Question

Sara and Mark transferred property to Owl Corporation in exchange for two-thirds of its stock. For services rendered, Alex received the remaining one-third of the stock.

Explain whether the exchanges will be taxable in the context of Section 351 and describe several steps which could be taken to mitigate tax liability.

Answer 1

Transfer of property to a corporation solely for its stock results in non-recognition of gain or loss on exchange. To qualify for it the exchange must meet three rules. To qualify shareholder should transfer only property in exchange of Corporations stock and in control of the corporation immediately after the transfer.

Transfer is for stock of the corporation: stock includes common, preferred and voting and non-voting. Securities of the corporation are not considered stock. Nonqualified preferred stock is considered as boot for this purpose. Stock warrants and stock options are not stock.

Nonqualified preferred stock: preferred stock which requires the issuer to redeem or the issuer is required to redeem, or the issuer has the right to redeem the purchase, and the right is more likely than not to be exercised. If the right cannot be exercised for 20 years then it is not nonqualified preferred stock.

Control of the corporation: the transfer immediately after the transfer must possess at least eighty percent of the total combined voting power and eighty percent of total number of shares of all other classes of nonvoting stock of the corporation. If more than one person transfers the property aggregate ownership of the group is used to determine if control exists immediately after the exchange.

If the stock received is small compared to the stock already owned or received for services rendered then the stock received is not considered in calculating eighty percent test.

One-third stock received is not considered in calculating eighty percent control test, result is they acquired only 66.67% control with property transfer and the exchange is taxable. Instead they should transfer property worth eighty percent of stock and pass the eighty percent control test to mitigate gain recognition on property transfer. And in any case stock received for services rendered are taxable, its only gain on exchange of property not taxable if control test is passed.