Exchanging and issuing shares under section 351
To overcome this problem and stock exchange problems, section 351 was included in the tax rules by the IRS. It is called the tax-free “Section 351 transfer.”
Now that you have started your business, have you thought of how issuing shares may affect your taxes? As a matter of fact, most entrepreneurs choose limited liability companies for the incorporation of their businesses mainly for the tax benefits of and structure of an LLC.
To overcome this problem and stock exchange problems, section 351 was included in the tax rules by the IRS. It is called the tax-free “Section 351 transfer.” As per this rule, the seller can offer their LLC interests (the assets of the LLC) to a new company while the buyer would give back stock (or other property) to the corporation. And if after the transfer is made and the buyer has greater than 80% control on the new corporation, the transfer would be tax-free.
But before we can understand what the section 351 is for exchange of shares, let us understand what a stock swap is.
What is stock swap?
A stock swap takes place when one equity-based asset is exchanged for another. There are two kinds of applications under this: business combinations and equity compensation for employees of a company. In short, there are two situations where a stock swap occurs:
- The stock swap takes place when the stock option is exercised by an employee and uses the shares that they already own to pay for new shares.
- The stock swap also takes place when the ownership of the shareholders of the shares of a company are exchanged for shares of the acquiring company during a merger or acquisition process. During this process, the shares of both the companies have to be valued accurately so that they can find out a fair swap ratio.
To be clear, stock swaps can have the complete consideration paid during the merger and acquisition (M&A) deal. What’s more, the stock swap can also have a portion of the consideration paid in an M&A deal along with a cash payment made to the shareholders of the company. Or, it can be calculated for both the target and acquirer for a newly-formed entity. To understand better, here is an example.
Two companies – E.I. du Pont de Nemours & Company (“DuPont”) and The Dow Chemical Company (“Dow”) closed a merger in 2017 when the DuPont shareholders obtained a swap ratio of 1.282 shares of DowDuPont (the combined entity) for each DuPont share and the Dow shareholders obtained a swap ratio of 1.00 share of DowDuPont for each Dow share.
It should be noted that if the deal is for stock only, after the swap terms are obtained and agreed upon, the value of the stock of the target company would fluctuate based on the stock swap ratio. The IRS doesn’t consider the initial investment of the shareholders of the target company as a “disposal” for tax purposes the moment the company is taken over.
Basically, when the deal is closed, the company would not have to report any gain or loss to the IRS. Additionally, the cost basis of the shareholders of any merged company would be the same as in the initial investment.
Back to the discussion of Section 351
With an understanding of a stock swap, let us get back to why the section 351 exists and what it is about. Usually, the process of transferring property into a corporation in exchange for shares is something that is taxed by the IRS. As mentioned above, this kind of transaction is considered as if a person is selling his property to a corporation in exchange for cash (equivalent to the value of stock). And the difference that comes between the tax basis and the stock value obtained in the property transferred to the corporation would have a gain or loss to the person.
Due to the tax liability that comes during a swap process, section 351 was introduced to make things easier.
What is section 351?
Section 351 of the Internal Revenue Code (IRC) permits a tax-free incorporation transfer where specific requirements are met. These requirements include that the property has to be transferred to a corporation by one or more people in exchange of shares of the corporation. And as soon as the exchange takes place, the transferor or transferors get control of the corporation.
Requirements for tax-free exchange
Let us understand more about the requirements for obtaining a tax-free exchange. The two main requirements that have to be met to qualify for a tax-free treatment as per the Section 351(a) are:
You are only getting stock in exchange for your property, and not stock PLUS any other property; and
- This includes you (you and the transferor group, like the partners). You can only get the stock (that does not include non-qualified preferred stock) from the corporation in exchange for the property that you are selling (transferring).
- Non-qualified preferred stock is where the owner of the stock has the right to require the issuer to buy or redeem it back or the issuer is required to buy or redeem it back. The dividend rate placed on these stock varies based on commodity prices, interest rates and similar indices.
- You should be in control of the corporation as soon as the exchange is made.
Issuing of shares for property
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Regardless of if you are starting a new corporation by yourself or with other partners, or you are getting involved in a corporation that is already existing, as per the Section 351(a) you can defer the tax consequences that come up.
The moment you transfer the property into a corporation, there are two valuation issues that would arise, as below:
The value given to the stock that you get from the corporation.
