If property is transferred to a corporation by one or more people solely in exchange for stock in the corporation and immediately after the exchange the person or people engaged in the exchange are in control of the corporation then generally speaking subject of course to certain thresholds no gain (or loss) is recognized for tax purposes. This is often referred to as a nonrecognition or 351 transaction which is a reference to the tax code number governing the transaction. The following four requirements must be met for a transaction to qualify as a Code Sec. 351 transaction:
1. The transaction must involve a corporation and a person (or people).
A person may be an individual, trust, estate, partnership, association, company, or corporation under IRC 7701(a)(1)
A corporation generally is an organization that is incorporated under state law. However, a corporation can also include an associations, joint-stock company, or insurance company.
2. The people involved must transfer property to the corporation.
The IRC does not specifically define property in these regards however the courts and the Internal Revenue Service have attempted to do just that, define property relevant to 351.
Generally it seems in my opinion the courts define property broadly and have a limited view of what can be excluded from property which means from my perspective that property transferred in a 351 exchange generally can be real or personal property.
The IRS on the other hand has taken a narrower view of the term property under 351, specifically that know-how, trade secrets, and patent rights qualify under the definition only in certain circumstances subject to Revenue Rules 64-56 and 71-564.
The IRC of course is the final authority and accordingly 351 property includes anything qualifying as secret processes or formulas under IRC 861(a)(4) and IRC 862(a)(4), and any other secret information, in the general nature of a patented invention even if it is NOT technically patented in the patent law sense. Other information that is secret will be given consideration as property on a case-by-case basis according to my research through Parker Tax Publishing as they referenced both Rev. Rul. 64-56 as well as Wall Products Inc. v. Comm’r, 11 T.C. 51 (1948); Evans v. Comm’r, 8 B.T.A. 543 (1927)).
The IRC does state that stock issued for services; indebtedness of the corporation; or interest on indebtedness of the corporation is not considered to be issuance of stock in return for property.
Once a transfer of intangible property is established, it can be tax-free under IRC 351 even though services were used to produce the property. Additionally if your transfer agreement requires you to perform services in connection with a transfer of such property, the performance of services will be tax-free under Code Sec. 351 under certain circumstances as long as the services are deemed “ancillary and subsidiary” to the transferred property.
3. The property must be transferred in exchange for the stock of the corporation.
The IRC does not specifically define stock in these regards however it has been safe to assume that common stock generally qualifies as stock. Stock does not include: securities; stock rights or stock warrants (e.g., stock options); or non-qualified preferred.
4. The people involved must have control of the corporation immediately after the exchange for the stock.
Control means ownership of stock equal to at least 80 percent of the total combined voting power of all classes of stock and at least 80 percent of the total number of shares of all other classes of stock of the corporation. IF you transfer property to a corporation you must own at least 80 percent of the voting stock of the corporation and at least 80 percent of the non-voting stock of the corporation immediately after the property is transferred in exchange for stock to qualify under 351.
Immediately after the exchange means in my opinion a situation where the rights of the people involved have been adequately defined and the agreement is executed expeditiously and orderly.
This IRC 351 nonrecognition treatment does not apply to the following:
1. A transfer to an investment company.
2. A transfer of the property of a debtor in a bankruptcy case to the extent the stock received in the exchange is used to satisfy the debt.
3. A foreign corporation. There is an exception to this rule if property is transferred to a foreign corporation for use in the active conduct of a trade or business outside the United States under IRC 367(a)(1) and (3)).
4. When property is sold to the corporation. Because the transfer of property must be made in an exchange of stock, a sale of property to the corporation does not qualify for Code Sec. 351 nonrecognition treatment.
It seems so simple but even the most experienced entrepreneurs can get put under scrutiny with regards to properly valuing the property being transferred to the corporation. It all seems to distill down to substantiation of value at the time of the transfer in my humble opinion.