Pre-Entity Sweat Equity Valuation and Tax Basis Determination
Pre-entity labor has zero tax basis and triggers ordinary income upon share issuance unless converted into documented property before assignment.
Section 368 Control Test
Meaning
A statutory requirement that dictates the level of stock ownership a transferor or acquiring corporation must possess immediately after an exchange to qualify for tax-free treatment defines the standard for reorganizations. This section 368 control test demands that the acquiring party own stock possessing at least eighty percent of the total combined voting power of all classes of stock entitled to vote. It also requires ownership of at least eighty percent of the total number of shares of all other classes of stock of the corporation.
Meeting this threshold allows corporations to merge or restructure without triggering immediate capital gains taxes.
Ownership Threshold
Strict aggregation rules apply when determining whether the required level of ownership has been achieved in a transaction. To satisfy the section 368 control test, the acquisition must result in direct ownership of the specified percentages, with no allowance for indirect or constructive ownership. This baseline is measured immediately after the transfer, meaning that any prearranged sale of the acquired stock can destroy the tax-free status of the exchange.
Corporate Transaction
Restructuring events must be carefully planned to ensure that the ownership changes align with the statutory definitions of control. The section 368 control test applies to various types of corporate reorganizations, including asset acquisitions and share exchanges.
Tax Treatment
Failing to meet the required ownership percentages results in the immediate recognition of taxable gain or loss for the transferring shareholders. If the section 368 control test is satisfied, the transferor’s basis in the stock received is the same as the basis in the property transferred. This preservation of basis ensures that the tax liability is deferred rather than eliminated, maintaining the revenue collection capacity of the tax authority.