Sec. 351 control requirement: opportunities and pitfalls.

• Author: Friedel, David B.

Sec. 351 allows a tax-free incorporation transfer if certain requirements are met, including that the property must be transferred to a corporation by one or more persons in exchange for stock in the corporation, and, immediately after the exchange, the transferor(s) is (are) in control (as defined in Sec. 368(c)) of the corporation.

Sec. 368(c) defines control as the ownership of stock possessing at least 80% of the total combined 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. (Unlike, e.g., Sec. 1504, this provision does not have a value requirement.)

Note: It is assumed for all the following examples that no special Sec. 351 rules--such as the investment company provisions in Sec. 351(e)(1)--apply.

Example 1: Si has three classes of stock Classes A and B are voting common stock, and Class C is nonvoting common stock. The shares are owned by P1 and P2 as shown in Exhibit 1 on the next page. P1 and P2 are unrelated parties. P1 transfers property (with unrealized gain) to Si in exchange for 50 shares of Class A stock and 120 shares of Class B stock in a value-for-value exchange. P2 does not transfer any property. The stock ownership of Si after the exchange is shown in Exhibit 2 on the next page. Exhibit 1: Stock ownership in S1 in Example 1 Class A (voting) Class B (voting) Class C (nonvoting) P1 70 40 20 P2 30 40 20 Total 100 80 40 Exhibit 3: Stock ownership S1 after the exchange in Exhibit 2 Class A (voting) Class B (voting) Class C (nonvoting) P1 120 160 80 P2 30 40 20 Total 150 200 100 After the exchange, P1 owns 80% of the total combined voting power of all classes of stock entitled to vote (Classes A and B) (280 / 350) and 50% of all other classes of stock (Class C). Because the threshold requirement for control under Sec. 351 is not met (P1 owns only 50% of Class C instead of at least 80%), Pl's transfer of property to Si does not meet the requirements of Sec. 351 and is subject to federal income tax.

Example 2: The facts are the same as in Example 1, except that in addition to the Class A stock and Class B stock received, P1 receives 60 shares of Class C stock (the total again in a value-for-value exchange). The stock ownership after the exchange is shown in Exhibit 3 on the next page. In this scenario, P1 meets the Sec. 351 control threshold after the transfer because it owns 80% of the total combined voting power of all classes...