Assumption of liabilities; avoiding the traps in IRC Sec. 357.by Harris, Richard W.
The U.S. tax law makes incorporation of a proprietorship, partnership or other group of assets as painless as possible by treating the transaction generally as a non-taxable exchange under IRC Sec. 351(a)(1). However, the transferor/shareholder may be required to recognize gain where cash or other property is received in addition to stock in the corporation. Where the incorporation transaction includes a transfer of liabilities to the corporation, or property subject to a liability, there is a variety of potentially adverse results, depending on the relative amounts of the liabilities and the intentions of the transferor at the time of the transaction. IRC Sec. 357 controls the tax treatment of liabilities assumed by the corporation, often causing recognition of gain where the transferor has not properly planned the transaction. Usually, however, the adverse consequences under IRC Sec. 357 can be avoided with proper foresight and planning.
Incorporation Transactions: General Rule
IRC Sec. 351(a) provides that no gain or loss is to be recognized if property is transferred to a corporation in exchange for stock and the transferors of such property have "control" of the corporation immediately after the transaction. For these purposes, control is generally defined as at least 80% of total combined voting power of all classes entitled to vote and 80% of the total number of shares of all other classes of stock |IRC Sec. 368(c). Thus, a person transferring appreciated property in exchange for stock does not generally recognize any gain on the transaction. The inherent gain in the property transferred is deferred to the future and will be recognized when the stock is later sold or disposed of in a taxable transaction, assuming the stock's value remains constant or increases. IRC Sec. 351 is a non- elective, mandatory rule causing any transfer within its gambit to be treated generally as a non-taxable transaction, whether the outcome is desirable or not. Taxpayers transferring loss assets or having unused NOL's may desire to structure their transaction as a taxable sale, rather than a IRC Sec. 351 transfer, to recognize gain or loss. Of course, the IRS may contest such a structure under the step transaction concept, depending upon the circumstances.
IRC Sec. 358 provides the mechanism to accomplish the deferral of gain or loss. The basis of the stock in the hands of the distributee/shareholder is generally determined equal to the basis of the property transferred--a substituted basis--with certain adjustments.
Example 1: A transfers Blackacre (FMV = $100,000, basis = $60,000) to Newco in exchange for 100% of its stock. A has realized gain of $40,000, but zero recognized gain under IRC Sec. 351. The basis of the Newco stock to A is $60,000. In the event A later sells his stock for its value ($100,000), the deferred gain ($40,000) would be recognized at that time.
Often a transferor/shareholder receives cash or other property ("boot") in addition to the stock received in exchange for the property transferred to the corporation. The receipt of boot by the shareholder triggers recognition of realized gain, if any, on the transfer, up to the value of the boot received. However, no loss may be recognized |IRC Sec. 351(b)(2). In such cases, the new basis in the stock received by the shareholder is computed as 1) the basis of the property transferred, plus 2) the amount of gain recognized by the transferor on the transaction, less 3) the value of any boot (cash or property) received by the transferor |IRC Sec. 358(a)(1).
Example 2: A transfers Greenacre (FMV = $100,000, basis = $60,000) to Newco in exchange for 80% of the Newco stock and $25,000 cash. A has a realized gain of $40,000, which is recognized to the extent of the boot received--$25,000. A's basis in the Newco stock is $60,000, calculated under IRC Sec. 358(a)(1), as follows:
Assumption of Liabilities--General Treatment under IRC Sec. 357(a)
Transfers under IRC Sec. 351, especially the incorporation of an existing business, usually include a transfer of liabilities to the corporation, such as trade accounts payable or notes payable in connection with property being transferred. Generally, the transfer of liabilities does not constitute the receipt of boot by the shareholder-- whether the corporation actually assumes the debt or merely takes property subject to it. On the other hand, the shareholder's basis in the stock received is reduced by the amount of the liability transferred to the corporation, even though the liability may not be treated as boot received by the transferor for purposes of gain recognition |IRC Sec. 358(d)(1).
