Receiving boot in a Section 351 transaction forces you to recognize gain on what would otherwise be a tax-free incorporation. The gain is capped at the fair market value of the boot you received, or your total realized gain on the exchange, whichever is smaller. That recognized gain then flows through to your basis in the stock you received, the corporation’s basis in the property you contributed, and the character of the income you report on your return.
What Counts as Boot
Boot is any consideration you receive in the exchange that isn’t stock of the controlled corporation. Section 351(b) triggers gain recognition whenever a transferor receives stock plus “other property or money.”1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor In practice, boot shows up in four forms:
- Cash paid by the corporation to the transferor.
- Debt instruments issued by the corporation, including promissory notes and bonds. Long-term debt securities were treated as stock before the 1989 amendments, but only equity stock qualifies today.
- Other property the corporation transfers to you, such as assets it already owned.
- Nonqualified preferred stock.
Nonqualified preferred stock (NQPS) is the trap most likely to surprise a founder. Section 351(g) treats preferred stock as NQPS if, within 20 years of issue, the holder can force redemption, the corporation must redeem it, the corporation is more likely than not to redeem it under its own option, or the dividend rate floats with interest rates, commodities, or similar indices. Those features make the instrument function like debt, so it gets boot treatment even though it’s technically stock.
How Much Gain You Recognize
Section 351(b) applies a two-step calculation. First, compute your realized gain: the total fair market value of everything you received (stock plus boot) minus the adjusted basis of the property you contributed. Second, recognize the lesser of that realized gain or the fair market value of the boot.
The mechanics matter more when you see them run:
High built-in gain. You contribute property with a $10,000 basis and a $100,000 fair market value, receiving $50,000 of stock and $50,000 of cash. Your realized gain is $90,000. The boot is $50,000. You recognize $50,000. The remaining $40,000 of built-in gain stays deferred.
Low built-in gain. Same exchange, but the property has an $80,000 basis. Your realized gain is only $20,000, and that caps your recognized gain even though you received $50,000 of boot. You are never taxed on more profit than you actually had.
The rule runs one direction only. If your basis in the contributed property exceeds the total value of stock plus boot, the resulting loss is not recognized. Section 351(b)(2) blocks loss recognition even when boot is present.1Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor That built-in loss is preserved through basis and becomes available when you sell the stock.
Ordinary Income or Capital Gain
The character of the recognized gain tracks the character of the property that produced it. Inventory generates ordinary income. Capital assets generate capital gain. That distinction can change your tax rate substantially if you’re an individual transferor.
When you contribute more than one asset, the IRS treats the transaction as a series of separate exchanges. You allocate boot across the assets in proportion to their relative fair market values, then run the lesser-of calculation on each asset independently. Contribute $60,000 of inventory and $40,000 of a capital asset along with some boot, and 60 percent of the boot rides with the inventory (ordinary income), 40 percent with the capital asset (capital gain).2Internal Revenue Service. Chief Counsel Advice 200840036
Depreciation recapture applies before capital gain treatment on Section 1231 property. Gain is ordinary income up to the depreciation you previously claimed; only what’s left over can qualify as capital gain.
The Section 1239 Trap
Section 1239 recharacterizes gain as ordinary income when you transfer property to a corporation you control and the property will be depreciable in the corporation’s hands. Control for this purpose means owning more than 50 percent of the corporation’s stock value, a lower threshold than the 80 percent control test that lets you into Section 351 in the first place.3Office of the Law Revision Counsel. 26 U.S. Code 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers The rule catches patent applications too. If you’re contributing equipment, buildings, or similar depreciable property to your own corporation, expect any boot-triggered gain to be taxed at ordinary rates regardless of how long you held the asset.
What Boot Does to Your Stock Basis
The whole deferral scheme of Section 351 runs through basis. Under Section 358, your basis in the stock you receive equals the basis of the property you contributed, minus the money and other boot you received, plus the gain you recognized.4Office of the Law Revision Counsel. 26 U.S. Code 358 – Basis to Distributees Adding the recognized gain back prevents you from paying tax on the same dollars twice.
