Creating a taxable event via a busted section 351 transaction

Anticipating a prospective capital gains tax rate increase

Oct 11, 2021
M&A tax services Mergers & acquisition Federal tax

President Biden and Congress have proposed to significantly increase the capital gains tax rate. In anticipation of a potential rate increase and assuming that the rate increase does not take place retroactively, taxpayers may wish to create a taxable event through a “busted 351.”


President Biden’s tax plan includes various components, one of which is a proposal to significantly increase the capital gains rates from its current 20% rate. Due to this proposal, some taxpayers may wish to create a taxable event to recognize their stock’s built-in-gain prior to a rate increase.

Suppose John Smith is the majority shareholder of a family-owned business organized as a C corporation, ABC Corp. ABC Corp was founded fifty years ago from scratch and is currently worth $50 million. John holds 80% of the ABC Corp stock (worth $40 million), is approaching retirement, and plans to sell his stock within the next several years. However, he has not yet found a buyer. His basis in the corporate stock is $10 million. If he sells his stock under the current tax regime, his capital gain tax on the $30M of gain would be $6M. If, however, he sells under the Biden tax plan regime, his capital gains tax could be significantly higher.

Accordingly, Mr. Smith has an incentive to recognize his stock’s built-in gain prior to the tax rate increase.1 He can do so by creating a taxable event, and one way to do so is through a busted section 351 transaction.

Section 351 generally

Section 351 generally provides for nonrecognition of gain or loss on transfers of property to a corporation in exchange for stock of that corporation if the transferor (or transferors) is in control of the corporation immediately following the transfer. Although the most common application of Section 351 may be in the area of initial incorporations of a business, section 351 also applies to transfers of property to previously existing corporations. Control is defined 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 number of shares of each other class of stock.2

If the transferor receives, aside from stock, “other property or money,” generally referred to as “boot,” from the corporate transferee, the transferor must recognize gain, if any, to the extent of the boot.3 Section 351 does not defer recognition where the stock is issued in exchange for services. In no event may the transferor recognize a loss in a transaction otherwise qualifying as a section 351 exchange.4

Finally, it is important to note that section 351 is not an elective provision; a transaction meeting all of the requirements of section 351 is a nonrecognition transaction even if the parties prefer not to defer recognition. A taxpayer who wishes to contribute property to a corporation in exchange for stock and recognize gain or loss on the transaction must therefore ensure that at least one requirement of section 351 is not met.

Busting a 351

There are several ways to bust a 351. Here are the most common ways:

  1. Ensure the transferors do not meet section 368(c) control: The transferors would contribute business assets to a new corporation (NewCo) in exchange for all of its voting stock. Aside from the voting stock, NewCo would also issue a class of nonvoting preferred stock to a key employee in exchange for services. As long as the employee does not contribute property to Newco, and the employee is the only shareholder of the nonvoting preferred stock, the section 351 would be busted, as 100% of one of the classes of stock (the nonvoting preferred stock) would be held by a non-transferor. The transfer will fail the requirement of section 351 that the transferors be “in control” of Newco immediately after the transfer, as the term is defined under section 351.
  2. Contribute property in exchange for stock of the recipient corporation’s parent: In order to qualify under section 351, a transferor must contribute property to a corporation in exchange for stock of that corporation. If the transferor instead contributes property to a corporation in exchange for stock of the transferee corporation’s parent, the contribution generally does not qualify under section 351.5 Accordingly, one common way to plan around section 351 is: (i) Transferor forms a corporation (Parent), (ii) Parent forms a subsidiary corporation (Sub), (iii) Transferor contribute property to Sub in return for stock of Parent.
  3. Violating the “control immediately after” requirement via a binding commitment: Section 351 requires that the transferors satisfy the control test "immediately after" the exchange. A transferor who receives stock in the exchange who is under a binding agreement to sell the stock received cannot count that stock for purposes of satisfying the “immediately after” control test. Due to the contractual obligation to dispose of the stock, that stock is treated as if it was never held by the original transferor.6 Accordingly, if, prior to the contribution, the transferors enter into a binding agreement to sell to a third party more than 20% of the shares they received in the exchange, section 351’s control requirement will not have been satisfied.
  4. The use of Nonqualified Preferred Stock: Nonqualified preferred stock (NQPS) is debt-like preferred stock that is treated as taxable consideration for purposes of section 351 exchange, although it is treated as stock for other purposes.7 If a taxpayer contributes property in exchange for a mix of voting stock and NQPS, the NQPS will be treated as boot and potentially generate gain.