Example 3: A transfers Redacre (FMV = $100,000, basis = $60,000), which is subject to mortgage of $50,000, to Newco in exchange for 80% of the Newco stock. A has a realized gain of $40,000, but zero recognized gain. The basis of the Newco stock is $10,000, as follows:
3 Notice in Example 3 that while no gain is recognized, A's basis in the Newco stock is much lower than the basis of the assets transferred. The entire realized gain ($40,000) is deferred--to be recognized when A sells the Newco stock, assuming the stock's value remains constant. The stock basis calculation under IRC Sec. 358(a) reflects the proper gain deferral since the shareholder had a $40,000 inherent gain in Redacre before the transaction, and a $40,000 inherent gain in the Newco stock after the transaction (FMV = $50,000, basis = $10,000).
Tax Avoidance Purpose
The preceding section assumes two critical points regarding the transfer of liabilities to the corporation. First, that the sum of the liabilities transferred does not exceed the aggregate basis of the assets transferred--this problem is dealt with under IRC Sec. 357(c). In addition, the transfer of liabilities must not be part of a scheme to avoid income tax or for some other non bona fide business purpose. If the transfer of a liability to the corporation is part of an arrangement which has a principal purpose the avoidance of Federal income tax or, at least, a non-business purpose, then the general rule of IRC Sec. 357(a) does not apply, and the liability is treated as cash boot received by the shareholder for purposes of gain recognition.
Example 4: A transfers Blueacre (FMV = $100,000, basis = $60,000), subject to a $25,000 mortgage, to Newco in exchange for 80% of its stock. The mortgage was acquired by A immediately before the transfer and is being transferred to the corporation pursuant to a plan which has tax avoidance as a principal purpose. A has a realized gain of $40,000, of which $25,000 is recognized under IRC Sec. 357(b)(1), since the liability is treated as cash boot received by A. A's basis in the Newco stock is calculated as follows:
Furthermore, the determination that any single liability violates IRC Sec. 357(b), taints the entire transaction and all liabilities transferred are similarly treated as cash boot |IRC Sec. 357(b)(1) and Regs. Sec. 1.357-1(c). Notice also in the following example that the amount of gain recognized under IRC Sec. 357(b) cannot exceed the total realized gain on the transfer.
Example 5: A transfers Orangeacre (FMV = $100,000, basis = $60,000) to Newco in exchange for 80% of its stock. The property is subject to a 10 year old purchase-money first mortgage of $30,000 and a $25,000 second mortgage acquired immediately before the transfer which is being transferred pursuant to a tax avoidance plan. A must recognize the entire $40,000 realized gain since the improper second mortgage "taints" the first mortgage and both are treated as cash boot (total-$55,000) received by A. A's basis in the Newco stock is:
The key factor to be analyzed under IRC Sec. 357(b) is the shareholder's purpose for the assumption or acquisition of the liability by the corporation, not the purpose of the incorporation or the simultaneous transfer of assets to the corporation.(1) Thus, a taxpayer may have a legitimate business purpose for transferring certain assets to the corporation, while, at the same time, having a prohibited purpose for transferring certain liabilities in the same transaction. Furthermore, application of IRC Sec. 357(b) requires that the taxpayer's improper motive be the principal purpose for the transfer of the liability. Tax avoidance as a secondary objective is not sufficient to invoke IRC Sec. 357(b).
It is interesting to note that IRC Sec. 357(b) contains its own "burden of proof" provision. The taxpayer has the burden to prove by a "clear preponderance of the evidence" that IRC Sec. 357(b) does not apply. The regulations further provide that the taxpayer must prove, to an extent "unmistakable," that the principal purpose of the transfer of liabilities was not to avoid Federal income tax, but was a bona fide business purpose.
