Corporate Formation and Capitalization


Incorporation  §351

Forming a corporation involves a transfer of money, property, or both by prospective shareholders in exchange for capital stock in the corporation. However, §351 provides that transferors (i.e., potential shareholders) don’t have to realize any gain or loss in such a transaction. Transfer to corporation controlled by transferor

Basic Requirements

For §351 to apply, the transferors of property to a corporation must, as a group, have control of the corporation immediately after the exchange 1. No gain or loss is recognized when the transferors receive solely stock. Gain, but not a loss, is recognized when the transferors receive other property in addition to stock.

Note: If the transferor receives property, including securities of the corporation, or money in addition to stock in exchange for the property transferred, gain (if any) is taxable to the extent of the money or fair market value of property received (§351(b)(1)).

Corporate Nonrecognition

A corporation recognizes no gain or loss on the transfer of property and money to the corporation in exchange for corporation stock (including treasury stock). A corporation does not recognize gain or loss on the acquisition or lapse of an option to buy or sell its stock (§1032).


Exactly what constitutes “property” for purposes of §351 is vague. No clear definition exists within the Code for the term “property” in this context. However, the Code and regulations defined some items that will not constitute property.

Stock Solely For Services

Stock or securities issued for services (past, present or future) is not issued in exchange for property (§351(a)). Transfer of functions to a corporation in return for stock results in taxable compensation to the transferor (§351(d); William S. James, 53 TC 63 (1959) acq.).

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Hence, if a new shareholder receives stock from a corporation in exchange for his future services to the corporation, he will realize income to the extent of the value of the stock so accepted 2.

Impact on Recipient

The person who receives the stock for services as ordinary income on the exchange (§61 and §83).

Impact on Other Shareholders

When some recipients of stock transfer services and others transfer property, the property transferors may not as a group receive the required control. Thus, they would recognize gain or loss on the exchange.

Stock for Debt

If a corporation issues stock in a discharge of its outstanding debt, both the corporation and the shareholder can have income. The corporation will have debt cancellation income if the value of the new stock is less than the amount of the debt (§108(e)(10)(A)) 3. When §351 doesn’t apply the shareholder recognizes gain or loss on the exchange. Debt/Equity Swap


Another definitive problem is what constitutes stock. There are a few problems as far as “stock” is concerned, however, where debt instruments are used, new issues arise.


As a general rule, notes with due dates of less than five years have not considered the stock. The other major problem with debt financing is the doctrine of the “thin corporation.” The result of this doctrine would be that the IRS would reclassify the debt instruments as stock, thereby disallowing the interest deduction to the corporation, and making the repayment of principal taxable as dividends to the newly created “shareholder.” This doctrine is contained in §385 however, the regulations in this area continue nebulous.


The transferors must be in control of the corporation immediately after the exchange. To be in control, the transferors must, as a group, own:

(1) At least 80% of the total combined voting power of all classes of stock entitled to vote, and

(2) At least 80% of the total number of shares of all other types of stock (§368(c)).

When a transferor receives stock for both property and services, he is counted in full as a transferor of property for purposes of the 80% control requirement. However, the value of the stock received for services is ordinary income (Reg.§1.351-1(a)(1)).

Property Basis

The basis of property a corporation receives in exchange for its stock in an 80% control transaction, or as paid-in surplus, or as a contribution to capital is the same basis the transferor had in the property increased by any gain the transferor recognized on the exchange (§362). Property Exchanged for Stock

If a corporation receives property by issuing stock for it, other than in an 80% control transaction, the basis of the property to the corporation is usually the fair market value of the stock at the time of the exchange. If the stock has no established value, evidence of the fair market value of the transferred property may be used to set the value of the stock if all outstanding stock is issued in exchange for that property (§1012)

Stock Basis

The basis of stock received in exchange for the transfer of property to a corporation is the same as the basis of property transferred decreased by:

(1) The fair market value of any other property (except money) received,

(2) The amount of any funds earned, and

(3) Any loss you recognize on the exchange;

and increased by:

(1) Any amount treated as a dividend, and

(2) Any gain realized on the exchange.

The basis of property received, other than money or stock, is its fair market value (§358(a)).


Occasionally, a new corporation will assume the liabilities of the previous business or take the property subject to liability. That does not affect §351. The amount of the liability will reduce the contributor’s basis in the stock, and the corporation’s basis in the property will be the basis of the contributor immediately before the exchange. The gain will be taxed, however, to the extent that the liabilities assumed to exceed the contributor’s adjusted basis (§357(c)).


Real property with a basis of $65,000 and the present value of $120,000 has a mortgage against it for $85,000 is transferred to a newly formed corporation in exchange for stock. $20,000 would be taxed as gain to the contributor ($85,000 liability – $65,000 basis = $20,000 gain).

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