C and S Corporations for Estate Planners: Code Section 351 and the Control Requirement
Understanding the exchange of property for stock
Table of Contents
Background
Recently, changes to the gain exclusion for qualified small business stock (QSBS) under § 1202 (as modified by OBBBA) have cast a brighter light on the potential perks of operating as a C corporation. Notwithstanding the flat 21% corporate income tax under § 11(b), the possibility of now excluding up to $15,000,000 (inflation-adjusted) of gain per taxpayer-shareholder or, if greater, 10 times the aggregate adjusted basis of the issued stock, is sure to increase the level of C corporation formations (since QSBS must be original issue). This may include a deemed incorporation under the check-the-box rules.
The subject of QSBS itself, and the OBBBA modifications, warrant a separate series of articles. For now, however, it helps to explore the landscape of C corporation taxation and individual taxation when a corporation issues stock. This discussion piggybacks off prior coverage on this newsletter of the taxation of C and S corporations, and is the first in a series of articles illustrating the tax consequences of a corporate formation.
Nonrecognition and Boot
A discussion of these principles warrants an introduction to some tax terms that may not be commonly known to those lacking prior education or experience in these areas. However, these terms have been simplified for purposes of the discussion and should be independently researched by any practitioner dealing with issues relating thereto.
Exchanges of property are generally subject to income tax under § 1001. But as an exception to this general rule, some exchanges of property solely for other forms of property are carved out under the Internal Revenue Code as “nonrecognition” transactions. In other words, no gain is recognized in such exchanges. Instead, the basis of property received in the exchange is generally static at the level of the taxpayer making the exchange, or substituted between exchanged properties. Because of this basis substitution, nonrecognition of gain may not be permanent but instead deferred until property acquired in the exchange is later disposed of in a transaction in which gain is recognized, unless the basis of property is later increased under a different Code Section (such as § 1014). Sometimes the nonrecognition might be one-sided (where property is exchanged for cash, since cash cannot generate gain by the person relinquishing in it in exchange). But, cash might muddy the waters if it accompanies other exchange consideration.
How so? Central to this nonrecognition concept is a term called “boot.” Boot can often be thought of as cash or other property that does not meet the express qualifications of the type(s) of property that can be exchanged under a nonrecognition transaction. For many Code Sections authorizing nonrecognition treatment, the presence of boot may not jeopardize eligibility for nonrecognition treatment in general. Instead, boot itself may create taxable gain without affecting the taxation of the underlying exchange of qualifying property. In other words, depending on the Code Section, nonrecognition might not be an all-or-nothing proposition where boot is involved. This is largely dependent on the Code Section and associated Treasury Regulations in general, but this theme emerges in a number of transactions involving stock in a C or S corporation.
Having considered these general concepts, let’s explore what happens when a taxpayer contributes cash or other property to a corporation in exchange for its stock. For purposes of this discussion, the term “corporation” can apply to both a C and S corporation, including entities not formed as corporations at the state level but nonetheless making a check-the-box election to be treated as an S corporation or as an association taxable as a C corporation.
Code Section 351, in General
The contribution of cash in exchange for a corporation’s stock is not a taxable event, as it is a simple purchase. As we will explore in a subsequent article, § 1032 generally prevents a corporation from recognizing gain on any sale or exchange of its stock or stock rights.
But, the creation of a new corporation may involve the contribution of business assets other than cash. When property is contributed to a corporation solely in exchange for its stock, § 351(a) provides that there is no recognition of gain or loss by either the contributor or the corporation, so long as:
…immediately after the exchange such person or persons [i.e., the contributors] are in control (as defined in section 368(c)) of the corporation.
This requirement can be challenging to decipher, not just because it forces us to read another Code Section but because it also prevents nonrecognition of gain or loss from being a blanket rule. Defining “control” is perhaps the easiest part, except in a situation where there are multiple classes of stock. Code Section 368(c) generally defines control to be:
…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.
This rule is often shortened to the term “by vote and value,” since both prongs independently factor into the percentage threshold for control. It is also important to note that this 80% threshold is defined as being equal to or greater than 80%, as opposed to simply greater than – an important distinction in tax law in general.
Many closely-held corporations involved in estate planning involve only one or two classes of stock, and thus should not be as challenging when analyzing this 80% control requirement. Instead, the challenge (for any corporation) lies in determining the class of “contributors” included in this requirement – especially for new stock issuances after the corporation has been formed. For example, what if stock in an existing corporation is being issued to a new shareholder who will only own 10% of the outstanding stock? Does this mean we fail nonrecognition treatment in this situation?