Factors Showing a Tax Avoidance or Non-Business Purpose under IRC Sec. 357(b)
The classic abuse of the generally favorable treatment under IRC Sec. 357(a), and the most deadly factor against the taxpayer attempting to show a proper purpose for the liability assumption under IRC Sec. 357(b), is the case of a taxpayer borrowing against property immediately before, and in contemplation of, the transfer of the property to the corporation and using the borrowed funds for purely personal purposes.(2) Various courts have held against the taxpayer when the interval between the loan acquisition and subsequent transfer to the corporation was several days to several months and the borrowed funds were used personally by the shareholder to pay Federal income taxes(3), purchase tax exempt securities,(4) or purchase a personal residence.(5) However, a loan not obtained in contemplation of a subsequent assumption by a corporation, even though used for purely personal purposes, should not trigger the application of IRC Sec. 357(b).
Other unfavorable factors under IRC Sec. 357(b) include the corporation's assumption of a liability without receiving the collateral asset(6) or the taxpayer's use of a complicated series of transactions to arrive at a given result without any apparent justification other than an attempt to circumvent IRC Sec. 357(b)(7). Finally, ignorance of the tax law concerning assumption of liabilities under IRC Sec. 357 may help a taxpayer's argument regarding the absence of a tax-avoidance purpose, but will not suffice to carry the taxpayer's burden to affirmatively show a bona fide business purpose for the assumption.(8)
Not all the cases in this area have held against the taxpayer, but where acquisition and transfer of the liability are closely related in time, it is imperative that the taxpayer be able to show a solid business purpose for the transfer of the liability to the corporation. Application of IRC Sec. 357(b) has been negated by showing a substantial corporate need for the asset transferred, combined with a continuing shareholder need for income from the asset for personal and investment requirements.(9) The most practical way to accomplish the business objectives in such cases is to borrow against the asset(s) before transfer, having the corporation assume the debt. The principal purpose of the liability assumption in such cases is furtherance of a legitimate business objective, not tax avoidance. In addition, one court held for the taxpayer based on his clearly established desire and intent to remain personally liquid in order to take advantage of anticipated investment opportunities due to an expected downturn in business.(10)
Liabilities in Excess of Basis
Even in the absence of an improper purpose, the transferor must still recognize gain equal to the amount by which the liabilities transferred exceed the basis of the assets transferred. Again, the liabilities at issue include both assumed liabilities and any liabilities to which the transferred properties are subject.
Example 6: A transfers Yellowacre (FMV = $100,000, basis = $60,000), subject to a mortgage in the amount of $75,000, to Newco in exchange for 80% of its stock. A's recognized gain is $15,000--the amount of liabilities in excess of basis. A's stock basis is calculated as follows:
There is one very important exception to the general rule under IRC Sec. 357(c)--liabilities which would lead to a deduction upon payment (i.e cash basis salaries or rents payable) are not to be included in the total amount of liabilities which are in excess of the assets basis transferred. Also, liabilities of a pre-incorporation partnership which constitute a distributive share or guaranteed payment under IRC Sec. 736(a) are not included in the amount of liabilities in excess of basis.
Example 7: A transfers all the assets of a cash-basis service proprietorship to Newco under IRC Sec. 351. The assets and liabilities transferred are as follows:
A's recognized gain is zero, and the new stock basis is $150,000. Under IRC Sec. 358(d)(2), liabilities excluded from gain treatment under IRC Sec. 357(c)(3) do not affect the stock basis computation.
Although total liabilities ($180,000) exceed the basis of the assets ($150,000) in Example 7, such liabilities are not included in the total liabilities in excess of basis, since the payment of these liabilities will result in deductible expenses under the cash basis of accounting. On the other hand, liabilities are to be included in the IRC Sec. 357(c) computation if the payment of such obligations would result in an increase in the basis of any property.
The nature of the gain recognized under IRC Sec. 357(c) is dependent on the nature of the assets transferred to the corporation, and is to be apportioned by reference to the fair-market value of the assets at the time of the transfer. In the event that both IRC Sec. 357(b) and IRC Sec. 357(c) apply to a transfer, the transaction will be controlled by IRC Sec. 357(b). In such case, the full amount of liabilities transferred are treated as boot, which generally results in the maximum gain recognized by the transferor.
