How Does Code Sec. 357(c) Apply to Liabilities Exceeding Basis?

When transferring property to a corporation in exchange for stock, tax rules generally allow the transfer to happen without immediate gain recognition. However, complications arise when liabilities attached to the transferred property exceed its adjusted basis.

This situation triggers Section 357(c), potentially resulting in unexpected taxable gain for the transferor. Understanding this rule is essential to avoid unintended tax consequences.

Transfers Involving Liabilities

When property is contributed to a corporation, any associated liabilities—such as mortgages or business loans—typically transfer with it. The tax outcome depends on whether the corporation assumes the liabilities or they remain with the transferor.

Under Section 357(a), if the transfer qualifies under Section 351, which governs tax-free exchanges of property for stock, the assumption of debt reduces the shareholder’s stock basis rather than creating taxable income.

Section 357(b) provides an exception. If a liability was incurred for tax avoidance or lacks a legitimate business purpose, the entire liability assumption is treated as taxable boot, requiring the transferor to recognize gain. The IRS closely examines transactions where debt is artificially increased before incorporation, as these may be abusive tax strategies.

Liabilities Exceeding Basis

If transferred liabilities exceed the adjusted basis of the contributed property, Section 357(c) requires the transferor to recognize taxable gain. The tax code treats this excess liability as consideration received, similar to cash.

For example, if a shareholder contributes an asset with a $50,000 adjusted basis and an $80,000 liability, the excess $30,000 is recognized as gain. The tax treatment depends on the asset type. Capital assets are taxed at capital gains rates, while depreciable business property may trigger ordinary income under depreciation recapture rules.

This issue is common when incorporating a sole proprietorship or partnership, particularly in industries with significant liabilities due to financing or depreciation deductions, such as real estate or equipment-heavy businesses. Many business owners assume incorporation is tax-free, only to find that excess debt triggers immediate taxation.

Calculation of Recognized Gain

To determine taxable gain under Section 357(c), compare total transferred liabilities to the aggregate adjusted basis of the assets. If liabilities exceed basis, the difference is recognized as gain in the transfer year.

For instance, if a business owner transfers assets with a combined $100,000 adjusted basis and $130,000 in liabilities, the excess $30,000 is taxable gain. The character of this gain depends on the assets. Depreciated equipment may trigger ordinary income under depreciation recapture rules, such as Section 1245 for personal property or Section 1250 for real property.

To mitigate Section 357(c) consequences, business owners can increase the adjusted basis of transferred assets before incorporation. This may involve capital improvements or contributing additional high-basis property. Another approach is restructuring liabilities so they are not considered assumed by the corporation, such as by having the shareholder personally retain certain obligations. However, these strategies must comply with IRS regulations.

Adjusting Corporate Stock Basis

A shareholder’s stock basis is determined by the adjusted basis of contributed assets, increased by any recognized gain under Section 357(c). Stock basis affects future capital gains or losses upon sale and determines the tax treatment of corporate distributions.

In an S corporation, stock basis also impacts a shareholder’s ability to deduct losses. Losses can only be deducted up to the shareholder’s stock and debt basis. If liabilities exceed asset values at the time of contribution, stock basis may be low, limiting loss deductions. In a C corporation, shareholders do not deduct corporate losses on personal returns, but a lower stock basis still affects capital gains taxes upon sale.

Key Exceptions

Certain exceptions can prevent or reduce taxable gain under Section 357(c).

One exception applies to liabilities that would have been deductible if paid by the transferor. For example, if a cash-basis taxpayer transfers accounts payable to a corporation, the assumption of that liability does not trigger gain because it represents a deferred deduction rather than an economic benefit.

Another exception applies when a partnership converts into a corporation under Section 351. Some liabilities transferred in this context may be excluded from Section 357(c) gain recognition if they qualify as “qualified liabilities” under Treasury regulations. These include debts incurred to acquire the transferred property or those arising in the ordinary course of business. Proper documentation of the liability’s business purpose is essential for this exception to apply.