 and welcome to the session in which we will discuss section 351. What is the big picture? What's the big idea of section 351? Well, when an individual form a corporation, what they will do, they will invest cash or property. So as shareholders what you will do is you might have some extra cash, you might have land, building, inventory, whatever asset you have, you will contribute to a corporation to form a corporation and you become a shareholder, basically an owner of the corporation. In return, the company will issue you stocks, stocks of this company that you formed. Simply put what you did, there's an exchange here. Well, if you exchange cash, it's easy. There are no consequences. So you basically purchase stocks of this company of company A with your cash and you become a shareholder of company A. The question becomes how about if you contributed property? What's the issue with the property? When you contribute the property, how much are they going to give you in terms of stocks? Well, if you contribute a property, let's think about you have a land, a piece of land. The adjusted basis, you bought this land for 100,000. That's your adjusted basis. When you contributed this land, it has a fair market value of 150,000. So if you want to sell it today, you can sell it for 150. So when you transfer this property, this land to the corporation, you are transferring $150,000 worth of assets and they're going to give you back 150,000 worth of company stocks. Well, this is an exchange. Well, what do we have to do when we have an exchange? When we have an exchange is if you sold the asset, sold your land for the stocks of the company. And this is what we're going to be discussing here. What happened to that exchange? Is it taxable? Is it not taxable? This is worth section 351. I'm going to give you the short version of it. If this transaction qualifies under section 351, this transfer of land, the transaction will not be taxable. Now we need to know what is section 351, what are the specific rules, but this is what we're trying to introduce. Section 351. Let's go ahead and get started. Now we know what the big picture is to discuss the little details. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead. Start your free trial today. So section 351 is involving transferring property to a corporation in return for stocks. Well, that's great. Generally, when you transfer a property to another party and they give you something in return, generally speaking, that's a taxable transaction. How do we compute the taxable amount? We'll take the fair value of the stock received, whatever you received, minus the adjusted basis of the property received, and as a result, you have a realized gain or a realized loss. So for example, if we go back to the example, the fair value of the land is 150 and they would give you fair value of 150, the adjusted basis of the land is 100,000, simply put, you have $50,000 of realized gain. Well, however, if this transaction is section 351, it's not taxable. Now, before we proceed and explain the details, I want you to think about why the government does not tax this transaction. What are the reasons for this exception? They're saying, well, if it's section 351, which we did not define yet, but why is this not taxable? Well, the first reason is there's wherewithal to pay doctrine. What does that mean? Well, think about it. You exchange land, they gave you stocks. Well, guess what? The IRS is not interested in stocks. The IRS is interested in cash. What we are saying here is you did not receive cash in return. Therefore, the IRS is not requiring you to pay taxes. That's one reason. Also, when you exchange this land, this piece of land that you have, and you got stock in return, stocks in return, basically it's a continuation of the investment doctrine. Well, also known as substance over form. What does that mean when you own stocks in the company? You are owner of this company, you are still the owner of this piece of land. All what you did, it basically transferred ownership from your personal account to your corporate account. So there's a continuation of investment doctrine. So you still own this property. You did not really sell it. And simply put, Congress wants to encourage corporate formation. So what Congress wants? The Congress wants to make it easy for us to do what? To form corporation and to conduct business on a larger scale. It's good for the economy. Let's take a look at some numbers to see how this whole thing works. Well, let's assume Adam incorporate his sole proprietorship or will incorporate his sole proprietorship. Adam invested $20,000 in cash. Well, the tax basis for cash is $20,000. Well, if you have $20,000 in cash, what's the fair market value of that? No one will pay you more than $25,000 in the right mind, right? Adam also contributed furniture of $25,000 at the DAX basis. The adjusted basis is $25,000. That furniture and fixture, if Adam sells it today, Adam would receive $65,000. Also, Adam contributed land and building with a basis of $250,000 and fair market value of $310,000. All in all, Adam