IRC Section 357: Assumption of Liability Rules

When forming a corporation, individuals often transfer property in exchange for stock. Under Internal Revenue Code (IRC) Section 351, this transaction is generally not a taxable event because it is considered a change in the form of the investment, not a sale. This allows business owners to incorporate their operations without an immediate tax cost.

Frequently, the property being transferred, such as real estate or business equipment, is subject to liabilities like a mortgage or a business loan. In a Section 351 exchange, the new corporation assumes these debts along with the assets. IRC Section 357 was created to provide rules for how these assumed liabilities are treated for tax purposes, determining whether they disrupt the otherwise tax-free nature of the transaction.

The General Rule of Nonrecognition

In tax-deferred exchanges, receiving anything other than the specified non-taxable property is considered “boot.” In a Section 351 transaction, receiving cash or other property in addition to stock is treated as boot, which forces the recognition of any realized gain up to the fair market value of the boot received.

IRC Section 357(a) establishes a general rule for liabilities, stating that when a corporation assumes a shareholder’s liability in a Section 351 exchange, that assumption is not treated as boot. Without this rule, nearly every transfer of property with attached debt would trigger a taxable gain. This allows a shareholder to transfer an asset, like a building with a mortgage, to their new corporation without the debt relief being considered a taxable payment. This nonrecognition treatment is the baseline for all Section 357 analyses, though specific exceptions can override it.

The Tax Avoidance Exception

The treatment under Section 357(a) is limited by an anti-abuse rule in IRC Section 357(b). This provision applies if the main reason for the corporation assuming a debt was to avoid federal income tax or lacked a bona fide business purpose. The taxpayer has the burden of proving the transaction had a valid purpose.

When this exception is triggered, the total amount of all liabilities assumed from that shareholder is treated as taxable boot, not just the single improper liability.

A common example illustrates this rule. A shareholder owns a debt-free piece of equipment they plan to transfer to their new corporation. Just before the transfer, the shareholder takes out a $50,000 personal loan secured by the equipment and uses the cash for personal expenses. The corporation then assumes this new loan as part of the Section 351 exchange. The IRS would likely determine the loan assumption’s purpose was to allow the shareholder to receive $50,000 in cash without paying tax, triggering the Section 357(b) exception.

Liabilities in Excess of Basis Exception

IRC Section 357(c) provides a mechanical exception that applies regardless of the taxpayer’s intent. This rule is triggered when the total amount of liabilities assumed by the corporation is greater than the total adjusted basis of all properties transferred by the shareholder. Adjusted basis is the original cost of an asset, adjusted for factors like depreciation. If the debts exceed the basis, the difference is automatically recognized as a taxable gain.

For example, a shareholder transfers an asset with an adjusted basis of $40,000 that is subject to a $50,000 mortgage. The shareholder must recognize a taxable gain of $10,000, which is the amount by which the liability exceeds the asset’s basis. This rule prevents a shareholder from having a negative basis in their new stock.

The character of the gain, whether capital gain or ordinary income, is determined by the type of property transferred. If the tax avoidance rule of Section 357(b) applies to a transaction, the Section 357(c) rule does not.

Impact on Basis Calculations

The assumption of a liability in a Section 351 exchange affects the basis for both the shareholder and the corporation. The shareholder’s basis in the stock received starts with the basis of the property they transferred. This basis is then reduced by the total amount of the liabilities the corporation assumed.

Using the prior example where a property with a $40,000 basis and a $50,000 mortgage was transferred, the shareholder recognized a $10,000 gain. The shareholder’s stock basis is calculated as the original property basis ($40,000), minus the liability assumed ($50,000), plus the gain recognized ($10,000), resulting in a stock basis of $0. This calculation is governed by IRC Section 358.

The corporation’s basis in the property it receives is a carryover basis, meaning it takes the same basis the shareholder had in the property. However, under IRC Section 362, if the shareholder recognized a gain on the transfer, the corporation can increase its basis in the asset by that amount. In the example, the corporation’s basis would be the shareholder’s original $40,000 basis plus the $10,000 recognized gain, for a total of $50,000.