Section 358: Calculating Shareholder Stock Basis

When forming a corporation, it is possible to structure the transaction as a tax-deferred exchange. These transactions, often governed by Section 351 of the Internal Revenue Code, allow shareholders to transfer property to a corporation for stock without immediately recognizing a gain or loss.

The principle of these nonrecognition provisions is tax deferral, not forgiveness. The tax liability is postponed until the shareholder sells the new stock. To track this deferral, the tax basis of the property given up is preserved and transferred to the new stock. The rules under Section 358 govern the calculation of this new stock basis, which determines the taxable gain or loss on a future sale.

Determining Shareholder Basis in Nonrecognition Transactions

Tax basis represents a taxpayer’s investment in an asset for tax purposes and is the amount used to determine gain or loss upon its sale. For example, if you buy equipment for $10,000, your initial basis is $10,000, which is then adjusted over time for factors like depreciation.

In a tax-deferred corporate formation, the basis of the stock received is the same as the basis of the property the shareholder transferred to the corporation. This is known as a “substituted basis” because the basis of the old asset is substituted for the new one, embedding the deferred gain or loss into the new shares. This substitution preserves the unrecognized gain or loss for future taxation.

Consider a shareholder who transfers land with a fair market value of $200,000 and an adjusted basis of $50,000 to a corporation for 100% of its stock. The shareholder does not recognize the $150,000 realized gain at the time of the exchange. Instead, the shareholder’s basis in the new corporate stock is $50,000, the same as the land’s basis. If the shareholder later sells the stock for $200,000, they will then recognize the $150,000 deferred gain.

Impact of Receiving Non-Qualifying Property (Boot)

The basis calculation becomes more complex when a shareholder receives property in addition to stock. Any non-qualifying property, such as cash or debt instruments, is referred to as “boot.” The receipt of boot can trigger the recognition of gain, though it does not automatically disqualify the entire transaction from tax-deferred status.

When a shareholder receives boot, they must recognize any realized gain, but only up to the fair market value of the boot. The stock basis calculation starts with the basis of the property transferred, is reduced by the fair market value of the boot received, and is increased by the amount of gain recognized. The basis of the boot itself is its fair market value.

For example, a shareholder transfers property with a $50,000 basis and a $200,000 market value for stock worth $190,000 and $10,000 in cash. The shareholder’s realized gain is $150,000, but they only recognize a gain of $10,000, the amount of the cash boot. The new stock basis is calculated as the original $50,000 basis, minus the $10,000 boot, plus the $10,000 recognized gain, for a final basis of $50,000.

Treatment of Assumed Liabilities

Another common adjustment involves the corporation assuming a shareholder’s liabilities. When a corporation takes on a shareholder’s debt, the liability relief is treated as if the shareholder received cash. For basis calculation purposes, the shareholder’s basis in the new stock is reduced by the amount of the liabilities assumed by the corporation.

This reduction reflects the economic benefit to the shareholder of being relieved of an obligation. For instance, if a shareholder transfers an asset with a basis of $100,000, subject to a $30,000 mortgage, in exchange for stock, the initial stock basis of $100,000 is reduced by the $30,000 liability, resulting in a final stock basis of $70,000.

There are two exceptions to this rule under Section 357. The first applies if the primary purpose for the corporation assuming the liability was tax avoidance or not a bona fide business purpose, in which case the entire liability is treated as cash boot. The second, more common exception occurs when the total liabilities assumed exceed the total adjusted basis of all property transferred.

In that scenario, the excess amount is treated as a taxable gain. For example, if a shareholder transfers property with a basis of $50,000 subject to a liability of $70,000, the shareholder must recognize a gain of $20,000. This recognized gain then increases the stock basis, preventing it from becoming negative; the final basis would be zero ($50,000 old basis – $70,000 liability + $20,000 gain).

Allocating Basis and Determining the Holding Period

If a shareholder receives more than one class of stock or securities, the total calculated basis must be allocated among them. Treasury Regulation §1.358-2 requires this allocation to be made in proportion to the relative fair market values of each class of stock and securities received.

For example, a shareholder has a total stock basis of $100,000 to allocate between common stock valued at $150,000 and preferred stock valued at $50,000. The basis allocated to the common stock would be $75,000 ($100,000 total basis x [$150,000 / $200,000]). The basis for the preferred stock would be $25,000 ($100,000 total basis x [$50,000 / $200,000]).

The holding period of the new stock is also an important factor, as it determines whether a future sale results in a short-term or long-term capital gain. Under Section 1223, the holding period of the property transferred “tacks on” to the holding period of the stock received, meaning the ownership periods are combined. If the property exchanged was a capital asset or a Section 1231 asset, this tacking rule applies.