25.2 Formation Contributions and Built-In Gain

Start With the Nonrecognition Rule

Formation problems look computational, but the first move is legal classification. A contribution to a corporation is tested under Section 351; a contribution to a partnership is tested under Section 721. Both defer tax when owners merely change the form of their investment, but their requirements and traps differ sharply. On a TBS, write the basis schedule first and the tax result usually falls out.

The key reason gain is deferred, not eliminated: the unrecognized gain survives through substituted basis (the owner's interest), carryover basis (the entity's asset), Section 704(c) allocations, or the Section 1374 built-in gains tax.

Corporate Formation: Section 351

Section 351 applies when one or more persons transfer property to a corporation solely in exchange for stock and the transferors are in control immediately after. Control under Sec. 368(c) means at least 80% of total combined voting power and at least 80% of the shares of each class of nonvoting stock.

Liabilities (Sec. 357). A corporation's assumption of liabilities is generally not boot. But under Sec. 357(c), gain arises if liabilities assumed exceed the aggregate adjusted basis of property transferred. Sec. 357(b) recharacterizes liabilities assumed for tax avoidance or with no bona fide business purpose as boot.

Partnership Formation: Section 721 and Section 704(c)

Section 721 is broader: a partner generally recognizes no gain or loss on contributing property for a partnership interest, and there is no control requirement. The partner's outside basis equals the adjusted basis of property contributed, increased by any gain recognized and adjusted for the partner's Sec. 752 share of partnership liabilities. The partnership takes carryover inside basis.

Unlike incorporation, partnership formation immediately raises allocation issues. When contributed property has fair market value (FMV) different from tax basis, the difference is built-in gain or built-in loss. Section 704(c) requires that precontribution built-in gain or loss be allocated back to the contributing partner as the property is depreciated or sold. Policy: a partner should not shift old tax gain or loss to partners who joined later.

Worked example. Partner A contributes land, basis 30,000, FMV 90,000, for a one-third interest. A's outside basis starts at 30,000 (carryover). If the partnership later sells the land for 90,000, the full 60,000 precontribution gain is allocated to A alone under Sec. 704(c), not split one-third each.

Built-In Gains Tax in S Corporation Conversions

Built-in gain also surfaces when a C corporation elects S status. The S election does not erase corporate-level tax history on appreciated assets. Under Section 1374, if the corporation sells assets that were appreciated on the conversion date during the recognition period, it owes the built-in gains (BIG) tax at the flat 21% corporate rate on the lesser of recognized built-in gain or net unrealized built-in gain existing on conversion day.

The recognition period is the 5-year period beginning on the first day of the first S year - made permanent by the PATH Act (2015) and still 5 years in 2026. So a calendar-year corporation electing S as of January 1, 2026 is exposed through December 31, 2030; a sale on January 2, 2031 escapes the tax. Shareholders still report pass-through items, so the planning question is whether to wait out the 5 years before selling appreciated assets.

Formation Workflow

1. Identify recipient: corporation (Sec. 351) or partnership (Sec. 721).
2. Separate property from services.
3. Compute realized gain, then recognized gain (boot/Sec. 357(c)).
4. Track basis both sides: owner basis and entity basis.
5. Ask whether built-in gain remains attached - Sec. 704(c) or Sec. 1374.

Basis Schedules: The Heart of Formation Simulations

Formation TBSs almost always require two basis numbers: what the owner takes in the new interest, and what the entity takes in the asset. Memorize both formulas because examiners frequently give all the inputs and test whether you assemble them correctly.

Corporate (Sec. 351) transferor stock basis = adjusted basis of property transferred + gain recognized - boot received (including cash and the FMV of non-cash boot) - liabilities assumed by the corporation. Corporate basis in the property (Sec. 362) = transferor's carryover basis + gain the transferor recognized.

Worked example. Transferor contributes equipment, basis 50,000, FMV 90,000, subject to a 30,000 liability the corporation assumes, plus receives stock worth 60,000. Liabilities (30,000) do not exceed basis (50,000), so no Sec. 357(c) gain. Stock basis = 50,000 + 0 gain - 30,000 liability = 20,000. The corporation's basis in the equipment is 50,000 (carryover, no gain recognized).

Partnership (Sec. 721) contributing partner basis = adjusted basis of contributed property + gain recognized + the partner's Sec. 752 share of all partnership liabilities (including the others' debt) - liabilities the partnership assumes on the contributed property that the other partners now bear. A common trap: a partner who contributes encumbered property is treated as receiving a deemed cash distribution equal to the net liability shifted to other partners, which can push gain if it exceeds basis.

Distinction examiners exploit: in a corporation, liabilities assumed reduce stock basis and can trigger Sec. 357(c) gain only when total liabilities exceed total basis. In a partnership, liabilities work through the Sec. 752 sharing rules and can both increase basis (your share of new debt) and decrease it (debt the others assume). Write the schedule line by line; never estimate the net.