contributed assets with a basis of $295,000 with a fair market value of $395,000. Well, simply put, if this was an exchange, if Adam's sole sells, well, you cannot sell the cash, but if Adam sells the furniture and fixture, sells the building and the land, well, if you think about it, Adam will have gains of $100,000 in total. There is a gain of $100,000, but what's going to happen with that game? Let's assume Adam's in a tax bracket of 25%. Adam will have to pay, send the government a check for $25,000 in taxes. This will be the result without Section 351. But since Adam, we're assuming this is a transaction under Section 351, simply put, Adam is incorporating, taking his asset, giving it to the corporation that he owns, and this is an important concept here, then this is Section 351. With Section 351, Adam will not recognize any gain or any loss. Why? Because his economic status has not changed. He still has the cash, but now it's in the corporate account. He still owns the furniture and fixture, but it's in his corporation. Therefore, there should be no taxes, no taxes, assuming this is Section 351. We haven't even defined what Section 351 is. We've been just saying, accept 351. What's the definition? Well, it's the transfer of property to a corporation, solely in exchange for stock, where the transferor, or transferors, many of them, are or in control of the corporation immediately after the transfer. What does that mean? It means we have either one individual or group of individual, they transfer property in return, the company issues stocks to them, and that stocks is form of ownership in that corporation. And after the transfer, this is important, right after the transfer, this group of individual, they own 80% of the company. Why 80%? They are in control of the corporation. If that's the case, this is Section 351 transaction. Now, what is transfer property? What's the property? Well, property could include everything, basically all property except services. So services is not a few contribute services, time, expertise, that's not property. And we're going to talk about services that are separate to recording. Property would include cash, land, building, equipment, intangible assets, secret processes and formulas, installment obligations, all of these are property. Once again, the code specifically executes services from the definition of property, and we're going to have a separate recording, because we need to know when the owners, when the new owners contribute services, kind of we have to discuss this separately. So for Section 351, the transferor must receive stock and not any stock, stock of the company that you are, that you are an owner, so not stock of another company. The type of stock could be common or could be preferred, not a big deal, okay? Anything received other than stock. So if the company gave you something other than the company's stock itself, it's a boot. Now a boot is involved, we're going to have to discuss this any in a separate recording as well. So we're keeping this transaction clean. You transfer property, it's Section 351. After that transfer, you have control of the corporation, because of that, this is Section 351, because of that, you don't have to pay any taxes on the gain of the transfer, okay? Now boot only flow from the corporation to individual. So boot, when we talk about boot, because we cannot confuse this with the boot of property transaction, the boot can only flow from the corporation to the owners, one way, only one way, okay? Because in an exchange, there are two ways, but boot for Section 351 is one way. Not like kind of transaction where boot can flow in both ways. We're not talking about this, we have to be careful. And remember, how do we define control? 80% or more. Now bear in mind, control when it comes to financial accounting, all what you need is 50%. For tax purposes, to have control, you need 80%. Now let's walk through a series of illustration that's going to illustrate this concept. So we have an individual A, and this individual contributed property, and stock received in return 7,000 shares, he owns 7,000 shares, individual B did not contribute any property, did not contributed any services, and ownership B already owned 3,000 shares. Well, let's talk about this. So total number of shares for this company is 10,000. How much does A represent after contributing property and receiving the stock? Well, 7,000 out of 10,000 is 70%. B did not contribute anything, but B already owned 30%. Now my question to you is this, with this transfer, with this transfer for A, because A transfer the property with A qualify under section 351, yes or no? Okay, because section 351 applies per transaction. Okay, so what happened is this A transfer some property received 7,000 shares, 7 out of 10,000, that's 70%. Is this section 351? And the answer is no. Why? Because to qualify for under section 351, you have to be 80% or more and 70% is less than 80%. So section 351 does not apply. What does that mean? It means whatever property A contributed, they will have to determine their gain. Now you're saying, what