How entity formation, contributions, redemptions, liquidations, reorganizations, and ownership changes affect recognition and basis in REG scenarios.
Entity planning questions in REG are not open-ended strategy prompts. They test whether a proposed transaction qualifies for nonrecognition, sale or exchange treatment, pass-through treatment, corporate-level recognition, or basis adjustment. The first task is to classify the transaction before computing gain, loss, basis, or distribution character.
This review page connects formation, contributions, redemptions, liquidations, reorganizations, and ownership changes. Use it after studying the C corporation, S corporation, partnership, property, and basis chapters.
Begin by asking what legal and tax event occurred.
| Transaction | First classification question |
|---|---|
| Property contributed to a corporation | Does Section 351 apply, and did transferors control the corporation immediately after the exchange? |
| Property contributed to a partnership | Does Section 721 nonrecognition apply, or are services, liabilities, disguised sale, or investment-company rules present? |
| Corporation redeems stock | Does the redemption receive sale or exchange treatment under Section 302, or is it treated as a dividend? |
| Corporation liquidates | Is the liquidation taxable under corporate liquidation rules, or does a parent-subsidiary nonrecognition rule apply? |
| Partnership liquidates an interest | Does the partner receive cash, property, hot assets, or a basis-adjustment issue? |
| Corporation reorganizes | Does the transaction fit a Section 368 reorganization category and satisfy continuity and business-purpose principles? |
| Ownership agreement changes | Does the change affect basis, control, eligibility, allocation, or entity status? |
The exam trap is naming the transaction without testing the requirements. A “reorganization,” “redemption,” or “tax-free formation” label is not enough.
Use this workflow when property, services, liabilities, or ownership percentages are part of the fact pattern.
flowchart TD
A["Identify transferee entity type"] --> B["Classify what each owner contributes"]
B --> C["Separate property from services"]
C --> D["Test control or partnership contribution rule"]
D --> E["Check liabilities, boot, and disguised sale facts"]
E --> F["Determine recognition or nonrecognition"]
F --> G["Compute owner basis and entity basis"]
G --> H["Document elections, agreements, and valuation support"]
The workflow is intentionally sequential. Services, boot, excess liabilities, or failed control can change a nonrecognition answer into a taxable result.
Section 351 generally permits nonrecognition when one or more persons transfer property to a corporation solely in exchange for stock and the transferors are in control of the corporation immediately after the exchange. For REG purposes, control generally means at least 80% of voting power and at least 80% of the total number of shares of each other class of stock.
| Section 351 issue | REG implication |
|---|---|
| Property requirement | Property can qualify; services alone do not. |
| Stock received | Stock supports nonrecognition; boot can trigger gain. |
| Control immediately after | Transferors as a group must satisfy the control requirement after the exchange. |
| Liabilities assumed | Assumed liabilities can affect basis and may trigger gain in special cases. |
| Transferor stock basis | Usually carries over from transferred property, adjusted for boot, gain recognized, and liabilities. |
| Corporation asset basis | Usually carries over from the transferor, adjusted for gain recognized. |
Do not treat every incorporation as tax-free. The control test, property requirement, boot, and liability rules must be tested before basis is computed.
Section 721 generally provides nonrecognition when property is contributed to a partnership in exchange for a partnership interest. The partnership structure is more flexible than Section 351, but the fact pattern can still include taxable elements.
| Partnership formation issue | REG implication |
|---|---|
| Property contribution | Generally nonrecognition to the partner and partnership. |
| Services for interest | Can create taxable compensation or other income consequences. |
| Liabilities | Liability shifts affect outside basis and can produce deemed distributions. |
| Built-in gain property | Built-in gain or loss must be tracked for allocation purposes. |
| Partner outside basis | Begins with contributed basis, adjusted for liabilities and later allocations. |
| Partnership inside basis | Generally carries over from the contributing partner. |
The key distinction is that partnership planning often creates two basis records: inside basis for the partnership assets and outside basis for each partner.
Buy-sell agreements describe how ownership changes, but the tax result depends on the transaction form and statutory tests.
| Buyout form | Tax question |
|---|---|
| Cross-purchase | Are remaining owners buying the interest directly, creating basis for those purchasers? |
| Entity redemption | Does the entity redeem the interest, and does the owner receive sale or exchange treatment? |
| Corporate redemption | Does Section 302 treat the redemption as an exchange, or does dividend treatment apply? |
| Partnership liquidating payment | Is the payment for the partner’s interest, unrealized receivables, goodwill, or other separately analyzed items? |
| Family-owned business buyout | Do attribution rules affect whether ownership was meaningfully reduced or terminated? |
A redemption can look economically like a sale but still be taxed as a dividend if the statutory tests are not met. REG questions often hide the answer in ownership percentages before and after the redemption.
