Taxation strategy is one of the key considerations when forming and funding a startup business. This article addresses key considerations of capital contribution tax on structuring a tax-free transaction for the stockholder(s) when contributing cash or property to a corporation in exchange for stock from the corporation. Such tax-free contribution is addressed under Internal Revenue Code Section 351.

 Under IRC Section 351, a contribution generally qualifies as a tax-free contribution if:

• Cash or other property, or both, is transferred solely in exchange for stock in the corporation.
• The contributing parties are in control of the corporation immediately after a contribution. For this purpose, control means ownership of at least 80% of the voting stock of the corporation and at least 80% of all other stock of the corporation.

80% Control Rule

While the 80% control requirement generally is met on the original formation of a corporation, contributions after formation in exchange for stock might not qualify because such contributing stockholders might not be able to meet the control requirement. If you are a stockholder who is doing a post-formation contribution in exchange for stocks, contact us to find out if your contribution to the company qualifies for a tax-free transaction.  

Some taxable events early stage company and start-up founders should be aware of are: 

• A contribution to a corporation in exchange for stock may be taxable if a contributing party receives cash or other property (referred to as boot) in addition to stock of the corporation. In this case, the transaction may still qualify as a tax-free transaction under Section 351 but the contributing party generally recognizes gain to the extent of the fair market value of the boot received.  
• A contribution to a corporation in exchange for stock may be taxable if more than 20% of the stock in the corporation is issued to a transferor solely for services. Many start-ups and share issuance to founders and co-founders may fall under this taxable event. 
• A contribution to a corporation in exchange for stock may be taxable if a contributing party transfers property subject to a liability (eg. a mortgage) and the liability was either:
• transferred to the corporation to avoid US federal income tax; or
• the liability exceeds the property’s basis.

If your company potentially falls under one of the above three taxable events, you are welcome to contact our firm for detailed tax guidance.