Do I Need To Worry About Triggering Taxes in Forming a Company?

It is very common in the formation of a company for one or more persons to contribute appreciated property to the corporation in exchange for stock, while others contribute cash.

For example, suppose you form a corporation (not a limited liability company) and you contribute $100,000 cash for 50% of the initial stock to be issued, and your co-founder contributes intellectual property he or she created for the other 50% of the initial stock to be issued. Are there tax issues that you need to worry about in this transaction?

The answer is yes–not so much for you–because you have contributed cash (and there is no gain on a purchase of stock for cash)–but for your co-founder, because he or she contributed property which probably had a very low or zero basis in exchange for property worth some positive value (at least $50,000).

Under the Internal Revenue Code (the “Code”), if you contribute appreciated property to a corporation in exchange for stock, you will realize and recognize gain to the extent that the value of the stock you receive exceeds the basis in the asset(s) you contributed–unless you avail yourself of a nonrecognition transaction provision of the Code.

In this instance, there is a nonrecognition provision of the Code that is of help. Section 351, which reads, in part, as follows:

No gain or loss shall be 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 are in control (as defined in section 368(c)) of the corporation.

So, under our example above, as long as the intellectual property your co-founder contributed to the corporation constituted “property” and the two of you received solely stock in exchange for your cash and the intellectual property contributed to the corporation, and you each received stock which considered together constituted immediately after the transaction more than 80% of the stock (including voting stock), then your co-founder would not have to pay tax on the intellectual property he or she contributed to the corporation for the stock.

Where can you go wrong? There are a number of ways founders can inadvertently “bust” Section 351 transactions.

One way is if a founder contributing intellectual property doesn’t actually contribute the IP to the company, but instead gives the corporation a license. In that case, the IRS may say that the founder didn’t contribute “property”, and therefore the stock he or she received is taxable to him or her as license income.

Another way to get in trouble under Section 351 is for non-property contributors to be part of the initial group of shareholders immediately after the transaction. If they are, and they didn’t contribute property (e.g., sweat equity), then you may not have property contributors owning more than 80% of the stock of the corporation immediately after the transaction.

Still a third way is for the corporation to issue to the founders “nonqualified preferred stock.” (See definition quoted below.)

In forming a company, you should consult with tax advisors to make sure that you don’t inadvertently trip a tax wire.

Similar but less burdensome rules apply to the capitalization of limited liability companies taxed as partnerships. See Rule 721.

From Section 351(g)(2):

(2) Nonqualified preferred stock
For purposes of paragraph (1)—
(A) In general
The term “nonqualified preferred stock” means preferred stock if—
(i) the holder of such stock has the right to require the issuer or a related person to redeem or purchase the stock,
(ii) the issuer or a related person is required to redeem or purchase such stock,
(iii) the issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, 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.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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