if they have a loss? Don't worry, we'll have a separate session if we have what's called built-in loss, because we have to worry about built-in gain now. So any gain that was involved in that property is taxable. So A, he or she must, he or she must recognize any gain or loss on the property. Well, we'll talk about loss later. We'll talk about loss later. Let's look at a different scenario. We have individual A and we have individual B, two individuals, A contributed property and B contributed property as well. A did not contribute any service, no service involved, we're going to give the service for the next session. As a result, A received 2,000 shares, B received 2,000 shares. So A owns 2,000, B owns 2,000, that's the total shares. So A owns 50% of the company, because we have 4,000 shares in total, B owns another 50%, which is in total, they own 100% of the company. Remember, section 351 applies per transaction. Now, is this section 351, A and B both transfer property and each one received 50% and the answer is yes. The answer is yes, because what we are saying here, each one of them got 50%, but section 351 is you could have A, B, C, D, many individuals contributing at the same time. It doesn't have to be the same day. They just have to be in close proximity where they organize this transfer together. Here, we are assuming that A and B, they organize this transfer together and within a time period, that's what they contributed. Two pieces of property, each one of them got 2,000 shares, they control the company. Why? Because 100% is more than 80%. Therefore, section 351 will applies. What does that mean? It means whatever property they contributed, we have no gain and no loss. We're more concerned with the gain. We'll talk about the loss later. No gain, no loss. Let's look at another transaction. Let's assume one year later. This is one year later after a corporation is formed. We have individual A and individual B. Individual A transferred property, individual B did not transfer any property. No services are provided here. Individual A received 4,000 shares and as a result, now individual A, they contributed, whatever property they contributed, they got 4,000 shares. Now, they own 6,000 shares. Individual B already owned 2,000, so total we have 8,000 shares overall for this company. Now, what happened is this? So now, right now, what is the ownership of A? Well, 6,000 divided by 8,000. A owns 75% of this company and B owns obviously the remaining 25%. So A transferred another property and received 4,000 shares. So this is the transaction. Now, after the transaction, he accumulated 6,000 shares because he already had 2,000 from before. You remember 2,000 plus 2,000 from the prior slide where they each had 2,000. Now, 75%. So after the transfer, what's the ownership now? 75%. Is this transaction subject to section 351? And the answer is no. Why? Because after the transfer, 75% of the total stock is owned by A, doesn't have control. It's less than 80%. So notice in the prior example, A only contributed 2,000 and B contributed to get 2,000 and it was section 351. This 4,000 shares what they received did not get the section 351 application. What does that mean? It means whatever property they transferred, they must recognize any gain or any loss on that property. Let's look at another illustration. We have individual A and we have individual B. A transferred property. B did not transfer any property. No services involved. We're going to keep this clean. A received 2,000 shares and now he owned 8,000. So remember, we went from, in other words, he had 6,000 prior to this contribution. 6,000 plus 2 equal to 8,000. B had 2,000 shares. Now we're total 10,000. Now we have to see if after the transfer, what happened to the shares? After the transfer A owns 8 out of 10,000. Out of 10,000 is 80%. That's the magic number. B owns 20%. Well, that's another year later. Is this section 351? Now we also transfer 2,000 shares and do we have section 351? And the answer is yes, because after the transfer A owns 80%. Section 351 applies and A don't recognize any gain or any loss on the property transferred. So this is the big idea of section 351. Now we're going to have to look at many different versions of it. First, we're going to involve service. So we're going to say, now what happened if the individual contributed service? Then we're going to involve liabilities. What if the person contributed property? And within that property, we have a liability attached to it. Then we're going to have to understand what if we contributed to the corporation property and the corporation gave us in return some boot, some boot, something in return other than the company stocks. And this is what we're going to have to deal with. But what should you do now? Go to Farhat Lectures and look at additional MCQs, true, false, additional simulations, exercises that's going to help you understand this important concept, which is section 351, contributing property to a corporation. And after the contribution, the new owners controlled 80% or more. Good luck, study hard and stay safe.