 Hello and welcome to the session in which we will discuss section 351 or when we are forming a corporation, what happened to the initial contribution of either cash or property? Let's start with a simple example. Let's assume you want to invest in a business. You want to start the business. So what can you do? You can transfer cash to that business and the business will issue stocks, common stocks or some sort of a stock that shows ownership. So let's assume you contributed 10,000 of stock, 10,000 of cash in exchange of stocks. And as a result, you obtain control and what we mean by control here, you own more than 80% of 80% or more of the company stocks. That's easy. You contribute 10,000 cash. They gave you the stock. There are no tax consequences to that transaction. Let's change the scenario a little bit. Sometime you don't have cash. So what would you contribute it instead? Well you can contribute some sort of a property, a building, a piece of land maybe, maybe inventory, equipment, it does not matter. How about if you contributed a property with a fair value of 15,000, has an adjusted basis of 10,000 in exchange for the stock. Now obviously they gave you in total $15,000 of stocks because the fair value is 15. But what happened is this. If you disposed of something that has a fair market value of 15 and a $10,000 adjusted basis, guess what you have? You have $5,000 in gain. Now what do you have to do with this gain? Guess what? If you transfer the property and you obtain control, a control is defined as 80% and more and in the company then you don't have to recognize the gain. Simply put the gain is not taxable. So at the time of formation as long as you contributed property and you obtain control it doesn't have to be one person. When this transaction happened you could have one, two, three, four individuals all together. As long together they obtain 80% control then they are considered one entity. Taxes don't apply, in other words the taxes on the gain don't apply. So at the time of the formation of a corporation, specifically here we're talking about S but it could be S, it could be C, the corporation that not recognize any gain or loss and you, you don't recognize any gain or loss as long as you meet certain conditions. Now why these rules apply? So why that's the case? Why the rules are so? Let's think about it. Another one thing is if you obtain stocks in return, can you pay the IRS stocks? And the answer is no. So you don't have the ability to pay. This is called the world with all to pay concept. Simply put what you received is not money. You received stocks and the IRS they want their money. Well you don't have the money you have stocks. Also after you contributed the property to the business the property is still yours. All what happened is there was a continuation of your investment. So you had that piece of property and you transferred to your business. So it's basically form over substance. You still own the property. You don't own it directly, but you own the company. You have control over the company that owns the property. Therefore, really your position did not really change. So it's basically form over substance. So that's why you should not be taxed on that gain at least for now. And also another reason is Congress wants to encourage business creation. So Congress would like you to create business. So what would they do? They create those rules which is section 351 which is corporate formation when you contributed property to the business and you obtain control and we're going to find these little bit more in detail. Certain conditions. Guess what? There are no tax consequences as long as certain conditions are met. There are three conditions for section 351. Let's discuss them. 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. No obligation, no credit card required. The three conditions are the first one is the contribution is made solely in exchange of stock and here what we are discussing is the company stock. So they gave you stocks of the company ownership of the company that you contributed the stock to. Why would that be confusing? Because they could give you stock of another company. Well that's considered a boot. Basically you are purchasing stock of another company. So a shareholder contributing property does not recognize any gain or loss if the conditions presented below are met. The first one is you contributed and they gave you the company stock. The second condition, the total contribution made by the shareholder or shareholders can be one or many shareholders. At the time of the formation constitute at least 80% of the corporate voting stock and 80% of the corporate non-voting stock. What does that mean? It means after that contribution is made it doesn't have to be one person. It can be a group of people forming the corporation. All of them together as long as they control more than 80% it's considered one transaction. Now do they have to form this corporation all together at the same time at the same day? It doesn't have to as long as they coordinated with a specific amount of time. They contributed the cash to property. They controlled 80%. Everything that they contributed in property they don't have to recognize the gain on it. Now it's also important to note that a shareholder contributing services is not considered in the 80% control. Now you can contribute cash to the company. You can contribute property which is property could be land vehicle, land vehicle, any type of an asset to the company or guess what else you can contribute. You can contribute services. What does that mean? Let's assume you are a successful accountant and what happened is a company will approach you. They'll say we need the CPA. But you need to contribute money if you want to be part of our business and you would say look I would like to join your company but I don't have money to buy stocks. How about I work one year for free and you will give me I don't know 10% of the company shares or 15% or whatever that percentage is. Well that's fine. Services this individual that CPA that's joining that new company their share cannot be counted with the 80%. So the services provided is taxable simply put it's as if this CPA work for this new company the company paid them let's assume $120,000 then they took this $120,000 and they contributed back to the company. So the $120,000 is earning for the CPA. So as far as services services are taxable and they are not counted when you consider the 80% control test because you want to know whether that 80% control test is math and how do you so how do you do so you count all these shares relative to the total and if you have 80% or more it's 80% it is controlled. And the third condition is the shareholder did not receive any boot from the corporation. What is a boot? Well it means you contributed a property and they gave you cash in return. The boot could be either cash paid to the shareholder or the other thing is considered a boot is that transferred from the shareholder to the corporation and that that is an access of the adjusted basis. So cash is easy you contributed a property they gave you back cash that's boot. Well that's it. That's no longer tax-free transaction. How about if you contributed a land with a value with a value with