Treasury Regulation § 1.351-1(a)(2), Example 2, illustrates this failure of nonrecognition. This Example states:
B owns certain real estate which cost him $50,000 in 1930, but which has a fair market value of $200,000 in 1955. He transfers the property to the N Corporation in 1955 for 78 percent of each class of stock of the corporation having a fair market value of $200,000, the remaining 22 percent of the stock of the corporation having been issued by the corporation in 1940 to other persons for cash. B realized a taxable gain of $150,000 on this transaction.
This scenario illustrates that a contribution by a person, or group of persons, that does not in and of itself satisfy this 80% by vote or value threshold will not qualify as a nonrecognition transaction. To the (resulting) shareholder(s) themselves, this may not be an issue if cash is being distributed in exchange for stock. But if appreciated property is exchanged as in the Example above, the recognition of $150,000 of gain by the contributor results in significant income tax.
That being said, § 351(a) looks at a “group” of contributors to determine control. What if, in the example above, an existing shareholder had also made a contribution for additional stock? Could their existing shares be counted towards the 80% control threshold? The answer is generally yes, depending on the shares received. As we will later see, § 351(a) previously extended to “securities” as well but this requirement necessitated that each member of the contributing group must have a “proprietary” interest in the corporation after the exchange for purposes of the 80% test. These outcomes are illustrated in Rev. Ruls. 73-472 and 73-473.
What’s Next?
Of course, this raises the question – does a corporation also recognize gain if an exchange of property for stock does not meet the requirements of § 351? That and other similar questions, such as the basis rules that apply to such an exchange, will be addressed in follow-up articles. Basis and fair market value are important topics for QSBS, as the gain limitation and status as a qualified small business can be affected by the values and aggregate adjusted bases of assets going in and stock coming out. Corporations themselves may, if party to a reorganization, be subject to a different contribution rule under § 361 if a corporation contributes property in exchange for stock or securities in another corporation as part of the plan of reorganization.
For now, the following are some basic examples and illustrations of how § 351(a) might work.
Illustrated Summaries
Keep in mind that § 351(a) applies where one or more persons are contributing property to a corporation in exchange for its stock, as this is an exchange that might otherwise be taxable.
A simple exchange is not enough, however. The person(s) contributing property as part of the exchange must own, in the aggregate, 80% of the stock of the corporation by vote and value after the exchange.
For example, let’s say John Smith contributes appreciated property in exchange for 100% of the common stock of a corporation. This transaction would meet the requirements of § 351(a), because John owns 100% of the stock afterwards – thus meeting the 80% requirement:
Afterwards, let’s say a sibling – Bill Smith – comes along and puts in appreciated property in exchange for 20% the common stock of the corporation. This dilutes John to 80%. In this transaction, since John did not participate in the exchange as a contributor, the 80% test of § 351(a) is failed and Bill recognizes gain on his contribution of appreciated property in exchange for 20% of the corporation’s stock.
However, if Bill had contributed cash, there would have been no gain recognition for him. The dilution of John likely would not fall under § 305, but it is important to note that if John had made a contribution in exchange for additional stock, his total ownership after the contribution likely would have counted for purposes of the 80% control test.
Interestingly, there is no family attribution under § 318 for purposes of § 351(a). Note that these same rules also apply to an S corporation, which allows for some aggregation of shareholders (such as spouses) under § 1361(c). However, these S corporation aggregation rules apply only for purposes of the 100-shareholder limit and not for purposes of § 351.
On that note, there may be situations where two or more “persons” could be treated as one under § 351(a). For example, let’s assume that John is still the 100% shareholder. He contributes some appreciated property to an LLC of which he is the sole member, thus causing the LLC to be taxed as a disregarded entity. He also transfers some appreciated property to a revocable trust, for which he is the sole grantor and which is treated as a grantor trust under § 676. Then, each of them contributes appreciated property to a newly-formed corporation of which the LLC receives 20 shares, John receives 60 shares, and the revocable trust receives 20 shares.
In this example, by operation of other deemed income tax ownership rules, John would be treated as the 100% shareholder. Since, as a group, the three shareholders collectively met the 80% control requirement, § 351(a) would have been satisfied anyway even if there was not deemed income tax ownership. But if John were later to contribute additional property for 10 newly-issued shares, his additional contribution alone would not meet the 80% threshold (70/110 shares = 63.64%). Nonetheless, since the grantor trust and LLC are deemed to be owned by John, his share ownership could be aggregated with the 40 shares owned by these other disregarded entities, respectively, not under any of the corporate tax rules but instead under the general deemed income tax ownership rules applicable to disregarded entities and wholly-grantor trusts.