A quick illustration: you contribute property with a $50,000 basis, receive stock plus $10,000 of cash, and recognize $10,000 of gain. Your stock basis is $50,000 minus $10,000 plus $10,000, which is $50,000. Now change the numbers. Contribute property worth $100,000 with a $30,000 basis, receive $80,000 of stock and $20,000 of cash. You recognize $20,000 (the lesser of $70,000 realized gain and $20,000 boot). Your stock basis is $30,000 minus $20,000 plus $20,000, which is $30,000. The $50,000 of deferred gain sits inside that basis and comes out when you eventually sell.
What Boot Does to the Corporation’s Basis
The corporation does not get a stepped-up basis. Section 362 gives it a carryover basis equal to your adjusted basis in the property, plus the gain you recognized.5Office of the Law Revision Counsel. 26 U.S. Code 362 – Basis to Corporations Using the $100,000 example above, the corporation holds property worth $100,000 with a $50,000 basis ($30,000 carried over plus $20,000 of recognized gain). The remaining $50,000 of built-in gain travels with the property and hits the corporation’s return when it sells the asset.
When Assumed Liabilities Turn Into Boot
If the corporation takes over your debts as part of the exchange, the general rule under Section 357(a) is that the assumption is not treated as boot.6Office of the Law Revision Counsel. 26 U.S. Code 357 – Assumption of Liability Most incorporations involve mortgages, trade payables, or similar debts tied to the contributed assets, and treating each assumption as taxable would gut the provision. Assumed liabilities still reduce your stock basis, but they don’t trigger recognition on their own.
Two exceptions reverse that result.
Tax Avoidance or No Business Purpose
Section 357(b) treats every assumed liability as cash boot if the principal purpose of the assumption was to avoid federal income tax, or if the assumption lacked a genuine business purpose. You carry the burden of showing a legitimate reason, such as a pre-existing mortgage or ordinary trade debt. Borrowing heavily against appreciated property shortly before contributing it is the classic pattern the IRS looks for. When 357(b) applies, the entire assumed liability counts as money received, and gain recognition follows up to your full realized gain.
Liabilities That Exceed Basis
Section 357(c) requires gain recognition whenever the total liabilities the corporation assumes exceed the total adjusted basis of the property you contributed. The excess is treated as gain from a sale, and you recognize it even if you received no cash and no other boot. Contribute property with a $10,000 basis subject to a $15,000 mortgage, and the $5,000 difference is immediately taxable. The gain takes the character of the transferred property, allocated across multiple assets by relative fair market value if you contributed more than one. The rule exists because a negative stock basis isn’t allowed, so the excess has to come out as gain.
Section 357(c)(3) carves out liabilities whose payment would have generated a deduction, such as accrued trade payables for a cash-method taxpayer, unless the liability previously created or increased the basis of any property. Cash-basis businesses transferring accounts payable alongside their assets rely heavily on this exception; without it, ordinary operating liabilities would inflate the excess-over-basis calculation.
Reporting the Exchange
Every significant transferor must attach a statement to the income tax return for the year of the exchange under Treasury Regulation 1.351-3. The statement identifies the transferee corporation by name and EIN, gives the transfer dates, and reports the fair market value and adjusted basis of the property contributed. Property on which gain or loss was recognized and loss duplication property must be reported separately.7eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed
The corporation files a parallel statement identifying each significant transferor, the transfer dates, and the fair market value and basis of property received, with separate reporting for importation property, loss duplication property, and gain- or loss-recognition property. The corporation can skip the separate filing only if every required item already appears in the transferor’s statement attached to the same return. Transfers to a foreign corporation require Form 926 under Section 6038B on top of the domestic reporting.
Penalty Exposure
Section 6662 imposes a 20 percent accuracy-related penalty on underpayments attributable to negligence, disregard of rules, or a substantial understatement of income tax, and the penalty jumps to 40 percent for gross valuation misstatements.8Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments Boot-inclusive Section 351 exchanges draw scrutiny because every downstream number, from recognized gain to stock basis to corporate basis, depends on the fair market values assigned to the contributed property and the consideration received. Overstating the basis of contributed property, undervaluing boot, and misallocating boot among assets of different characters are the recurring errors. Contemporaneous independent appraisals and detailed documentation of each component of the exchange are the practical defense.