Let’s say you have some intellectual property (IP) that you’d like to give to a corporation in exchange for shares of its common stock. The IP and stock are both worth $10,000 and you have tax basis in the IP of $800. Normally such an exchange would trigger $9,200 of taxable income to you.
“But wait,” you say. You have a buddy who recently exchanged appreciated assets for stock of a corporation and your buddy says it didn’t trigger any tax.
Enter tax code Section 351.
Section 351 provides that no gain or loss is 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 hold at least 80% of the total combined voting power and at least 80% of the shares of each class of non-voting stock.
While you can see that the 80% test has a little nuance, in many, if not most, emerging companies all shares have an equal right to vote. When that’s true, Section 351 is satisfied so long as the person or group exchanging property for stock holds at least 80% of the outstanding shares after the exchange.
As you might guess, the 80% test is almost always met when a new corporation is being formed because it is issuing 100% of its stock. Note however, that services are not property for purposes of Section 351. So, if for example, Shareholder A exchanged appreciated IP for 70% of a new corporation’s stock, and Shareholder B received the remaining 30% as a taxable stock award for services, Shareholder’s A exchange would also be taxable.
And if you are really paying attention, you may have noticed the bolded word “solely” above. What happens if you exchange property for stock of the corporation plus something else? If boot is issued in the exchange (“boot” being an odd tax word for something other than tax-free stock) the shareholder recognizes taxable income equal to the lesser of realized gain or the fair market value of the boot.
The type of boot I see most often is cash. But nonqualified preferred stock is also treated as boot for Section 351 purposes. Nonqualified preferred stock means preferred stock if (i) it has a put option, (ii) it has a mandatory redemption feature, (iii) it has a call option, or (iv) the dividend rate on such stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices.
So how does an exchange with boot work? Returning to our original example, let’s assume you hold IP worth $10,000 with a tax basis of $800. You contribute the IP to a corporation in exchange for $2,000 of cash and shares worth $8,000 which represent 80% of the corporation’s only class of stock. Your taxable income would be $2,000 because that’s the lesser of the boot and your $9,200 built in gain.
Mike Baker frequently advises regarding tax considerations in connection with corporate formations. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.