• CAUTION. Do not rely solely on the federal tax return to document the formation. The tax return is a summary document. The underlying agreements, appraisals, board resolutions, and stock ledger entries provide the substantive audit defense. An IRS examiner will ask for the documents, not just the return.

Step 15. Post-Formation and Recent Law Considerations

"The amount allowed as a deduction under this chapter for business interest...shall not exceed the sum of...30 percent of the adjusted taxable income of such taxpayer for such taxable year." (IRC § 163(j)(1))

Step 15A. The § 163(j) Business Interest Limitation

• The § 163(j) interest deduction limitation affects leveraged formations. IRC § 163(j) limits the deduction for business interest expense to the sum of business interest income, 30% of adjusted taxable income (ATI), and floor plan financing interest. For taxable years beginning after December 31, 2021, and before January 1, 2025, ATI was computed as EBIT (earnings before interest and taxes), which is more restrictive than the EBITDA-based calculation that applied from 2018 through 2021. The One Big Beautiful Bill Act (OBBBA), enacted July 4, 2025, permanently restored the EBITDA-based ATI computation for taxable years beginning after December 31, 2024. (IRC § 163(j)) (Bloomberg Tax, "What Is the Limitation on Business Interest Expense Deductions?" (Nov. 24, 2025)) (GBQ, "163(j) Limitation, The One Big Beautiful Bill" (Dec. 1, 2025))
  • Impact on leveraged formations. When a transferor contributes debt-laden property and the corporation assumes the liabilities, the interest expense on that debt becomes the corporation's business interest expense. If the corporation has low or negative ATI in its initial years, the § 163(j) limitation may defer interest deductions. Excess business interest expense is carried forward indefinitely. (IRC § 163(j)(2))
  • The small business exception. Taxpayers with average annual gross receipts of $31 million or less (indexed for inflation, $31 million for 2024-2025) are exempt from § 163(j). Many newly formed corporations qualify for this exception in their initial years. If the corporation expects to remain below the threshold, the § 163(j) limitation may not apply. (IRC § 163(j)(3))
  • The real property trade or business election. A trade or business that elects under § 163(j)(7)(B) to be treated as a "real property trade or business" is exempt from § 163(j) but must use the alternative depreciation system (ADS) under § 168(g). If real property is contributed to a corporation under § 351, evaluate this election. The election is irrevocable.
  • Model the § 163(j) impact in the planning phase. Project the corporation's ATI and business interest expense for the first three years. If the limitation applies, the deferred interest deductions reduce the tax benefit of leverage and may affect the optimal capital structure.

Step 15B. Corporate Alternative Minimum Tax (CAMT)