Example 8: A transfers Purpleacre (FMV = $100,000, basis = $40,000), subject to a mortgage of $50,000, to Newco for 80% of its stock. The mortgage transfer has tax avoidance as a principal purpose. A's realized gain of $60,000 is recognized to the extent of the amount of the mortgage treated as cash boot under IRC Sec. 357(b), rather than the amount of liabilities in excess of basis.
Strategies to Avoid Gain Recognition
Several methods may be employed where pre-incorporation liabilities exceed the basis of assets to be transferred. The basic strategy is to include additional property in the transfer to raise the total amount of basis being transferred. Of course the easiest method is to simply transfer additional cash or another unencumbered asset sufficient to cover the deficiency. The drawback is that the cash or other property will probably produce dividend treatment to the shareholder (IRC Sec. 301) and/or recognized gain to the corporation |IRC Sec. 311(b)(1), in the case of appreciated property, upon later distribution.
Another strategy, which has been the subject of some controversy, requires the transferor to transfer a personal promissory note to the corporation sufficient to cover the deficit in basis in the IRC Sec. 351 transaction. The IRS has opposed this strategy on several occasions-- always successfully until 1989.
In Alderman v. Commissioner, |55 T.C. 662 (1971) the taxpayer incorporated an existing sole proprietorship having liabilities in excess of asset basis. In an attempt to avoid recognition of gain under IRC Sec. 357(c), the taxpayer executed a personal promissory note in favor of the corporation. The tax court determined that the promissory note did not increase the total combined basis transferred since the taxpayer incurred no cost in making the note. Thus, gain was to be recognized under IRC Sec. 357(c).
However, more recently a taxpayer prevailed using a similar argument on essentially identical facts. In Lessinger v. Commissioner, 872 F2d 519, 89-1 USTC Para. 9254, (1989), the 2nd Circuit held that "Where the transferor undertakes genuine personal liability to the transferee, adjusted basis in IRC Sec. 357(c) refers to the transferee basis in the obligation, which is its face amount." The court reasoned that the corporation must have a basis in the note equal to its principal amount since a later receipt of the principal does not result in income recognition. The court also found that the transaction did not violate legislative intent in enacting IRC Sec. 357(c); since the transferor's liability to the corporation was a real obligation, enforceable by corporate creditors, the taxpayer did not experience the enrichment which IRC Sec. 357(c) seeks to prohibit.
The holding in Lessinger that the adjusted basis addressed in IRC Sec. 357(c) is the basis to the transferee corporation seems to reach beyond the wording of the statute and is an assessment probably beyond the pale of its most liberal interpretation. This decision is probably vulnerable to future IRS attack and is suspect as a vehicle for tax planning, especially outside the second circuit. However, much of the reasoning is sound and expresses the proper intent of the statute.
An alternate analysis is that a shareholder's promissory note in these cases does have basis since the transferor has a real cost in executing and transferring the obligation to the corporation. Generally, the basis of property is its cost (IRC Sec. 1012). There is no question that the maker of a bona fide promissory note incurs an economic cost equal to the amount of the obligation to be paid in the future. As properly noted by the court in Lessinger, a shareholder note held by the corporation is generally enforceable by corporate creditors under state law. The note obligation is not an illusion or device to be ignored simply because the corporation is controlled by the transferor/obligor--it stands as an asset attachable by others outside the corporation. Furthermore, the shareholder could incur income from discharge of indebtedness should the corporation fail to enforce collection of the note in the future (IRC Sec. 61(a)(12)). Generally, gross income includes income from the discharge of indebtedness unless an exception applies under IRC Sec. 108. Execution and transfer of such an obligation certainly entails a cost to the obligor.
Yet another way of analyzing this transaction is as a contribution of cash by the shareholder to the corporation, unquestionably resulting in increased basis, followed by a loan back to the shareholder, who then executes a promissory note to the corporation.(11) No interpretation of IRC Sec. 357(c) prevents this transaction from avoiding recognition of gain, and the economic and practical result is identical to that obtained in cases such as Alderman and Lessinger.
