Sec. 351 Control Requirement: Opportunities and Pitfalls

By David B. Friedel, J.D., and Yaw O. Awuah, J.D., Washington

Editor: Annette B. Smith, CPA

Corporations & Shareholders

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: S1 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, below. P1 and P2 are unrelated parties. P1 transfers property (with unrealized gain) to S1 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 S1 after the exchange is shown in Exhibit 2, also below.

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%), P1' s transfer of property to S1 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, below.

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 of stock entitled to vote (Classes A and B ) (280 ÷ 350) and 80% of the total number of shares for all other classes of stock (Class C ) (80 ÷ 100). Because the control requirement is met, the transfer qualifies for tax-free treatment under Sec. 351.

Example 3: S1 has two classes of voting stock (Classes A and B ). P1 owns all the Class A shares. P2 transfers property (with unrealized gain) to S1 for all the Class B shares. The S1 charter provides that the Class A shareholders can elect two of the 10 directors of the company, while the Class B shareholders can elect the remaining eight directors (i.e., the Class B shares are "supervoting" shares).

P2' s transfer qualifies for tax-free treatment under Sec. 351 because P2 has acquired 80% of the total combined voting power of all classes of stock entitled to vote, and there are no other classes of shares. P2' s ownership of the Class B shares dilutes or diminishes P1' s voting power.

Observation: Example 3 shows that when there are two or more classes of voting stock, the control requirement of Sec. 351 can serve as either an opportunity or a hindrance in obtaining tax-free treatment. Corporate instruments can be drafted or amended with consideration of the control requirement. That said, taxpayers should be careful in designing exotic voting rights. Undue restrictions should not be placed on the power embedded in the voting rights. At least one court has held that restrictions on a board's power to manage the taxpayer's business reduced shareholders' voting power below the 80% requirement ( Alumax , 165 F.3d 822 (11th Cir. 1999)).

Example 4: P , a member of a consolidated group, owns all the stock of S1 and S2 . Both S1 and S2 are members of the same consolidated group of which P is a member. The S1 stock is voting stock. S2 transfers one of its assets, asset A , which has a fair market value (FMV) of $1,000 and an adjusted basis of $40, in exchange for $1,000 of S1 stock. After the transfer, S2 owns 10% of the S1 outstanding stock (i.e., before the transfer, the S1 stock had an FMV of $9,000, and $10,000 after the transfer).

Observations: Initially, this transfer appears to fail as a Sec. 351 transaction because the control requirement is not met. S2 owns only 10% of the S1 outstanding stock and may have to recognize gain on the exchange. However, pursuant to a special aggregate stock ownership rule under Regs. Sec. 1.1502-34, stock owned by all members of a consolidated group is included for purposes of determining application of Sec. 351(a). Therefore, S2 is deemed to own the S1 stock owned by P . As a result, Sec. 351 applies to prevent gain recognition on the exchange.

Example 5: Assume the facts of Example 4 occur in a separate-filing state.

In a state that has not adopted the consolidated return regulations, Regs. Sec. 1.1502-34 would not apply, and S2 would recognize gain. To prevent this result, S2 can ask P to be an "accommodating transferor." Pursuant to Rev. Proc. 77-37, P must make a meaningful transfer and contribute property worth at least 10% of the S1 stock it already owns to accommodate S2 and allow S2 to obtain Sec. 351 treatment. This means that P must transfer property worth at least $900 ( P owns $9,000 worth of S1 stock) to S1 when S2 transfers asset A to S1 so that S2 can obtain Sec. 351 treatment.

Note: The Obama administration's fiscal year 2015 budget proposals (available at ) would conform the control test under Sec. 368(c) with the affiliation test under Sec. 1504. As a result, "control" would be defined as the ownership of at least 80% of the total voting power and at least 80% of the total value of the stock of a corporation.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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