Section 357(c): Gain From Liabilities in Excess of Basis

When forming a corporation, individuals often transfer property in exchange for stock. This process, governed by Section 351 of the Internal Revenue Code, frequently occurs without immediate tax consequences. For the transfer to qualify, the person or group transferring the property must control the corporation immediately after the exchange. Control is defined as owning at least 80 percent of the total combined voting power and at least 80 percent of the total number of shares of all other classes of stock.

This tax-deferred treatment is based on the idea that the transfer is a change in the form of ownership, not a disposition of the asset. The transferor has continued their investment in corporate form, so the tax code allows for the deferral of any gain or loss on the property until the new stock is sold.

The General Rule for Assumed Liabilities

Property transferred to a new corporation is often subject to liabilities, such as a mortgage or business loans. Under Section 357(a), when a corporation assumes a shareholder’s liabilities as part of a Section 351 exchange, this assumption is not treated as the receipt of taxable “boot” by the transferor.

The relief from debt does not trigger an immediate taxable gain for the person contributing the property. Instead, the amount of the assumed liability reduces the shareholder’s basis in the stock they receive from the corporation. This basis adjustment postpones any potential gain recognition until the shareholder sells their stock.

This rule maintains the principle of tax deferral in a Section 351 transaction. However, under Section 357(b), if the primary purpose of the debt assumption was to avoid federal income tax or was not for a bona fide business purpose, the entire liability is treated as taxable boot.

The Exception for Liabilities Exceeding Basis

An exception exists under Section 357(c), which triggers a taxable gain if the total liabilities assumed by the corporation exceed the total adjusted basis of all properties transferred. The adjusted basis is the original cost of an asset, minus depreciation, plus capital improvements. A liability can include mortgages, loans, and other debts attached to the property.

The purpose of Section 357(c) is to prevent a negative basis in the stock received by the transferor. A shareholder’s basis in the new stock is calculated by starting with the basis of the property they transferred and then reducing it by the liabilities the corporation assumed. If liabilities were greater than the property’s basis, this calculation would result in a negative stock basis, which tax law does not permit.

The law requires the transferor to recognize a gain equal to this excess amount, which increases the shareholder’s basis in the stock back to zero. This rule applies automatically, regardless of the transferor’s intent. The character of the gain, whether it is a capital gain or ordinary income, depends on the type of property that was transferred.

Calculating the Recognized Gain

The calculation of gain under Section 357(c) is a direct formula: total liabilities assumed minus the total adjusted basis of all property transferred. The basis of all assets transferred in the exchange must be aggregated, not just the basis of the asset securing the debt. This means cash and other unencumbered properties contributed can be used to offset the liabilities.

To illustrate, consider an individual who transfers a single asset to a newly formed corporation in a qualifying Section 351 exchange. The asset has an adjusted basis of $40,000 but is subject to a mortgage of $60,000. The corporation assumes the full mortgage as part of the transaction. In this scenario, the liabilities assumed ($60,000) exceed the adjusted basis of the property transferred ($40,000).

The recognized gain is calculated by subtracting the basis from the liability: $60,000 – $40,000 = $20,000. The individual must report this $20,000 as a taxable gain for the year of the transfer. The shareholder’s basis in the new stock starts at the property’s basis ($40,000), is increased by the gain recognized ($20,000), and is decreased by the liability assumed ($60,000), resulting in a final stock basis of $0.

Special Considerations for Certain Liabilities

A modification to the gain calculation under Section 357(c) excludes certain liabilities. This exception applies to liabilities that would have resulted in a tax deduction if paid by the transferor. Common examples for a cash-basis taxpayer include accounts payable, accrued salaries, or rent payable.

The rationale for this exclusion is that for a cash-basis taxpayer, accounts payable have a zero basis because no deduction has been claimed. Including these zero-basis liabilities in the gain calculation would artificially create a taxable gain on items that have not yet provided any tax benefit.

This exception does not apply to any liability if its incurrence resulted in the creation of, or an increase in, the basis of any property. For example, if a liability was incurred to purchase a machine, that liability would have created basis in the machine and would be included in the gain calculation.