You might be wondering, "If I contribute my business to a new corporation in exchange for founder stock, is that a taxable exchange?" Somewhere in the back of your mind you might be recollecting something one of your professors said in college...
For example, say you have been running a software as a service business as a sole proprietor for a couple of years (sole proprietorships are a bad idea in this context, by the way). You are making somewhat decent progress. Maybe you have 500 subscribers at $10 a month. You've talked to some friends, and they've told you that you have to form a corporation or LLC to protect your individual assets. You've decided to form a corporation because you hope to raise angel or venture capital, and you want to grant stock options to advisors and workers.
When you contribute your software and IP and customer contracts and everything else relating to the business to the new corporation for your founder stock, will you trigger a tax?
You should not trigger a tax for federal income tax purposes in this situation. Under Section 351 of the Internal Revenue Code, as long as the property contributors (in this case, just you), hold at least 80% of the stock of the corporation immediately after the exchange, the exchange of the property for the stock is tax deferred. Meaning, your basis in your stock will be the basis of the property contributed. Your holding period should carryover as well. You have to attach a report to your first corporate tax return. Obviously, always consult tax counsel in these situations. There are a variety of special rules that could disrupt the happy answer.
Tax CPA Jordan Taylor has this to say about it:
“Non-recognition of gain under IRC 351 is a valuable avenue for companies and their founders to avoid unintended tax consequences, but a careful evaluation of the facts and circumstances as well as the order of events is crucial to achieving the goal of not paying tax” – Jordan Taylor, founder of vestboard.com
But what about Section 83(b) elections? Do you need to file one if you have contributed property in exchange for your stock? Doesn't Section 83(b) only apply if you are receiving stock for services?
Be careful! Just because you contributed property in exchange for stock doesn't take you out of Section 83(b).
If your shares are subject to service based vesting conditions--meaning, the corporation could purchase them back at the lesser of cost or FMV which repurchase right was lapsing over a service period--you will still want to file an 83(b) election.
Just because you contributed property for your stock does not take you out of Section 83(b).
But what if your shares are not subject to vesting at all--but three years later investors demand that your shares be put on a vesting schedule? Do you have to file an 83(b) then, when you have owned the shares for 3 years? There is a helpful IRS revenue ruling in this context which says no (http://www.irs.gov/pub/irs-drop/rr-07-49.pdf)--but even then a protective election could be a good idea--because you won't owe any tax in any event. Always consult legal or tax counsel in these situations.
Be careful out there.