Some have argued that allowing a shareholder's promissory note to increase basis to avoid gain under IRC Sec. 357(c), provides an easy escape hatch from the provision. However, most would agree that the primary purpose and intent of Secs. 351 and 357(a) are to allow taxpayers to incorporate without the adverse impact of taxation, except in abusive situations. Secs. 357(b) and 357(c) should therefore be viewed as pertaining to abusive situations only, and such is not the case in Lessinger-type transfers. As indicated in Lessinger, a promissory note obligates the shareholder to pay an amount in the future which is equal to the benefit which would otherwise be recovered currently because liabilities exceed basis (i.e., previous depreciation deductions or previous cash retained from mortgages, etc.). The shareholder's bona fide note obligation should prevent the finding of abuse in these transactions, and IRC Sec. 357(c) should not be applied to tax the transferor.
The Negative Basis Dilemma
Finally, the concept of negative basis should be addressed. IRC Sec. 357(c) is sometimes viewed as necessary to avoid this problem which would occur unless gain is recognized to the extent liabilities exceed basis.
Example 9: A transfers Whiteacre (FMV = $100,000, basis = $30,000, mortgage = $70,000) to Newco for 80% of its stock. Without IRC Sec. 357(c), A's recognized would be zero, and A's stock basis would be:
However, since nature abhors two things--a vacuum and negative basis-- IRC Sec. 357(c) rescues the situation by triggering sufficient recognized gain to offset the negative basis.
Example 10: Same as the previous example above, except IRC Sec. 357(c) does apply. A's recognized gain is $40,000, and A's basis is calculated as follows:
But, as the following example illustrates, treating a transferor's promissory note as having a basis equal to its FMV--generally the face amount of the transferor's obligation--also solves the negative basis dilemma, by producing a basis similar to that produced under IRC Sec. 357(c), i.e., no negative basis.
Example 11: A transfers operating assets (FMV = $100,000, basis = $40,000), and liabilities of $70,000. In addition, A transfers a personal promissory note to the corporation in the face amount of $30,000. If the promissory note is deemed to have a basis equal to $30,000, no gain results under IRC Sec. 357(c), and A's stock basis is as follows:
The face amount, or FMV, if different, of a bona fide promissory note of the shareholder transferred to the corporation in IRC Sec. 351 transaction should constitute additional basis and prevent application of IRC Sec. 357(c). This is not an abusive situation and complies with the rationale and purpose of the incorporation provisions. Although no case has yet determined such analysis as controlling, it seems to be the best interpretation of the statute.
1. Drybrough v. Commissioner, 376 F. 2d 350 (6th Cir. 1967), aff'g in part and rev'g, in part 42 T.C. 1029 (1964), and Thompson v. Campbell, 64-2 USTC Para. 9659 (N.D. Tex. 1964), aff'd, 353 F. 2d 787 (5th Cir. 1965).
2. See Campbell v. Wheeler, 342 F.2d 837 (5th Cir. 1965), reversing 63-2 USTC 9805 (N.D. Tex 1963); Thompson v. Campbell, ibid.; and Drybrough v. Commissioner, ibid.
3. Campbell v. Wheeler, ibid.
4. Drybrough v. Commissioner, ibid.
5. Thompson v. Campbell, ibid.
6. Harrison v. Commissioner, T.C. Memo 1981-211 (1981), Estate of Stoll v. Commissioner, 38 T.C. 223 (1962).
7. Weaver v. Commissioner, 32 T.C. 411 (1959).
8. Eck v. U.S., 70-2 USTC Para 9465 (D.N. Dak., 1969).
9. Simpson v. Commissioner, 43 T.C. 900 (1965), acq., 1965-2 C.B. 6.
10. Easson v. Commissioner, 33 T.C. 963 (1960).
11. For further discussion of this concept, See, "The Highly Avoidable Section 357(c): A Case Study in Traps for the Unwary and Some Positive Thoughts About Negative Basis," J. Clifton Fleming, Jr., The Journal of Corporate Law, Fall, 1990.
Richard W. Harris, JD, LLM, CPA is an assistant professor of taxation in the graduate tax program, The Kogod College of Business Administration at The American University. He is a frequent contributor to professional journals.
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