Note that, as with all transactions, busting transactions must contend with general step-transaction and substance-over-form principles. A transaction that would result in a busted 351 that is followed by a second transaction that, when stepped together, produces different results can sometimes be challenged by the IRS.8 For example, although one approach to bust a 351 is to issue all the shares of a class of stock to a non-transferor, if the recipient of those shares then transfers the shares to a member of the transferor group, the transaction might be stepped together and treated as a straightforward section 351 transaction. Similarly, a transaction that is substantively different than its form can sometimes be challenged as well.9

Application to the above example

Mr. Smith can create a taxable event by entering into a busted 351 transaction. The most straightforward approach might be ensuring the transferors do not meet section 368(c) control. Mr. Smith would form a new corporation, NewCo, and contribute all his ABC Corp stock to NewCo in exchange for NewCo’s voting stock. Alongside voting stock, NewCo would issue 100 shares of nonvoting preferred stock, which it would transfer to one of the company’s employees as bonus compensation for his services. Because section 351’s requirements will not have been satisfied in full – the “control” requirement will not be satisfied because all the nonvoting preferred stock would be held by a non-transferor – Mr. Smith’s transfer of his stock to NewCo will fail section 351 and instead constitute a section 1001 taxable sale.

A second option involves the use of section 351 boot rather than a busted 351. Under this approach, NewCo can issue two classes of stock, common stock and NQPS, and transfer all the shares of both classes of stock to Mr. Smith in exchange for his ABC Corp stock. Mr. Smith would stipulate that he is transferring the built-in-gain shares of ABC Corp stock in exchange for the NQPS and the high basis shares of ABC Corp stock in exchange for the common shares. The receipt of the NQPS in the exchange would constitute boot and therefore trigger gain up to the lesser of the total amount realized and the boot (NQPS) transferred.

Other situations in which a taxpayer may wish to bust 351

There are several other scenarios in which a taxpayer may wish to enter into a busted 351 transaction. We include here two of the most common such scenarios:

Scenario 1: Suppose a buyer wishes to purchase the stock of an S corporation target but desires a step-up in the basis of the target’s assets. The parties would typically achieve this result by making a section 338(h)(10) election. However, section 351 sometimes stands in the way. For example, in private equity (PE) transactions, it is common for the PE fund to create a new corporation (Newco) and contribute cash to fund the cash portion of the acquisition, after which NewCo would acquire the stock of the target. It is also common for some of the selling shareholders of the target to "roll" their interest in the target into stock of Newco.

This transaction could be a tax-free section 351 transaction without careful planning. Because the PE fund and selling shareholders both contribute property to Newco in exchange for NewCo stock, the PE fund and selling shareholders are considered part of the same transferor group for purposes of section 351’s control test. The valid section 351 would prevent the ability of the parties to make a section 338(h)(10) election, as a section 338(h)(10) election can only be made upon a qualified stock purchase (QSP), and a transaction qualifying under section 351 does not constitute a QSP.   

In this case, parties typically bust the 351 to allow for a QSP, and they so by contributing property in exchange for stock of the recipient corporation’s parent. The PE fund sets up a subsidiary under Newco. The subsidiary, rather than Newco, purchases the target stock, but as consideration, delivers to the "rolling" shareholders Newco stock instead of subsidiary stock. Because the rolling shareholders are transferring assets to the subsidiary but taking back stock of NewCo, the subsidiary’s parent, the subsidiary will have received property from transferors who are not “in control” as required under section 351. Since the transaction is not a valid section 351, it can be a valid QSP and permit a section 338(h)(10) election.

Scenario 2: A taxpayer may wish to transfer built-in-loss property to a corporation and recognize a loss on the transfer. If the transfer constitutes a valid section 351 transaction, that loss will be deferred until the taxpayer sells the corporate stock, she received in the section 351 transfer. A busted section 351 can sometimes allow for that loss to be recognized upon transfer to the corporation.


A busted section 351 transaction is one way to create a taxable event and thereby recognize built-in gain or loss. This can be a beneficial tax-planning tool in certain scenarios, including when tax rates are expected to rise. We recommend taxpayers considering creating a taxable event discuss the issue with their tax advisers.

mm'r v. Court Holding Co., 324 U.S. 331 (1945).


1 This planning method assumes that an increase in tax rates would apply prospectively and not retroactively. As of the date of this article’s publication, several legislative proposals have proposed to increase the capital gains tax rate retroactively, which, if passed into law, would make this tax planning suggestion moot.

2 Section 368(c); Rev. Rul. 59-259, 1959-2 CB 115.

3 Section 351(b).

4 Section 351(b)(2).

5See Rev. Rul. 84-44, 1984-1 CB 105.

6 Seee.g., Intermountain Lumber Co., 65 T.C. 1025 (1976); Rev. Rul. 79-194, 1979-1 CB. See also Reg. §1.338-3(b)(3)(iii), Example 1; Reg. §1.197-2(k), Example 24.

7 Section 351(g).

8 Seee.g.Kimbell-Diamond Milling Co. v. Comm'r, 14 T.C. 74 (1950).

9 Seee.g.Co


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