• The CAMT under § 55 applies to applicable corporations with large financial statement income. The Inflation Reduction Act of 2022 amended § 55 to impose a new Corporate Alternative Minimum Tax, effective for taxable years beginning after December 31, 2022. An "applicable corporation" is a corporation (other than an S corporation, RIC, or REIT) with average annual adjusted financial statement income (AFSI) exceeding $1 billion for the 3-taxable-year period ending with the preceding taxable year. Special aggregation rules apply for members of foreign-parented multinational groups. (IRC § 59(k)(1)) (IRC § 55(b)(2)(A))
  • § 351 nonrecognition is generally respected for CAMT purposes. Notice 2025-46 (Sept. 30, 2025) provides interim guidance on CAMT treatment of corporate transactions. For a § 351 exchange in which the transferor recognizes no gain under § 351(a), the transaction is treated as a covered nonrecognition transaction. No AFSI inclusion results. If boot is received and § 351(b) applies, the recognized gain is included in AFSI using CAMT basis. The transferee corporation takes a carryover basis in the transferred assets under § 362(a), substituting CAMT basis for regular tax basis. (Notice 2025-46, § 3)
  • The "cliff effect" has been eliminated. The 2024 Proposed Regulations (REG-112129-23) created a cliff effect where receipt of even a de minimis amount of boot could cause full recognition for CAMT purposes. Notice 2025-46 eliminates this cliff effect. AFSI adjustments now follow regular tax treatment (recognition or nonrecognition) with CAMT basis substituted for regular tax basis. (Notice 2025-46, § 3) (KPMG, "IRS modifies CAMT proposed rules in interim guidance" (Oct. 22, 2025))
  • CAMT basis must be computed separately. CAMT basis in stock received in a § 351 exchange is determined under § 358 using CAMT basis in lieu of regular tax basis. CAMT basis in property received by the corporation is determined under § 362 using the transferor's CAMT basis. The § 362(e)(2) adjustment applies independently for CAMT purposes. Maintain dual basis schedules. (Notice 2025-46)
  • A newly formed corporation generally will not be subject to CAMT in its initial years. The applicable corporation determination looks backward at historical AFSI. A newly formed corporation has no prior 3-year period of AFSI to measure. However, a corporation formed in a § 351 exchange may be subject to CAMT if it is a successor to an applicable corporation, if it is a member of a tax consolidated group that includes an applicable corporation, or if its AFSI, when aggregated with related entities under § 52(a) or (b), exceeds the threshold. (IRC § 59(k))
  • Monitor Notice 2025-27 for the simplified method. Notice 2025-27 (June 2025) provides an optional simplified method for determining applicable corporation status. This may reduce the compliance burden for corporations near the threshold.

Step 15C. § 174 Research and Experimental Expenditure Amortization

• R&E expenditures must be amortized rather than immediately expensed for certain years. The TCJA amended § 174, effective for taxable years beginning after December 31, 2021. Domestic R&E expenditures must be capitalized and amortized ratably over 5 years. Foreign R&E expenditures must be amortized over 15 years. Amortization begins at the midpoint of the taxable year in which the expenditures are paid or incurred. Software development costs are treated as R&E expenditures. (IRC § 174(a)(2)(A)) (IRC § 174(a)(2)(B)) (IRC § 174(a)(3))
  • OBBBA restored immediate expensing for domestic R&E. The One Big Beautiful Bill Act created new IRC § 174A, effective for taxable years beginning after December 31, 2024. Domestic R&E expenditures and domestic software development costs are again immediately deductible. Foreign R&E expenditures continue to be capitalized and amortized over 15 years. (IRC § 174A)
  • Transitional relief for 2022-2024. Small businesses (average annual gross receipts under $31 million for 2022-2024) may amend returns for 2022 through 2024 to immediately deduct domestic R&E expenditures previously capitalized. All taxpayers may elect to accelerate remaining deductions for previously capitalized R&E expenditures over a 1-year or 2-year period. (OBBBA transitional rules)
  • Impact on § 351 transfers of R&E property. If a transferor contributes a business with unamortized R&E costs to a corporation under § 351, the corporation steps into the transferor's amortization position under § 362(a). The corporation continues amortizing the R&E expenditures on the same schedule. (RSM, "Comment Letter regarding § 174 Costs in M&A Transactions" (Sept. 9, 2024))
  • Post-formation R&E planning. The corporation's tax treatment of R&E costs incurred after formation is governed by § 174 (as amended by § 174A for years after 2024). Domestic R&E is immediately deductible. Foreign R&E is amortized over 15 years. Account for this in post-formation tax projections.