The basis that you get for the stock you receive is the same as the adjusted basis in the property that you transfer. The basis here is also called the transferred basis, carryover basis, or the exchanged basis.
For example, let us assume that the adjusted basis of the property that you transferred is $10,000. This means that your stock basis would also be $10,000.
The value given to the property that is being transferred to the company.
The corporation’s basis for the property that you obtain in exchange for shares of the same company is the same basis that you had in the property when it was transferred. Basically, the corporation takes your basis.
For example, let us assume that the adjusted basis in the property transferred is $10,000. In this case then, the corporation’s basis in the property is also the same, which is $10,000.
What is meant by control?
With all this clear, you might still wonder how control is defined under Section 351. Section 368(c) defines control of ownership of the stock of at least 80% of the complete voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. This provision does not have any value requirement. The control requirement works for both the partially taxable and tax-free exchanges. You can learn more about the partially taxable exchanges from the IRS website.
Taxable exchange for shares
Whereas a transfer of property for only the company shares is a tax-free exchange, taxable exchanges can occur. These exchanges normally happen when the shareholder receives money, reduction of liabilities, or shares for services rendered to the company.
From the explanation above about IRC section 351, property can only be exchanged for stock to be eligible for the tax-free exchange. In fact, there is a recognized gain applied to the transfer of property in exchange of cash or any other property other than stocks of the company. Moreover, if the shareholder gets cash along with another property and the corporation stock for an exchange in property, gains would be recognized up to the FMV of the other property or amount of cash the shareholder received.
Let us take an example to understand better: Tom transfers a building to a corporation which has a property basis of $100,000 for the FMV of the shares of the company and $100,000 in cash. For this, Tom gets a recognized gain of $100,000 due to the transfer of the property, which is the amount of the fair market value of the boot ($100,000). This means that he is taxed for the cash he received for the transfer of the property.
Offering services to a corporation in exchange for shares is normally a taxable event. Under section 351, the value of the stock obtained for services is recognized as income to the recipient. Under this case, the shareholder’s basis in the stock is the total value of the services offered plus the value basis of the property transferred to the corporation in exchange for its stock.
Let us take an example to understand this better, where you transfer both property and offer services in exchange for shares. You transfer a property that is worth $35,000 and in exchange for this, you render services valued at $3,000. In this case, you would get stocks of the corporation whose value is $38,000 and own about 85% of the outstanding stock as soon as the exchange is made.
The result of this, as you had control of at least 80% of the outstanding stock, as soon as the exchange was made, this exchange is considered tax-free for the property given. Your stock basis would be $38,000, and if you recognize the ordinary income of $3,000 for the services offered to the corporation, the corporation would be able to deduct the $3,000, as it would be considered as compensation paid by the corporation.
Any property contributed to a corporation as per section 351 exchange can be subjected to liabilities. These liabilities are usually assumed by the transferee corporation as per the rules of section 357(a). Basically, as per the section, the assumed liability can’t be in excess of the contributed property’s tax basis under section 357(c). Moreover, it should also have been generated for a bona fide business purpose as per the section 357(b).
Nonetheless, in case the liabilities exceed the adjusted shareholder’s basis in the property, the recognized gain is on the excess and the shareholder’s basis in the company stock becomes zero. Let us take an example to explain this better.
Case 1: John contributes a building that has a property basis of $1 million and the FMV of $3 million to a new corporation in exchange for shares. As per the section 351, John would have a tax-free exchange and would not recognize any taxable gain.
Case 2: In this case, John gets stock and about $50,000 in cash in exchange for what he has contributed. Here, the contribution still meets the requirements of the section 351(a). However, the $50,000 million recognized gain that John is now subjected to the Federal income tax to the extent of the boot that he received.
Case 3: In this case, the transferee corporation also assumes a $500,000 purchase money mortgage note on the building. Here, the contribution of the building would not qualify for a tax-free exchange as per the section 351(a), and John would be taxed on the $500,000 received as a reduction in liabilities.
With everything clear about the section 351 and its requirements, you can now easily enjoy a tax-free exchange of shares the next time you are about to sell a property or issue shares in your company. But to do all this, do not forget to keep a records of all the shares in your company on your cap table.
If you have not yet decided how to make your cap table, you can try out Eqvista, an app which allows you to record, track and manage all the shares in your company. Find out more about it here or contact us for any doubts related to the section 351 rule!