Liquidation rules differ sharply by entity type.
| Liquidation type | Recognition pattern |
|---|---|
| C corporation complete liquidation | Corporation generally recognizes gain or loss as if assets were sold; shareholders recognize gain or loss based on stock basis and property received. |
| Parent-subsidiary corporate liquidation | Nonrecognition may apply when the parent owns the required level of subsidiary stock and statutory requirements are met. |
| S corporation liquidation | Corporate-level recognition can still occur on asset distributions; shareholder basis and pass-through items affect owner results. |
| Partnership liquidating distribution | Partner recognition often depends on cash received, outside basis, hot assets, and property basis rules. |
| Partial liquidation or spin-off | Corporate distribution rules and possible Section 355 treatment must be tested. |
The exam trap is assuming liquidation means one tax answer. Corporate liquidation is often entity-level plus owner-level; partnership liquidation is usually partner-level with special asset and basis rules.
Section 368 reorganizations are structured transactions that can receive nonrecognition treatment if the statutory and judicial requirements are met. REG usually tests classification, boot, continuity, and business purpose rather than obscure transaction drafting.
| Reorganization category | Typical description |
|---|---|
| Type A | Statutory merger or consolidation. |
| Type B | Stock-for-stock acquisition. |
| Type C | Stock-for-assets acquisition. |
| Type D | Divisive or acquisitive asset transfer, often connected with a controlled corporation. |
| Type E | Recapitalization. |
| Type F | Mere change in identity, form, or place of organization. |
| Type G | Bankruptcy or insolvency reorganization. |
Boot matters. If shareholders receive cash or other nonqualifying property along with qualifying stock, gain may be recognized to the extent required by the reorganization and boot rules.
Basis is the link between nonrecognition today and gain or loss later.
| Transaction | Basis consequence to track |
|---|---|
| Section 351 contribution | Shareholder stock basis and corporation asset basis usually carry over with adjustments. |
| Section 721 contribution | Partner outside basis and partnership inside basis usually carry over with liability adjustments. |
| Corporate redemption treated as exchange | Redeemed shareholder compares amount realized with stock basis. |
| Dividend-equivalent redemption | Shareholder may not recover stock basis in the same way as a sale or exchange. |
| C corporation liquidation | Shareholder stock basis determines owner gain or loss; corporation asset basis affects corporate gain or loss before distribution. |
| Partnership liquidating distribution | Outside basis, cash, hot assets, and property basis rules determine partner consequences. |
| Reorganization | Basis often carries over or substitutes, preserving deferred gain. |
When an answer choice ignores basis, it is often incomplete. Nonrecognition does not eliminate gain permanently; it usually preserves gain through carryover or substituted basis.
Use one scenario to keep the rules separate.
| Fact | Analysis |
|---|---|
| Three individuals transfer appreciated equipment and cash to Newco for all of its stock. | Test Section 351 property, stock, and immediate control requirements before determining nonrecognition and carryover basis. |
| One founder also receives stock for services. | Services are not property for Section 351; the service component can create compensation income. |
| Newco later elects S corporation status. | Check S eligibility, one class of stock, shareholder status, and built-in gain exposure if appreciated C corporation assets exist. |
| A shareholder is redeemed after family ownership changes. | Apply Section 302 and attribution rules before concluding sale or dividend treatment. |
| Newco merges into a buyer for buyer voting stock plus cash. | Classify the transaction under reorganization rules and identify boot. |
| A related partnership distributes appreciated inventory during a partner exit. | Analyze partnership liquidation, hot assets, outside basis, and possible Section 754 effects separately from corporate rules. |
This is the discipline REG rewards: one fact pattern can contain corporate formation, S status, redemption, reorganization, and partnership rules, but each rule retains its own requirements.
Entity planning answers often turn on records.
| Record | Why it matters |
|---|---|
| Contribution agreement | Shows property transferred, stock or interest received, liabilities assumed, and control after exchange. |
| Valuation support | Supports built-in gain, boot, liquidation value, and redemption price. |
| Ownership ledger | Tracks control, shareholder eligibility, family attribution, and post-transaction percentages. |
| Basis schedules | Preserve carryover, substituted, stock, debt, outside, and inside basis calculations. |
| Buy-sell agreement | Determines whether the owner sells directly to other owners or is redeemed by the entity. |
| Reorganization documents | Support statutory form, continuity, business purpose, boot, and shareholder consideration. |
| State filings | Confirm whether the state follows federal nonrecognition, S status, or reorganization treatment. |
The best exam answer often selects the response that asks for the missing agreement, valuation, basis schedule, or ownership record before finalizing tax treatment.