Step 15D. BEAT for Cross-Border Formations

• The Base Erosion and Anti-Abuse Tax may apply to corporations with foreign related party payments. IRC § 59A imposes BEAT on applicable taxpayers with average annual gross receipts of $500 million or more and a base erosion percentage of 3% or higher (2% for banks and registered securities dealers). The BEAT rate is 10% through 2025 and 10.5% permanently under OBBBA. (IRC § 59A) (IRS Practice Unit, "IRC 59A Base Erosion Anti-Abuse Tax Overview" (Feb. 5, 2025))
  • A § 351 transfer itself is not a base erosion payment. A contribution of property to a corporation in exchange for stock is not a deductible payment. BEAT applies to deductible payments (such as interest, royalties, and services) made to foreign related parties. (IRC § 59A(d)) (Treas. Reg. § 1.59A-3(b)(1))
  • Post-formation base erosion exposure. After formation, if the newly formed corporation makes deductible payments to foreign related parties, those payments may be base erosion payments. If the corporation assumed foreign related-party debt in the § 351 exchange, the subsequent interest payments are base erosion payments subject to both § 163(j) and § 59A. The § 163(j) limitation caps the interest deduction, which correspondingly limits the base erosion tax benefit.
  • Cross-border § 351 transfers involving foreign corporations. When a U.S. person contributes property to a foreign corporation under § 351, subsequent payments from the U.S. entity to the foreign corporation may implicate BEAT. The § 367(b) regulations govern the outbound transfer of property to a foreign corporation. Consider whether the formation triggers or facilitates base erosion payments.
  • Anti-hybrid rules under § 267A. § 267A disallows deductions for interest or royalty payments to a related party pursuant to a hybrid transaction or made by or to a hybrid entity if the payment is not included in the recipient's income under foreign law. This interacts with BEAT planning for cross-border formations. (IRC § 267A)

Step 15E. Practitioner Checklist for Post-2017 Formations

• § 163(j) interest limitation modeling for leveraged formations. Project the corporation's adjusted taxable income and business interest expense. Confirm whether the small business exception applies. Evaluate the real property trade or business election if applicable. For tax years 2022 through 2024, use EBIT-based ATI. For tax years beginning after December 31, 2024, use EBITDA-based ATI under OBBBA.
• CAMT applicability for newly formed corporations. Determine whether the corporation or any entity in its aggregated group has average annual AFSI exceeding $1 billion. If yes, compute CAMT basis separately from regular tax basis. File Form 4626 if applicable. Monitor proposed regulations under §§ 1.56A-18 and 1.56A-19 for developments following Notice 2025-46.
• Account for § 174 R&E amortization in projections. For tax years 2022 through 2024, domestic R&E is amortized over 5 years and foreign R&E over 15 years. For tax years beginning after December 31, 2024, domestic R&E is immediately deductible under § 174A and foreign R&E remains subject to 15-year amortization. If the corporation has unamortized R&E balances from a § 351 transfer, continue amortization on schedule.
• BEAT exposure for cross-border formations. Confirm the corporation's average annual gross receipts and base erosion percentage. If the corporation is an applicable taxpayer, model the BEAT impact on post-formation payments to foreign related parties. Coordinate BEAT analysis with § 163(j) and § 267A.
• Post-2017 state conformity review. States have decoupled from TCJA provisions at varying rates. Confirm that each state where the corporation files has adopted or rejected § 163(j), § 174, § 168(k), and CAMT. Model state tax separately from federal tax. See Step 13 for detailed state conformity analysis.
• Monitor sunset provisions and legislative developments. The TCJA individual provisions sunset after 2025. Bonus depreciation phases down under pre-OBBBA law but OBBBA made 100% bonus depreciation permanent for property acquired after January 19, 2025. The OBBBA also created new § 168(n) qualified production property deduction for manufacturing structures with construction beginning after January 19, 2025 and before January 1, 2029. The § 461(l) excess business loss limitation is now permanent for tax years beginning after December 31, 2026, with thresholds reset to $250,000 ($500,000 joint), adjusted for inflation from a 2024 base. Each of these provisions may affect the corporation's post-formation tax posture. (IRC § 168(k) as amended by OBBBA) (IRC § 461(l) as amended by OBBBA)
• Private letter ruling considerations for uncertain transactions. Rev. Proc. 2024-3 removed the long-standing "no rule" position for § 351 transactions. Full no-gain-or-loss rulings are now available. Rev. Proc. 2025-1, Appendix F, specifies the checklist for § 351 ruling requests under Rev. Proc. 83-59. A ruling provides the highest level of certainty for complex formations. (Rev. Proc. 2024-3) (Rev. Proc. 2025-1)