The Thesis
Section 351 is the gateway rule for forming a corporation without immediate tax. It allows transferors to contribute property in exchange for stock and defer gain or loss, but only when specific conditions are met. CPA REG tests Section 351 every cycle because it combines a recognition rule, a control test, a basis rule, and a holding period rule into one transaction.
The biggest mistake on the exam is treating Section 351 as automatic. It is not. The transferors must meet the control test in the aggregate, services do not count as property, and any boot received triggers gain to the extent of the boot or the realized gain, whichever is less.
The Decision Map
The boundary conditions are the most-tested. The 80 percent test is measured after the exchange, looking at all transferors as a group. Services are not property. Stock attributable to services creates compensation income, breaks the property requirement for that transferor, and can disqualify the entire transaction if the service provider's stock causes the group to fall below 80 percent.
The 80 Percent Control Test
Treasury defines control under Section 368(c) as ownership of at least 80 percent of the total combined voting power and at least 80 percent of the total number of shares of each class of nonvoting stock. Both tests must be satisfied.
A transferor who contributes only services receives stock that does not count toward the 80 percent. The other transferors must still meet the 80 percent threshold without their help. If a service provider receives more than a de minimis amount of stock for services and his stock is excluded, the property transferors must reach 80 percent on their own.
Exam pattern: three founders contribute. Two contribute property worth 100,000 dollars each in exchange for 100 shares each. One contributes services in exchange for 50 shares. Total shares outstanding: 250. The two property contributors own 200 shares out of 250, or 80 percent. The test is met. If the service shares had been 75, the property contributors would own 200 out of 275, or 72.7 percent, and the transaction would fail Section 351.
Boot and Realized Gain
When a transferor receives boot (cash, debt assumed in excess of basis, or any non-stock property) in addition to stock, the transferor recognizes gain equal to the lesser of:
- The boot received.
- The realized gain on the transfer.
Losses are never recognized in a Section 351 exchange even when boot is received.
Worked example: a transferor contributes property with adjusted basis of 40,000 dollars and fair market value of 100,000 dollars. In exchange they receive stock worth 90,000 dollars and 10,000 dollars cash. Realized gain is 60,000 dollars (100,000 minus 40,000). Boot is 10,000 dollars. Recognized gain is 10,000 dollars (the lesser).
The character of the recognized gain follows the character of the asset transferred. Capital asset to capital gain. Section 1245 recapture to ordinary income if applicable. Section 1231 to the netting process.
Liability Assumption and Section 357
When the corporation assumes a transferor's liability, the liability is generally not treated as boot (Section 357(a)). Two exceptions:
- Section 357(b): if the principal purpose was tax avoidance or there was no business purpose, all liabilities assumed are treated as boot.
- Section 357(c): if the total liabilities assumed exceed the total adjusted basis of property transferred, the excess is recognized as gain.
The 357(c) rule prevents a transferor from contributing property with very low basis and high debt and walking away with no taxable event despite economic enrichment.
Example: a transferor contributes property with adjusted basis of 30,000 dollars and fair market value of 150,000 dollars. The corporation assumes 50,000 dollars of debt secured by the property. Basis exceeded by debt: 50,000 minus 30,000 equals 20,000 dollars of gain recognized under Section 357(c).
Transferor Basis in Stock Received
Substituted basis under Section 358:
Stock basis = adjusted basis of property transferred minus boot received minus liabilities assumed plus gain recognized.
The formula sequence matters on the exam. Work through the example: property with adjusted basis 40,000 dollars, boot of 10,000 dollars, no liabilities assumed, recognized gain 10,000 dollars.
Stock basis = 40,000 minus 10,000 minus 0 plus 10,000 = 40,000 dollars.
This preserves the deferred gain. The transferor will recognize the remaining 50,000 dollars of gain when the stock is sold for its fair market value of 90,000 dollars.
Corporate Basis in Property Received
Carryover basis under Section 362:
Corporate basis = transferor's adjusted basis plus gain recognized by the transferor.
In the same example, the corporation's basis in the property is 40,000 plus 10,000 equals 50,000 dollars.
A special rule limits corporate basis in property with built-in losses (Section 362(e)(2)) to fair market value when the transferor and corporation are related and the basis would otherwise exceed FMV. This rule prevents importation of losses through formation.
Holding Period
Under Section 1223(1), the transferor's holding period in the stock includes the holding period of the property transferred if the property was a capital asset or Section 1231 asset. The corporation's holding period in the property tacks under Section 1223(2) for the transferor's holding period regardless of asset type.
This is important on later sales of stock or property to determine long-term versus short-term treatment.
Worked Example: A Complete Section 351
Three founders form Acme Inc.
- Alex contributes equipment: basis 30,000 dollars, FMV 80,000 dollars, with 20,000 dollars of debt the corporation assumes. Receives stock worth 60,000 dollars.
- Brooke contributes cash 60,000 dollars. Receives stock worth 60,000 dollars.
- Cara contributes services. Receives stock worth 20,000 dollars.
Total stock outstanding: 140,000 dollars (60,000 plus 60,000 plus 20,000).
Step 1: 80 percent control test. Property contributors are Alex and Brooke with 120,000 dollars of stock (60,000 plus 60,000). Total stock is 140,000. Property contributors own 120,000 over 140,000 equals 85.7 percent. Test passes.
Step 2: Alex's gain. Realized gain is 80,000 minus 30,000 equals 50,000 dollars. Liability assumed is 20,000 dollars. Section 357(c) check: liability of 20,000 does not exceed basis of 30,000, so no 357(c) gain. Boot otherwise is zero. Recognized gain is zero.
Step 3: Alex's stock basis under Section 358. 30,000 (property basis) minus 20,000 (liability) minus 0 (other boot) plus 0 (gain) equals 10,000 dollars.
Step 4: Corporate basis in equipment under Section 362. 30,000 (transferor basis) plus 0 (gain recognized) equals 30,000 dollars.
Step 5: Brooke's stock basis is 60,000 dollars (cash contributed equals basis).
Step 6: Cara has compensation income of 20,000 dollars (FMV of stock for services) and stock basis of 20,000 dollars (fair market value because included in income).
This pattern shows up repeatedly on REG. Practice these scenarios in our CPA REG question bank to build speed.
Common Exam Traps
- Treating services as property and counting service shares toward the 80 percent.
- Recognizing a loss on a Section 351 transfer.
- Forgetting that liabilities assumed reduce stock basis under Section 358 even when not treated as boot.
- Missing the Section 357(c) gain when debt exceeds basis.
- Computing the corporation's property basis from FMV instead of carryover plus gain.
- Forgetting the holding period tack for capital and Section 1231 assets.
Exam Framing
CPA REG questions on Section 351 typically test:
- Whether the transaction qualifies (control test, property versus services).
- Gain recognition with boot or 357(c) liability.
- Stock basis under Section 358.
- Corporate basis under Section 362.
- Compensation income for a service provider.
Map each fact to a step before computing. A clean answer says "Section 351 applies because the control test is met. The transferor recognizes X gain because of Y boot. Stock basis is Z under Section 358. Corporate basis is W under Section 362."