an adjusted basis of 100,000 but this land has a notes payable of 120,000 guess what? You contributed negative 20 really to the corporation so you contributed 20,000 in liabilities. Guess what? That 20,000 that's also a boot. So that transfer from a shareholder to the corporation and access of the adjusted basis of his total contributed asset so this is considered a boot. If the shareholder received cash by the corporation guess what? You would recognize again and again will be the lesser of the gain realized from the increase in the property value or the cash received. The lesser of these two will be a taxable amount also if the debt is transferred from the shareholder to the corporation exceeds the adjusted basis again would be recognized for the access amount as I showed you it will be 20,000. Let's take a look at an example in exchange for 15% ownership interest John contributed the machinery with a fair value of 15 adjusted basis of 27 to Malik's Inc. Which is an S corporation determine the amount of the gain realized and recognized by John if any well 50 minus 27 we have a gain of 23,000 realized gain is this gain recognized and the answer is yes why because after the exchange John only controlled 15% remember to have that transaction tax free you'll have to control 80% so after the country after the contribution John did not acquire 80% of the of the company so the contribution is treated as a taxable event and John is required to recognize to recognize the total gain realized of 23,000 therefore this gain is taxable taxable. Let's take a look at the shareholder initial basis well when you start the corporation the shareholder initial basis is basically what you contributed starting with the adjusted basis of the property contributed if you if you if you contributed property it's the adjusted basis not the fair market value plus you might contribute some cash that's fine plus fair value of contributed services remember the fair value of contributed services because this amount is taxable it's already get taxed on it if you received any cashback that's going to reduce your basis if you contributed liabilities to be assumed by the corporation that's in minus and if you recognize any gain from the contribution you add why because if you recognize the gain once you recognize the gain the gain is taxable so once you pay taxes on something that's it it's going to be part of your basis and that's why the fair market value of the contributed services it's already taxable therefore it increases your basis and therefore any gain recognized from the contribution is also an increase in your basis so this is your initial stock basis initial stock basis now the stock basis of an S corporation does not include any corporate liability the shareholders have a separate debt basis which include any direct loan made by the shareholder to the seat to the S corporation so therefore the sum of the stock basis and the debt basis constitute the shareholder tax basis we will explain this later on this is just an initial initial initial examination now what about the S corporation basis and then add cash property you contributed the property to the corporation now what is their basis well on the other hand the corporate basis for a non-cash property acquired is the greater of the shareholder adjusted basis remember the shareholder adjusted basis is used plus any gain he or she recognized on the contribution he or she recognized on the contribution or that assumed by the corporation less any cash contributed by the shareholder the greater of these two now let's look at the previous example the 15% contribution by John and let's work the example from the corporate perspective determine the amount of gain realized and recognized by John if anywhere he did this 23,000 determine John's basis in the corporate stock well John basis in the corporate stock equal to 50,000 why because John contributed an asset with an adjusted basis of 27 that's usually what you start with but also remember John paid taxes on the 23,000 on the gain therefore the gain is added to the basis therefore the basis is in the stock is 50,000 now determine Malik's basis in the contributed property which is the company same thing the company not same thing the company it's gonna be it's gonna be also 50,000 the adjusted basis plus the gain recognized by the shareholder 27 plus 23 equal to 50 this is the basis the basis of the property contributed inside the corporation now what happened to the basis does it stay the same and the answer is not basis are subsequently changed well the S corporation basis and the corporate stock is increased by his or her proportionate share of S corporation income item or any additional contribution made by the S corporation in contrast it decreases by the opposite by his or her share of S contribution losses and deduction and by some distribution received from the S corporation so let's review real quick let's start with the initial basis the initial basis is the adjusted basis contributed plus any cash contributed plus fair market value of services provided minus cash collected minus contributed liability to be assumed by the corporation plus any gain recognized from the contribution so this is the this is when you start with your initial basis then what's gonna happen to those initial basis after you start with your initial basis what's gonna happen you're gonna have the company's gonna generate income well shareholder share of corporate income it's gonna increase your basis any dividend tax exempt interest ordinary business income that's gonna increase your basis if you contributed more money if you have any additional contribution it's gonna increase your basis and now the opposite is true if the corporation incur losses you're gonna reduce your basis by losses deductions and non deductible expenses and we'll talk about those little bit more in the tails in the next lesson that's important any distribution the shareholder is appropriate just like contribution will increase it just like your contribution will increase your basis distribution would reduce your basis and this is how you come up with your ending basis in the corporate stock let's take a look at a quick example on January 1st Alex contributed 100,000 for an ownership interest of 30% and an existing S corporation the corporation reported ordinary business income of 30,000 and a dividend of 2,000 determine Alex basis well we're starting with what starting with $100,000 then the company earned 30,000 well that 30,000 belong 30 of 30% of it belongs to Alex which is 9,000 that's gonna increase Alex's basis the dividend 30% of it also belongs to Alex 109,600 is the basis again this is dividend income not expense so this is basically a quick overview what should you do now go to forehead lectures and look at additional MCQs true false that's gonna help you understand this topic this topic is important we're only gonna be expanding on this topic basis contribution so on and so forth make sure you understand this inside out so section 351 which is S corporation or C corporation formation is an important topic whether you are a CPA candidate or an enrolled agent student or of course if you're an accountant student as well study hard invest in your career and good luck